Question

On January 2, 2017, Dwyer Corporation granted 10,000 nonqualified stock options each to four of its key executives (40,000 options in total). Under the terms of the option plan, upon exercise, each executive will pay the exercise price of $10 per share of common stock ($1 par value). The options were exercisable after January 1, 2020, and the executives were required to be employees of Dwyer at the date of exercise. The Black–Scholes value of the option on the grant date is $12.50. Three employees exercised options for 30,000 shares of stock on January 2, 2021. Dwyer has a tax rate of 35% in all years. Relevant dates and stock prices are as follows:

January 2, 2017	$	10
December 31, 2017		19
December 31, 2018		28
December 31, 2019		45
December 31, 2020		26
January 2, 2021		26
December 31, 2021		25

Required:

Prepare the compensation expense and related tax journal entries from 2017 to 2019.

Prepare the journal entries required to record the stock option exercise on January 2, 2021. Include the journal entries to record the tax effects.

Prepare a schedule to show how the January 2, 2021, option exercise affects Dwyer’s 2021 income tax expense.

Answer 1

Compensation cost is the Fair value of service represented by the fair value of the option granted in return of the service.

In this case fair value of service is the price of the share at the grant date i.e $12.50

Calculation of compensation expense for vesting period of 3 years: = Number of option * Fair value of option at grant = 40000*$12.50 = $ 500000

Compensation expense for 1 year = $500000/3= $166,667

Employee Stock option compensation expense is non cash expense and thus is not allowed as deduction for tax purposes.

Thus the difference between accounting income and Tax Income will lead to creation of deferred Tax Assets for $166667*35%= $58,333 per year

Total Deferred tax asset Created for 40,000 stocks = $58,333*3 = $175,000

Journal Entry for each year 2017- 2019

Recording Compensation expenses in books of accounts:

Stock Expense Compensation Account Dr $166,667

APIC- Stock Option Cr $166,667

APIC- Additional Paid In Capital ( Part of total Equity of business)

Recording Deferred Tax assets:

Deferred Tax Asset Dr $58,333

Income Tax Expense Cr $58,333

Calculation on Exercise Date:

No of shares exercised * exercise price = 30000* $10= $300,000

Cash Dr $300,000

Current Stock Cr $30,000

APIC-Common Stock Cr $270,000

Journal entry for Tax effect : Year 2021

Income Tax Expense Payable Dr $131,250

Deferred Tax Asset Cr $131,250

Effects on Income Tax Expenses

Deductible tax Expenes : Market value- Exercise price = $26-$10 = $16

Number of stock exercised = 30,000.

Deductible tax expense =30000* $16 = $ 480,000

Tax benefit available = $480,000*35% = 168,000

Deferred tax created in books for 30,000 Shares = ($58333*3)*30,000/40,000 = $131,250

As tax benefit available is more than the deferred tax created in books of accounts for 30,000 Stocks , Year 2021, Tax expense payable will be reduced by $131,250.