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

Employees Stock Options

Stock options have become a very pervasive

vehicle in compensation of employees.

Especially in the high growth industries, such as hitech.

Offer employees the opportunity to purchase

the firms common stock at a price (the
exercise price) that is lower than the market
price.

Paul Zarowin

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 firms stock price

Note: FV is a function of (exercise price, volatility, expected life,
stock price, market interest rate)

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

Grant
date

Option
vested

Option
exercise
d

Price on Jan 2002 is $120

Employee earns: ($120-$55) x 2,000 =$130,000
Did the option have value on Jan. 1 st 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

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

2.

must show footnote disclosure of pro-forma NI and EPS

under the fair value method (and the option pricing method
used along with the methods relevant assumptions)

FV (Fair Value) Method (SFAS #123)

recognize compensation expense @ grant date
equal to the FV of the options at that date

Paul Zarowin

Intrinsic Value Method

1. grant @ 12/31
ex price = mkt
price

3. Dont
exercise

3a. Reprice
(reset ex
price)
3b. Lapse

2. Exercise

Paul Zarowin

Intrinsic Value Method (contd)

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)
employees 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 (contd)

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:
DRCash #shares*ex price
DRCompensation expense #shares (mrk price-ex price)
CR C/S
#shares*mkt price@exercise

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

Cash=cash received

Same as (C)

APC=offset CR from 1

No event

Same as (A)

Comp exp
=#shrs*(ch in ex pr)

Same as (A)

Paul

Same as (A)

Comp exp = in FV
of options
Zarowin

Same as (A)
Same as (C)

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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 methods 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.(mktprexpr)
5. contingent liability
unexercised value

amount
options FMV
change in FMV

def. compensation (B/S)

amort. amount

C/S (market price)

APC

Paul Zarowin

remaining,

15

Modified Accrual IV Method to

Account for Stock Options (dont know
options
FMV)
(use difference between market price and exercise price to measure
1.
2.

3.

4.

5.

contingent liability and deferred compensation asset)

no entry at grant date if mkt. price = exercise price
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
amortize deferred compensation to compensation expense over
specified service period
at exercise, extinguish contingent liability and record share
issue at its MV
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)
excess of
mktpr - expr
2a. same as #1 (or reverse)

change in mktpr

3. compensation exp (I/S)

def. compensation (B/S) amort. amount

4. cash (exercise price)

C/S (market price)
contingent liab (mktprexpr)
5. contingent liability
unexercised value

APC

remaining,

Paul Zarowin

17

Modified Accrual IV, JEs - Contd

correction entry*
DR
CR
Deferred compensation asset xxx
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 doesnt account for amortized

Deferred compensation asset, which is difficult to estimate

Paul Zarowin

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