Chapter 19 Share Based Compensation and Earnings Per Share

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1 SHARE-BASED COMPENSATION PLANS In accounting for stock-based compensation plans our objective is to: 1. Determine the value of the compensation, and 2. Expense the compensation over the periods in which the participants perform services Stock Award Plans Stock award plans are executive compensation programs that provide the employee with a specified number of shares of stock subject to continued employment. The total compensation is the market price at the grant date of unrestricted stock. As most stock is restricted and becomes vested over time the compensation expense is recorded over the service period for which the employee received the shares. This is normally from the date of grant to the date to the vesting date (when the restriction is removed.) Changes in market price from the date of grant to the vesting date are not recorded. Stock Option Plans Stock option plans have been in the news recently because of all of the accounting failures. The warrant associated with a compensation plan is called a stock option. It gives the employee the option to purchase common stock at a specific price over some period of time. There are several dates that are important in recording and reporting stock options. 1. Grant date This is the date that the employee receives the options 2. Vesting date The date the employee can first exercise the options 3. Exercise date The date the employee actually exercises the options 4. Expiration date The date that the unexercised options expire At the grant date the exercise price and the market prices are normally identical. The only way that the employee will benefit from the stock option is if the value of the stock increases before the expiration date. Intrinsic Value Method Under the intrinsic value method compensation expense is computed based on the excess of the market price over the option price as of the measurement date (normally the grant date). Your textbook has a fairly lengthy discussion as to the politics related to the use of the intrinsic value method. The adoption of SFAS #123 in 2004, the intrinsic value method is no longer available for most publicly traded companies. Fair Value Method The fair value method is not required for virtually all publicly traded companies. Under the fair value method, compensation expense is computed based on the fair value of the options on the grant date. The fair value is computed based on option pricing models. Example: Spencer Company adopts a stock option program for Mr. Spencer. The service period is for two years starting on the grant date of January 1, The stock options are F:\course\ACCT3322\200720\module4\c19\tnotes\c19a.doc1

2 for 1,000 shares of the $5 par common stock. The option price per share is $50 and the market price at the date of grant is $65 per share. The fair market value of the options would be valued based on an options pricing model. We will assume that the results of running the model indicate that the fair market value of the options is $35,000. The journal entries to record compensation expense are as follows: 1/0/00 No entry on the grant date 12/31/00 Compensation expense 17,500 Additional paid-in capital, stock options 17,500 12/31/01 Compensation expense 17,500 Additional paid-in capital, stock options 17,500 Assume that Mr. Spencer exercised 40% of his options (purchases 400 shares) on March 15, Complete the following journal entry that would be recorded. 12/31/10 Cash? Additional paid-in capital, stock options 14,000 Common stock? Additional paid-in capital, common stock Answer 32,000 12/31/10 Cash 20,000 Additional paid-in capital, stock options 14,000 Common stock 2,000 Additional paid-in capital, common stock 32,000 On December 31, 2010 the remaining stock options expired. The following journal entry reflects the expiration 12/31/10 Additional paid-in capital, stock options 21,000 Additional paid-in capital, expired stock options 21,000 Allocating Compensation Expense: The service period is defined as the number of accounting periods that the employee performs services for the company. Compensation expense is allocated based on this service period. Normally the service period is the vesting period. Although compensation expense is determined on the grant date, it is allocated among the service periods. F:\course\ACCT3322\200720\module4\c19\tnotes\c19a.doc2

3 Disclosure of Compensation Plans SFAS #123 requires that following information about the stock option plan must be disclosed in the notes to the financial statements. 1. The number of shares under option 2. Options exercised and forfeited 3. The weighted average option price 4. The weighted average fair value of options granted during the year 5. The average remaining contractual life of the outstanding options Stock Appreciation Rights Rather than requiring the employee to purchase shares of stock, stock appreciation rights (SARS) provide compensation to employees based on the increase in share price over some specified time period. It the employer can elect to settle in shares of stock rather than cash, the award is considered to be equity. If the employee can elect to receive cash, the award is considered a liability. SARS Payable in Shares (Equity) If the SARs are payable in shares of stock the accounting depends on which method of reporting the company has elected. Fair value approach Using the fair value approach the company estimates the fair value of the SARS at the grant date and allocates the expense over the service period. Intrinsic value approach Using the intrinsic value approach, the intrinsic value of the SARs is allocated to expense over the service period. SARS Payable in Cash (Liability) If the employee can elect to receive cash for the SARs, the amount of compensation is estimated each period and continually adjusted to reflect changes in the market price of stock until the cash payment is made. Example: Spencer Company established a stock appreciation rights (SAR) program on January 1, 2000, which entitles executives to receive cash at the date of exercise for the difference between the market price of the stock and the preestablished price of $20 on 5,000 SARs. The required service period is two years. The market price of the stock is $22 on December 31, 2000 and $29 on December 31, The SARs are exercised on January 1, Compensation expense for 2000 and 2001 are computed as follows: F:\course\ACCT3322\200720\module4\c19\tnotes\c19a.doc3

4 12/31/00 Compensation expense $5,000 Liability, SAR Plan $5,000 To record compensation as a result of change in stock value Analysis of compensation expense: Market price $22 Price at grant date 20 Increase in value 2 Number of SARs 5,000 Total increase in SARs value 10,000 Portion recognized in this period 1/2 Compensation expense $5,000 12/31/01 Compensation expense $40,000 Liability, SAR Plan $40,000 To record compensation as a result of change in stock value Analysis of compensation expense: Market price $29 Price at grant date 20 Increase in value 9 Number of SARs 5,000 Total increase in SARs value 45,000 Previously recognized compensation 5,000 Compensation expense $40,000 When the SARs are exercised on January 1, 2002 the following journal entry will reflect the transaction. 1/1/02 Liability, SAR Plan $45,000 Cash $45,000 F:\course\ACCT3322\200720\module4\c19\tnotes\c19a.doc4

5 T-Account: Liability, SAR Plan Description Debit Credit 12/31/00 accrual $5,000 12/31/01 accrual 40,000 Balance at 12/31/01 45,000 Payment on 1/1/02 $45,000 $0 F:\course\ACCT3322\200720\module4\c19\tnotes\c19a.doc5