In: Accounting
Smaller Corporation has been in operation for several
years. Each year, around the holidays, Smaller gives a cash bonus
to each of its employees and records the bonuses as compensation
expense. Smaller has reached the point at which it is now making a
reasonable return on its shareholders' equity. At the end of the
current year, the company president is considering establishing a
compensatory share option plan for Smaller's key executives,
instead of paying cash bonuses to any of its employees. At this
time, the market price and the planned option (exercise) price of
the company's common stock are the same. The plan would allocate a
specified number of options to each executive based on the
executive's level within the company and meeting Smaller's targeted
income goals. The service period would be 3 years and the options
would have to be exercised within 10 years. You are the controller
for Smaller and one of the key executives who would participate in
the plan. You also already own a substantial number of shares of
Smaller common stock. The company president comes to you for advice
about this plan and says, “If Smaller establishes this plan, it
will work out for all of us. It looks like the plan is pretty
valuable, since an option pricing model shows a high fair value for
each option. The corporation will be saving cash because it won't
have to pay bonuses to either the executives or the other
employees. But executives will manage better because their share
options will depend on meeting the company's targeted income.
Because the market price and the option price are the same, there
won't be any compensation cost or expense related to this plan.
Furthermore, since no bonuses would be paid to any employees, the
corporation will decrease its compensation expense. This will
increase its net income and earnings per share compared to last
year, as well as its return on shareholders' equity. So the stock
value will go up. This seems like a win-win situation for everyone.
Am I right on this?” Do you think Smaller should adopt this
compensatory share option plan?
Required: From financial reporting and ethical
perspectives, how would you reply to the president?