Monday, 26 December 2011

Apple Inc.'s Share based compensation - Extract from Form 10K

Above is the snapshot from Apple inc.'s Form 10K submitted on 24 September, 2011. The above paragraph explains the share-based compensation used by the company and the way of reporting them, the valuation models used and the accounting treatments related to how the expense is recognized and recorded over service periods.

Below are some extracts from the Reading 23, Employee Compensation which totally relate to the extract above.

"Restricted Stock Grant: 
• Compensation expense is reported based on the fair value of the stock on the Grant Date (i.e. market value at grant date).
• Compensation expense is allocated over the service period of the employee

Stock Options:
• Grant date: It is the day that options are granted to employees.
• Service Period:  It is usually the period between the grant date and the vesting date.
• Vesting Date: It is the date that employees can first exercise stock options. The vesting can be immediate or over a future period.
• Exercise Date: The date when employees actually exercise the options and convert them to stock

Accounting Treatment of Stock Options (IFRS & US GAAP): 
• Compensation expense related to option grant is reported at fair value of the option on the grant date based on the number of options that are expected to vest.
• If the share-based payments vest immediately, then compensation expense is recognized in the income statement on the grant date.
• If share-based compensations do not vest until a specified service period is completed, compensation expense is recognized in the income statement and allocated over the service period (the time between the grant date and the vesting date).
• If the share-based compensation are contingent upon achievement of performance or a market condition e.g. target share price, compensation expense is recognized over the estimated service period in the income statement.

Determining Fair Value: 
Fair value of stock options must be estimated using an appropriate valuation model unlike stock grants whose  fair value is based on the market value at the grant date.

When market price is not available, the firm can use option pricing model i.e. Black scholes or binomial model. No specific method is preferred under IFRS and U.S. GAAP.

Option pricing model is based on the following six inputs: 
1. Exercise price (It is known at the time of grant).
2. Stock price at the grant date.
3. Expected term (It is a highly subjective measure).
4. Expected volatility (It is a highly subjective measure).
5. Expected dividends.
6. Risk-free rate

Effects of changes in inputs on the Estimated fair value of options: 
Inputs that lead to increase in Estimated Fair Value and higher compensation expense:
• Higher volatility
• Longer estimated life
• Higher risk-free rate
• Lower assumed dividend yield

Inputs that lead to decrease in Estimated Fair Value and lower compensation expense:
• Lower volatility
• shorter estimated life
• Lower risk-free rate
• Higher assumed dividend yield"

The reason why this charter is given such respect is evident through the skills & knowledge which it develops. Above is one such example that how preparing for the exam equips one with the knowledge which is being used and applied by large companies. Reading Form 10K after going through FRA segment was a totally new  experience for me. I had never understood the essence so clearly before.

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