Question

At the beginning of the first year, the Olympic company issued 10,000 stock options to an executive at an exercise price of US $ 45 (convertible to 10,000 ordinary shares), provided that the executive met the performance requirements and served for 3 years. On the grant date, the estimated fair value of the stock option with an exercise price of $ 45 is $ 15. If the exercise price is $ 25, the estimated fair value of the option is $ 31. If the revenue of the Olympic company grows at an average annual rate of 15% within three years, the execution price will be reduced to $ 25.
In the first year, the company's earnings increased by 16%, and it is expected to continue to grow at this rate in the next two years. In the second year, the company's profit increased by only 3%, the company does not expect the profit target to be achieved. In the third year, the company's earnings increased by 4%. The supervisor completed three years of service and therefore met the performance requirements.

Required:

1. a) Prepare journal entries for Year 1 to Year 3 relating to compensation expense.

2. b) The executive exercised half of the share options on 3 January of Year 4. The executive did not exercise the remaining share options and the right is lapsed in Year 4. Prepare all journal entries for Year 4 relating to the share options.

Answer 1

At the end of Year one

Since the profits of the company crossed 15% ,the company would assume that it should issue the shares at 25 and the market price shall be 31

So a discount of $ 6 is allowed to the executives.On the other hand if the same is sold to public at $31..So the compensation that company has to bear is $6 per share.So total compensation will be $60,000($6*10000)to be borne over 3 years.So compensation to be borne in current year will be $20,000($60000/3)

Journal in Year 1

Employees Compensation Expense A/c Dr 20,000

To Employees Compensation Outstanding Expense A/c 20,000

(Being compensation exepnses recognises on account of ESOP)

Profit & Loss A/c Dr 20,000

To Employees Compensation Expense A/c 20,000

(Being expenses transferred to Profit and Loss A/c at the end of the year)

At the end of Year Two

The company earns a profit of 3%,thus average profit will be 9.5% (16+3/2) which is below the 15% so the campany shall issue shares at $45 to the employees.Since the excercise price is greater than market price which is $ 15.This is a case of underwater stock option and no employee compensation on account of ESOP may be recognised this year

At the end of Year Three

The company earns a profit of 4% in year 4 making the average profit rate to 7.67%(16+3+4/3),which is below the 15% so the campany shall issue shares at $45 to the employees.Since the excercise price is greater than market price which is $ 15.This is a case of underwater stock option and no employee compensation on account of ESOP may be recognised this year.

Excercising Year - Year Four

Since the ESOP is excercised at a price higher than market price there is no question of Employee Compensation Expense Recognition.Since the stock is excercised at a value higher than market price,the company will account for the premium.Premium=(Excercise price per share-Fair Value per share)*ESOP excercised

=>(45-15)*5,000=150,000

Journal

Bank A/c Dr.225,000

To Stock Capital(15*5000) 75,000

To Premium on Issue of Stock 150,000

(For ESOP excercised)

At the end of excercising the outstanding compensation expense reserve created in first year is transferred to securities premium.

Journal

Employees Compensation Outstanding Expense A/c Dr 20,000

To Securities Premium A/c 20,000

(For outstanding compensation expense reserve created in first year is transferred to securities premium.)