Stock Options
Stock Option Plans (Features of the Plan)
1. Features of the Plan -- a. The $5 fixed price of the stock is called the option price or exercise price; b. The four-year period before the option can be exercised is called the service period, vesting period and amortization period; c. During the service period, compensation expense is recognized; d. To fully exercise the option, the employees must pay $50,000 for the 10,000 shares; e. The options vest at the end of the service period; (The ability to exercise the option is no longer contingent on continued employment with the firm at this point.) f. This type of plan is called a "fixed" plan because the relevant terms are set at the grant date; g. This plan illustrates "cliff" vesting because all options vest at the same time.
Compensatory Plan
3. Compensatory Plan -- If not all 5 criteria are met, then the plan is compensatory. For example, if the discount is substantial, then that amount is recorded as expense. Dr:Compensation expense discount from market price on date of purchase Dr:Cash discounted price Cr:Common stock par of stock issued Cr:PIC-CS remainder B. The remaining parts of this section pertain to incentive plans for selected employees - typically upper management. The terms of these plans provide an incentive for the employee to provide significant value and be well-compensated.
How is compensation expense determined after a change in estimated forfeitures?
Compensation expense in period of change is the amount resulting in total compensation through the period of change that equals the fraction of service period elapsed multiplied by the new estimate of total compensation expense.
On what date is total compensation expense determined for a fixed stock option plan?
Grant date.
What effect does the fair value of one option have on a stock price at grant date?
Higher prices yield higher fair values.
What is the effect of expected forfeitures on compensation expense recognized?
Reduces total compensation expense.
How are compensation expenses reported?
Reported as a component of income from continuing operations.
Matching Portion
2. Matching Portion -- If noncompensatory, the shares are recorded as any other stock issuance. The only expense is the portion paid for by the firm (the matching portion), if any. Dr:Compensation expense amount paid by firm Dr:Cash amount paid by employee Cr:Common stock par of stock issued Cr:PIC-CS price - par of stock issued
Stock Option Plans
A Stock Option Plan : Provides an employee with the option to purchase shares of employer firm stock at a fixed price in the future, after a reasonable service period. The options expire beyond a certain point.
Under the fair-value method of accounting for stock option plans, total compensation recognized A. Is based on the value of the option at the grant date, adjusted for forfeitures. B. Equals the net increase in OE after all relevant journal entries are recorded. C. Is the difference between market price and option price at the grant date. D. Is unaffected by the option price.
Correct! A. Is based on the value of the option at the grant date, adjusted for forfeitures. The fair value of the option sets the compensation expense to be recognized for each option expected to be vested. Applying the forfeiture rate ensures that only options expected to be vested will be entered into the calculation.
Forfeitures
F. -- The above example did not include forfeitures. Firms must incorporate an estimate of forfeitures if probable and estimable because the expense must be based on the number of options expected to vest. This reduces the total amount of compensation expense to recognize.
How is compensation expense for a stock option plan measured?
Fair value of options granted are estimated using an option pricing model at grant date.
What is the period over which compensation expense is recognized for a fixed stock option plan?
Service period - grant date to first exercisable date.
What is the total compensation expense for a fixed stock option plan?
The fair value at grant date of options expected to vest.
On which of the following dates is a public entity required to measure the cost of employee services in exchange for an award of equity interests, based on the fair market value of the award?
The fair value on the grant date is used for measuring compensation expense, because, on that date, the employer has given a resource of value to the employee.
What is the accounting effect of the expiration of stock options?
No change in compensation expense or owners' equity.
List the criteria for noncompensatory employee stock options plans.
1. Essentially all employees can participate; 2. Employee must decide within one month of firm setting the stock price to enroll in the plan; 3. Discount does not exceed employer cost savings inherent in issuing directly to employees; 4. Purchase price based solely on market price of the stock; 5. Employees can cancel their enrollment before purchase date for refund.
Noncompensatory Plans
1. Noncompensatory Plans -- a. Such plans are considered noncompensatory (no significant compensation is provided) if all apply: i. Essentially all employees can participate; ii. Employee must decide within one month of the firm setting the price for the stock whether to enroll in the plan; iii. Discount does not exceed the employer cost savings inherent in issuing directly to employees (<5% market price meets this criterion); iv. Purchase price must be based solely on the market price of the stock; v. Employees can cancel their enrollment before purchase date and obtain a full refund.
Measuring Compensation Expense (Fair Value Method)
2. Fair Value Method -- Assume that Flowers's choice of option-pricing model at grant date establishes the fair value of one option to be $2.20. Note that the market price of the stock at grant date is not used for measuring the cost of the option plan to the firm. a. Total compensation expense for the four-year service period is $22,000 (10,000 x $2.20). This amount is allocated on a straight-line basis. The following journal entries illustrate the accounting. 12/31/x1, x2, x3, x4 Dr:Compensation expense 5,500 $22,000/4 Cr:PIC-stock options 5,500
Stock Purchase Plans Open to All Employees
A. Before discussing stock option plans, plans for the rank and file are presented as a background to this significant reporting area. In this type of plan, employees purchase stock directly from firms, they may receive a small discount, and the employer may match a portion of the purchase.
Stock Option Plans
A. The value of such a grant stems from the potential for the stock price to increase. The ability of employees to influence the stock price provides the incentive. B. Basic Example -- On 1/1/x1, selected executives of Flowers Inc. are granted the option to purchase 10,000 shares of the firm's $1 par common stock for $5 per share during the two-year period beginning 1/1/x5 and ending 12/31/x6 (exercise period). The market price of the stock on the grant date also is $5. To maintain their eligibility for the option plan, the employees must continue to be employed by the firm for the four years after the grant date.
Measuring Compensation Expense
C. Measuring Compensation Expense -- 1. To measure compensation expense, the FASB chose the more reliable of the following (1) value of employee services to be received, and (2) value of options provided. Because the value of the employee services cannot be directly measured, GAAP requires that the fair value of the options granted be estimated using an option-pricing model. Various option-pricing models are available that use the following six variables at grant date to determine the value of the option (including Black-Scholes, lattice, and others): a. Exercise price (option price) - higher fair value with lower option price (less must be paid to obtain the shares); b. Expected average life of the option (service period + exercise period) - higher fair value with longer option period (there is a greater chance the stock price will increase and the time value of money is greater); c. Current stock price - higher fair value with higher price (the fair value of the option is in part a function of current stock price); d. Expected volatility of the stock - higher fair value with greater volatility (there is a greater chance of price increase - decreases don't hurt the holder); e. Risk-free rate of interest - higher fair value with higher interest rate (the option holder can invest the exercise price and earn interest during service period); f. Dividend yield at the grant date - higher fair value with lower dividend yield (dividends foregone reduce the time value of money).
In a stock option plan, the estimated forfeitures rate is increased during the second year of a four-year service period. Therefore,
Correct! C. Compensation expense for year two causes total recognized compensation expense through year two to be half of total compensation expense using the new estimate. The new estimate is used to compute compensation expense on prior years and the year of change. The resulting total amount of expense through the year of change, less the expense already recognized, is the amount of expense recognized in the year of change. The new estimate continues to be applied in later years.
Compensation Expense is Reported
D. Compensation Expense is Reported as a component of income from continuing operations. For manufacturing firms, a portion may be allocated first to an inventory account and then to cost of goods sold. PIC-stock options is an owners' equity account which will be closed to another contributed capital account upon exercise. At exercise Dr:Cash 50,000 10,000($5) Dr:PIC-stock options 22,000 5,500(4) Cr:Common stock 10,000 10,000($1) Cr:PIC-CS 62,000 1. Net Effect of the accounting: a. Earnings is reduced $5,500 for each year in the service period; b. Retained earnings is reduced $22,000 from compensation expense; c. Contributed capital increases $72,000 = the fair value of the options at grant date ($22,000) + cash paid in by employee ($50,000); d. Net effect on total OE = $72,000 - $22,000 = $50,000 = cash increase. 2. Essentially, retained earnings is converted into permanent capital for the amount of the fair value of the option, but its placement on the income statement is the key idea. The firm increases its permanent value by the value of the manager's services.
Expiration of Options
E. Expiration of Options -- When the market price fails to increase above the option price (here $5), the options expire. There is no retroactive adjustment and the compensation expense remains (because there was value at grant date), and the PIC-stock options account is simply renamed. 1. Assume all 10,000 options expire - entry at end of exercise period: PIC-stock options 22,000 PIC-expired stock options 22,000 2. Net effect of all the journal entries is to reduce RE by $22,000 (through compensation expense), and increase permanent capital by the value of the grant ($22,000).
Example: Forfeitures
Example: Assume in the Flowers example that initially there were no forfeitures expected, but in 20x3 new information implies that a total of 10% of the options will be forfeited. The entries for the first two years are as above. Relevant amounts (assume net method) at the end of 20x2: PIC-stock options balance, $11,000 (5,500 x 2) Compensation expense recognized to date, $11,000 New estimate of total compensation expense, $19,800 (.9 x $22,000) 12/31/x3 Dr:Compensation expense 3,850 $19,800(3/4) - $11,000 Cr:PIC-stock options 3,850 By the end of 20x3, 3/4 of the total compensation expense is recognized. The more typical estimate change procedure would have allocated the last two years of expense ($19,800 - $5,500 - $5,500) evenly over the last two years, or $4,400 per year. This approach is not permitted. 12/31/x4 Dr:Compensation expense 4,950 $19,800(1/4) (SL) Cr:PIC-stock options 4,950 Total compensation expense recognized over the 4 years = $11,000 + $3,850 + $4,950 = $19,800. Constant percentage of estimated forfeiture: A quick calculation of total compensation cost is possible if the firm anticipates a constant percentage of estimated forfeitures each year during the service period. For example, a plan grants 100,000 options on 1/1/x1. The fair value of each option is $2.45, service period is four years, and the anticipated forfeiture rate is 4% per year during the service period. Total compensation expense = 100,000($2.45)(1 - .04)4= $208,090 Inability to estimate forfeitures: If the firm is unable to estimate forfeitures and forfeitures occur, the expense recognized in previous periods on the forfeited shares is reversed in the current period. This procedure reduces the compensation expense otherwise recognized in the current period.
Example: Forfeitures
Example: If as of the grant date, 10% of the 10,000 options are expected to be forfeited, then only 90% of the $22,000 total fair value is used for the accounting (.9 x $22,000 = $19,800). The entries would be the same except use $19,800 in place of $22,000, and 9,000 options in place of 10,000. If there is a change in estimated forfeitures, the amount of compensation expense in the year the change is determined is increased or decreased by the effect of the change on all previous years and current year (but no retroactive application). The year of the change receives the entire "catch up" adjustment. The result is that the amount of compensation expense recognized through the end of that year reflects the amount of expense that would have been recognized using the new estimate all along. In effect, the new estimate is applied to periods before it was known. This procedure is contrary to the usual approach to estimate changes that would allocate the remaining expense over the remaining service period.
(Start of CPAexcel Exam Questions) A stock option plan with a positive fair value at grant date caused compensation expense of $50,000 per year to be recorded over the five-year service period. During the exercise period (two years), the stock price never exceeded the option price. Therefore, none of the options was exercised. Choose the correct statement about the accounting for these options. A. the contributed capital increase from recording compensation expense is reversed, causing compensation expense to be reduced in the eighth year after grant. B. The contributed capital increase from recording compensation expense is left intact. C. The financial statements during the service period are retroactively restated by removing the compensation expense. D. The compensation expense for later option grants is reduced by the amount recognized on the options that expired.
Expiration of stock options does not cause reversal of compensation expense because, at the grant date, the firm did provide value to the employee, given that the option had a fair value at that time. The expense recognized for stock option plans is not based on the expected value of the employee services; rather, it is based on the value of what was given by the employer to the employee.
(Start CPAexcel Flashcards) What does a stock option plan provide an employee?
Provides an employee with the option to purchase shares of employer firm stock at a fixed price in the future, after a reasonable service period.
The stockholders of Meadow Corp. approved a stock-option plan that grants the company's top three executives options to purchase a maximum of 1,000 shares each of Meadow's $2 par common stock for $19 per share. The options were granted on January 1 when the fair value of the stock was $20 per share. Meadow determined that the fair value of the compensation is $300,000 and the vesting period is three years. What amount of compensation expense from the options should Meadow record in the year the options were granted?
The fair value of a fixed option plan at grant date is the fair value of the option. Typically the fair value of one option is given and that is multiplied by the number of options, but this problem provides the entire fair value. That total fair value is the total compensation expense to be recognized over the service period - the number of years from grant date to vesting. Once the options vest, no more compensation expense is recognized because the manager has provided the necessary service. Compensation expense per year is the total $300,000 compensation expense divided by 3 years, or $100,000 per year.
Cash and owners' equity are increased by the cash paid in by the employees; retained earnings are reduced by the amount of compensation expense recognized.
What is the net effect of accounting for a fixed option plan (assuming the options do not expire)?
Measuring Compensation Expense (Fair Value Method)
b. If stock options vest immediately at grant, then the entire compensation expense as measured by the option's fair value is recognized immediately. c. When the firm issues a stock dividend or splits its stock, unexercised options are adjusted. The number of shares under option, fair value and exercise price are proportionately adjusted. For example, a two-for-one split doubles the number of shares under option, and halves the fair value and exercise price. The total fair value and compensation expense to be recognized remain unchanged.