ACC 545 Week 2 Capital Changes and Stockholders' Equity Example

Paying Engineers in Stock: Measuring and Recognizing Restricted Stock Units, Performance Shares, Options and an Employee Purchase Plan, Plus a Three-for-One Split, at a Composite Cybersecurity Software Company

[Student Name]

University of Phoenix

ACC/545: Financial Reporting

Week 2 Assignment

[Instructor Name]

[Date]

The company, its awards and all figures are composites written for a model paper; standards and research findings come from the sources listed.

A composite company sells threat detection software to mid-sized enterprises and has grown revenue about 30% a year since its public offering. Like its competitors, it pays engineers and sales staff partly in equity to conserve cash. Last year its board approved a broad grant program, and in November it split its shares three for one. The controller must calculate stock-based compensation, record the tax effects and present the equity section and earnings per share. For a software company, stock compensation is often its second-largest expense, and none of it is paid in cash. This paper works through each piece.

Restricted Stock Units

On January 2, the company granted 400,000 time-based restricted stock units, before the split, when its shares traded at $62. Each unit converts into one share as it vests over four years. Equity-classified awards are measured once, at grant-date fair value, which for restricted units is the share price (Financial Accounting Standards Board, 2004). Total compensation cost is $24.8 million, fixed at grant regardless of later price changes. The company recognizes service-only awards on a straight-line basis over the full vesting period, $6.2 million a year.

The company elected to account for forfeitures as they occur rather than estimating them, a choice permitted since the 2016 simplification (Financial Accounting Standards Board, 2016). When 20,000 units were forfeited by employees who left in the first year, the company reversed the cost previously recognized for those units, $310,000.

Performance Share Units

Executives received 100,000 performance share units at target, also valued at $62. The number that will vest ranges from zero to 200% of target, depending on the three-year compound annual growth rate of revenue. At grant, management judged 100% of target probable, so cost was based on 100,000 units, $6.2 million over three years, about $2.07 million a year.

By year end, strong bookings made 120% of target probable. The standard requires recognizing cost based on the probable outcome, with a cumulative catch-up when the estimate changes. Total expected cost is now 120,000 units times $62, or $7.44 million, and one-third of the service period has passed, so cumulative cost should be $2.48 million. The company records $2.48 million in the first year rather than $2.07 million.

Stock Options

New engineering hires received 250,000 options with an exercise price of $62, vesting over four years and expiring in ten. Options are measured using an option pricing model. The company used the Black-Scholes model, which values an option from the share price, exercise price, expected term, expected volatility, risk-free rate and dividend yield (Black & Scholes, 1973). Inputs were a share price of $62, an expected term of 6.25 years, volatility of 45% based on the company's own trading history and that of peers, a risk-free rate of 4.2% and no dividends. The fair value was about $21 per option, total cost about $5.25 million, recognized straight-line at about $1.31 million a year.

Volatility and expected term are judgments. A five-point change in expected volatility would change the option value by roughly 8%, so the company discloses its assumptions and their basis.

Employee Stock Purchase Plan

Employees may buy shares every six months at 85% of the lower of the price at the start or end of the period. A plan with a discount above 5% or a lookback feature is compensatory, so the company measures the plan's fair value as a combination of the discount and the lookback option. Expense for the year was about $900,000. Purchase plans without a lookback and with a discount of 5% or less, available to nearly all employees, would be noncompensatory and produce no expense, which is why some companies design their plans that way.

Tax Effects at Vesting

For tax purposes, the company deducts restricted units when they vest, at the value then. When 100,000 units vested in the first quarter of the second year, the share price was $80, so the tax deduction was $8.0 million, while cumulative book cost for those units was $6.2 million. The tax effect of the $1.8 million excess, about $450,000 at a 25% rate, is recognized as a reduction of income tax expense in the period of vesting, not in additional paid-in capital, since the 2016 update. That treatment makes the effective tax rate move with the share price.

The Three-for-One Split

In November, the company split its shares three for one. A split does not change total equity; it triples the number of shares and reduces the per-share price. The company restates all share counts, award quantities, exercise prices and earnings per share for all periods presented as if the split had occurred at the beginning of the earliest period. After restatement, the options have an exercise price of about $20.67 and the restricted units cover 1.2 million shares.

Presentation and Dilution

The statement of stockholders' equity shows share-based compensation as an increase in additional paid-in capital, vested units issued as shares and shares withheld to cover employee taxes as a reduction. Unvested units and options are included in diluted earnings per share using the treasury stock method. The company's total share-based compensation for the year, about $10.6 million, equals about 16% of revenue, and diluted shares exceed basic shares by about 4%.

Shares Withheld for Taxes and Repurchases

When restricted units vest, the company withholds enough shares to cover employees' tax withholding and pays the tax in cash, a net share settlement that reduces the number of shares issued. Withholding up to the maximum statutory rate does not change the award's equity classification. The cash paid, about $2.9 million this year, is presented as a financing outflow. The board also authorized a repurchase program to offset dilution from awards; repurchased shares are recorded as treasury stock at cost and reduce the shares outstanding used in earnings per share.

How Investors View the Expense

Aboody et al. (2004) found that stock-based compensation expense measured under the fair value approach was negatively associated with share prices, evidence that investors treat it as a real cost rather than ignoring it. Many software companies present non-GAAP earnings that exclude it; the company's audit committee requires that any such measure be reconciled to GAAP net income and that the dilution be explained.

Conclusion

The company measured each award at grant-date fair value: restricted units at the share price, performance units at the share price times the probable number of shares, with a catch-up when the estimate rose, options with an option pricing model and the purchase plan as a compensatory discount with a lookback. Excess tax benefits at vesting reduced income tax expense, and the three-for-one split restated all share data. Together, these awards cost about $10.6 million this year, a real expense even though no cash changed hands.

References

Aboody, D., Barth, M. E., & Kasznik, R. (2004). SFAS No. 123 stock-based compensation expense and equity market values. The Accounting Review, 79(2), 251-275. https://doi.org/10.2308/accr.2004.79.2.251

Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81(3), 637-654. https://doi.org/10.1086/260062

Financial Accounting Standards Board. (2004). Share-based payment (Statement of Financial Accounting Standards No. 123 [revised 2004]).

Financial Accounting Standards Board. (2016). Compensation, stock compensation (Topic 718): Improvements to employee share-based payment accounting (Accounting Standards Update No. 2016-09).