Accounting for Stock Compensation

Two Main QuestionsHow should compensation expense be determined? Over what periods should compensation expense be allocated?

TermsStock OptionGrant DateVested DateExercise Date

TermsIntrinsic Value Method – APB 25Fair Value Method – SFAS No 123

Fair Value MethodEstimate fair value of the options expected to vest on the date they are grantedValue of the option is based upon an option pricing model

Intrinsic Value MethodTotal 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

Allocating Compensation Expense

Compensation is recognized over the service period

ExampleNovember 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, 2001May 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

Intrinsic Value MethodMarket 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

Fair ValueAssume they use the Black-Scholes option pricing model results in a total fair value of $220,000

Journal Entries – Intrinsic Value Method

At date of grant 1/1/2001 – no entryTo record compensation for 2001

Compensation Expense $50,000 Paid in Capital – Stock Options $50,000

To record Compensation for 2002Compensation Expense $50,000 Paid in Capital – Stock Options $50,000

Intrinsic Value Method Cont.

To record the exercise of 20% of the shares on June 1,2004 (regardless of stock price

Cash (2000x60) $120,000Paid in Capital – Stock options 20,000 Common Stock $2000 Paid-in Capital in excess of Par

138,000

Journal Entries –Fair Value Method

At date of grant 1/1/2001 – no entryTo record compensation for 2001

Compensation Expense $110,000 Paid in Capital – Stock Options $110,000

To record Compensation for 2002Compensation Expense $110,000 Paid in Capital – Stock Options $110,000

Fair Value Method Cont.To record the exercise of 20% of the shares on June 1,2004 (regardless of stock price

Cash (2000x60) $120,000Paid in Capital – Stock options 44,000 Common Stock $2000 Paid-in Capital in excess of Par

162,000

Note Generally, the stock option price is greater than the market price of the sharesTherefore, using the intrinsic value is $0So no compensation expense is recorded

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

Another Example

University Corp

DisclosureTo comply with SFAS you must disclose the impact of the fair value method – Gateway F/S

Theory - NeutralityEconomic consequences issue FASB believes the neutrality concept should be followed – others disagreed

The DebateJune 1993 – Exposure DraftReactionEquity Expansion Act of 1993Late 1994Recently

Boeing

Tax IssuesIncentive Plan - Qualified Plans favorable tax treatment to the executive – employer receives not tax deduction for compensation – no deferred tax consequencesNonqualified plan offers favorable tax treatment to the employer – deduct the difference between exercise price and market price at the exercise date