CEP-L1

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jab410
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CEP-L1
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2014-05-24 18:19:06
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cep stock certification
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Test materials for the Level 1 CEP certification exam.
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  1. On February 15, 2011, an employee is granted an ISO to purchase 2,500 shares at a price of $16 per share.  The option vests in full one year after the date of grant.  She exercises the option in full on June 25, 2013, when the market value is $30 per share.  On December 10, 2013, she sells the option-acquired shares for $27 per share.  Which of the following is true in 2013?

    A.  She recognizes a capital loss of $7,500.
    B.  She recognizes $35,000 in additional income for AMT purposes.
    C.  Her employer is entitled to a tax deduction of $35,000.
    D.  She recognizes compensation income of $27,500.
    D.  She recognizes compensation income of $27,500.

    Section 422 limits the recognition of gain on a DD of ISO shares to the shareholder's actual gain.  Thus, in this DD the employee will recognize compensation income equal to the difference between the option price and the lesser of the FMV of the company's stock on the date of exercise or the amount realized from the disposition.  In this fact scenario the FMV on the data of exercise is higher than the sale price so the gain will be the difference between the $16 per share exercise pricfe and the $27 per share sale price, for a total of $27,500 in ordinary income.
    (this multiple choice question has been scrambled)
  2. Definition:  Cashless Exercise
    An option exercise in which the broker "loans" the money to buy the stock then immediately sells all or some of the stock, with part of the sale proceeds being used to repay the loan as soon as the cash becomes available.  Another part of the sale proceeds will be used to cover any withholding requirement that applies and any brokerage commissions and other fees.  You receive whatever is left in the form of cash (if you sold all the shares) or unsold stock (if you sold only some of the shares.
  3. Which of the following would cause a company to recognize expense for a Section 423 qualified ESPP under ASC 718?
    A.  Offering a discount of 5%
    B.  Allowing part-time employees to participate in the plan
    C.  Making the purchase price the lower of the price on the first or last day of the offering periodAllowing employees to enroll in the plan for up to a week after the purchase price has been fixed.
    • Answer: The correct answer is C.
    • Reference: The Stock Options Book section 10.1 and table 10-1
    • Explanation: The correct answer is c. A Section 423 ESPP that has a look-back feature in which the purchase price is based on the price on the first or last day of the offering period does result in a compensation expense under ASC 718 because the look-back is an "option-like feature" under the accounting standard.
  4. What are the requirements for stock plans that are “Non-Compensatory”?
    • 1.  Discount of 5% or less
    • 2.  No look-back feature
    • 3.  Must be offered to substantially all employees
  5. What type of stock plans are Compensatory”?
    • Most forms of stock compensation are compensatory, meaning they result in an income statement expense.  Specifically:
    • 1.  Stock Options and Appreciation Rights
    • 2.  Restricted Stock/Units
    • 3.  Most Section 423 ESPPs
  6. What is Accounting Standards Codification 718 (or ASC 718)?
    An accounting provision mandating that compensation expense for options and awards granted to employees is determined at grant.  It is generally not adjusted for subsequent events (with the exception of forfeitures), provided that the option or award can only be settled in stock.
  7. What is ASC 505-50?
    A subtopic of the Accounting Standards Codification 718 or (ASC 718) that defines how the compensation expense is recorded for options and awards granted to NON employees.
  8. A public company grants ISOs to employees and NSOs to outside directors and outside consultants, and it maintains a Section 423 ESPP with a 15% discount.  Which of the following are accounted for under ASC 718?
    A.  All option grants and ESPP participation
    B.  Option grants to employees only, and ESPP participants.
    C.  Option grants to employees and directors only, and ESPP participants.
    D.  Option grants to employees and directors only, but not the ESPP participants since the plan is non-compensatory.
    • Answer: The correct answer is C.
    • Reference: The Stock Options Book sections 10.3 and 10.5.3
    • Explanation: The correct answer is c. ASC 718 applies to compensatory equity compensation granted to employees. Because the ESPP offers "an option-like feature" in the form of a 15% discount, it is compensatory under the accounting standard and thus is reflected in the company's income statement. In contrast, it is a noncompensatory plan for tax purposes, meaning participants are eligible for preferential tax treatment. ASC 718 and the IRS also disagree about outside directors. The accounting statement specifies that outside directors are considered to be employees, even though they are nonemployees for tax purposes. Thus, the expense for outside directors' stock options is accounted for under ASC 718, the same as for company employees. Grants to outside consultants are accounted for under ASC 505-50.
  9. Definition:  Employee
    As defined for tax purposes, an employee of a company is someone that is issued a W-2, whereas a NON employee receives a 1099.  Non-employee Board of Directors are the exception to this rule (even though they receive a 1099 for their compensation).  They are considered "employees" for ASC 718 purposes as long as their equity awards were granted to them because of their service as a director.
  10. The board of directors of a publicly traded company is responsible for:
    A.  Setting the stock price.
    B.  Electing new board members.
    C.  Appointing corporate officers.
    D.  Setting the stock price, electing new board members, and appointing corporate officers.
    • Answer: The correct answer is C.
    • Reference: Consider Your Options chapter 3 and The Stock Options Book Glossary under "Board of Directors" and "Fair Market Value"
    • Explanation: The correct answer is c. Stockholders elect board members, who are responsible for appointing corporate officers. In a privately held company, the board sets the share price. However, in a publicly traded company, the share price is set by those buying and selling shares.
  11. [Please refer to the sample plan document XYZ Corporation Stock Incentive Plan and related documents in your CEP binder to answer this question.]
    XYZ Corporation, a privately held company, grants ISOs to employees pursuant to the XYZ Corporation Stock Incentive Plan. How is the grant date fair market value established?
    A.  An annual valuation is conducted by an independent firm.
    B.  A semi-annual valuation is conducted by an independent firm. 
    C.  The last price for which the stock was purchased in an arm's-length transaction is used.
    D.  The board of directors establishes a value in good faith.
    • Answer: The correct answer is D.
    • Reference: CEP Institute binder materials, XYZ Corporation Stock Incentive Plan section 2.19(iii)
    • Explanation:  The plan's definition of "fair market value" specifies that:  "In the absence of any established market for the Common Stock, the Fair Market Value thereof shall be determined in good faith by the Board." Do not get confused by answer a. which is industry best practice and is a Section 409A safe harbor - this question is asking specifically about the XYZ Corporation Stock IncentivePlan. Even when an independent firm performs an annual valuation, the board of directors must still vote to adopt the value established by the independent firm.
  12. On June 1, 2012, a publicly held company grants 5,000 NSOs to a member of the board of directors under its broad-based stock incentive plan, under which shares are registered on a Form S-8. When the options vest, on June 1, 2014, the board member completes a notice of exercise and instructs his broker to use the sale proceeds to cover the exercise cost and the taxes due. Which of the following is true?
    A.  She must calculate her AMT liability for 2011.
    B.  She must pay ordinary income taxes on the gain on exercise in 2011.
    C.  She must pay taxes on her short-term capital gain in 2013.  The company must withhold FICA and FUTA taxes in connection with the sale in 2013.
    D.  The company must withhold FICA and FUTA taxes in connection with the sale in 2013.
    • Answer: The correct answer is D.
    • Reference: The Stock Options Book sections 7.1.1 and 7.1.3
    • Explanation: The correct answer is d. Under the Sarbanes-Oxley Act of 2002, publicly traded companies are prohibited from extending loans to officers and directors. However, under Regulation T, a broker can extend a margin loan to an insider who is exercising options under an employee benefit plan that is registered on a Form S-8. The SEC has not yet ruled on this point, but such broker-assisted cashless exercises, which do not involve an extension of credit from the company itself, have become common.
  13. A plan prospectus is:

    A.  a document pursuant to which stock options are issued that is adopted by the board of directors and approved by the shareholders.
    B.  a document that spells out key terms of the employee option, including number of shares that can be bought, purchase price, and time periods during which employees are permitted to exercise options
    C.  a summary of the plan terms, description of the options' tax consequences, and other information to help employees decide whether to exercise options
    D.  a summary of employee shareholdings in company stock and stock options granted to the employee.
    • Answer: The correct answer is C.
    • Reference: Selected Issues in Equity Compensation section 1.3.13
    • Explanation: A prospectus is a condensed version of the registration statement filed with the SEC in connection with the offering of securities. Answer a. describes the plan document itself. Answer b. describes an option agreement. Answer d. describes an individual's holdings report.
  14. The compensation cost for fixed stock options under ASC 718 is:
    A.  the intrinsic value on the vesting date.
    B.  estimated fair value on the grant date.
    C.  intrinsic value marked to each reporting date.
    D.  the estimated fair value on the vesting date.
    • Answer: The correct answer is B.
    • Reference: The Stock Options Book section 10.1
    • Explanation: ASC 718 requires companies to calculate an estimated fair value on employee stock options as of the date of grant, and to reflect that value as a charge to earnings during the service period. The estimated fair value is calculated using an option pricing model which includes the intrinsic value (fair market value) as one of the model inputs.
  15. Under ASC 718, which of the following statements is true of the compensation expense associated with time-vested stock options granted to employees?
    A.  The compensation expense is frequently zero.
    B.  The compensation expense is equal to the full fair market value of the granting corporation's stock on the date an option is granted. 
    C.  The compensation expense is equal to the fair value of the option, as determined using an option pricing model and adjusted for forfeitures. 
    D.  The compensation expense is never zero.
    • Answer: The correct answer is C.
    • Reference: The Stock Options Book sections 10.1 and 10.4
    • Explanation: Under ASC 718, the fair value of employee stock options is determined using an option pricing model. Fair value is distinct from fair market value, which generally refers to the trading price of the underlying stock. ASC 718 requires companies to place a fair value on employee stock options as of the date of grant, and to reflect that value as a charge to earnings during the service period.
  16. Definition:  ESPP Offering Period
    The period during which rights to purchase stock under an ESPP are outstanding.  The period begins for all participants on the offering date and ends on a predetermined exercise date.
  17. Definition:  ESPP Offering Date or Enrollment Date
    The first date of the offering period.
  18. Definition:  ESPP Grant Date
    The same as the “offering date” for tax purposes so long as the plan includes a limit on the number of shares that a single person can purchase during an offering period – whether an absolute number or formula.  (This requirement is not satisfied by a statement of the $25,000 limit.)  If the maximum number of shares that may be purchased during the offering period is not determinable until the exercise date, then the grant date does not occur until that date.
  19. Definition:  Participant or Optionee
    Employee who enrolls in an offering period.
  20. Definition:  Option (ESPP)
    The participant’s right to participate in an offering period.  For tax purposes, a Section 423 plan option begins on the offering date and has a term equal to the duration of the offering period.
  21. Definition:  Exercise Date or Purchase Date (ESPP)
    Predetermined date or dates upon which stock is purchased for all participants during an offering period.  There is always an exercise date at the end of the offering period.  There may also be interim exercise dates at the end of multiple purchase periods during a single offering period.
  22. Definition:  Purchase Period (ESPP)
    A period during the offering period that is shorter in duration than the offering period.  There is always an exercise date at the end of a purchase period.  Although the first day of a purchase period may not be the offering date, the use of the term “purchase period” generally indicates that the exercise price will be determined with reference to the first day of the offering period rather than with reference to the first day of the purchase period.
  23. [Please refer to the sample plan document XYZ Corporation Employee Stock Purchase Plan and related documents in your CEP binder to answer this question.]
    How long are the offering periods under the XYZ Corporation ESPP?
    A.  3 months
    B.  6 months
    C.  12 months
    D.  27 months
    • Answer: The correct answer is B.
    • Reference: CEP Institute binder materials, XYZ Corporation Employee Stock Purchase Plan section 2(k)
    • Explanation: The offering periods under the plan run from May 1-October 31 and November 1 to April 30 each year. Be sure that you understand the difference between "offering period" and "purchase period." In the XYZ ESPP there are only two six month offering periods per year, with no intervening purchase periods.
  24. An employee begins participating in her employer's Section 423 employee stock purchase plan. The six-month purchase period begins January 1, 2010, when the stock is worth $5 per share. The plan provides for the most generous allowable purchase price under Section 423. On June 30, 2010, the stock price is $8. She holds on to the shares and sells them on January 2, 2012, when the stock price is $15. What price will she pay for each share of stock she purchases under the plan.
    A.  $4.25
    B.  $5
    C.  $6.80
    D.  $8
    • Answer: The correct answer is A.
    • Reference: Select Issues in Equity Compensation section 9.1
    • Explanation: Section 423 allows the company discretion on two features which can serve to lower the stock price - a maximum 15% discount and a look-back feature - combining both of these features results in "the most generous allowable purchase price under Section 423." The employee will get a 15% discount off the $5 share price at the beginning of the offering period, because the offering date price is lower than the $8 share price on the purchase date. $5 x 0.15=$0.75, $5-$0.75=$4.25. (Or the answer can be calculated by figuring that she is paying 85% of the price and thus multiplying $5 by 0.85.)
  25. What are the 6 inputs required to determine an equity award's fair value?
    • 1.  The award's exercise price (The underlying stock's FMV [for public companies, this is the price for which the stock is trading on an exchange; for private companies, the BOARD sets the FMV.)  For tax reasons, this should be set using standards set by IRC Section 409A.
    • 2.  The expected term of the awards.  Companies are required to project the amount of time options will remain outstanding.  For options granted to employees, this is generally shorter than the award’s contractual term.  For options granted to non0employees, this is generally the award’s contractual term.
    • 3.  The expected volatility of the underlying stock’s.  For public companies, this is a best estimate of the market volatility over the expected term of the option.  Public companies often use historic volatility rates to assist in this determination.  Private companies that cannot produce a reliable estimate of their stock volatility can look at similar public companies (often the same peer companies that were used for 409A valuation purposes) or industry indices.  Public companies are not allowed to use industry indices.
    • 4.  The expected dividend yield of the underlying stock.  Again, this is over the expected term of the option.
    • 5.  The risk-free interest rate.  Generally companies use the current Treasury rate applying to bills or bonds with terms equal to the award’s expected term, as the prescribed zero-coupon rate on US government issues is not as readily accessible.
  26. A/An _____________ is an adjustment by the issuer that increases or decreases the number of securities outstanding, and adjusts the value of the securities accordingly, without a corresponding change in the assets or capital of the issuer; an internal reorganization of the capital structure of the corporation involving a change to the type or number of securities outstanding. Usually such an adjustment will affect the value of an individual share, but not the overall value of the number of shares authorized by the issuer or held by an individual stockholder. What type of an adjustment is described by the preceding statement?
    a. Dividend reinvestment.
    b. Recapitalization.
    c. Repricing.
    d. Increasing the plan reserve pool
    •  
    • Correct answer: B
    • Explanation: While the CEP exam textbooks generally discuss the more common administrative aspects of maintaining and implementing equity compensation plans, the "Plan Administrator" contemplated by and discussed in the formal equity compensation plan and any governing regulations and statutes is always the Board of Directors or a Compensation Committee authorized by the board. You or someone else in your company or your client's company may perform the administrative duties to keep the plan compliant with the applicable laws, regulations and statutes or may work diligently to keep the data clean, but you (or they) are not the official Plan Administrator (with a capital P and a capital A) for the purposes of authorizing grants and amending the Plan.
  27. What most often happens to an employee who holds an unvested restricted stock award when a company issues a stock dividend to investors?
    a. Nothing. The holder of an unvested RSA is rarely entitled to dividends on unvested awards.
    b. The company issues unrestricted stock to the employee in the same amount as if the shares were vested.
    c. The company issues unvested restricted stock to the employee in the same amount as if the shares were vested. The dividend stock vests over the same period as the RSA stock.
    d. The company pays the employee the cash equivalent of the amount he would have received if the stock were vested.
    • Correct answer: c
    • Explanation:  Restricted stock awards frequently carry the same dividend rights that are available to other shareholders. In most cases, the dividend shares are subject to the same restrictions as the shares under the grant, meaning they will also be subject to the vesting schedule.
  28. [Please refer to the sample plan document XYZ Corporation Stock Incentive Plan and related documents in your CEP binder to answer this question.] An employee leaves XYZ Corporation to take a new job. She holds vested and unvested NSOs under the company's Stock Incentive Plan. What happens to those options?
    a. All options are canceled as of her termination date.
    b. Vesting ceases as of her termination date. Unvested options are cancelled, but she can exercise her vested options for three months after termination.
    c. All options continue to vest and to be exercisable for three months after termination.
    d. Vesting ceases after three months, then unvested options are cancelled, but she can exercise her vested options until their original expiration date.
    • Correct answer: B
    • Explanation: The XYZ Corporation Stock Incentive Plan specifies that the vesting of stock options ceases upon termination, but that vested options can be exercised for three months following termination.
  29. [Please refer to the sample plan document XYZ Corporation Stock Incentive Plan and related documents in your CEP binder to answer this question.] An employee conducts a same-day sale of options she holds under the XYZ Corporation Stock Incentive Plan. For income tax purposes, when is the exercise considered to occur?
    a. When she delivers same-day-sale instructions to the broker.
    b. When she delivers the necessary instructions to the company.
    c. When the company delivers the necessary instructions to the broker.
    d. On the day the sale transaction settles.
    • Correct answer: a
    • Explanation: Under the XYZ Corporation Stock Option Agreement, the exercise shall be deemed to occur upon the execution of a same-day sale with the designated broker. The agreement goes on to state that "for income tax purposes, the Exercised Shares shall be considered transferred to Optionee on the date on which the Option is exercised with respect to such Exercised Shares." Answer b. is incorrect because any instructions provided to the company must also include payment of the aggregate exercise price.
  30. The CEO of a publicly traded company conducts a same-day sale exercise during an open window period. The exercised options had been granted to her three years earlier, immediately after the company's successful IPO. The shares under the grant were covered by an S-8 registration statement. Which is true of this transaction?
    a. No restrictions apply to the shares. b. The shares are subject to Rule 144
    c. The shares can be sold only if the CEO has a Rule 10b5-1 plan in place.
    d. The shares can be sold in reliance on the Rule 701 exemption.
    • Correct answer: b
    • Explanation: While the shares are unrestricted, the CEO is an affiliate and must still conduct the sale of the shares in compliance with Rule 144.
  31. An example of "diminishment" of an outstanding option is tricky, but would NOT include:
    a. Acquiring company accelerates and cashes out options of target company.
    b. Acceleration of vesting and exercisability.
    c. Modification that causes grant to lose ISO status.
    d. Changing plan to make it more difficult to exercise.
    • Correct answer: b
    • Explanation: Answer b. is the only choice that does not reduce the benefit to the option holder. The other choices "diminish", or reduce the benefit to the option holder.
  32. On January 1, 2010, when the market value is $12 per share, an employee enrolls in his employer's ESPP, which has an 18-month purchase period. On June 30, 2011, when the market value is $10 per share, his contributions purchase 200 shares under the plan at a price of $8 per share. On July 15, 2013, the employee sells all 200 shares at a price of $15 per share. How much compensation income does he recognize for the sale?
    a. $0
    b. $720
    c. $800
    d. $1,600
    • Correct answer: a
    • Explanation: Under Section 423, the minimum price cannot be discounted by greater than 15% of the market value on enrollment or purchase. The price in this scenario is discounted 20% off the purchase date market value and an even greater discount off the enrollment date market value. Therefore, the plan is not a Section 423 qualified plan. Because the plan is not qualified, it is taxed upon exercise as if it were an NSO. When he purchased the stock (the "exercise" under the ESPP), the employee recognized compensation income equal to the spread at that time. At the time of sale, he will recognize capital gains but not compensation income. The exercise avoids taxation under Section 409A because the exercise date is set in advance.
  33. What is the difference between restricted stock for tax purposes and restricted stock for securities law purposes?
    a. Taxation occurs when vesting is completed or payment is accelerated; securities law restrictions apply to the sale of unregistered stock.
    b. Taxation occurs when vesting is completed or income recognition is accelerated; securities law restrictions apply to sale of unregistered stock.
    c. Taxation occurs when exercise is completed or payment is accelerated; securities law restrictions apply to the purchase of unregistered stock.
    d. Taxation occurs when exercise is completed or income recognition is accelerated; securities law restrictions apply to the purchase of unregistered stock.
    • Correct answer: b
    • Explanation:  Under restricted stock award plans, companies grant shares but restrict them for a time after grant. The recipients, who may or may not pay anything for the shares, cannot take possession of them until the specific restrictions lapse, and thus are not taxed until they receive the shares, unless they file an 83(b) election to accelerate the recognition of income to the date of grant. For securities law purposes, "restricted stock" generally refers to unregistered shares and the restrictions on sale of such unregistered securities.

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