Question

• Why do corporations issue convertible securities?

• What are the advantages of using restricted stock to compensate employees?

• What are the disadvantages of using restricted stock to compensate employees?

• What are some reasons that employees might prefer this type of compensation?

• Skim through the major tenets of the PwC Stock-based compensation. In March 2016, the FASB issued Accounting Standards Update (ASU) 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which amends ASC 718. What are a few of the improvements to employee share-based payment accounting discussed in the report?

Answer 1

A convertible bond represents a hybrid security that has a bond and equity features; this type of bond allows the conversion of its nominal value to either cash or a specified number of common shares of equal value. A corporation issues a convertible bond to take advantage of reduced interest rates, since the presence of the conversion option provides upside potential for the bondholders, and these bonds tend to demand lower interest rates compared to standard nominal bonds. Another advantage of issuing convertible bonds rather than equity is the tax deduction of interest, which lowers the cost of capital for a company. Also, as the bonds are converted to equity, a company has no more obligations. However, depending on the number of additional shares issued as a result of the conversion, shareholders' equity value declines as a result of stock dilution.

A restricted stock unit (RSU) is a form of compensation issued by an employer to an employee in the form of company shares. Restricted stock units are issued to an employee through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time.

ADVANTAGES:

MOTIVATE THE EMPLOYEES: Companies would issue restricted stocks on the condition that an employee has to achieve certain performance targets and to provide certain services before actually receiving shares and having the right to acquire them. It motivates the employees as it is the reward against the performance. It is also beneficial for the company as the reward will be paid only after achieving the performance level.

DIVIDEND AND VOTING RIGHTS: The restricted stocks can carry the dividend and the voting right if the issuing company chooses. After the vesting period, the stock becomes common stock.

AN ADVANTAGE OVER STOCK OPTIONS-Restricted stocks require fewer shares to offer an equal level of benefit in comparison to what is needed for stock options. Because restricted stocks retain some value even if the share price declines.

DISADVANTAGES:

VESTING REQUIREMENT: Let’s assume an employee is purchasing a stock at the market price. He does not get the actual possession of stock. Buying such stocks may not seem very attractive to an employee. The situation of restricted stock is similar to this situation.

HIGHER TAXATION:There is no capital gain treatment available at exercise. The entire amount of the vested stock becomes the ordinary income in the year of vesting. The capital gain treatment means paying tax only for any appreciation between the price at vesting and sale of stock.

TIMING OF TAXES:The employee has to pay tax at the time of exercise regardless of when he sells the shares. Restricted stock usually becomes taxable upon the completion of the vesting schedule. The entire amount of vested stock becomes ordinary income for that year.

SIGNIFICANT FINANCIAL RISK: In comparison to other plans, restricted stocks has more complications. They involve financial risk for the employees when he makes a choice in Section 83 (b). After selection, if the price of stock declines or the employee leaves the company, he would end up paying unnecessary tax.

Reasons that employees might prefer this type of compensation:

Issuing restricted stock is a better motivating tool than granting stock options for two reasons. First, many employees don't understand stock options. They don't know that they have to take action in order to realize any gain. It is far easier for them to understand a vesting period on restricted stock. The second reason is that restricted stock can't become worthless like stock options. Even if the stock price falls, the restricted stock retains some intrinsic value.

One of the advantages restricted stock has from a management perspective is that as a motivating tool it allows employees to think, and act, like owners. When a restricted stock award vests, the employee who received the restricted stock automatically becomes an owner of the company. The employee doesn't have to take any action to achieve ownership and is now entitled to vote at the annual meeting. Becoming a stakeholder also encourages employees to focus more on meeting corporate goals.

Stock options, on the other hand, do little to instill a sense of ownership and are usually viewed as a high-risk gamble that has a potentially great reward.employees often choose actions that will raise stock price in the short term (to increase their potential gain) rather than taking the long view that ultimately helps the company grow and prosper over time.

FASB's issuance of Accounting Standards Update (ASU) No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, received significant attention during the comment letter process, as adoption can have a significant impact on a company's financial statements. Under current GAAP, an entity must account for stock-based compensation from share-based payments in accordance with the fair-value-based method set forth in FASB Accounting Standards Codification (ASC) Paragraph 718-10-30-3.

Compensation cost generally is measured on the grant date the equity instrument is issued and is recognized over the requisite service period under ASC Paragraph 718-10-35-2. For tax purposes, the tax deduction related to stock-based compensation varies depending on the type of stock option. In general, the tax effect related to stock-based compensation is measured at the intrinsic value of the shares on the date of exercise for regular stock options (i.e., nonqualified stock options) and of vesting for restricted stock units.

Prior to adoption of ASU No. 2016-09, the excess tax benefit under ASC Paragraph 718-740-35-3 over the recognized deferred tax asset would be credited to additional paid-in capital (APIC) under ASC Paragraph 718-740-45-2 and tracked as part of the tax windfall pool. Any tax deficiencies generally would be charged to APIC to the extent of the tax windfall pool, with the excess recognized or expensed through the income statement under ASC Paragraph 718-740-45-4; this required the company to calculate and track its existing pool every year.

The excess tax benefit, under current GAAP, is not permitted to be recognized until the cash benefit is realized (i.e., reduction to current taxes payable) under ASC Paragraph 718-740-25-10. This left some companies with "off-balance sheet" tax attributes—such as net operating losses and credits that were created as a result of large stock-based compensation tax deductions—that were tracked separately. In these scenarios, the tax attributes that were "on-balance sheet" for financial statement purposes would be less than those recorded on the company's tax return.