Accounting principles board issued âaccounting for stock compensation to employeesâ opinion number 25 which required that compensation in form of stocks be recognized using intrinsic value and this gives an option not recording in the books if stocks have an option of getting money in future. In the year 2004 Ball adopted this method together with statement 123. Statement number 123 which required the reporting of stock options to be done either recognized using fair value method or intrinsic value method. This statement did not make it mandatory but it gave a leeway for companies to use any of the two methods. This statement introduced fair value method which was adopted by the company in the year 2004.
The recognition of compensation cost of stock options by companies is not mandatory is not mandatory in SFAS 123 and this firm has used this financial statements in reporting the stock options issued to employees. However they have reported in their books because the statements give them an option of either recognizing in the financial statement or putting it in a footnote. The footnote is a form of disclosing for the purpose of third party who will be using the financial statements. This method uses various assumptions in getting the fair value of the shares. The assum0tions that are disclosed include risk free rate, expected option life, expected stock volatility and expected dividends. In the year 2004 and 2005 for this company they have given all the above information and it is as follows:
Expected dividend yield 2005 its 1.01%,, 2004 1.17 %, expected stock price volatility 30.09% & 32.78%, Risk-free interest rate 3.89 % and 3.45%, expected-life of options 4.75 years and 4.75 years.
However Financial accounting statement no. 123R required companies to recognize stock compensation in fair value. This will be recognized in the profit and loss account of the company. Statement no 123 introduced the mandatory reporting of stock options to employees. This company Ball introduced the method in the year 2006, and the evaluation method used was black-scholes and the method is calculated as follows:
Pc = [ps] [n (D1} â [pPe] antlin (-Rft)] N (d2)]
Where Pc = market value of the call option, Ps = price of the stock, Pe = striking price of the option, Rf = annualized interest rate, Antlin = antilog (base e) and T = time to expiration (in years)
IN (d1) and N (d2) are the values of the cumulative normal distribution, defined by the following expressions:
D1 = in (Ps/Pe) + (Rf + 5Ă° ) t
Ă â« t
D2 = d1 â (Ă° â«t)
Where: In P5/pe = the natural logarithm of (Ps/Pe)
The definitions of d1 and d2 are somewhat difficult to understand. They result from solving very complex mathematical equations and are admittedly not quickly grasped by the reader. Nonetheless, the basic properties of the Black-scholes model are easy to envision. Estimated option prices vary directly with an optionâs term-to-maturity and with the difference between the stocks market price and the optionâs striking price.
The company is using intrinsic value method in the year 2005 although they changed to fair value during the same period. The market value of the share is greater than the exercise value of the shares therefore the company decided to use 6.6 million as stock based compensation. If the exercise price was greater than the market value then the figure could have not been recorded as 6.6 million in 2005 however since the method requires such treatment therefore the figure was high. A declining of the stock prices in the market will see a decline in option premium. Thus affecting the value that will be written down (Abode and Bognanno, 1995).
The fair value of a share or a stock for compensation is the price that is derived using various factors.
Black and Scholes reached the conclusion that the estimated prices of calls could be calculated with the following equation (Fischer and Jordan, 2006).
Pc = [ps] [n (D1} â [pPe] antlin (-Rft)] N (d2)]
Where Pc = market value of the call option, Ps = price of the stock, Pe = striking price of the option, Rf = annualized interest rate, Antlin = antilog (base e) and T = time to expiration (in years)
IN (d1) and N (d2) are the values of the cumulative normal distribution, defined by the following expressions:
D1 = in (Ps/Pe) + (Rf + 5Ă° ) t
Ă â« t
D2 = d1 â (Ă° â«t)
Where: In P5/pe = the natural logarithm of (Ps/Pe)
For the year 2005 it is 8.7 and year 2004 is 9.3
These figures have been provided in the table therefore the option increased in value from the year 2004 to the year 2005.
Stock options are perfect compensation model for senior management because they attract. They attract the best human resource because they feel by joining the company which gives them options to buy the stock gives them along term reward. This is because most executives will which to won part of the company they work for, since they understand the long term income for any person come form dividends. This means that any forward looking senior executive will opt for a company that compensated using stock options rather than cash options (Rose and wolfram, 1997).
Ball Company changed the method of recognizing stock options from intrinsic value methods to fair value method. Before adopting the fair value method, companies were required to calculate the stock options as well. However, the impact of earnings was only disclosed in footnote only. The change of method from intrinsic to fair value method would increase the compensation expense because all stock-based payments were recorded in income statement. Therefore, Ball Company opted to reduce stock options given to employees since no companies would like to increase expenses. Reserving of common stock for issuance to executives and key employees is an expense to the company. They form shares of the company that are authorized but unissued and the price of the stock options should be less than the market value. When companies reduced the value of stock option awards or even curtailed their use of stock options, the recorded expenses would be lower and thus giving them higher net income. This shows the company more profitable as well as having a better look on the income statement. Although the reduction of options to the employees may sound as a discouraging factor, the employees will wish to be associated with the company and be motivated to work if the company is very profitable in the long run(Fischer and Jordan, 2006).
From the workings above it appears that the company, Ball reduced its stock options used and they joined other companies. The use of stock options for compensation also did not take place in the year 2006 because if the managers opted to take up the shares and sell them they could affect the share prices in the market. Therefore they opted not to pay them because the eventual prices of the share could have been affected. In short the todayâs volatile labor market, a critical area of concern is the fair and equitable compensation of senior management. The various forms of direct and indirect compensation comprise a total compensation concept. Benefits are integral tot total compensation approach. Benefits should reflect an organizationâs philosophy of âmaking the person wholeâ. Effective benefits packages have the following objectives. This is what has been pursued by Ball in compensating their employees. The above listed benefits show the benefits that fit this option that is used by the company (Gapenski & Brigham, 1994).
The company in the year 2006 reported tax benefit associated with option exercise price in the profit and loss account because of the reduced use of options. The company should change the policy of the company of reporting for stock options. This will have good impact on the profits assuming that the employees will take up their options. The fair value method does not require foot notes since it considers the principle of prudence. This method also considers the expense which is used to reduce the profits of the firm. Reporting foot notes uses the intrinsic value method in reporting for the option. While fair value uses current rates in valuing the options. Fair value current information and relevant information meaning that accounting information will make a difference in decision making as provided to most shareholders who may not be able to read the foot notes. This means that the information provided can easily be understood as it must be reliable i.e. you can be able to verify the information and it must be neutral. Fair value provides accounting information which is consistency and comparable to other financial statement for a company operating in the same industry as most companies is moving towards fair value (Fischer and Jordan, 2006).
References
- Abode, J. and Bognanno, M, (1995). âInternational differences in executive in and managerial compensation.â In (R, Freeman and L. Katz, Eds.) Differences and changes in wage structures, Chicago: university of Chicago press.
- Fischier D. E. and Jordan R. J., (2006); Security Analysis and Portfolio Management, Prentice âhall, India
- Gapenski l, Brigham E; (1994) Financial Management: Theory and Practice; Dryden Press. Hall, 7 th Enhanced Media Edition,
- Penrose, E. T. (1959). The Theory of the Growth of the Firm, New York: John Wiley.
- Rose, N. and wolfram, C. (1997). âRegulating CEO pay: assessing the impact of the tax deductibility cap on executive compensation. MIT.