Methods to Measure Stock-Based Compensation
There are two methods of accounting stock-based compensation as follows:
- The intrinsic value method: This method measures compensation expense as the excess, if any, of the quoted price of the stock at the measurement dare over the amount of which the employee must pay to acquire the stocks. Where the exercise price of the stock is equal to or greater than the market price of the stock at grant date, then there is no intrinsic value and no compensation expense would be reported on the income statement.
Factors which might influence the price of an option, are as follows:
§ The price of the underlying asset.
§ The striking price of the option itself.
§ The time remaining till the expiration date.
§ The voluntary of the underlying stock.
§ Expected dividends on the underlying stock.
- The fair value method: Under this method, compensation cost is measured at the grant date of the option based on the estimated fair value of the option as determined using an option pricing model. Stock options have a determinable fair value at grant date because of time, usually several years, during which the option is excisable and this amount should be reported as an expense on the organization’s income statement.
Process of Stock-Based Compensation: The process of a stock-based compensation involves the following activities:
- Granting activities: It involves decisions pertaining to number of grants, grant dates, lock-in- period and date on which stock options will be granted by the compensation committee and the board of directors.
- Administration activities: It involves reconciling employee data with granting information, ensuring booking in financial statements of the organization, stock exercise patterns, data on forfeiture, and deciding methods for calculations.
- Calculation activities: It involves documenting the rationale behind the assumptions used in calculations and forfeiture assumptions.
- Reporting activities: It involves reporting stock compensation details in balance sheets of the organization for ensuring appropriate income tax reporting. Maintaining appropriate records for internal and statutory audits to ensure compliance with SEBI guidelines.
Essential Characteristics of Effective Stock-Based Compensation: According to Martin, if a company is using stock-based compensation, despite its shortcomings, there are four ways to reduce its problematic outcomes:
- Use long vesting periods to make it more difficult to sell efficiency on the basis of knowingly excessive expectations.
- Prohibit selling until the point of retirement or exit from the company.
- Use stock, not stock options, because ownership of stock options provides the strongest incentive to create excessive expectations, then sell out, let the stock fall dramatically and start over again.
- Force managers to publicly announce their intent to sell stock or exercise options one week before the actual transactions, to allow the market to adjust price in the basis of the forth incoming inside sale, rather than allowing the market to find out about insider sales only when it is too late.
These methods will only serve to decrease the schism in incentives between real earnings for shareholders and future expectations for employees with stock-based compensations.
Limitations of Stock-based Compensation: Although a properly stock-based compensation plan is an efficiency way of linking compensation to organizational performance, but stock-based compensation has number of pitfalls as follows:
- Stock market fluctuations: Due to fluctuations in the stock market which is beyond the control of the employees or their companies, the value of a stock varies at different points of time. In a bullish market, the value of stocks may increase significantly providing employees with increased income whereas on a bearish market, the income of employees through stocks may be significantly deceased. For example, the stock market in India reached its all time low in January 2008 and every person lost heavily in their stocks. In some cases, it was reported that stock portfolio valued at Rs.1 crore got reduced to as low as 25 lakhs after the crash in stock market.
- Cost of options: Often employees are unwilling to pay to the full cost of their options, therefore, it is inefficient substitute for cash compensation and thus an inefficient way to attract employees.
- Tax liability: For non-qualified options, the spread between the market and exercise price upon exercise constitutes taxable personal income to the employee, and a compensation expense deductions for the company. For qualified options, the employee pays nothing upon exercise, and pays capital gains taxes when eventually selling the stock. Thus, in either case, employee bears a substantial personal income tax.
- Enhanced equity base: It increases the capital base of the company, which will lead to fall in stock prices. If large number of stocks has been issued to employees, then a significant drop in company’s stock prices shall result. As stock prices decease, not only employee’s stock-based income will decease but the return on investment for shareholders will also decease.
- Attrition: If stock prices fall below the exercise prices, then employees will rationally leave their current company to join offering a fresh compensation package.
- Managerial manipulation: It provides an incentive for managers to create unrealistic expectations that drive up the stock price even if the process of creating the unrealistic expectations irreparably harms the company.
- Not universal: It cannot be devised or implemented for employees working in one-stock companies like government service.
- Deep- pockets: It requires accumulation of sufficient funds to exercise the stock options by the employee.