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options issued to employees However, during the EITF s discussion of EITF Issue No 96 18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, an FASB staff representative stated that when applying the consensuses in that Issue, the minimum value method is not an acceptable method for determining the fair value of nonemployee awards by nonpublic companies (e) RECOGNITION OF COMPENSATION COST As previously discussed, FASB Statement No 123 requires either recognition of compensation cost in an employer s nancial statements for those companies adopting the new standard or disclosure of pro forma net income and earnings per share for companies remaining under APB Opinion No 25 for all awards of stock options and other stock-based instruments FASB Statement No 123 applies the same basic accounting principles to all stock-based plans, including those currently considered noncompensatory under APB Opinion No 25 At the date of grant, compensation cost is measured as the fair value of the total number of awards expected to vest Adjustments to the amount of compensation cost recognized should be made for actual experience in performance and service-related factors (ie, forfeitures, attainment of performance goals, etc) Changes in the price of the underlying stock or its volatility, the life of the option, dividends on the stock, or the risk-free interest rate subsequent to the grant date do not adjust the fair value of options or the related compensation cost A stock option for which vesting or exercisability is conditioned upon achievement of a targeted stock price or speci ed amount of intrinsic value does not constitute a performance award for which compensation expense would be subsequently adjusted For awards that incorporate such features, compensation cost is recognized for employees who remain in service over the service period regardless of whether the target stock price or amount of intrinsic value is reached FASB Statement No 123 does indicate, however, that a target stock price condition generally affects the value of such options Previously recognized compensation cost should not be reversed if a vested employee stock option expires unexercised Awards for past services would be recognized as a cost in the period the award is granted Compensation expense related to awards for future services would be recognized over the period the related services are rendered by a charge to compensation cost and a corresponding credit to equity (paid-in capital) Unless otherwise de ned, the service period would be considered equivalent to the vesting period Vesting occurs when the employee s right to receive the award is not contingent upon performance of additional services or achievement of a speci ed target Compensation cost for an award with a graded vesting schedule should be recognized in accordance with the method described in FASB Interpretation 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, if the fair value of the award is determined based on different expected lives for the options that vest each year, as it would be if the award is viewed as several separate awards, each with a different vesting date However, if the value of the award is determined based on a composite expected life, or if the award vests at the end of a period (ie, cliff vesting), the related compensation cost may be recognized on a straight-line basis over the service period, presumed to be the vesting period FASB Statement No 123 does require that the amount of compensation cost recognized at any date must at least equal the value of the vested portion of the award at that date FASB Statement No 123 requires that dividends or dividend equivalents paid to employees on the portion of restricted stock or other equity award that is not expected to vest be recognized as additional compensation cost during the vesting period Also, certain awards provide for reductions in the exercise or purchase price for dividends paid on the underlying stock In these circumstances, FASB Statement No 123 requires use of a dividend yield of zero in estimating the fair value of the related award This provision would have the effect of increasing the fair value of a stock option on a dividend-paying stock (f) ADJUSTMENTS OF INITIAL ESTIMATES Measurement of the value of stock options at grant date requires estimates relative to the outcome of service- and performance-related conditions FASB Statement No 123 adopts a grant date approach for stock-based awards with service.

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39 45

M-Morales [34] Rosen [35] Laumann [36] deBoer [37] Ponholzer [38]

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requirements or performance conditions and speci es that resulting compensation cost should be adjusted for subsequent changes in the expected or actual outcome of these factors Subsequent adjustments would not be made to the original volatility, dividend yield, expected life, and interest rate assumptions or for changes in the price of the underlying stock Exhibit 3910 illustrates the impact on compensation cost when actual forfeitures resulting from terminations deviate from the rate anticipated at grant date A performance requirement adds another condition that must be met in order for employees to vest in certain awards, in addition to rendering services over a period of years Compensation cost for these awards should be recognized each period based on an assessment of the probability that the performance-related conditions will be met Those estimates should be subsequently adjusted to re ect differences between expectations and actual outcomes The cumulative effect of such changes in estimates on current and prior periods should be recognized in the period of change (g) MODIFICATIONS TO GRANTS FASB Statement No 123 requires that a modi cation to the terms of an award that increases the award s fair value at the modi cation date be treated, in substance, as the repurchase of the original award in exchange for a new award of greater value Additional compensation cost arising from a modi cation of a vested award should be recognized for the difference between the fair value of the new award at the modi cation date and the fair value of the original award immediately before its terms are modi ed, determined based on the shorter of (a) its remaining expected life or (b) the expected life of the modi ed option For modi cations of nonvested options, compensation cost related to the original award not yet recognized must be added to the incremental compensation cost of the new award and recognized over the remainder of the employee s service period As an example of a modi cation of a vested option, assume that, on January 1, 2000, Company A granted its employees 300,000 stock options with an exercise price of $50 per share and a contractual term of 10 years The options vested at the end of three years and 15,000 of the original 300,000 options were forfeited prior to vesting On January 1, 2004, the market price of Company A stock has declined to $40 per share, and Company A decides to reduce the exercise price of the options Under FASB Statement No 123, Company A has effectively issued new options and would recognize additional compensation cost as a result of the reduction in exercise price The estimated fair value of the original award at the modi cation date would be determined using the assumptions for dividend yield, volatility, and risk-free interest rate at the modi cation.

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2001 2004 2005 2004 2005

ADJUSTMENT OF FORFEITURE RATE UNDER FASB STATEMENT NO 123 Assumptions: Options granted Vesting schedule Estimated forfeiture rate Actual forfeiture rate Option value at grant date Estimated fair value of award at grant date: Compensation cost recognized in years 1 and 2: Compensation cost recognized in year 3 (3% forfeiture rate): Total compensation cost to be recognized: (10,000 94 94 97) $10 = $85,700) Cost recognized in year 1 Cost recognized in year 2 Cost recognized in year 3 Exhibit 3910 Adjustment of forfeiture rate under FASB Statement No 123 10,000 100% at end of third year (cliff vesting) 6% per year (upon termination) 6% in years 1 and 2; 3% in year 3 $10 (10,000 94 94 94) $10 = $83, 100 $83,100 3 = $27, 700

(27,700) (27,700) $30, 300

2476 27839 13618 2117 2869

(This sounds like it takes a long time, but you can probably do it in less than five minutes)

39 46

MODIFICATIONS TO GRANTS UNDER STATEMENT FASB NO 123 Assume the following for stock options granted and subsequently modi ed by Company A, a public company: Fair Value of Fair Value of Fair Value of Original Award New Award Original Award January 1, 2000 January 1, 2004 January 1, 2004 Exercise price Stock price Expected volatility Expected dividend yield Expected option life Risk-free interest rate Estimated fair value of each option2

121 16 129 281* 168 323

value calculated using an acceptable pricing model $ 3,705,000 (1,425,000) $ 2, 280, 000

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