Question

a. describe the accounting treatment for employee stock options under the fair value method (SFAS 123 R: share based payment)
b. what is the reason for applying stock dividends and stock split events retroactively in calculating the earnings per share?

Answer 1

Answer a. The compensation expense is computed based on the fair value of the options on the date the options are granted to the employees. SFAS No. 123(R) requires firms to recognize the fair value of stock options as compensation expense over the vesting period of the options

Answer b. The retroactive assumption is a sound approach because:

1.In contrast to new issues and treasury share purchases, stock dividends and stock splits do not change cash or net assets. That is, stock dividends and stock splits do not change the economic resources available to generate income. As a result, including the additional shares on a retroactive basis does not mismatch the numerator and denominator of the EPS fraction.

2.It results in stating the shares before and after a stock dividend or split on the same basis. Financial statement users can therefore compare changes in EPS over time.

3.The retroactive assumption prevents management manipulation of EPS by the timing of stock dividends and stock splits.