Accounting for Stock Compensation

1. Accounting for Stock Compensation

2. Two Main Questions • How should compensation expense be determined? • Over what periods should compensation expense be allocated?

3. Terms • Stock Option • Grant Date • Vested Date • Exercise Date

4. Terms • Intrinsic Value Method – APB 25 • Fair Value Method – SFAS No 123

5. Fair Value Method • Estimate fair value of the options expected to vest on the date they are granted • Value of the option is based upon an option pricing model

6. Intrinsic Value Method • Total compensation cost is computed as the excess of the market price of the stock over the option price • on the date when both the number of shares to which employees are entitled and the option or purchase price for those shares are known

7. Allocating Compensation Expense • Compensation is recognized over the service period

8. Example • November 1, 2000, Kirk Company approve a plan - 5 executives options to purchase 2,000 shares each of the company's $1 par value common stock. • Options are granted on January 1, 2001 • May be exercised within next 10years. • The option price per share is $60, and the market price of the stock at the date of grant is $70 per share

9. Intrinsic Value Method Market value of 10,000 shares at date of grant ($70 per share) $700,000 Option price of 10,000 shares at date of grant ($60 per share) 600,000 Total compensation expense (intrinsic value) $100,000

10. Fair Value • Assume they use the Black-Scholes option pricing model results in a total fair value of $220,000

11. Journal Entries – Intrinsic Value Method • At date of grant 1/1/2001 – no entry • To record compensation for 2001 Compensation Expense $50,000 Paid in Capital – Stock Options $50,000 • To record Compensation for 2002 Compensation Expense $50,000 Paid in Capital – Stock Options $50,000

12. Intrinsic Value Method Cont. • To record the exercise of 20% of the shares on June 1,2004 (regardless of stock price Cash (2000x60) $120,000 Paid in Capital – Stock options 20,000 Common Stock $2000 Paid-in Capital in excess of Par 138,000

13. Journal Entries –Fair Value Method • At date of grant 1/1/2001 – no entry • To record compensation for 2001 Compensation Expense $110,000 Paid in Capital – Stock Options $110,000 • To record Compensation for 2002 Compensation Expense $110,000 Paid in Capital – Stock Options $110,000

14. Fair Value Method Cont. • To record the exercise of 20% of the shares on June 1,2004 (regardless of stock price Cash (2000x60) $120,000 Paid in Capital – Stock options 44,000 Common Stock $2000 Paid-in Capital in excess of Par 162,000

15. Note • Generally, the stock option price is greater than the market price of the shares • Therefore, using the intrinsic value is $0 • So no compensation expense is recorded

16. What to do???? • While SFAS 123 recommends the fair value method, it is not required.

17. Another Example University Corp

18. Disclosure • To comply with SFAS you must disclose the impact of the fair value method – • Gateway F/S

19. Theory - Neutrality • Economic consequences issue • FASB believes the neutrality concept should be followed – others disagreed

20. The Debate • June 1993 – Exposure Draft • Reaction • Equity Expansion Act of 1993 • Late 1994 • Recently

21. Boeing

22. Tax Issues • Incentive Plan - Qualified Plans favorable tax treatment to the executive – employer receives not tax deduction for compensation – no deferred tax consequences • Nonqualified plan offers favorable tax treatment to the employer – deduct the difference between exercise price and market price at the exercise date