Question

January 2010, Gigabyte Inc. granted 10,000 "at the money" employee stock options (i.E the exercise price was equal to the stock price on the grant date.) to align the compensation of the employees with financial performance of the company, the award will vest only if cumulative revenue over the following three year reporting period is greater than $100 million and if they are still employed. as of the date of the grant, management believe it is probable that the company will achieve cumulative revenue in excess of 100 million over the next three year period.

Each award has a grand - date fair value of $15. Gigabyte's valuation professionals have indicated that if the revenue target was factored in to the fair value assessment, the grant date fair value would be $10

gigabyte adopted ASC 718. Revenue in each of the next three years was as follows:

2010 : $30 million.

2011: 30 million

2012: 40 million

Required:

1. should gigabyte use the $10 grand date fair value or the $15 grand date fair value to measure it's compensation cost? citation from ASC is required to support the conclusion.

2. over how many years should gigabyte recognize compensation cost associated with stock options? and how much, if any, should be recognized in each off those years? the effects of forfeitures and income taxes should be ignored. citation from ASC is required to support the answer.

3. how would the year 2 accounting change if management determined that the performance condition of cumulative revenue in excess of $100 million over the three year period was improbable of achieving on Dec 31, 2011? what would be the cumulative amount of compensation cost recognized? Citation from ASC is required to support your conclusion

Answer 1

Since Gigabyte's valuation professionals have indicated that if the revenue target was factored in to the fair value assessment, the grant date fair value would be $10. Hence Gigabyte should use $10 grand date fair value irrespective of its own valuation of grant date fair value of $15.

The SEC staff in Section 718-10-S99 acknowledges that fair value estimates cannot predict actual future events and provides comfort to companies that, so long as the estimates are made in good faith, they will not be subsequently questioned no matter what the actual outcome. The SEC staff will not object to a company's choice of option-pricing model provided it meets Topic 718's three-pronged requirements that the valuation technique (1) is consistent with the fair value measurement objective, (2) is based on established principles of financial economic theory, and (3) reflects all substantive characteristics of the award. So long as fair value estimates are prepared by a person with “requisite expertise,” it is not a requirement that companies must hire an outside third party to assist in the valuation

As per ASC 718, Compensation cost recognized to date must be at least equal to the measured cost of the vested tranches. In this question fair value of option will be $10. Hence total compensation expense will be $100,000 (10000 x 10). It will be charge equally over 3 years i.e. compensation expenses $33,333 per year.

if management determined that the performance condition of cumulative revenue in excess of $100 million over the three year period was improbable of achieving on Dec 31, 2011, then cumulative amount of compensation remains at $33,333. Compensation cost should not be reversed. And no compensation cost should be recognized in second year.

As per paragraph 718-10-35-3, compensation cost recognized before December, 2011, would not be reversed until the award is forfeited. However, company would be required to assess at the date of the modification whether the performance or service conditions of the original award are expected to be satisfied.