Share based payments

Question 1

What are share based payments IFRS 2 ( we are only looking at equity today) ?

Answer 1

Supplement salary with equity ownership ( stock options)

Question 2

What are some of the benefits of shares based payments?

Answer 2

1) Principal agent problem
2) No big cash payments ( only dividends)
3) Competitiveness in labour market ( reduces cash burden as it is difficult ot match another firms payment of cash)

Question 3

What are some drawbacks of SBP?

Answer 3

Dilution ( when a company issues additional stock, you reduce the ownership proportion of current shareholders)
2) Dependent on share price ( you would only pay in equity if you thought share price would go up)

Question 4

Is there a link between Equity compensation and fraud?

Answer 4

yes as it creates an incentive for CEO to maxmise short term equity value, which could lead to fraud

Question 5

So when are stock options attractive?

Answer 5

When the share price is going up.

Question 6

What are some arguments as to why stock compensation should be taken out of income statement?

Answer 6

1) When you give shares, they become part of shareholders, and this isn’t apart of income.
2) Not a cash payment, so not related to performance.
But its very common in industry hence it helps with comparability. As we see with snap and Facebook.

Question 7

What is a stock option first of all?

Answer 7

Is a contract that gives one party the right but not the obligation to buy a certain number of shares at a specific excerise or strike price at a specific excerise date, which can be European option( at the end of period) or American option ( no later than specific date).

Question 8

What is the intrinsic value of an option?
For example what is the intrinsic value here?

Answer 8

The intrinsic value of an option is the difference between current and the exercise price. in this example it is 0. ( the amount the option is in the money)

Question 9

Is the fair value of this option 0 too?

Answer 9

No as the FV = IV + TV.
Time value = option premium - instinstic value (The time value of an option is the premium a rational investor would pay over its current exercise value (intrinsic value), based on the probability it will increase in value before expiry.)

Question 10

SO lets say an option is 5 dollars in the money and is available in the market for 6 dollars?
What does it even if an option is in the money, at the money and out of the money?

Answer 10

The option price is made up of 5$ of intrinsic value and one dollar of time value.
In the money = Current share price > Exercise price ( 120>100)
Out of the money = Current share price < Excerise price ( 80<100)
At the money = Share price = Exercise price.

Question 11

When are Employee stock options given?
Are stock options transferable and when you leave the company, do you still have them?

Answer 11

They are issued at the money ( 0 intrinsic value) over a vesting period.
Stock options are not transferable and when you leave the company you forfeit the right.

Question 12

What does Grant date, vesting date and vesting period mean?

Answer 12

1) Grant date = employee and company agree terms of the scheme.
2) Vesting date = the number of years from grant date, when the employee is entitled to the share based payment. e.g. Elon musk shares vest when he is able to hit a performance target ( e.g. double market cap)
3) Vesting period= is the difference between grant date and vesting date.

Question 13

Why can it be argued that share based compensation is a real cost?
What happened prior to IFRS 2 eith shares?

Answer 13

1) Transfer of value
2) Opportunity cost of cash ( shares could be used to raise capital for investment)

If there was intrinsic value of employee shares then it was recognised as an expense, if all the grants were at the money then there would be no expenses.

Question 14

What is a non-vesting condition?

Answer 14

all requirements that do not represent service or performance conditions, but which have to be met in order for the counterparty to receive the share-based payment.

Question 15

What are the 5 steps of dealing with share based payments according to IFRS 2?

Answer 15

1) Estimate the FV ( TV + IV) of each instrument at the grand date. Take into account any market and non vesting conditions but not the service and non market conditions. Use the number of instruments that are expected to vest
2) We recognise the cost over the vesting period e.g if we have a vesting period of 3 years but i can only exercise option in 10 years, i only recognise compensation expenses for the 3 years.
3) Do not adjust the FV estimates for any market events happening after the grant date.
5) The cost is trued up for changes in estimates of the number of instruments that are going to vest.

Question 16

Lets go through an example ( PART 1)
We grant 100 options to buy 100 shares of stock to each one of our 10 salespeople
The options are at the money with a strike price of £3 per share, the grant vests uniformly over 3 years, the expiration date is 4 years from today
Parameters for the Black-Scholes formula: the dividend yield is 0%, risk-free interest rate is 3%, the annualized volatility is 20%. Use: B&S Calculator
At the grant date, we expect all salespeople to stay with the firm for 3 years
After 1 year the stock price goes up to £3.50.
What does it mean that the the grant vests uniformly?
( FV usually given in example
What is the journal entry for the first year of service

Answer 16

Means they take 1/3 of the right of the 100 options that we can use to buy 100 shares after 1 year, 2/3 for second year and the full 100 after 3 years.
1) First step estimate the FV = IV + TV
Interstice value = 0.5 as at the end of period the MP goes to 3.5 -3 = 0.5, for FV we use the BS model = 0.638 hence TV = 0.138.
2) Step 2 we already did because we took into account the market conditions like interest rate and that in BS calculation
3) Step 3 measure cost over the vesting period
- Grand date FV of each option is £63.8
- We expect all contracts to vest, so FV of the grant at grant dat e is £63.8 x 100 options per person x 10 persons. = £63800 ( cost over the whole vesting period)
-So the cost per year is 1/3 of 63800 = £21,267
So Dr comp expense 21,267 ( i give the right to exercise a third of the options)
Cr Equity 21,267
We don’t adjust FV estimate.

Question 17

Lets go through an example ( PART 2)
We grant 100 options to buy 100 shares of stock to each one of our 10 salespeople
The options are at the money with a strike price of £3 per share, the grant vests uniformly over 3 years, the expiration date is 4 years from today
Parameters for the Black-Scholes formula: the dividend yield is 0%, risk-free interest rate is 3%, the annualized volatility is 20%. Use: B&S Calculator
In year 2, the stock price drops to £2. At the beginning of the year, one salesperson leaves to get a PhD in accounting.

Answer 17

Step 4 ) we do not adjust our FV estimates.
We still recognise the same compensation expense ( 21,267), as in the time value lies the part where my share price goes up or down or not.
What does change is Step 5) there is a change in the number of instruments that are going to vest. Remember if someone leaves, their 100 options are forfeited, so we have to account for this.
So the entry is:
Dr Comp Expense 19, 140 (21, 267 × 9/10),
Cr Equity 19, 140,
So we adjust number down as we are only vesting 900 options.

Question 18

What is a cliff schedule?

Answer 18

the entire grant vests after three
years?

Question 19

PART 3
We grant 100 options to buy 100 shares of stock to each one of our 10 salespeople
The options are at the money with a strike price of £3 per share, the grant vests uniformly over 3 years, the expiration date is 4 years from today
Parameters for the Black-Scholes formula: the dividend yield is 0%, risk-free interest rate is 3%, the annualized volatility is 20%. Use: B&S Calculator
What if you have a cliff schedule and that 1 person still drops, considering what we already calculated in part 1? ( so this not taken into account part 2)

Answer 19

We see what we have left to recognise 9 people x 100 options x fair value of each option at grand date and we have already done one year, so we have to account for 2 more years
Calculate the total amount that needs to be recognized over two years or the amount after second year: 900 × 63.8 × 2/3 = 38, 280
We have already recognised 21,267,
So we have a new dr and cr’s
So, in the second year, the journal entry is:
Dr Comp Expense 17, 013 (38, 280 − 21, 267)
, Cr Equity 17, 013

Question 20

Part 4 is there compensation expense recognised in year 4?

Answer 20

Regardless of whether the vesting schedule is uniform or cliff, in year 4, there is no compensation expense related to this option grant since all options are either vested or forfeited.

Question 21

Part 5 ) If employees buy the shares when in the market they are £4.30 at the end of the vesting period, how do we account for this as the employees have to pay money for excersing these options?

Answer 21

Dr Cash £30, 000 (100 × 100 × 3), Cr Equity 30, 000
So as they are worth 4.3 in the market the employee can sell this and pocket the difference ( 1.3 per share)

Question 22

What is the grant date?
What is the vesting date?
What is the vesting period?
What is the fv of option we should use in 2017, 2018 and 2019?

Answer 22

1) 1 Jan 2017
2) 31 Dec 2019
3) 3 years
1) We just use 9 remember the steps.

Question 23

Answer 23

Question 24

Answer 24