Welcome. In this module, we're talking about Share-Based Payments and Stock Options. This was a topic of much sound and fury at the FASB during the 1990s, when this originally came up as a proposal to expense the cost of giving stock options to employees. It remains controversial today. So, let's get started. First of all, what is a Stock Option? Well, it's a right to buy a certain number of shares in the company at a fixed price for a period of time. Now, you can go to many exchanges for certainly for publicly traded stocks. A lot of times, there is an option available that you can go and purchase, which allows you to make a very small investment and profit from the increase in the share price of that stock. So, that's a little bit different though than an employee stock option and that's not the kind of options that we'll be talking about in this module. Employee Stock Options are a little different. One, they're usually given to employees to incentivize their behavior, but also, they tend to be much longer in term. You can't really find an exchange traded stock option that will go out for say eight or 10 years, but you can find them in Employee Stock Comp Plans. Why? Because, the pricing models that are used to price models become very uncertain when you go out after over a larger number of years, which is why the trades and the exchanges generally don't go out that far. But compensation plans often do cover multiple years, in order to incentivize long term performance of management. So, the price at which an option is provided is called the "grant" price, and it's usually the market price at the time when the options are granted. So, why issue stock options? Or there was a seminal paper back in 1976 by two academics Jensen and Meckling, which described how the interests of the executives, and the interest of shareholders can diverged. So, in their model, executives would be more risk adverse. They would rather not take risks in order to increase shareholder value. They'd rather just have the perks of office as opposed to taking risk, whereas the shareholders themselves, partly because they're able to diversify their risk through portfolio management, would prefer a riskier approach to increased returns. So, how do you solve that problem? How do you encourage managers to take more risk? Well, Jensen and Meckling suggested reducing the divergence of interest by issuing stock options, which would give managers the claim on the upside and profits that would occur from taking those risks without necessarily suffering any consequences if it didn't pan out. So, that would encourage more risk taking. What could go wrong with that? Stock option use has been implicated, of course, in some market bubbles especially the tech bubble that incurred in the late 1990s, and other bad behavior by managers, because it would encourage people to manipulate stock prices in order to increase the value of their stock options. So, since that bubble in the late 90s, the use of stock options has gradually declined over time. One reason for that is that the stock options at that time were not expensed. The cost of issuing stock options to managers, to employees as compensation was considered to be zero. But now, they're expensed. How could it be zero? Well, in the traditional model, the accountants used intrinsic value to account for stock options. So, recall from our discussion of convertible debt, that intrinsic value is the difference between the exercise price and fair value. So, if we issue stock with a exercise price equal to the fair value on the grant date, there's no intrinsic value. Intrinsic value, the option is zero. So, the expense recorded was zero, and even today, a lot of people would insist that was the right answer. Of course, if the value is actually zero, then of course they might be willing to give them away and in fact, one of the members of the FASB at the time, Jim Heinzerling, insisted that if the value was truly zero, please load up his cart with some, so he can take advantage of this as well. Of course, the value is not zero. The question was how to value these stock options, or whether to expense them or not. So, here is View A, the employee stock options were considered to be a transaction between the entity and its employees. And the fair value should be expensed. Another argument that came through, of course, was that the stock options should not be an expense of the entity, because it was a transaction between the shareholders and the employee, and not between the entity and the employee. So, two views arose, as to whether the fair value of the stock options should be included in expense or not. Lets call View A, that the employee stock options are a transaction between the entity and its employees. They're giving the employees something valuable, something very valuable, in many cases, in the form of a stock option over an extended period of time. And whatever that fair value is, should be expensed on the books of the company. Well, the argument to not expense it, View B was the employee stock options are a transaction between the owners and the employees. The entity isn't actually involved. It's not an expense of the entity. The only cost to the shareholders is dilution of the ownership interest due to the additional shares being issued. We'll talk a lot about dilution in the next module. So, this again was a bitter conflict. The path to current accounting was full of compromise. The FASB did try to require expensing of stock options in the early 1990s, but they compromised in the face of political opposition, intense opposition especially from Silicon Valley firms, and even the Congressional involvement at that time in the SCC's decision that wasn't advisable to go forward with expensing stock options. They did disclose, however, the value of these options, even that was opposed by many executives. But it was the compromise that they were at least disclosed in the notes to the financial statements. Subsequently, after another round of accounting scandals in the early 2000s, and again, that collapse in the stock market, the FASB was able to require expensing at that time. It's still complicated, however. It's still a complicated model. They're still putting equity. The increase in the value of the stock options, as we will see, is not accounted for as an expense. It's just the initial value of the stock options at the time their issued unless the stock option somehow get classified as a liability. So, one of the important issues will be, when you look at a stock option, is it an equity grant or is it a liability grant? That will affect greatly how you measure and how much expense is recognized on the options. So, here's the accounting model. The measurement objective for equity instruments are awarded to employees is to estimate the fair value of the option, not the shares, the fair value at the grant date that the entity is obligated to issue when they vest. And that's usually, there's a service requirement, and sometimes, there's other conditions that are necessary in order to earn the right to benefit from the instrument. This is straight out of the FASB codification. It's not a fair value model. It's not like accounting for trading instruments, financial instruments that are accounted for, trading or fair value through net income. The subsequent accounting is more of an amortized cost model because once I put that fair value, the compensation, into equity, that's the amount that stays there. The feasibility of measuring fair value, of course, is due to financial innovation starting with the Black-Scholes model which won a Nobel Prize. There's constant innovation, however, in how these models are applied and worked. It's been refined over time in response to perceived shortcomings, what were sometimes referred to as Black Swan events. Some models, they have something that's referred to as fat tails. They increase the probability of what would otherwise be unlikely events occurring. There are now binomial models and iterative models that are commonly used today. The FASB standard does not specify which model to use. They left that up to the market place which means that you could have different firms using different models to estimate the values of options, but you do have to still comply with the fair value accounting requirements and valuation requirements when you do it. So, here's some typical model assumptions. Now, usually, stock options are considered a European model because the employee can't exercise them at any point in time. So, you have to wait until they're vested. So, a European model assumption works for that type of exercise option, a more of a European option. Options that can be exercised at any time are referred to as American options. The stock returns are considered to be normally distributed. There are zero dividends during the terms of the options and efficient markets and zero transaction costs. It looks very complicated. The equation looks typically something like this. You're going to use variables like the current stock price, the strike price of the option, the exercise price, the term of the option, how long it lasts, how long you have the option period, the risk-free interest rate, and the volatility of the underlying stock. Remember, options are really a derivative based on the underlying which is the stock. But don't worry about doing that. This course is not about calculating fair values of stock options. The fair values that are normally provided by valuation experts anyway. This course will address the accounting for employee stock options. The option pricing calculation of fair value, that's beyond the scope of this course. But how you account for it is not. Now, there are some simplifications allowed for non-public entities. For example, a non-public entity. If your stock isn't traded, you may not be able to just go to the newspaper or online and see what the value of your stock is like you could with a publicly traded stock. So, because it's sometimes not practicable to estimate the expected volatility of those shares, you have some options. One is called a calculated value. Your account for the equity shares based on a calculated value which uses the historical volatility of an appropriate Industry Sector Index, kind of like a level two fair value measure. Now, again, it's going to be very important whether you'd recognize a stock option as a liability or as equity. How do you tell the difference between the two? Well, generally, stock options can be classified as equity as long as the employer is required or has an option to settle the option with shares. However, if the awards are settled in cash or the employee has the option to receive cash instead of shares, the stock option is a liability. So, if I give an option to an employee, and at the end of three years the stock price has appreciated, if I actually give them the shares of the stock, it's going to be typically an equity classified obligation. If it's settled in cash instead of giving the employee the shares of the stock which is fairly common with private companies, for example, that may be classified instead as a liability. So, how it's settled can determine whether it's an equity transaction or a liability. And when it's an equity transaction, it's measured at the cost, at the grant date. When it's a liability, it's remeasured at fair value each reporting period. We'll see some examples. Also, there are some different rules for different payees. Generally, shared base payments to common law employees and most independent directors are accounted for under the model that we're going to be talking about here in ASC 718. There are non-employee awards that are subject to different GAP guidance which is at ASC 505-50, and awards to customers, if I pay for goods that I'm going to get from customers or if I give awards to customers for doing business with me which maybe more common, then those are going to be subject to the guidance in ASC 606 which is the new revenue recognition standard. The accounting models are very different. We're going to be talking about ASC 718 stock compensation here. So, let's get started.
