JP Morgan Chase 2006 Annual Report Download - page 109

JPMorgan Chase & Co. / 2006 Annual Report 107
Impact of adoption of SFAS 123R
During 2006, the incremental expense related to the Firm’s adoption of SFAS
123R was $712 million. This amount represents an accelerated noncash recog-
nition of costs that would otherwise have been incurred in future periods. Also
as a result of adopting SFAS 123R, the Firm’s Income from continuing opera-
tions (pretax) for the year ended December 31, 2006, was lower by $712 mil-
lion, and Income from continuing operations (after-tax), as well as Net income,
for the year ended December 31, 2006, was lower by $442 million, than if the
Firm had continued to account for share-based compensation under APB 25
and SFAS 123. Basic and diluted earnings per share from continuing opera-
tions, as well as basic and diluted Net income per share, for the year ended
December 31, 2006 were $0.13 and $0.12 lower, respectively, than if the Firm
had not adopted SFAS 123R.
The Firm recognized noncash compensation expense related to its various
employee stock-based incentive awards of $2.4 billion (including the $712 mil-
lion incremental impact of adopting SFAS 123R), $1.6 billion and $1.3 billion
for the years ended December 31, 2006, 2005 and 2004, respectively, in its
Consolidated statements of income. At December 31, 2006, approximately $1.0
billion (pretax) of compensation cost related to unvested awards has not yet
been charged to Net income. That cost is expected to be amortized into com-
pensation expense over a weighted-average period of 1.2 years. The Firm does
not capitalize any compensation cost related to share-based compensation
awards to employees.
Cash flows and tax benefits
The total income tax benefit related to stock-based compensation arrange-
ments recognized in the Firm’s Consolidated statements of income for the
years ended December 31, 2006, 2005 and 2004, was $947 million, $625
million and $519 million, respectively.
Prior to adopting SFAS 123R, the Firm presented all tax benefits of deduc-
tions resulting from share-based compensation awards as operating cash
flows in its Consolidated statements of cash flows. SFAS 123R requires the
cash flows resulting from the tax benefits of tax deductions in excess of the
compensation expense recognized for those share-based compensation
awards (i.e., excess tax benefits) to be classified as financing cash flows. The
$302 million of excess tax benefits classified as a financing cash inflow dur-
ing 2006 would have been classified as an operating cash inflow if the Firm
had not adopted SFAS 123R.
The following table sets forth the cash received from the exercise of stock
options under all share-based compensation arrangements and the actual tax
benefit realized related to the tax deduction from the exercise of stock
options.
Year ended December 31, (in millions) 2006 2005 2004
Cash received for options exercised $ 1,924 $ 635 $ 764
Tax benefit realized 211 65 204
Comparison of the fair and intrinsic value measurement methods
The following table presents Net income and basic and diluted earnings per
share as reported, and as if all 2005 and 2004 share-based payment awards
were accounted for at fair value. All 2006 awards were accounted for at fair
value.
Year ended December 31,
(in millions, except per share data) 2005 2004(a)
Net income as reported $ 8,483 $ 4,466
Add: Employee stock-based compensation
expense included in reported Net income,
net of related tax effects 938 778
Deduct: Employee stock-based compensation
expense determined under the fair
value method for all awards, net of related
tax effects (1,015) (960)
Pro forma Net income $ 8,406 $ 4,284
Earnings per share:
Basic: As reported $ 2.43 $ 1.59
Pro forma 2.40 1.52
Diluted: As reported $ 2.38 $ 1.55
Pro forma 2.36 1.48
(a) 2004 results include six months of the combined Firm’s results and six months of heritage
JPMorgan Chase results.
The following table presents the assumptions used to value employee stock
options and SARs granted during the period under the Black-Scholes valuation
model:
Year ended December 31, 2006 2005 2004
Weighted-average annualized
valuation assumptions
Risk-free interest rate 5.11% 4.25% 3.44%
Expected dividend yield 2.89 3.79 3.59
Expected common stock price volatility 23 37 41
Expected life (in years) 6.8 6.8 6.7
Prior to the adoption of SFAS 123R, the Firm used the historical volatility of its
common stock price as the expected volatility assumption in valuing options.
The Firm completed a review of its expected volatility assumption in 2006.
Effective October 1, 2006, JPMorgan Chase began to value its employee stock
options granted or modified after that date using an expected volatility assump-
tion derived from the implied volatility of its publicly traded stock options.
The expected life assumption is an estimate of the length of time that an
employee might hold an option or SAR before it is exercised or cancelled. The
expected life assumption was developed using historic experience.