Question

On November 1, 2018, London Corp. adopted a stock option plan allowing certain of their executives to purchase a total of 30,000 common shares. The options were granted on January 2, 2019, and were exercisable four years after the grant date (Jan 2, 2023), as long as the executives were still employees. The options expire eight years from the grant date. The exercise price was set at $ 46 and, using an option pricing model to value the options, the total compensation expense was estimated to be $ 510,000. At January 2, 2019, the market price of the shares was $ 50.

On January 1, 2020, 3,000 options were terminated (forfeited) when an employee left the company. The market value of the shares at that date was $ 32. All the remaining options were exercised during 2023: 17,000 on January 3 when the market price was $ 62, and 10,000 on May 1 when the market price was $ 77.

Instructions

a)      Calculate the intrinsic value and the time value of the stock option.

b)      Prepare journal entries relating to the stock option plan for the years 2019 through 2023. Assume that the employees perform services equally from 2019 through 2022. Year end is December 31.

c)       Discuss the advantages and disadvantages of offering stock options to employees as a means of compensation.

Answer 1

To Solve this Problem we need to first understand the Concept of ESO (Employee Stock Option Plan) Commnly known as Stock Option. It (ESO) is a type of Compensation granted by Companies to its employees & executives. Rather than giving shares directly the company gives derivates option on the stock instead. These options come in the form of regular call options and gives the employee the right to buy the company's stock at a specified price for a finite period of time

It is benfitial for the employee/executive once company's stock price rises above the "Exercise Price". ESOs are issued by the company and cannot be sold. When a Stock's price rises above the call option exercise price, call options are exercised and the holder obttains the companys stock at a discount. To book the profit holder may choose to immediately sell the stock in the open market for a profit or hold onto the stock over the period.

Few Key Definition associated with this are as follows.

1) The Grantee ( i.e. Employee/Executive of the Companyalso known as Optionee)

2) The Grantor (i.e. Employer/Company )

3) Vesting Period :- It is the Length of Time that an employee must wait in order to be able to exercise their ESO option. In other words it is the time for the employee or executive to perform well and stay with the Company. You can also say that it is compensation paid by the company to retained the employee. Vesting Follows a Pre-determined schedule that is setup by the company at the time of the option grant.

4) Vesting :- It means it is the time allowed by company to exercise the options and purchase the company's stock . Note that the stock may not be fully Vested when purchased with an option in certain cases, despite excerise of the stock options, as the company may not want to run the risk of employees making a quick gain (by exercising their options and immeditely selling there shares) and subsequently leaving the company.

5) Intrisic Value & Time Value :- Time Value depends on the amount of time remaining until expiration (i.e. the Date When ESO expires (generally 10 years times) here 8 years time ) . On the Other Hand Intrinsic Value Means difference between Stock Market Price & ESO Exercise Price. It never be Negative. If Exercise Price is more than its Market Price then the Intrinsic Value of such ESO is 'ZERO ' (i.e. 0). Time alue can be determined as the difference between Intrinsic Value & Fair Value of the ESO.

Accordingly.....

First we calculate Intrinsic Value as follows.

Intrinsic Value = Market Price - Exercise Price.

= $ 50 - $ 46 ($ 50 was the Market Price on 02.01.2019 & $ 46 was the Exercise Price)

= $ 4

Therefore Time Value calculated as follows.

Time Value = Intrinsic Value - Calculated Fair Value of ESO

= $ 4 - $2 (Assume )

= $ 2

The Advantages & Disadvantages of ESO are as follows.

Advantages :-

1) It is an Opportunity to share directly in the Companye's sucess through Stock Holdings (employee can became the owner of the company).

2) Employees may feel motivated to be fully productive because they own a stake in the Company i.e Pride of Ownership.

3) Provides a Tangiable Representation of How much their contribution is worth to that employer. (Employee can check its contribution of increasing its wealth )

4) Depending upon the scheme it may offer substantial tax savings upon sale or disposal of the shares.

Disadvantages

1) Employer always feel insecure about the employees behaviour and hence it enhaces Vesting Periods.

2) It is (ESO Scheme) is an alternative to Cash Incentive & Bonus hence it takes more time to realised its gain to employees. Hence employee hesitate to participate in the scheme.

3) If the scheme is not properly formulated it will be a tax burden to both emloyee as well as employer.

4) In case of Global economy the ESO scheme may be tax free in one county but it is taxable in other country hence it is not advisable for all locations.

Journal Entries are as follows after taking into account following Points.

1) As the Company Granted the rights on 02.01.2019 there were no entries.

2) When the Employees exercise its right then the entries were made (i.e after 4 years in this case on 02.01.2023)

3) As the Stock Option is an expense for the company the account will be debited by $ 46 per share

4) if the company makes the provision of ESO of all companies at 31st December 2019 assuming all employees opt for the option and none will left the company during the vesting period the provision should be made on full 30000 shares @ $ 46 per share.

5) After above provision of $1380000 if any employee left the organisation then between vesting period then company should reverse its provision proportionately. And the provision for the rest will be made accordingly.Hence above Provision of $ 138000 should be reversed on 31.12.2000

6) As Remaining (i.e. 30000-3000=27000 employees ) exercise its rights to enroll in to the scheme no sale entry were made and all shares were allotted to the employees.

Following are the related Journal Entries.

(Amount in $)

Date Particular Amount (Dr)     Amount (Cr)

31.12.2019 Employee Salary Account 1380000

Employee Stock option Payable A/c 1380000

( Provision of 30000 employees made @ $ 46 per share)

31.12.2019 Profit & Loss A/c 1380000

Employee Salary Account 1380000

(Expenses transfer to Profit & Loss Account)

31.12.2020 Employee Stock Option Payable A/c 138000

Employee Salary A/c    138000

( Provision of 3000 left employees reversed)

31.12.2020 Employee Salary Account 138000

Profit & Loss Account    138000

( Earlier Expenses Reversed to the extent of left employees)  

03.01.2023 Employee Stock option Payable A/c 782000

Share Capital Account 782000

(17000 shares allotted to employees @ $ 46 per Share)

01.05.2023 Employees stock Opt Payable a/c 460000

Share Capital Account    460000

( 10000 shares allotted to employees @ $ 46 per share)