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ASC 718: Equity Compensation

CPE March 17, 2010

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Agenda

Overview

1 2 3 4Fair Value

MeasurementCase Study

Disclosure

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Equity Compensation Overview

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Overview of ASC 718

» Measure or estimate fair value of share-based compensation at grant date

» Record expense as services are received (over requisite service period)

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» Recognize compensation expense as the employee services are received with corresponding increase in equity or liability

» Recognize cost as services are consumed

Recognition Principle

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Grant Date As a “practical accommodation”, grant date is generally presumed to be the date share-based awards are approved

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Equity vs. Liability Classification» Some instruments granted as equity compensation are

reported as liabilities, rather than equity, on the issuing company’s balance sheet

» Specific rules are complex and beyond our scope today. In general, if the issuing company is (or can be) required to settle the obligation with cash, rather than the issuance of stock, the instrument will be classified as a liability

Stock Options: Equity

Stock Appreciation Rights: Liability

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Fair Value Based

» Equity compensation cost is generally measured based on the fair value of instruments issued

» Sometimes “calculated value” or “intrinsic value”

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Fair Value

» For most applications fair value is defined in ASC Topic 820; not for accounting for equity compensation

» Under Topic 718, fair value is defined as:

“The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”

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Requisite Service Period

» The period or periods during which an employee is required to provide service in exchange for the award

Service condition only: typically the vesting period

» Types of requisite service periods

Explicit service period: stated in terms of share-based award

Implicit service period: not stated, but may be inferred from terms of share-based award

Derived service period: for awards with market conditions, inferred by application of valuation techniques

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Measurement Objective

» Estimate fair value at the grant date of equity instruments the entity is obligated to issue once employees have 1) rendered requisite services and 2) satisfied any other conditions

» Estimate is based on inputs at the grant date

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Vesting vs. Nontransferability

» Restrictions that continue after instruments have been issued to employee (or vested) are considered in fair value measurement

» Example: Restrictions on transfer of vested options or sale of vested shares (e.g., Restricted Stock)

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Forfeitability

» Restrictions related to forfeitability of unearned (unvested) instruments are not reflected in fair value estimate at grant date

» These restrictions are taken into account by only recognizing compensation cost for awards that ultimately vest

» Depends on type of condition

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Service Conditions

» A condition affecting the value of the award that depends solely on an employee rendering service to the employer for the requisite service period

» Example: Time-vesting schedule

» Not considered in measuring grant date fair value

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Performance Conditions

» A condition affecting the value of the award that depends on achievement of specified performance target defined by reference to employer’s operations

» Example: Vesting based on EBITDA targets

» Not considered in measuring grant date fair value

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Market Conditions

» A condition affecting the value of the award that depends on the price of issuer’s shares or amount indexed to issuer’s shares

» Example: Share price hurdle

» Considered in measuring grant date fair value

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Requisite Service Period

» Estimate requisite service period at the grant date and accrue compensation cost over this period

» Estimate should incorporate the probability that performance or service (but not market) conditions will be satisfied

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Private Companies

» Fair Value vs. Calculated Value

» Primary difference is that calculated value is based on measure of historical volatility, rather than implied volatility

» Similar to Level 1 vs. Level 3 inputs under ASC 820

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Option Pricing Model Assumptions

» Exercise price

» Expected option term (consideration of contractual term and expected exercise behavior)

» Current price of underlying share

» Expected volatility of underlying share price (for expected term)

» Expected dividends on underlying share (for expected term)

» Risk-free rate (for expected term)

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Application Consistency

» Consistency in assumptions / valuation techniques from period to period is important

» Valuation technique / assumptions should not be changed unless expected to produce “better estimate of fair value”

» Change in valuation technique represents change in accounting estimate for purposes of ASC Topic 250

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Selecting Risk-free Rate

U.S. entity should use implied yields currently available from the U.S. Treasury zero-coupon yield curve over the expected term of option

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Estimating Expected Term

» Contractual Term vs. Expected Term» Employee stock options not transferable / hedgeable» Depends on model (lattice vs. closed form)» Considers the following:

Vesting period Historical exercise / post-vesting employment termination behavior Expected volatility / share pricing Blackout periods / other restrictions Employee demographics (age, length of service, etc.)

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Estimating Expected Volatility

» Objective is to determine the assumption about expected volatility that marketplace participants would likely use.

» Higher volatility Higher option fair value

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Estimating Expected Volatility

» Estimate of expected volatility should consider:

Historical volatility over period similar to expected term

Implied volatility based on publicly traded options

Historical volatility of similar entities in terms of:» Industry» Stage of life cycle» Size» Financial leverage

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Estimating Expected Dividends

» Depending on model, estimate either: Yield Payments

» Consider trends in historical dividends

» Objective is to determine the assumption about expected dividends that marketplace participants would likely use

26Case Study – Stock Grant with Market Conditions» GrantCo approves grant of 1,000,000 shares to employees on

March 17, 2010

» Before employees receive title to the shares, two vesting conditions must be met:

Condition 1: The 20-trading-day average stock price must exceed certain hurdles. Once this condition is met, shares are considered outstanding and receive dividends as declared and paid

Condition 2: The grantee (i) completes 15 years of continuous employment, (ii) reaches age 64, or (iii) dies or become disabled

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Case Study – Continued

» Grant Date: 3/17/2010

» Condition 1 is a market condition, and must be incorporated into the fair value of the award

» Condition 2 is a service condition, and is not reflected in the fair value of the award

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Case Study – Continued

» The market condition is not conducive to a closed-form (i.e., Black-Scholes) solution

» Binomial analysis also difficult to implement (not only eventual outcome, but price path matters)

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Case Study – Continued

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Case Study – Resolution

» Develop a simulation model that takes into account unique features of instrument, and calculate average outcome from many iterations

» Inputs to model: Expected Volatility: 30% Risk-Free Rate: 4.58% Expected Dividend Yield: 0.62%

» Fair Value: $6.58 per unit

» Compensation Cost: $6.58 x 900,000 (number of shares expected to meet Condition 2)

» Requisite Service Period: 11 years, based on census data regarding grantees

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Disclosures

» Must disclose information so that financial statement users understand:

Nature and terms of share-based payment arrangements (and effect on shareholders)

Effect of compensation cost on the income statement

Method of estimating grant date fair value

Cash flow effects resulting from share-based payment arrangements

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Disclosures Example: Apple, Inc. 10-K

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Questions

Matthew R. Crow, ASA, CFA901.322.9728crowm@mercercapital.com

Mercer Capital5860 Ridgeway Center Parkway, Suite 400Memphis, TN 38120901.685.2120www.mercercapital.com