Question

Clara Corp. is a publicly traded entity. On January 1, 20X3, it is trying to decide whether
to grant equity-settled stock options or cash-settled share appreciation rights (SARs) to
its employees. Its bank loan has a debt-to-asset covenant that must be maintained and
the board of directors is concerned about the impact these compensation plans will
have on this covenant. The directors are considering two alternatives as described
below:

1. Grant 20,000 equity-settled stock options to its management team. Relevant
information is as follows:
• The exercise price is $45 per share, which is the same as the share price on the
date the options are granted.
• The options vest three years after the grant date and expire on December 31,
20X9. Any employee that leaves during the vesting period forfeits their options.
• The fair value of the options on the date of the grant is $2.60 per option.
The company expects that 10% of the options will be forfeited throughout the vesting
period. The fair value of the options at December 31, 20X3, is expected to be $2.90
each.

2. Grant 20,000 cash-settled SARs to its management team. The benchmark price will
be $45. The SARs must be exercised by December 31, 20X5. The same forfeiture
rates are expected as for the stock options. The fair value of each SAR at
December 31, 20X3, is expected to be $11.00.
At December 31, 20X3, the company’s year end, Clara is expected to have total debt
and asset balances of $160,000 and $300,000, respectively.

Required:
a) Prepare the journal entries for 20X3 for the stock option alternative. Calculate the
forecasted debt-to-asset ratio under this alternative.

b) Prepare the journal entries for 20X3 for the SARs alternative. Calculate the
forecasted debt-to-asset ratio under this alternative.

c) Recommend whether Clara should issue stock options or SARs to its management
team. (1 mark)

Answer 1

a) Journal Entries for 20X3 for stock option alternative

Numbers of options grant = 20000

Option vest after 3 years

Fair Value as on grant date= $ 2.60

Fair Value at December 31,20X3= $ 2.90

Forfieted in 3 years= 10% i.e. 20000*10%*1/3= 667

Management Benefit expenses= (20000-667)*$2.60*1/3= $16755

Journal Entry will be

1. Management Benefit Expenses a/c Debit $16755

Share Based payment reserves a/c Credit $ 16755  

( Being 1/3rd of the expected vested equity share value)

2. Profit and Loss a/c Debit $ 16755

Management benefit expenses a/c $16755

( Being Management benefit expenses transfered to Profit & Loss account

Debt to asset ratio

Debts= $160000+$16755= $176755

Asset= $300000

Ratio= $176755/$300000= 0.5891

b) Journal Entries for 20X3 for SAR alternative

Number of Options= 20000

Forfeit options= 20000*10%*1/3= 667

Fair value of each SAR as at December 31,20X3= $11 per SAR

Management Benefit expenses= (20000-667)*$11*1/3= $70888

Journal Entry will be

1. Management Benefit Expenses a/c Debit $70888

Share Based payment reserves a/c Credit $ 70888  

( Being Fair value of SAR recognised)

2. Profit and Loss a/c Debit $ 70888

Management benefit expenses a/c $ 70888

( Being Management benefit expenses transfered to Profit & Loss account

Debt to asset ratio

Debts= $160000+$70888= $230888

Asset= $300000

Ratio= $230888/$300000= 0.76963

c) Clara Corp should issue Stock option to Management team since this option has more favourable Debt to Asset Ratio.