Question

On January 1, 2007 Brown issued 10 million stock options that would permit key executives to buy 10 million shares of the Brown’s $1 par value common stock at an exercise price of $15. The options vest after 5 years and expire in 15 years. The fair value of these options on the grant date was estimated at $4 each.

During 2010 Brown Company reacquired 15 million common shares as follows:

       2/1/2010       3 million shares at $10 each

       4/15/2010     4 million shares at $20 each

       6/1/2010       8 million shares at $30 each

On January 1, 2012 the stock price was $32 per share, and half the executives exercised their options. On Feb 1, 2013 the stock price was $45 per share, and the other half of the executives exercised their options.

Assume that Brown reissues treasury shares to executives that exercise options, and that it is using the first-in first-out cost flow method.

Required:

1. Prepare the journal entry for compensation expense in 2007.

2. Prepare the journal entries to record the shares repurchase during 2010.

3. Prepare the journal entries to record the exercise of the options on 1/1/2012 and on 2/1/2013.

Answer 1

1. Journal Entry for compensation expenses in 2007:

Calculation:

As nothing is mentioned in the question regarding the number of employees and number of option expected to vest, it is assumed that total number of stock option granted is 10 million.

Stock option compensation cost = Options * Fair value of option at grant

Stock option compensation cost = 10 million * $4 = $40 million

Since the vesting period is 5 years and one year of the service period (i.e, 2007) has now been completed the business calculates the stock option compensation expense for the year 2007 as follows:

Total stock option compensation = $40 million
Vesting period = 5 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 = $40 x 1/5 = $8 million
Previously recognized expense = 0
Stock option compensation expense for year 1 = $8 million

Journal Entry:

Stock option compensation cost Debit $8 million

To Additional Paid in Capital - Stock Option Credit  $8 million

(Being Stock compensation cost recognized)

2. Prepare the journal entries to record the shares repurchase during 2010.

During 2010 Brown Company reacquired 15 million common shares as follows:

(i) 2/1/2010       3 million shares at $10 each: Journal entries are as follows:

Treasury Stock (Debit) $30 million

To Equity Share holders Account (Credit) $30 million

(Being 3 million equity share capital bought back which has a par value of $1 per share. Treasury stock = 3 million share *$10=$30 million)

Equity Share holders Account  (Debit) $30 million

To Bank   (Credit) $30 million

(Being equity shareholders are paid for 3 million shares bought back)

(ii) 4/15/2010     4 million shares at $20 each: Journal entries are as follows:

Treasury Stock (Debit) $80 million

To Equity Share holders Account (Credit) $80 million

(Being 4 million equity share capital bought back which has a par value of $1 per share. Treasury stock = 4 million share *$20=$80 million)

Equity Share holders Account  (Debit) $80 million

To Bank   (Credit) $80 million

(Being equity shareholders are paid for 4 million shares bought back)

(iii) 6/1/2010       8 million shares at $30 each: Journal entries are as follows:

Treasury Stock (Debit) $240 million

To Equity Share holders Account (Credit) $240 million

(Being 8 million equity share capital bought back which has a par value of $1 per share. Treasury stock = 8 million share *$30=$240 million)

Equity Share holders Account  (Debit) $240 million

To Bank   (Credit) $240 million

(Being equity shareholders are paid for 8 million shares bought back)

3. Prepare the journal entries to record the exercise of the options on 1/1/2012 and on 2/1/2013.

Journal Entry on 1/1/2012:
Cash	Debit	$75 Million
Additional Paid in Capital - Stock Option (Balance amount)	Debit	$20 Million
Retained earnings (27+38, see working)	Debit	$65 Million
To Common Stock	Credit	$5 million
To Additional Paid in capital	Credit	$155 million
(Being 50% of 10 million stock option issued out of treasury stock on FIFO basis) Calculations: Cash paid = 5 million*$15 option price Common Stock= 5 million*$1 per share Additional Paid in capital= 5 million* (32 market value - $1 par value) Retained earning: As the stocks are repurchased are reissued for options vested, part of the interensic value (market value on vesting date - option exercise price) will go to retained earning. Calculation (shares are reissued on FIFO basis) is as follows: - Stock reissued out of lot purchased on 2/1/2010: 3 million share *($10 i.e. repurchase price - $1 par value)=$27 million - Stock reissued out of lot purchased on 4/15/2010: 2 Million shares * ($20 i.e. repurchase price - $1 par value)=$38 million

Journal Entry on 2/1/2013:
Cash	Debit	$75 Million
Additional Paid in Capital - Stock Option (Balance amount)	Debit	$25 Million
Retained earnings (38+87, see working)	Debit	$125 million
To Common Stock	Credit	$5 million
To Additional Paid in capital	Credit	$220 million
(Being 50% of 10 million stock option issued out of treasury stock on FIFO basis) Calculations: Cash paid = 5 million*$15 option price Common Stock= 5 million*$1 per share Additional Paid in capital= 5 million* (45 market value - $1 par value) Retained earning: As the stocks are repurchased are reissued for options vested, part of the interensic value (market value on vesting date - option exercise price) will go to retained earning. Calculation (shares are reissued on FIFO basis) is as follows: - Stock reissued out of lot purchased on 4/15/2010: 2 Million shares * ($20 i.e. repurchase price - $1 par value)=$38 million - Stock reissued out of lot purchased on 6/1/2010: 3 Million shares * ($30 i.e. repurchase price - $1 par value)=$87 million