11/02/2021 CFA Exam Review - Level 2 - Lesson 5: Share-Based Compensation

Overview
Lesson 5: Share-Based Compensation

This lesson includes printable lecture slides. Download

Upon completion of this lesson, candidates should be able to:

LOS 14g: Explain issues associated with accounting for share-based compensation.

LOS 14h: Explain how accounting for stock grants and stock options affects financial statements, and
the importance of companies' assumptions in valuing these grants and options.

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11/02/2021 CFA Exam Review - Level 2 - Lesson 5: Share-Based Compensation

Study Guide
Lesson 5: Share-Based Compensation

LOS 14g: Explain issues associated with accounting for share-based compensation. Vol 2, pp 90–97
LOS 14h: Explain how accounting for stock grants and stock options affects financial statements, and the
importance of companies’ assumptions in valuing these grants and options. Vol 2, pp 93–96

Employee compensation packages are usually composed of salary (for liquidity needs), bonuses (to provide
short term performance incentives), nonmonetary benefits (to facilitate employees performing their jobs),
and share-based compensation (to provide longer term incentives). Under both IFRS and U.S. GAAP,
companies are required to disclose key elements of management compensation in their annual reports.
Further, in the United States companies are required by the SEC to provide disclosures regarding
management compensation on the proxy statement.
Share-based compensation is a form of deferred compensation and includes items such as stock, stock
options, stock appreciation rights, and phantom shares.

Advantages

Aligns employees’ interests with those of shareholders.

Does not typically require a cash outlay.

Disadvantages

The employee may have limited influence on the company's market value, so share-based
compensation may not necessarily provide the desired incentives.
Increased ownership may make managers more risk-averse and conservative in their strategies.
The option-like (asymmetrical) payoff may encourage management to take excessive risk.
Leads to dilution of existing shareholders’ ownership.

Accounting for cash compensation is straight-forward; compensation expense is recognized during the
period in which employees are awarded the compensation. Accounting for share-based compensation,
however, is more complicated.

Both IFRS and U.S. GAAP require companies to measure share-based compensation expense based
on the fair value of the compensation granted.
Both IFRS and U.S. GAAP require companies to disclose the following regarding share-based
compensation:
The nature and extent of share-based compensation for the period.
The basis for determining the fair value of share-based compensation over the period.
The effects of share-based compensation on the company's net income for the period and its
financial position.
As far as accounting for share-based compensation is concerned, the specifics depend on the type of
compensation.

The various types of share-based compensation can be categorized as equity-settled compensation and
cash-settled compensation.

Equity-settled share-based compensation (e.g., stock grants and stock options) allow the employee
to obtain direct ownership in the company.
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11/02/2021 CFA Exam Review - Level 2 - Lesson 5: Share-Based Compensation

Cash-settled share-based compensation (e.g., stock appreciation rights and phantom stock) does not
require the employee to hold shares in the company.

5.1  Stock Grants
Stock grants include outright stock grants, restricted stock grants, and performance shares.

With outright stock grants, shares are granted to the employee without any conditions.
Restricted stock grants require the employee to return the shares to the company if certain
conditions are not met (e.g., if certain performance goals are not met).
Performance shares are contingent on meeting performance goals, where performance is usually
measured by accounting earnings or return on assets. Performance shares may provide incentives to
management to manipulate reported earnings.

Compensation expense for stock grants is based on the fair value of shares, which typically equals their
market value on the grant date. Compensation expense for stock grants is allocated over the employee's
service period.

5.2  Stock Options
Under both IFRS and U.S. GAAP, compensation expense related to stock options is based on fair value,
where fair value must be estimated using an appropriate valuation model. The market value of traded
options on the company's stock cannot be used to measure the value of stock options-related
compensation expense because stock options granted to employees are different from traded options.
Inputs to option valuation models include exercise price, stock price volatility, estimated life of stock
options, estimated number of stock options that will be forfeited, dividend yield, and the risk-free rate.
While some of these inputs (e.g., the exercise price) are known at the time that options are granted, others
(e.g., stock price volatility and estimated life of stock options) are highly subjective and can change the
estimated fair value and compensation expense significantly. Assumptions of higher stock price volatility,
longer estimated life, higher risk-free interest rate, and a lower dividend yield increase the estimated fair
value of employee stock options, increasing compensation expense.

Before moving on to accounting for stock options, we need to be familiar with the following terms:

The grant date is the date when options are granted to employees.
The vesting date is the date when employees can first exercise the stock options.
The service period is the period between the grant date and the vesting date.
The exercise date is the date when employees actually exercise the options and convert them to
stock. If options go unexercised, they expire at a pre-determined future date (usually 5 or 10 years
from the grant date).

Accounting for Compensation Expense Related to Stock Options

If stock options vest immediately, the entire cost (fair value) of options awarded is recognized on the
grant date (in the current period).
If stock options vest after a specified service period, compensation expense is allocated over the
service period.
If vesting of stock options is conditional (e.g., upon a target share price being reached),
compensation expense is recognized over the estimated service period.

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11/02/2021 CFA Exam Review - Level 2 - Lesson 5: Share-Based Compensation

As option expense is recognized over the relevant period, expenses increase and net income falls.
Therefore, retained earnings also fall. The offsetting entry is an increase in paid-in-capital so total
shareholders’ equity remains unchanged. See Example 5.1.

Measurement of Compensation Expense Related to Stock Options

If the number of shares and option price are known, compensation expense is measured at the grant
date.
If the fair value of options depends on events after the grant date, compensation expense is
measured at the exercise date.

Example 5.1
Disclosures of Stock-Based Compensation
The following information is provided in the notes to the financial statements of Madrigal Inc. for 2011:
  2009 2010 2011
Total stock-based compensation expense 415 326 208
million million million
Total income tax benefit recognized for share-based 65 million 81 million 98 million
compensation

Further, total unrecognized compensation cost relating to nonvested share-based compensation

arrangements as of the end of 2011 equals $428 million. This cost is expected to be recognized over a
weighted average period of 1.9 years.
Determine:

1. Total compensation expense relating to options already granted that will be recognized in future
years as options vest.
2. Approximate compensation expense in 2012 and 2013 relating to options already granted.

Solution:

1. The unrecognized compensation expense relating to stock options already granted but not yet
vested totals $428 million.
2. The options already granted are expected to vest over the next 1.9 years. Therefore, compensation
expense related to stock options already granted will be approximately $225 million (= $428/1.9) in
2012 and $203 million (= $428 − $225) in 2013.

5.3  Stock Appreciation Rights (SARs)

With stock appreciation rights (SARs) an employee's compensation is tied to increases in the company's
stock price, but the employee does not own the company's stock. Compensation expense for SARs is
measured at fair value and allocated over the service life of the employee.
Advantages:

The potential for risk aversion is limited as SARs holders have limited downside risk and unlimited
upside potential.
Ownership interests of existing shareholders are not diluted.

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11/02/2021 CFA Exam Review - Level 2 - Lesson 5: Share-Based Compensation

Disadvantage:

SARs require a current period cash outflow.

5.4  Phantom Shares
With phantom share plans compensation is based on the performance of hypothetical stock rather than the
company's actual stock. Phantom share plans can be used by private companies, by business units within a
company, and by highly illiquid companies.

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11/02/2021 CFA Exam Review - Level 2 - Lesson 5: Share-Based Compensation

Flashcards
Lesson 5: Share-Based Compensation

1
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List the advantages of share-based

compensation. Aligns employees’ interests with those of
shareholders.

Does not typically require a cash outlay.

2
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May not provide desired incentives for

Identify the disadvantages of share-based employees with no impact on market value.
compensation.
Increased ownership may make managers
more risk-averse and conservative in their
strategies, or the option-like (asymmetrical)
payoff may encourage management to take
excessive risk.

Leads to dilution of existing ownership.

3
fc.L2R15L05.0003_1812

Explain accounting for share-based Both IFRS and U.S. GAAP require companies
compensation. to measure share-based compensation
expense based on the fair value of the
compensation granted.

4
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11/02/2021 CFA Exam Review - Level 2 - Lesson 5: Share-Based Compensation

Explain disclosure for share-based Both IFRS and U.S. GAAP require disclosure of:
compensation.
The nature and extent.
The basis for determining fair value.
The effects of share-based
compensation on the company's net
income and financial position.

5
fc.L2R15L05.0005_1812

Differentiate between equity-settled and Equity-settled share-based compensation

cash-settled share-based compensation. (e.g., stock grants and stock options) allows
an employee to obtain direct ownership in the
company.

Cash-settled share-based compensation (e.g.,

stock appreciation rights and phantom stock)
does not require holding shares company.

6
fc.L2R15L05.0006_1812

Outright stock grants: Shares are granted to

an employee without any conditions.
Describe the types of stock grants.
Restricted stock grants: An employee returns
shares to the company for failing to meet
certain conditions.

Performance shares: Contingent on meeting

performance goals, where performance is
usually measured by accounting earnings or
return on assets.

7
fc.L2R15L05.0007_1812

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11/02/2021
Explain the accounting for compensation
expense related to stock options.
8
fc.L2R15L05.0008_1812
Explain measurement of compensation
expense related to stock options.
9
fc.L2R15L05.0009_1812
Identify the advantages and disadvantages of
stock appreciate rights (SARs).
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CFA Exam Review - Level 2 - Lesson 5: Share-Based Compensation
Immediate: Entire cost of award at fair value
is recognized in the period of the grant date.
Specified service period: Allocates
compensation expense over the service
period.
Conditional: Recognized over the estimated
service period required to fulfill condition.
If the number of shares and option price are
known, compensation expense is measured
at the grant date.
If the fair value of options depends on events
after the grant date, compensation expense is
measured at the exercise date.
Advantages:
SARs holders have limited downside
risk and unlimited upside potential,
which may encourage risk.
Protects share owners from dilution.
Disadvantage:
SARs require a current cash outflow.
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