Chapter 19 Share Based Compensation and Earnings Per Share

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, 2000. The stock options are

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Chapter 19 Share Based Compensation and Earnings Per Share

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:

DATE ACCOUNT DEBIT CREDIT

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, 2003. Complete the following journal entry that would be recorded.

DATE ACCOUNT DEBIT CREDIT

12/31/10 Cash ?
Additional paid-in capital, stock options 14,000
Common stock ?
Additional paid-in capital, common stock 32,000
Answer
DATE ACCOUNT DEBIT CREDIT
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

DATE ACCOUNT DEBIT CREDIT

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.

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Chapter 19 Share Based Compensation and Earnings Per Share

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, 2001. The SARs are exercised on January 1, 2002. Compensation
expense for 2000 and 2001 are computed as follows:

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Chapter 19 Share Based Compensation and Earnings Per Share

Date Account Debit Credit

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

Date Account Debit Credit

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.

Date Account Debit Credit

1/1/02 Liability, SAR Plan $45,000
Cash $45,000

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Chapter 19 Share Based Compensation and Earnings Per Share

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

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