Dr. Jensen
Students
may use any reference materials available in the Trinity Library and on the
Web.
Students may not obtain help from any person other than Dr. Jensen. His help is limited to clarification questions regarding what is required for a given question or problem.
Part
1 ESO Tax Benefits
The
starting point for Part 1 is Appendix A of a letter written by Professor Jensen
to Senator Charles E. Schumer. An Appendix C has been added to Professor
Jensen’s original letter, and the letter has not yet been mailed. The purpose of Part 1 of this examination is
to compare how you would write an Appendix C that addresses the tax benefit
controversy of employee stock options (ESOs).
The letter of Walter Schuetze to Senator Schumer, The primary documents useful to this
examination are as follows:
1. “Accounting for Tax Benefits of Employee Stock Options and
Implications for Research,” Accounting Horizons, Vo. 16, No. 1, March
2002, pp. 1-16.
2. Chapter 11 of Business Analysis & Valuation, by K.G. Palepu, P.m. Healy, and V.I. Bernard (South-Western Publishing, 2000, ISBN 0-324-02002-3).
3.
FAS 123 entitled “Accounting for Stock-Based
Compensation.” This standard is
available from the Financial Accounting Standards Board at http://accounting.rutgers.edu/raw/fasb/
Trinity University students may find the document on the path J:\courses\acct5341\ExamHints\Fas123
4. On March 25, 2002, Walter P. Schuetze, former Chief Accountant of the Securities and Exchange Commission, wrote Senator Schumer a letter that leaves no doubt that he opposes booking of employee stock options when they vest. That letter is now on the Web at http://www.trinity.edu/rjensen/theory/sfas123/schuetze01.htm
5.
Bob
Jensen’s reply that points out some opposing arguments. The initial reply is on
the Web at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Initially,
the above document contains an incomplete Appendix C that is Part 1 of this
examination. You are prepare an answer
key for this examination. That key will
complete the Appendix C.
Required:
1.
You are to fill in the cells that have been blanked out
below. Please enter your results in the
Excel spreadsheet that accompanies this examination. That spreadsheet can be downloaded from the
exam02q.xls file on the path http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/
Warning: Since you will be asked
what happens when the tax rate varies, it is best to derive your spreadsheet
answers in such a way that you can easily derive different outcomes with each
change in the tax rate.
2.
A copy of Hanlon and Shevlon (2002) cited above is provided
in this examination. You are to use
this paper for guidance in completing the spreadsheet required above.
3.
Fill in all the table blanks and answer the questions on
the following pages. Assume that ESO
tax benefits arise only when stock options are exercised. Initially assume that the options in
Appendix C can only be exercised at the end of Year 5.
4.
When you are asked to value these companies at the
beginning of Year 1, pretend that the revenue and expense cash flows are
estimates. For guidance on the
valuation calculations, to the Excel workbook on the path J:\courses\acct5341\ExamHints\FAS123\Appendices.xls
Part
1.1 (40 Points)
Fill in the blanks below after filling in the yellow cells of the Part 1
spreadsheet in the Exam3q.xls file. The
accounting is to proceed according to APB 25 procedures (see Hanlon and Shevlon
(2002)).
Grading Note: Half the points
on Part 1 depended upon the correct accounting for the exercise of the stock
options under APB 25 at the end of Year 5.
In particular, note the top of Page 3 in Hanlon and Shevlon (2002).
The
Excel Workbook Answers to Part 1.1 are in the exam02a.xls file at http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/
|
Year 5 After Exercise of Options |
Nobel Cash Company |
Nobel Option Company |
|
Operating revenue |
$320,000 |
$320,000 |
|
Interest
revenue |
$12,367 |
$23,424 |
|
Labor
expense |
$160,000 |
$0 |
|
Net
profit before income tax (NBOT) |
$172,367 |
$343,424 |
|
Income
tax expense |
$51,710 |
$103,027 |
|
Net
profit |
$120,657 |
$240,397 |
|
Cash |
$244,329 |
$727,659 |
|
Capital |
($10,000) |
($263,027) |
|
Retained
earnings |
($234,329) |
($464,632) |
|
Number
of shares |
10,000 |
25,000 |
|
Earnings
Per Share |
$12.07 |
$9.62 |
|
Value
of options before exercised |
$0 |
$500,000 |
|
Value of options after exercised |
|
$0 |
|
Book
Value Per Share |
$24.43 |
$29.11 |
|
|
|
|
|
|
Nobel Option Reconciliation of Cash in Year 5 |
|
Appendix
A Cash without interest and taxes = |
$780,000 |
|
Interest
revenue = |
$43,760 |
|
Less
Income Taxes Payable paid in cash = |
($96,101) |
|
Appendix
C Cash With Taxes = |
$727,659 |
|
|
|
|
|
Nobel Option Reconciliation of Capital in Year 5 |
|
Appendix
A Capital without taxes = |
($160,000) |
|
Additional
paid-in capital from ESO tax benefit = |
($103,027) |
|
Appendix
C Capital With Taxes = |
($263,027) |
|
|
|
|
|
Nobel Option Reconciliation of Retained Earnings in Yr 5 |
|
Appendix
A Retained Earnings without interest and taxes = |
($620,000) |
|
Interest
revenue = |
($43,760) |
|
Less
Income Tax Expense in financial statements = |
$199,128 |
|
Appendix
C Retained Earnings With Taxes = |
($464,632) |
|
|
|
|
|
Initial Investment and Net Profits |
Nobel Cash Company |
Nobel Option Company |
|
0 |
$7,700 |
$10,000 |
|
1 |
$7,700 |
$14,700 |
|
2 |
$15,239 |
$29,729 |
|
3 |
$30,306 |
$59,810 |
|
4 |
$60,427 |
$119,997 |
|
5 |
$120,657 |
$240,397 |
|
NPV = |
$166,254 |
$324,096 |
|
Cost of Capital = |
10.00% |
10.00% |
|
Dividend Cash Flow Valuation |
$151,709 |
$451,819 |
|
Residual Income Model Valuation |
$151,709 |
$387,847 |
|
FCF Flow Valuation |
$151,709 |
$451,819 |
|
|
|
|
|
Dividend Cash Flow Valuation |
Nobel Cash Company |
Nobel Option Company |
|
Cost of Capital = |
10.0000% |
10.0000% |
|
Year t |
Dividend Cash Flows |
Dividend Cash Flows |
|
1 |
$0 |
$0 |
|
2 |
$0 |
$0 |
|
3 |
$0 |
$0 |
|
4 |
$0 |
$0 |
|
5 |
$244,329 |
$577,659 |
|
ESO New Equity Investment in Year 5 = |
$0 |
$150,000 |
|
Dividend Est. Value of Firm at Time 0 |
$151,709 |
$451,819 |
|
Dividend Est. Value Per Share at Time 0 |
$15.17 |
$18.07 |
|
|
|
|
|
|
|
|
|
Residual Income Valuation |
|
|
|
|
|
|
|
Residual Income Valuation |
Nobel Cash Company |
Nobel Option Company |
|
Cost of Capital = r = |
10.00% |
10.00% |
|
Year t |
Book Value (0) |
Book Value (0) |
|
0 |
$10,000 |
$10,000 |
|
|
Net Profit (t)-(r)(Book Value (t-1)) |
Net Profit (t)-(r)(Book Value (t-1)) |
|
1 |
$6,700 |
$13,700 |
|
2 |
$13,469 |
$27,259 |
|
3 |
$27,012 |
$54,367 |
|
4 |
$54,103 |
$108,573 |
|
5 |
$108,290 |
$216,973 |
|
ESO New Equity Investment in Year 5 = |
$0 |
$150,000 |
|
RI Estimated Value of Firm at Time 0 |
$151,709 |
$387,847 |
|
RI Est. Value Per Share at Time 0 |
$15.17 |
$15.51 |
|
|
|
|
|
|
|
|
|
Free Cash Flow Valuation |
|
|
|
|
|
|
|
Free Cash Flow Valuation |
Nobel
Cash Company |
Nobel
Option Company |
|
Cost of Capital = |
10.0000% |
10.0000% |
|
Year t |
FCF(t) |
FCF(t) |
|
1 |
$0 |
$0 |
|
2 |
$0 |
$0 |
|
3 |
$0 |
$0 |
|
4 |
$0 |
$0 |
|
5 |
$244,329 |
$577,659 |
|
ESO New Equity Investment in Year 5 = |
$0 |
$150,000 |
|
FCF Estimated Value of Firm at Time 0 |
$151,709 |
$451,819 |
|
FCF Est. Value Per Share at Time 0 |
$15.17 |
$18.07 |
Part
1.2 (10 Points) Abnormal Earnings
Valuation
When
comparing the Dividends versus Abnormal Earnings/Residual Income valuation
outcomes, note that these outcomes are identical ($151,709) for the Nobel Cash
Company. They are not identical for the
Nobel Option Company. What is this
difference and how do you account for the difference. Why is that the case, and what is a fundamental problem with
Abnormal Earnings/Residual Income Model valuation?
Hint: Carefully read the introduction to the
Abnormal Earnings Valuation Method introduction on Page 11-3 of Business
Analysis & Valuation, by K.G. Palepu, P.m. Healy, and V.I. Bernard
(South-Western Publishing, 2000, ISBN 0-324-02002-3). Especially note the underlying assumption and Footnote 1 on Page
11-22.. What are some of the reasons
analysts still prefer the Abnormal Earnings Valuation model?
Suggested Answer:
|
|
Nobel Cash Company |
Nobel Option Company |
|
Dividend Cash Flow Valuation |
$151,709 |
$451,819 |
|
Residual Income Model Valuation |
$151,709 |
$387,847 |
|
Valuation
Difference |
$0 |
$63,972 |
The valuations are estimated at the beginning of Year 1. If we
compute the future value of the $63,972 valuation difference five years out
using the Nobel Option's cost of capital rate of 10.00%, that future value is $103,027,
which is exactly equal to the ESO tax benefit. Or put in another way, the
valuation difference of $63,972 is the present value (at Time 0) of the ESO tax
benefit of $103,027 at the end of Year 5.
The reason for the $63,972 lower valuation from the Residual
Income/Abnormal Earnings Model, is that this valuation model assumes a
"clean surplus" in which all equity capital changes other than new
share issuances pass through earnings. Under APB 25, the ESO tax benefit
arising from the intrinsic value of exercised stock options gives rise in this
illustration to a $103,027 tax benefit that wiped out all taxes payable for the
Nobel Option Company in Year 5. The APB 25 required entry for this is a
debit to Cash (or Taxes Payable) and a credit to Capital (or Paid-in
Capital). As a result, Nobel Option Company does not satisfy the required
assumption of a "clean surplus" in Year 5 due to the fact that the
$103,027 did not increase earnings but did increase Capital.
The $150,000 received from the issuance of new shares is not a cause
of any valuation model difference since this does not violate the clean surplus
assumption.
Part
1.3 Market Value at the End of Year 4
Part
A (5 Points)
What are the book values per share at the end of Year 4?
$12.37 in the Nobel Cash
Company
$23.42 in the Nobel Option
Company
Part
B (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset
of each company --- Cash. If each
company went public with an IPO at the end of Year 4, what factors might make
the market value of a Nobel Cash Company’s share of stock worth more
than the market value of Nobel Option Company?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5.
Suggested Answer:
Astute investors may see the Nobel Option Company ESO obligations
lying in wait. Although Nobel Option
Company has higher earnings performance, higher book value, and more cash, all
of these items are completely due to the fact that in this example, Nobel
Option Company had lower wages.
Before they are exercised, the ESOs are off-balance sheet claims to
the assets of the company. They have
lower priority than creditor claims, and they are contingency claims in the
sense that they must have intrinsic value at the time they are exercised. Intrinsic value is equal to the option value
minus strike price. If intrinsic value
of ESOs exists, there is a dilution impact that will lower the book value and
market value per share if a significant number of such options are exercised.
Part
C (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset of
each company --- Cash. If each company
went public with an IPO at the end of Year 4, what factors might make the
market value of a Nobel Cash Company’s share of stock worth less
than the market value of Nobel Option Company?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5.
Suggested Answer:
The first reason can be a real economic reason. When employees, such as in the Nobel Option
Company, take ESOs in lieu of higher wages, the company has more cash and lower
labor expense under APB 25 accounting.
If that cash is invested in the future for returns higher than the
firm’s cost of capital, investors should give higher value to the added
earnings.
In some sense, the outcome described above acts like an
interest-free loan from employees to the company. They eventually want some type of cash return on their ESOs, but
they are willing to forego cash now for later returns.
The second reason is that investors may not be as astute as assumed
in Part B above. Investors may not see
the Nobel Option Company ESO obligations lying in wait. Or they may see them, but may not be aware
of the full potential of the dilution impacts.
Part
D (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset of
each company --- Cash. Could the market
value of a Nobel Option Company’s share of stock worth less than
the company’s book value at the end of Year 4?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5
Suggested Answer:
It is somewhat confusing if investors value each share less than the
cash they would receive if the firm is liquidated. However, if the firm is not being liquidated, investors
anticipate future earnings and cash flows.
Their outlook for the future may assign a higher or lower value
vis-à-vis current exit value.
There are many types of intangibles, contingent liabilities, and
other factors that make book value of dubious importance when estimating market
value.
Robert
K. Elliott
Challenge and Achievement in Accounting During the Twentieth Century,
edited by Daniel L. Jensen (The Ohio State University and the University of
Florida's Fisher College of Business, 2002, pp. 22-23)
MR. ELLIOTT:
If I could just respond to one point. No one says that GAAP
isn't important or that it doesn't give important information about value
realization. But in the marketplace there's an increasing gap between value
creation, about which we have no good models, and value realization,
the later realization of the value that's created. If we look back to the
Industrial Era, the gap between when value was created and when it was realized
wasn't so great, and we could live with it. But now there is a huge
gap, and we never claimed as accountants that the net worth on the balance
sheet was supposed to equal the value of the company. But 10 or 20 years
ago, the ratio of market value to book value was about 2 to 1. Today it's
about 6 to 1. And for some companies over 100 to 1. What that tells us, I think, is
that what's measured in the balance sheet is seriously lagging what's happening
in the marketplace.
Yes, we have to be concerned with value realization. In the end we have
to make profits and have cash. But our GAAP measures are really not
diagnostic for investors to figure out which companies are actually creating
value. In the absence of disciplined information about those areas,
assured information about those areas, the marketplace runs on rumors.
Those rumors tend to be wrong and that expresses itself in the marketplace in
terms of huge volatility. That volatility then leads to higher cost of
capital, as investors demand to be compensated for that volatility.
Now, I'm not recommending that these assets necessarily be
reduced to debits and credits and put on the balance sheet. I'm not
talking about the necessity to incorporate them all into the existing GAAP
model. What I am saying is that there is objective information that could
be developed about these things, that this could be done in a way that's
similar across enterprises in the same industry, and that assurance could be
given about such information which would make the market estimates in value
creation better than they are today. Perfect? No. I'm not
looking for perfection. I'm looking for better than today.
Part
1.4 (10 Points) ESO Tax Benefits
How
can current APB 25 rules adjusting for the ESO tax benefits lead to misleading
conclusions by analysts about how much management is managing earnings through
the use of its discretionary changes in the FAS 109 valuation allowance?
Hint: See the bottom of Page 7 in the
Hanlon and Shevlon (2002) paper.
Suggested Answer:
Firms are obligated by FAS 109 to provide a valuation allowance when
any part of the deferred tax asset is not likely to be realized. Adjustments to this valuation allowance flow
through income tax expense and affect income on an after-tax basis. Tests searching for evidence of earnings
management often view manipulation of the valuation allowance as a prime
suspect. But when some part of th
evaluation allowance change flows directly to shareholders’ equity, bypassing
income tax expense, the tests may signal unwarranted conclusions.
Studies by Miller and Skinner (1998) and Visvanathan (1998) conclude
that changes in this valuation allowance, after controlling for known economic
determinants of its balance, do not signal earnings management. Both these sutides mignt have concluded
differently had the ESO tax benefits associated with the valuation allowance
changes been properly treated. See
Hanlon and Shevlon (2002, Page 8)
Part
1. 5 ESO Expense Recognition
Paragraph
74 of FAS 123 reads as follows.
Paragraphs 75-117 of this (FAS 123)
appendix discuss the reasons for the Board's principal conclusions on
recognition and measurement issues, which support the Board's belief that
recognition of stock-based employee compensation cost determined according to
the fair value based method is preferable to continued application of Opinion
25 with only pro forma disclosures of the effect of recognizing stock-based
employee compensation cost. That discussion begins with the basic issue of why employee stock
options give rise to recognizable compensation cost.
Part
A (10 Points)
In your own words, briefly summarize in less than 400 words, the arguments for
the FASB conclusions in Paragraph 74 above. Only the first 400 words will be graded.
I think the main argument against APB 45 accounting in which
continues to allow firms not to book ESOs can be found in the following
paragraph from FAS 123:
85.
Some people told the Board that a requirement to recognize compensation cost
might bring additional discipline to the use of employee stock options. Unless
and until the stock price rises sufficiently to result in a dilutive effect on
earnings per share, the current accounting for most fixed stock options treats
them as though they were a "free good." Stock options have
value--employee stock options are granted as consideration for services and
thus are not free.
There are many other arguments for booking of ESOS that are
discussed below.
There is a terrible inconsistency between tax law and APB 25
accounting rules for ESOs. APB 25
allows firms to never book ESO intrinsic value given to employees including
intrinsic value on the date they are exercised. The tax code says that employees receive intrinsic value and
allows companies to charge this intrinsic value to reduce taxes payable. Firms get huge permanent tax benefits for
things of value given to employees that are never recognized assets being given
up by the firms. The amounts involved
are not trivial.
Many large
corporations tend to avoid virtually all taxation. For example, employee
stock options allow enormous permanent reductions in corporate taxes for benefits
that will never cost the corporation anything in terms of corporate
assets. Michele Hanlon and Terry Shevlon, Accounting Horizons,
March 2002, Page 2 state the following:
A recent article in
the Wall Street Journal (August 4, 2002, Page A2) "Cisco, Microsoft, Get
Income Tax Break on Gains from Employee Stock Options" reports that for
its fiscal year ended July 29, 2000, Cisco received a Tax benefit of nearly
$2.5 billion dollars from the exercise of employees' stock options
(ESOs). As a result, the company paid little or no federal income taxes
while reporting $2.67 billion in profits.
The arguments for booking of all employee stock options and counter
arguments against the critics are summarized very well in Appendix A of FAS
123. Several of the most important
paragraphs are quoted below.
|
Excerpts from FAS
123 Appendix A |
|
56. Accounting for stock-based
employee compensation plans is a pervasive subject that affects most public
entities and many nonpublic entities. Opinion 25 continues to be criticized
for producing anomalous results and for lacking an underlying conceptual
rationale that helps in resolving implementation questions or in deciding how
to account for stock-based compensation plans with new features. A frequently
cited anomaly is that the requirements of Opinion 25 typically result in the
recognition of compensation cost for performance options but no cost is
recognized for fixed options that may be more valuable at the grant date than
performance options. Critics of Opinion 25 also note that long-term fixed
options granted to employees are valuable financial instruments, even though
they carry restrictions that usually are not present in other stock options.
Financial statements prepared in accordance with the requirements of Opinion
25 do not recognize that value. The resulting financial statements are less
credible than they could be, and the financial statements of entities that
use fixed employee options extensively are not comparable to those of
entities that do not make significant use of fixed options. Because of the
various criticisms of Opinion 25, in March 1984, the Board added a project to
its agenda to reconsider accounting by employers for stock-based compensation
plans. Why the Board Decided Not to Require
Fair Value Accounting 59. Unlike other highly c |