Question

As part of its stock-based compensation package, International Electronics (IE) granted 10 million stock appreciation rights (SARs) to top officers on January 1, 2021. At exercise, holders of the SARs are entitled to receive stock equal in value to the excess of the market price at exercise over the share price at the date of grant. The SARs cannot be exercised until the end of 2024 (vesting date) and expire at the end of 2026. The $1 par common shares have a market price of $43 per share on the grant date. The fair value of the SARs, estimated by an appropriate option pricing model, is $3 per SAR at January 1, 2021. The fair value re-estimated at December 31, 2021, 2022, 2023, 2024, and 2025, is $4, $3, $4, $2.50, and $3, respectively. All recipients are expected to remain employed through the vesting date.
  
Required:

1-a. Will the SARs be reported as debt or as equity?
1-b to 4. Prepare the appropriate journal entries pertaining to the SARs on January 1, 2021 and December 31, 2021–December 31, 2024. Assuming the SARs remain unexercised on December 31, 2025, prepare the appropriate entry. Prepare the entry when the SARs are exercised on June 6, 2026, when the share price is $50.

Answer 1

1 a) In this case, SARs will be reported as EQUITY as the holders of these SARs are entitled to receive stock , at exercise date.

2-B TO 4

For passing journal entries, we need to calculated compensation expense at the end of each year which is shown as follows:-

1) The SAR cannot be exercised until the end of 2024. Therefore the period for allocating compensation expense is 4 years (2021 to 2024).

On Jan 1, 2021 no journal entry required.

On Dec 31, 2021 the fair value is $ 4.

Compensation expense on Dec 31, 2021 = 10000000 Shares*$4*1/4 yrs = $10000000

2) Up to Dec 31, 2022, Compensation expense = 10000000 shares*$3*2/4 years = 15000000

Compensation expense for 2022 = Total compensation upto 2022 - Compensation expense for 2021

= 15000000-10000000=5000000

3) Up to Dec 31, 2023, Compensation expense = 10000000 shares*$4*3/4 years = 30000000

Compensation expense for 2023 = Compensation upto 2023 - Compensation expense for 2022 and 2021

= $30000000- $5000000- $10000000 = $15000000

4) Up to Dec 31, 2024, Compensation expense = 10000000 shares*$2.5*4/4 years = 25000000

Compensation expense for 2024 = Compensation upto 2024 - Compensation expense for 2023,2022 and 2021

= $25000000 - $15000000- $5000000- $10000000= -5000000

Therefore $5000000 needs to be reversed on Dec 31, 2025.

5) On Dec 31, 2025, option remain unexercised, therefore journal entry will be required on this date.

On Dec 31, 2025 = (10000000*$3*4/4) - 25000000= $5000000

6) Option exercised on June 6, 2026 when share price is $50.

We have debited compensation expense at $43 per share hence $1 per share need to be debited to compensation expense on June 6, 2026

The required journal entries are shown as follows:-  

Journal Entries (Amounts in $)

No	Date	General Journal	Debit	Credit
1	Jan 1, 2021	No Journal Entry required
2	Dec 31, 2021	Compensation Expense	10000000
		Liability-SAR Plan		10000000
		(To record the compensation expense)
3	Dec 31, 2022	Compensation Expense	5000000
		Liability-SAR Plan		5000000
		(To record the compensation expense)
4	Dec 31, 2023	Compensation Expense	15000000
		Liability-SAR Plan		15000000
		(To record the compensation expense)
5	Dec 31, 2024	Liability-SAR Plan	5000000
		Compensation Expense		5000000
		(To reverse the compensation expense)
6	Dec 31, 2025	Compensation Expense	5000000
		Liability-SAR Plan		5000000
		(To record the compensation expense)
7	June 6, 2026	Compensation Expense [(50-43)*10000000]	70000000
		Liability-SAR Plan		70000000
		(To record the compensation expense)
8	June 6, 2026	Liability-SAR Plan (10000000*$50)	500000000
		Cash		500000000
		(To record the cash paid for options)