Stock options

Question 1

Stock option plans

do what

Answer 1

give employees the option to buy

1. a specified *number of shares of the firm’s stock,
2. at a specified *exercise price,
3. *during a specified *period of time

Question 2

compensation expense

Answer 2

1. accrued at fair value of stock option
2. expensed over service period when participants receive benefits. from date of grant–> when exercisable ( vesting date)

Question 3

when are options exercisable

Answer 3

Vesting date

Question 4

option pricing models

Answer 4

How compensation expense be measured/recognized

1. Exercise price of the option.
2. Expected term of the option.
3. Current market price of the stock.
   4. Expected dividends.
4. Expected risk-free rate of return.
   6. Expected volatility of the stock.

Question 5

Calculate total compensation expense:

Answer 5

estimated fair value per option x options granted

= total compensation

Question 6

journal entry for compensation expense

• dr what
• –cr what

Answer 6

Compensation expense ($80 million ÷ 4 years)20	
             Paid-in capital – stock options                     20

Question 7

estimated forfeit in beginning

Answer 7

($80 × 95%) ÷ 4

total expense X amount not forfeited ) ÷ service period

Question 8

Revised its estimate of forfeitures in middle

Answer 8

3rd year
you do it as it should have been done each year MINUS what you already accrued
1. revise total estimate
2. journal entry for period reflects change

Question 9

Journal entry

Revised its estimate of forfeitures in middle

Answer 9

3rd Year = $16M = ($80 mill x 90% x ¾) – [$19 + 19])
4th Year = $18M = ([$80 mill x 90% x 4/4] – [$19 + 19 + 16])

Question 10

WHEN OPTIONS ARE EXERCISED

Answer 10

Not all shares have to be excised.

market value in period of exercise DOES NOT MATTER

cash is excersise amount, value at grant

P.i.c/ stock option= option price X amt

Question 11

Exercising Stock Options

journal entry

Answer 11

Cash ($35 exercise price x 5 mill shares) 175
Paid-in capital - stock options 40
Common stock (5 mill at $1 par ) 5
Paid-in capital – ex of par 210

Question 12

WHEN VESTED OPTIONS EXPIRE WITHOUT BEING EXERCISED

Answer 12

you credit paid in capital
expiration of stock options

K.I.M at the option price

Question 13

Journal entry

expiration of stock options

Answer 13

Paid-in capital – stock options (account balance) 80

Paid-in capital – expiration of stock options 80

Question 14

Plans with Performance Conditions

Answer 14

1. we record compensation depends on whether or not we feel it’s probable the target will be met

a. not–> no record
b. when it is probable–> cummulative expense for that period

Question 15

Performance Target Example

Answer 15

An option may not be exercisable until a performance target is met.The target could be:

• Divisional revenue,
• Earnings per share,
• Sales growth or
• ROA.

Question 16

Market-related Targets: examples

WHATS the difference

Answer 16

• A specified stock price;
• A stock price change exceeding a particular index;
• *we recognize compensation expense regardless of when, if ever, the market condition is met.

Meaning, no special accounting is required!!

Question 17

Plans With Graded-Vesting

Answer 17

1) The company may estimate a single fair value for each of the options, even though they vest over different time periods, using a single weighted-average expected life of the options.
2) In this approach, we view each vesting group separately, as if it were a separate award.

For example, a company may award stock options that vest 25% in the first year, 25% in second year, and 50% the third years.

For accounting purposes we have three separate awards.

Question 18

U.S. GAAP vs. IFRS

Answer 18

One major difference is the treatment of deferred tax assets and when options have graded-vesting

Fasb:on the straight-line basis over the entire vesting period.

IFRS:Straight-line choice is not permitted. Companies not required to recognize the award that has vested by each reporting date.

Question 19

Tax consequence of stock option plans

Answer 19

1. either qualify as “incentive stock option plans” under

the IRS code or as 2. “nonqualified plans”

Question 20

qualified plan stock option plan

Answer 20

1)Under a qualified plan, option recipients (employees) pay no income tax until any shares
acquired from the exercise of stock options are subsequently sold, but the company issuing the
stock options does not get a tax deduction

2)Because accounting recognizes an expense related to the stock options when the tax code
does not allow the same recognition, a **permanent difference is created

3)No additional entries are required from those previously discussed.

Question 21

unqualified plan stock option plan

Answer 21

Under a nonqualified plan, option recipients cannot defer the payment of taxes (must pay when
the options are exercised), but the company may take a deduction equal to the difference
between the exercise price and the market price at the exercise date.

Question 22

when and why is a DTA created

Answer 22

Unqualified Plan
Accounting recognizes the expense as soon as options are granted.

Taxes recognizes expenses when they are excercised

Question 23

exercise price

Answer 23

The exercise price is the market price of

the shares on the date of grant

Question 24

Employee Share Purchase Plans

Answer 24

compensation expense is recorded.

discount is recorded as compensation expense

Question 25

Employee Share Purchase Plans Employees may buy 100 shares of no par stock for $8.50 per share. The current market price is $10.00.

Answer 25

``` Cash (100 × $8.50) 850 Compensation expense (100 × $1.50) 150 Common stock (100 × $10.00) 1,000 ``` The discount is the compensation expense

Question 26

exercise price be equal to the market price at the grant date

Answer 26

incentive stock option plan” (qualified) | permanent difference, no change, nothing different done

Question 27

permitted to deduct the difference between  the exercise price and the market price at the exercise date

Answer 27

nonqualified plans

Question 28

U.S. GAAP DTA

Answer 28

A deferred tax asset (DTA) is created for the cumulative amount of the fair value of the options the company has recorded for compensation expense.

Question 29

IFRS DTA

Answer 29

The deferred tax asset is not created until the award is “in the money;” that is it has intrinsic value

Question 30

``` Record initial DTA Unqualified plan with 40% tax bracket. Option price= 8$ exercise price= 35 10 million shares, 1 par ```

Answer 30

December 31, 2013, 2014, 2015, 2016 ($ in millions) ``` Compensation expense ($80 million ÷ 4 years) .......... 20 Paid-in capital—stock options .................. 20 ``` Deferred tax asset (40% × $20 million) ................. 8 Income tax expense ....................... 8

Question 31

``` Unqualified plan with 40% tax bracket. Option price= 8$ exercise price= 35 10 million shares, 1 par ***what is the after-tax effect on earnings ```

Answer 31

The after-tax effect on earnings is thus $12 million each year ($20- 8)

Question 32

``` Unqualified plan with 40% tax bracket. Option price= 8$ exercise price= 35 10 million shares, 1 par ****Options exercised when the tax benefit below the deferred tax asset:**** ```

Answer 32

DR: Income taxes payable [($40 – 35) × 10 million shares × 40%] ............... 20 DR: Paid-in capital—tax effect of stock options or retained earnings† (remainder)................... 12 CR: Deferred tax asset (4 years × $8 million) ............. 32

Question 33

Unqualified plan with 40% tax bracket. Option price= 8$ exercise price= 35 10 million shares, 1 par ****Options exercised when the tax benefit exceeds the deferred tax asset:**** If the market price on April 4, 2018, is$50per share:

Answer 33

DR: Income taxes payable [($50 – 35) × 10 million shares × 40%]... 60 CR: Deferred tax asset (4 years × $8 million) . 32 CR: Paid-in capital—tax effect of stock options 28(remainder)*.....

Question 34

Stock Options; Graded Vesting; Separate Valuation Approach

Answer 34

vesting is only on the amount of shares X the fv per option

Question 35

PLANS WITH PERFORMANCE CONDITIONS Let’s say we initially estimate that it is probable that sales will increase by 10% after four years. Then, our initial estimate of the total compensation would have been unchanged at: then that after two years, we estimate that it isnot probable that sales will increase by 10% after four years

Answer 35

``` If it later becomes probable that a performance target will notbe met, we reverse any compensation expense already recorded. ```