Question

XYZ Company has 70 executives to whom it grants compensatory share options on January 1, 2013.
The plan grants each executive options to acquire a maximum of 100 shares of the
company's $5 par common stock at $50 per share after completing three years of continuous
service. However, the number of options that vest depends on the increase in the company's market
share over the three year period. The following schedule shows the number of options granted
to each executive based on the increase in market share by the end of the service period:

Increase in Market Share Number of Share Options Granted
o to 4% 40
5 to 8% 60
More than 100

Based on past trends, on the grant date XYZ predicts that its market share will increase
about 3% by the end of 2013. At the end of 2014, due to improved market position over the previous
two years, XYZ revises this estimate to 7%. At the end of 2015, XYZ determines that
its market share has increased 9% over the three year period.
On the grant date, XYZ Company estimates that (1) the fair value of each option is $16.25,
and (2) its employee turnover rate will be 9% per year over the service period. At the end of
2014, because of increased resignations, Connors changes its estimated turnover rate to 12% for
each year in the service period. At the end of 2015,59 executives vest in the plan. On
January 17, 2016, 30 executives exercise their options when the stock is selling for $68
per share.
Required
1. Prepare a schedule of the XYZ Company's compensation computations for its compensatory
share option plan for 2013 through 2016. Round to the nearest dollar.
2. Prepare the journal entries of XYZ Company for 2013 through 2016 in regard to this plan.
3. Show how the account(s) related to the plan is(are) reported in the stockholders'
equity section of XYZ Company's balance sheet on December 31,2014.
4. Do you see a problem with your answer to Requirement 3 and the eventual value of the
vested stock options? How might this problem be avoided?

Answer 1

On the date of grant, Jan 01 2013:

No entry to be recognised

At the end of 2013:

Stock option expense will be recognised assuming 1 year out of total 3 years of vesting period has been lapsed-

Total number of executives (70 x 91%) as employee turnover rate is 9%=63.7=64 (rounded off)

Total number of shares available assuming market share 3%=40 per executive

Fair value= $16.25

Period lapsed= 1 year

Total vesting period= 3 years

Expenses already booked = 0

Formula= [(64 x 40 x 16.25) 1/3] - 0 = $13867 expense to be booked at the end of year 13

Employee stock benefits A/c Dr. 13,867

To, Employee Stock Option A/c 13,867

At the end of 2014:

Stock option expense will be recognised as 2 years out of total 3 years of vesting period has been lapsed-

Total number of executives (64 x 88%) as employee turnover rate is 12%= 56 (rounded off)

Total number of shares available assuming market share 7%=60 per executive

Fair value= $16.25

Period lapsed= 2 years

Total vesting period= 3 years

Expenses already booked = 13,867

Formula= [(56 x 60 x 16.25) 2/3] - 13,867 = $22,533 expense to be booked at the end of year 14

Employee stock benefits A/c Dr. 22,533

To, Employee Stock Option A/c 22,533

At the end of 2015:

Total number of executives = 59

Total number of shares available assuming market share 9%= 100 per executive

Fair value= $16.25

Period lapsed= 3 years

Total vesting period= 3 years

Expenses already booked = 13,867+22533 = $36,400

Formula= [(59 x 100 x 16.25) 3/3] - 36,400 = $59,475 expense to be booked at the end of year 15

Employee stock benefits A/c Dr. 59,475

To, Employee Stock Option A/c 59,475

On January 17, 2016:

Total executives who exercised the option=30

Assuming each of them received 100 shares

Exercise price = $50

Face value of share = $5

Market price = $68

For the amount received from the employees who finally exercised their option:

Bank A/c Dr. (30x100x50) 150,000

To, Employee Stock Option A/c 150,000

For allotting the additional share capital under ESOP scheme:

Employee Stock Option A/c Dr. [(30x100)x68] 204,000

To, Share capital A/c (30x100x5) 15,000

To, Securities premium A/c (balancing figure) 189,000

For expenses to be cancelled:

Employee Stock Option A/c Dr. (net balance in the account) 41,875

To, General reserve 41,875

Answer to point no.3:

Two entries have been posted till date:

Employee stock benefits A/c Dr. 13,867

To, Employee Stock Option A/c 13,867

Employee stock benefits A/c Dr. 22,533

To, Employee Stock Option A/c 22,533

Employee stock benefits A/c is an expense account which would have reduced the profit by a total of $36,400

Employee stock option account is a liability account which will form part of shareholder's equity.

Answer to point no.4:

The eventual value of vested stock option is 30x100x18(Intrinsic value)=54,000

Every year 18,000 expense should have booked but we can see the fluctuation in this because of difference in targeted number and actual number. This problem could have been avoided by bridging this gap.