Example 2 Solution (Stock-Based Compensation)

Acct 592 – Spring 2008Prof. Teresa Gordon

solution – Cliff vesting - Example 2

Share-based Compensation Classified as Equity

For a Christmas bonus on December 31, 2010, Genessee Engineering, Inc. gave its executives stock options that entitle them to purchase up to 5,000 shares of Genessee Engineering company stock for $20 per share. The executives cannot exercise the options until the end of 2012, and they must decide whether to exercise their option to buy stock at $20 per share on or before July 1, 2013. To remain eligible for the stock options, they have to remain in the employment of Genessee Engineering. On December 31, 2010, the date of the grant, Genessee Engineering stock was selling for $25 per share. Assume that the fair value of the options at 12-31-10 was $9.00 each and that there were 20 executives eligible for participation. Based on past history, Genessee Engineering expects a 5% annual turnover rate among its executives. The company’s income tax rate is 34%.

20 executives * 5,000 options each = 100,000 options

100,000 options * .95 * .95 = 90,250 options expected to vest

Value of compensation as measured at grant date: $812,250 {90,250 * $9}

12/31/10 (Mkt. price $25)

No entry needed – none of the compensation has been earned. Memorandum entry to note the issuance of 100,000 options

12/31/11 (Market value $19), 1 executive quit during 2011$812,250 compensation * ½ earned

Compensation expense 406,125
Additional Paid-in Capital - stock options 406,125
Deferred tax asset 138,083
Income tax expense (deferred) 138,083

12/31/12 (Market value $27), another executive quit during 2012Actual options that vest = 90,000 * $9 each = $810,000Amounts previously recognized = 406,125Therefore, compensation expense = 403,875

Compensation expense 403,875
Additional Paid-in Capital - stock options 403,875
Deferred tax asset (403,875 * .340 137,317
Income tax expense (deferred) 137,317

12/31/11

406,125

12/31/11

138,083

12/31/12

403,875

12/31/12

137,317

810,000

275,400

Example 2, continued

Assume that on January 5, 2013, executives exercised 85,000 of the stock options purchasing 85,000 shares of Genessee Engineering common stock ($10 par value) for $20 per share. The market price was $30. Assume that the stock market crashed early in February, 2013 and the one executive was never able to exercise the remaining 5,000 options. Instead, they expired on July 1, 2013 when the stock price was $15.

Note: Actual value of option is greater than amount computed at grant date.

1/5/13 (Market price $30), 85,000 options exercised

Cash [85,000 * $20] 1,700,000
Additional paid-in capital - stock options [85,000 * $9] 765,000
Common stock ($10 par * 85,000) 850,000
Paid in capital in excess of par 1,615,000

The actual tax deduction will be $10 per share or $850,000 * .34 = $289,000
We need to zero out the amounts set up in deferred taxes and record actual amount due to government.
The unanticipated tax savings are considered an addition to paid-in capital.

Income tax expense (deferred) {$3.06 * 85,000} 260,100
Deferred tax asset 260,100

Income taxes payable 289,000
Income tax expense (current) 260,100
APIC – excess tax deductions 28,900

7/1/03 (Market price $15), 5,000 remaining options expire

APIC - stock options 45,000
Additional paid-in capital - expired stock options 45,000
Income tax expense (deferred) 15,300
Deferred tax asset 15,300
(There will never be a deduction for these options. Therefore, there is no effect on current taxes payable)

Example 2, continuedALTERNATE VERSION (Stock price at exercise less than projected using option pricing model)

Assume that the market price at exercise was $28 instead of $30. What journal entries would have been made on January 5, 2013 and July 1, 2013.

Note: Actual value of option is less than amount computed at grant date.

1/5/13 (Market price $28), 85,000 options exercised

Cash [85,000 * $20] 1,700,000
Additional paid-in capital - stock options [85,000 * $9] 765,000
Common stock ($10 par * 85,000) 850,000
Paid in capital in excess of par 1,615,000

The actual tax deduction will be $8 per share or $680,000 * .34 = $231,200
We need to zero out the amounts set up in deferred taxes and record actual amount due to government
In this situation, if there is no APIC from earlier stock options, the entire tax amount due must be absorbed by the income statement.

Income tax expense (deferred) {$3.06 * 85,000} 260,100
Deferred tax asset 260,100

Income taxes payable 231,200
Income tax expense (current) 231,200
Additional paid-in capital - stock options 0

7/1/13 (Market price $15), 5,000 remaining options expire

APIC - stock options 45,000
Additional paid-in capital - expired stock options 45,000
Income tax expense (deferred) 15,300
Deferred tax asset 15,300
(Same as before. There will never be a deduction for these options. Therefore, there is no effect on current taxes payable)

There used to be an alterative method of recognizing forfeitures only when they happen (FAS 123) that is no longer available under SFAS No. 123 Revised 2004

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