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The Fair Value Method of Measuring Compensation for Employee Stock Options: Basic Principles and Illustrative Examples May 2002 Deloitte & Touche LLP 95 Wellington Street West Suite 1300 Toronto, Ontario M5J 2P4 www.deloitte.ca Introduction This memorandum has been prepared by Deloitte & Touche at the request of the Ontario Teachers Pension Plan Board to illustrate the basic properties of the fair value method of accounting for compensation related to employee stock options. For the purposes
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    The Fair Value Method of Measuring Compensation for Employee Stock Options: Basic Principles and Illustrative Examples May 2002   Deloitte & Touche LLP 95 Wellington Street West Suite 1300 www.deloitte.ca Toronto, Ontario M5J 2P4   1 Introduction This memorandum has been prepared by Deloitte & Touche at the request of the Ontario Teachers Pension Plan Board to illustrate the basic properties of the fair value method of accounting for compensation related to employee stock options. For the purposes of the memorandum, stock options are defined as those awards granted to an employee requiring the employee to pay an exercise price in cash for the receipt of stock issued by the company. The options may vest based on the passage of time or based on the achievement of performance conditions. Stock options that provide for settlement in cash or cashless exercises are not included in the definition of a stock option. With this document, it is our intention to give preparers and users of financial statements an intuitive grasp of the fundamentals of the method, and its implications for measuring compensation expense for employee stock options. The document does not address accounting for stock options granted to non-employees or to any other type of award granted to employees or non-employees. This guide should be used for illustrative purposes only. Preparers of financial  statements should consult the CICA Handbook, other guidance prepared by the Canadian  Accounting Standards Board, and/or their auditors or accounting advisors for expert opinion on the application of these principles in specific situations. A Brief History and Background of Fair Value Accounting The “fair value” method of accounting for employee stock options and other stock-based compensation was introduced into the CICA Handbook, and thus into Canadian generally accepted accounting principles (GAAP), in late 2001. The fair value method is mandated for all non-employee transactions involving stock options and other forms of stock compensation. It is also mandated for certain types of employee compensation transactions involving consideration such as direct awards of stock, stock appreciation rights (SARS), stock awards payable in cash or other assets, and cashless exercise options. However, for traditional employee stock options, the fair value method is not mandatory but only “encouraged” as a method of accounting. Its use is mandatory, nonetheless, in the computation of certain pro forma disclosures required by entities that do not use the fair value method for all stock compensation plans. Prior to its appearance in the CICA Handbook, the fair value method was rarely if ever used to record stock compensation expense by public enterprises reporting under Canadian GAAP. As a consequence, uncertainty may exist about the accounting process and effects of using the fair value method as defined in Canadian GAAP. Key issues include the question of whether one must reflect changes in the market value of options once granted, the effects of different vesting patterns and methods, and the potential volatility in net income that might arise from using this method either in the primary financial statements or in supplemental disclosures.   2  Basic Terminology The Components of Fair Value The fair value method records compensation for stock option transactions with employees at the fair value of the option instrument granted – the value that would generally be received when a similar option was issued in any other arm’s length transaction, such as in an options market. Fair value is generally determined at the date the employer grants the option to the employee and the employee understands the terms of the grant. The fair value of any option is the sum of two component parts: its intrinsic value and its time value.  The intrinsic value  of an option reflects the extent to which it is “in the money” (the underlying stock has a market value that is greater than the exercise price of the option) at any date. The intrinsic value does not measure the upside to the option holder from potential future increases in the value of the underlying shares that may occur over the remaining term of the option.   In  practice, options granted to employees of public companies will frequently have zero (or close to zero) intrinsic value on the date they are granted. This is the result of stock exchange or similar regulations prohibiting the issuance of options that are in the money, and hence instantly dilutive to existing shareholders. The value of such an option at grant date is almost entirely determined by its time value.  The time value   of the option is the value of these potential increases to the option’s holder at any given time. This estimated time value is added to the intrinsic value to determine the fair value of the option at any time. While the estimation process is reasonably complex, commercially available software  puts this capability within the reach of most enterprises. Types of Stock Options  Not all employee stock options are alike. Many compensation plans feature “plain vanilla” options that are exercisable by an employee in accordance with a vesting schedule that may be all-at-once (“cliff vesting”), or “graded” (vested proportionately over time). Other options may be performance related, that is, exercisable only under market certain conditions (e.g. the underlying stock price achieves a specified target  price), or upon the achievement of certain non-market conditions (e.g. the accomplishment of certain organizational performance objectives).  “Plain vanilla” situations: The fair value of options awarded is simply the total fair value of the number of options awarded. If the ultimate number of shares or options is initially uncertain because of non-market performance conditions, the fair value method requires the employer to make its best estimate of the number of options expected to be exercisable as a result of the  performance condition. This estimate is continuously updated until the options are vested.   3    Performance-related situations:  The effects of market performance conditions, such as those that depend on achieving a specific stock price or a specified amount of intrinsic value, are reflected directly in computing the fair value of the awarded options. The total fair value may also reflect the fact that an estimated number of employees initially rewarded options may not satisfy the vesting conditions through voluntary departures or other reasons. No direct recognition is given in the valuation process to the effects of vesting conditions on the value of an employee option; however, to reflect the effects of the holder’s inability to sell unvested options, the value of an unvested option is calculated by reference to its expected life (i.e. expected time to exercise) rather than its maximum term, reducing its value. Applying Basic Accounting Principles Tools for determining the fair value : The fundamental assumption underlying the use of fair values for employee stock options is that they can be reasonably estimated by modern option valuation techniques. Two of these techniques are the Black-Scholes and the binomial methods. These methods take into account the following factors: ã The time value attributed to options given data on the style of the option (American or European), ã The term of the option ã The volatility of the underlying share price (for options on publicly-traded equity securities) ã Dividend rates on the underlying shares ã Prevailing risk-free interest rates ã Other relevant factors General amortization principles:  The fair value is amortized over the subsequent  periods that employees render service to earn the unconditional right to the reward. The amount allocated to each period is reflected as a charge to periodic compensation cost. This process is essentially an extension of the historical cost principle to stock-based compensation. As a general rule, under the historical cost method, a recorded transaction is measured at the value of the consideration exchanged between the enterprise and the  parties to the transaction as established on the transaction date. Costs measured in this way are then charged or amortized over the period(s) in which the services reflected in the costs are rendered. In the case of stock options granted as employee compensation, the amortization period is generally determined to be the vesting period, as it is over this period that an employee renders service in exchange for the right to exercise the option. Vesting provisions and expected and actual patterns of employee forfeitures will affect the amortization pattern. As a general rule, if the number of shares and exercise price of an award is fixed from the start, the total cost of the award to be expensed over the vesting period does not change  
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