Accounting for Stock Compensation

Two Main Questions How should compensation expense be determined? Over what periods should compensation expense be allocated?

Terms Stock Option Grant Date Vested Date Exercise Date

Terms Intrinsic Value Method – APB 25 Fair Value Method – SFAS No 123

Fair Value Method Estimate fair value of the options expected to vest on the date they are granted Value of the option is based upon an option pricing model

Intrinsic Value Method Total compensation cost is computed as the excess of the market price of the stock over the option price on the date when both the number of shares to which employees are entitled and the option or purchase price for those shares are known

Allocating Compensation Expense Compensation is recognized over the service period

Example November 1, 2000, Kirk Company approve a plan - 5 executives options to purchase 2,000 shares each of the company's $1 par value common stock. Options are granted on January 1, 2001 May be exercised within next 10years. The option price per share is $60, and the market price of the stock at the date of grant is $70 per share

Intrinsic Value Method Market value of 10,000 shares at date of grant ($70 per share) $700,000 Option price of 10,000 shares at date of grant ($60 per share) 600,000 Total compensation expense (intrinsic value) $100,000

Fair Value Assume they use the Black-Scholes option pricing model results in a total fair value of $220,000

Journal Entries – Intrinsic Value Method At date of grant 1/1/2001 – no entry To record compensation for 2001 Compensation Expense $50,000 Paid in Capital – Stock Options $50,000 To record Compensation for 2002 Compensation Expense $50,000 Paid in Capital – Stock Options $50,000

Intrinsic Value Method Cont. To record the exercise of 20% of the shares on June 1,2004 (regardless of stock price Cash (2000x60) $120,000 Paid in Capital – Stock options 20,000 Common Stock$2000 Paid-in Capital in excess of Par 138,000

Journal Entries –Fair Value Method At date of grant 1/1/2001 – no entry To record compensation for 2001 Compensation Expense $110,000 Paid in Capital – Stock Options $110,000 To record Compensation for 2002 Compensation Expense $110,000 Paid in Capital – Stock Options $110,000

Fair Value Method Cont. To record the exercise of 20% of the shares on June 1,2004 (regardless of stock price Cash (2000x60) $120,000 Paid in Capital – Stock options 44,000 Common Stock$2000 Paid-in Capital in excess of Par 162,000

Note Generally, the stock option price is greater than the market price of the shares Therefore, using the intrinsic value is $0 So no compensation expense is recorded

What to do???? While SFAS 123 recommends the fair value method, it is not required.

Another Example University Corp

Disclosure To comply with SFAS you must disclose the impact of the fair value method – Gateway F/S

Theory - Neutrality Economic consequences issue FASB believes the neutrality concept should be followed – others disagreed

The Debate June 1993 – Exposure Draft Reaction Equity Expansion Act of 1993 Late 1994 Recently

Boeing

Tax Issues Incentive Plan - Qualified Plans favorable tax treatment to the executive – employer receives not tax deduction for compensation – no deferred tax consequences Nonqualified plan offers favorable tax treatment to the employer – deduct the difference between exercise price and market price at the exercise date