# Stock Options Compensation

```Stock Options Compensation
RCJ Chapter 15
(842-854)
Key Issues
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Intrinsic Value method
Fair Value method
Grant date
Exercise price
Vesting period
Expiration period
Expected life
Volatility
Repricing
Footnote disclosures
Pro-forma NI
Option activity
Options outstanding and exercisable
Paul Zarowin
2
Employees’ Stock Options

Stock options have become a very pervasive vehicle
in compensation of employees.


Especially in the high growth industries, such as hi-tech.
Offer employees the opportunity to purchase the
firm’s common stock at a price (the exercise price)
that is lower than the market price.
Paul Zarowin
3
Key Terms and Variables
variables in italics must be estimated; all others are observable






Grant date - date at which the options are granted to the
employee (usually the end of the year)
Exercise price - price at which employee can buy the stock; the
exercise price is usually set equal to the market price at the grant
date
Vesting period - period over which the employee first becomes
eligible to exercise the options
Expiration period - period after which the options lapse (i.e.,
can no longer be exercised)
expected life - expected time from grant date to exercise (must
be \$vesting period and #expiration period)
volatility - variance of the firm’s stock price
Note: FV is a function of (exercise price, volatility, expected life,
stock price, market interest rate)
4
Example of a Stock Option


On Jan. 1st 1998 IBM grants one of its employee an
option to purchase 2,000 stocks:
 Vesting period of 3 years
 Exercise price \$55
 Duration 10 years
 Employee exercises option in 2002
How much money will the employee earn upon
exercise of this option?
Paul Zarowin
5
Grant
date


Option
vested
Option
exercised
Price on Jan 2002 is \$120
Employee earns: (\$120-\$55) x 2,000 =\$130,000
 Did the option have value on Jan. 1st 1998 (when price
was \$55)?
In,Out and At the Money Options
Options can be:
 “In the money”, i.e., the exercise price is below
the current stock price.
 “Out of the money”, i.e., the exercise price is
above the current stock price.
 “At the money”, i.e., the exercise price is the
same as the current stock price.
 Employees’ stock options are typically granted at the
money.
Paul Zarowin
7
Accounting for Employees’ Stock Options
Firms have choice of 2 methods:
1. IV (Intrinsic Value) Method (APB #25) –
method most firms use to account for stock options:
only recognize compensation expense if exercise
price < market price @ grant date

must show footnote disclosure of pro-forma NI and EPS under the
fair value method (and the option pricing method used along with
the method’s relevant assumptions)
2. FV (Fair Value) Method (SFAS #123) –
recognize compensation expense @ grant date
equal to the FV of the options at that date
Paul Zarowin
8
Intrinsic Value Method
3a. Reprice
(reset ex price)
1. grant @ 12/31
ex price = mkt price
3. Don’t
exercise
3b. Lapse
2. Exercise
Paul Zarowin
9
Intrinsic Value Method (cont’d)
1. No compensation expense if exercise price  market price; no
accounting event, so no entry
2. Entry is:
DR
CR
Cash xxx
C/S xxx
where xxx is the amount of cash collected (i.e., the exercise price *
# of shares)


note: option exercise is a balance sheet event, a stock issuance
at the exercise price, (no compensation expense)
employee’s taxable income= #shares*(market price - exercise price);
firm tax deduction is same
3a. Firm recognizes compensation expense = # shares * (change in
exercise price)
3b. No accounting event, no entry
Paul Zarowin
10
Intrinsic Value Method (cont’d)
key points:
1. there is no effect on NI (no compensation expense)
except 3a (repricing)
2. real cost is dilution (reduction of EPS due to extra
shares outstanding) or cash outflow (to repurchase
shares to counteract dilution)
correct exercise entry to show economic cost of options:
DR Cash #shares*ex price
DR Compensation expense #shares (mrk price-ex price)
CR C/S
#shares*mkt [email protected]
Ex. E15-11, 15
Paul Zarowin
11
IV vs. FV Methods
IV Method
1. grant
FV Method
(a)
(b)
(c)
(d)
ex pr < mkt pr @ grant
ex pr  mkt pr
@ grant
ex pr < mkt pr @ grant
ex pr  mkt pr
@ grant
comp exp =
#shrs*(mkt pr-ex pr)
No event
Comp exp - Determined
by option pricing model
Same as (C)
APC
2. exercise
cash
APC
Same as (A)
C/S
3. lapse
4. reprice
Same as (C)
APC=offset CR from 1
No event
Same as (A)
Same as (A)
Same as (A)
Comp exp =#shrs*(ch
in ex pr)
Same as (A)
Comp exp =  in FV of
options
Same as (C)
APC
APC
Paul Zarowin
12
Stock Option Footnote Disclosures
1. Existing options at B/S date
a. outstanding options (usually grouped by range of ex prices)
exercise price # outstanding Wt avg remaining life Wt avg ex price
b. repeat for options currently exercisable
2. Option activity during the year
#
wt avg ex price
options @ beginning of year
+ options granted
- options exercised
actual figures go here
- options forfeited
= options @ end of year
3. Option pricing method used and the method’s assumptions
note: IV firms show pro-forma NI and EPS under FV method
Ex. P15-6, C15-1
Paul Zarowin
13
Pure Accrual IV Method to Account
for Stock Options
(use options’ FMV to measure contingent liability and deferred
compensation asset)
1. recognize options’ FMV at grant date as a contingent liability and
deferred compensation asset
2. increase (or decrease) contingent liability and deferred compensation
accounts as options’ FMV changes
3. amortize deferred compensation to compensation expense over
specified service period
4. at exercise, extinguish contingent liability and record share issue at
its MV
5. if lapse, extinguish contingent liability (if any value remains) and
record increase in O/E (for uncompensated services received)
Paul Zarowin
14
Pure Accrual IV Method – JEs
(entries 1, 4, and 5 are transactions; entries 2 and 3 are adjustments @ EOY)
DR
1. deferred compensation (B/S)
CR
contingent liability (B/S)
2. same as #1 (or reverse)
3. compensation expense (I/S)
4. cash (exercise price)
contingent liab.(mktpr–expr)
5. contingent liability
amount
options’ FMV
change in FMV
def. compensation (B/S)
amort. amount
C/S (market price)
APC
Paul Zarowin
remaining,
unexercised value
15
Modified Accrual IV Method to Account
for Stock Options (don’t know options’ FMV)
(use difference between market price and exercise price to measure
contingent liability and deferred compensation asset)
1. no entry at grant date if mkt. price = exercise price
2. recognize contingent liability and deferred compensation assets as
stock price rises above exercise price; 2a. increase (or decrease)
contingent liability and deferred compensation accounts as stock
price changes
3. amortize deferred compensation to compensation expense over
specified service period
4. at exercise, extinguish contingent liability and record share issue at
its MV
5. if lapse, extinguish contingent liability (if any value remains) and
record increase in O/E (for uncompensated services received)
Paul Zarowin
16
Modified Accrual IV – JEs
(entries 4 and 5 are transactions; others are adjustments @ EOY)
DR
CR
amount
1.
no entry if mkt price = exercise price
2. def. compensation(B/S)
contingent liability (B/S)
2a. same as #1 (or reverse)
3. compensation exp (I/S)
excess of
mktpr - expr
change in mktpr
def. compensation (B/S) amort. amount
4. cash (exercise price)
C/S (market price)
contingent liab (mktpr–expr)
5. contingent liability
APC
Paul Zarowin
remaining,
unexercised value
17
Modified Accrual IV, JEs - Cont’d
correction entry*
DR
Deferred compensation asset xxx
CR
contingent liability xxx
xxx = (market price – exercise price) x # of outstanding in the money
options; often referred to as option overhang, amount of loss incurred
if all outstanding options were exercised at current price; conservative
liability estimate, because it ignores price rise; can discount it for
probability of non-exercise and tax benefits of exercise
* overstates O/E, because it doesn’t account for amortized Deferred
compensation asset, which is difficult to estimate
Paul Zarowin
18
```