Question

Communication Case 19–2 Stock options; basic concepts; prepare a memo

You are assistant controller of Stamos & Company, a medium-size manufacturer of machine parts. On October 22, 2017, the board of directors approved a stock option plan for key executives. On January 1, 2018, a specific number of stock options were granted. The options were exercisable between January 1, 2020, and December 31, 2024, at 100% of the quoted market price at the grant date. The service period is for 2018 through 2020.

Your boss, the controller, is one of the executives to receive options. Neither he nor you have had occasion to deal with GAAP on accounting for stock options. He and you are aware of the traditional approach your company used years ago but do not know the newer method. Your boss understands how options might benefit him personally but wants to be aware also of how the options will be reported in the financial statements. He has asked you for a one-page synopsis of accounting for stock options under the fair value approach. He instructed you, “I don’t care about the effect on taxes or earnings per share—just the basics, please.”

Required:

Prepare such a report that includes the following:

1.   At what point should the compensation cost be measured? How should it be measured?

2.   How should compensation expense be measured for the stock option plan in 2018 and later?

3.   If options are forfeited because an executive resigns before vesting, what is the effect of that forfeiture of the stock options on the financial statements?

4.   If options are allowed to lapse after vesting, what is the effect on the financial statements?

Answer 1

Before we get into problem solving let us first understand the concept of Employee Stock option and related terminology

Stock option compensation is a form of equity based compensation which the organizations grants it to its key employees by granting them a right to purchase the shares in the organization in return for their services. The holder of the option has the right to acquire the stock of the company at a future date. it is important to understand that the stock options are not shares but a right to purchase the shares of the company.

Grant Date - is the date on which the options are granted.

Vesting Date - The date on which the rights to exercise the stock options are obtained. The difference between the Grant date and Vesting Date is called Vesting Period.

Exercise Date - The date on which options are exercised and shares are purchased.

Since options are a form of compensation provided to employee it should be expensed basis their fair value. Like for example in case salary paid, the salary is the reflection of the fair value of the services provided by employee similarly stock option also needs to be expensed on the fair value basis.

Now as per the guidelines issued in SFAS 123

1. Stock option measurement should be done on the date of Grant basis the fair value of option. And with an assumption that the option is already vested. Hence total value of option is total number of option granted multiplied by fair value of one option. On the date of grant the option value is recognized as a liability for stock option along with a deferred (unearned) compensation asset as per SFAS 123. The liability recognized is contingent in nature since on the grant date the liability is not incurred but an option is given to employees.

2. The deferred compensation shall be expensed over the vesting period which is generally the service period. Hence in the given example the options were granted on 1 Jan 18 and the exercise rights are from 1 Jan 20 hence the vesting period is 2 year i.e. From 1 Jan 18 to 31 December 19. Say the total value arrived is $100 then $50 shall be expensed in each year. Also the liability shall be remeasured for the fair value of the liability and the effect of the same shall be accounted for. Say for example at the grant date the value of liability/option was $100 but the value at the balance sheet date 31 December in current question is $120, 20 shall be accounted for as Unrealized loss on Stock option in line with SFAS 123R.

3. When the options are forfeited before the the vesting because of employee leaving the organization after the accounting value of the option is already accounted for, in this situation the accounting treatment shall be reversed by passing a credit entry to employee compensation expense account equal to the amortized portion of the accounting value of the lapsed options as well as a credit to deferred employee compensation expense equal to un-amortized portion with the corresponding impact on Employee stock option liability. This is done because the expense charged already and lying in deferred expense as well as liability will no longer be needed.

4. If the options are lapsed after vesting unlike in part 3 the expense already incurred in previous periods shall not be reversed but the employee stock options outstanding shall be reversed/debited to the tune of vested options with credit to Employee compensation expense.