Question

. How would a Company account for stock options that vest based on reaching a target amount of net income? Group of answer choices No expense is recorded for awards that vest based on achieving a target net income because the Company has no control over the net income Estimate fair value of the options and expected time until vesting on the grant date and recognize expense based on those assumptions – but make adjustments to the amount and timing of stock compensation expense in the future if assumptions reaching the target net income change Estimate fair value of the options on the grant date and recognize all of the expense on the date the Company achieves the target net income Estimate fair value of the options and expected time until vesting on the grant date and recognize expense based on those assumptions regardless of what actually happens after the grant date

Answer 1

Stock options give the option holder the right to buy shares of company stock at some date in the future at a prearranged, specified price. If today's stock price is used as that price, the only way the option holder can profit is if the stock price goes up. If it goes down, the option will be worthless.

Important Dates

There are important dates to remember with stock options since they determine when accounting needs to be done. They are:

• Grant date: The day the options are given to the employee.
• Exercise date: The day the options are used to buy shares at the specified exercise price.
• Vesting date: The first day the employee can exercise or use the option to buy shares.
• Expiration date: The day the options expire and can no longer be used.

Accounting for Stock Options

The granting of stock options is a form of compensation given to key personnel (employees, advisers, other team members etc.) for providing their services. Like any other form of compensation, such as the cash payment of wages and salaries or fees to advisers, it is a cost to the business. In the case of stock option compensation the amount is ‘paid’ in the form of stock options instead of cash.

Amount-:

Like any cost, the cost of compensating the key personnel for their services if the fair value of the service they provide.

If for example an employee is paid a salary then the amount paid is regarded as a reflection of the fair value of the service provided. Likewise for stock option based compensation the fair value of the options granted can be used as an indication of the fair value of the service provided and therefore the cost to the business.

Vesting Period-:

The vesting period is important in stock option compensation accounting as it sets the time period over which the cost of compensating the option holder is treated as an expense in the income statement.

The purposes of granting stock options is to enable a business, particularly a startup business, to recruit, reward, and retain key personnel.

To ensure a employee does not immediately exercise their newly granted options and leave the business before the task they were employed for is complete, it is normal to have a vesting period. The vesting period is the period of time between the grant date and the vesting date at which the option holder receives the rights to exercise the option and purchase shares in the business. This is shown in the diagram above. So for example an employee might be granted 20,000 options but only receives the right to exercise then over a 4 year period at the rate of 5,000 options each year.

In addition a business will often have a requirement that if an employee leaves within a certain time period, for example one year, then they forfeit the right to excise any options and therefore leave without any shares in the business. The date before which the employee loses all rights to exercise the options is referred to a cliff.

Stock Option Compensation Example-:

At the start of the year a business grants five key personnel 300 stock options each. The fair value (FV) of each option at the date of grant is 7.00. The options vest at the end of a 3 year period at which point the option holders can exercise their options.

The exercise (strike) price is the same as the share price at the date of grant which is 20.00 and the nominal par value of each share is 1.00.

During the Vesting Period-:

During the vesting period the business needs to expense the total stock option compensation cost of the employees providing the service. The total cost is the fair value of the service which is represented by the fair value of the options granted in return for the service. In this example the cost is 7.00 for each option granted.

Year 1-:

The total expected stock option compensation cost over the 3 year vesting period is calculated as follows.

Options expected to vest = Options x Employees Options expected to vest = 300 x 5 = 1,500

Stockoption compensation cost = Options x Fair value of option at grant

Stock option compensation cost = 1,500 x 7.00 = 10,500

Since the vesting period is three years and one year of the service period has now been completed the business calculates the stock option compensation expense for the year as follows.

Total stock option compensation = 10,500 Vesting period = 3 years

Service period completed = 1 year Cumulative expense at end of year 1 = Total cost x Service period / Vesting period

Cumulative expense at end of year 1 = 10,500 x 1/3 = 3,500

Previously recognized expense = 0

Stock option compensation expense for year 1 = 3,500

The stock option expense for year 1 (3,500) is the difference between the cumulative expense at the end of year 1 (3,500) and the cumulative expense previously recognized (0).

Stock Option Journal Entries – Year 1

The stock option expense journal entry for the year is recorded as follows.S

Stock option expense journal entry – Year 1

Dr.Stock option compensation expenses 3500

Cr. APIC – Stock options 3,500

The stock option compensation is an expense of the business and is represented by the debit to the expense account in the income statement. The other side of the entry is to the additional paid in capital account (APIC) which is part of the total equity of the business.

Year 2-:

In year 2 suppose one employee leaves the business and forfeits their stock option rights.

The total expected stock option compensation cost is now calculated as follows.

Options expected to vest = 300 x 4 = 1,200

Stock option compensation cost = 1,200 x 7.00 = 8,400

Since two years of the service period have now been completed the business calculates the stock option compensation expense for the year as follows.

Expected total stock option compensation = 8,400

Vesting period = 3 years

Service period completed = 2 years

Cumulative expense at end of year 2 = 8,400 x 2/3 = 5,600

Previously recognized expense = 3,500

Stock option compensation expense for year 2 = 2,100

The stock option expense for year 2 (2,100) is the difference between the cumulative expense at the end of year 2 (5,600) and the cumulative expense previously recognized in year 1 (3,500).

Stock Option Journal Entries – Year 2

The stock option expense journal entry for the year is recorded as followsS

Stockoption expense journal entry – Year 2

Dr.Stock option compensation expense 2,100

Cr.APIC – Stock options 2,100

Year 3-:

In year 3 suppose another employee leaves the business and forfeits their stock option rights.

The total expected stock option compensation cost is now calculated as follows.

Options expected to vest = 300 x 3 = 900

Stock option compensation cost = 900 x 7.00 = 6,300

Since three years of the service period have now been completed the business calculates the stock option compensation expense for the year as follows.

Expected total stock option compensation = 6,300

Vesting period = 3 years

Service period completed = 3 years

Cumulative expense at end of year 3 = 6,300 x 3/3 = 6,300

Previously recognized expense = 5,600

Stock option compensation expense for year 3 = 700

The stock option expense for year 3 (700) is the difference between the cumulative expense at the end of year 3 (6,300) and the cumulative expense previously recognized in year 2 (5,600).

Stock Option Journal Entries – Year 3

The stock option expense journal entry for the year is recorded as follows

Stock option expense journal entry – Year 3

Dr.Stock option compensation expense 700

Cr.APIC – Stock options 700

The table below summarizes the stock option compensation expense for the three year vesting period.

Stock option compensation expense summary are as follows;

The total stock option compensation expense is 6,300 (900 x 7.00), and this has been allocated to the income statement over the vesting period in the following amounts, year 1 (3,500), year 2 (2,100) and finally year 3 (700).

Exercise of Options

After the options have vested the employees have the right to exercise their options and purchase shares in the business at the exercise (strike) price of 20.00.

Assuming all the options are exercised the increase in capital is calculated as follows.

Number of options exercised = 900 Exercise price / share = 20.00

Amount paid for shares = 900 x 20.00 = 18,000

The stock based compensation journal entries are as follows.

Increase in capital on exercise of the options

Dr.Cash 18000

Cr.Common stock 900

Cr.APIC – Common stock 17,100

The employees exercise their options and purchase the shares at the exercise price of 20.00 a share. The business receives cash of 18,000 and since the par value of the shares is 1.00 allocates 900 to common stock and the balance 17,100 to additional paid in capital (APIC).

Intrinsic Value

If the market value of each share at the exercise date is say 30.00 then the intrinsic value of the shares is calculated as follows.

Number of shares sold = 900 Market value / share = 30.00

Exercise price / share = 20.00

Market value = 900 x 30.00 = 27,000

Exercise price = 900 x 20.00 = 18,000

Intrinsic value = Market value - Exercise price Intrinsic value = 27,000 - 18,000 = 9,000