Ch 16.3 (Stock Compensation Plans)

Question 1

Effective compensation programs do the following:

Answer 1

1. Base compensation on employee and company performance.
2. Motivate employees to high levels of performance.
3. Help retain executives and allow for recruitment of new talent.
4. Maximize the employee’s after-tax benefit and minimize the employer’s after-tax cost.
5. Use performance criteria over which the employee has control.

Question 2

Stock-based Compensation Plans

Answer 2

Long-term compensation plans that attempt to develop company loyalty among key employees by giving them “a piece of the action”—that is, an equity interest.

These plans provide the employee with the opportunity to receive stock if the performance of the company (by whatever measure) is satisfactory.

Question 3

Stock Option

Answer 3

Gives key employees the option to purchase common stock at a given price over an extended period of time.

Question 4

Grant Date

Answer 4

The date you receive the option to purchase shares for the firms common stock as part of your compensation.

These options are good for 10 years.

Market price v exercise price (Need to get stock when market price > exercise price).

Question 5

Intrinsic Value Method (How to report the granting of shares)

Answer 5

Measures compensation cost by the excess of the market price of the stock over its exercise price at the grant date.

Question 6

Fair Value Method (How to report the granting of shares)

Answer 6

Companies use acceptable option-pricing models to value the options at the date of grant.

GAAP/IFRS requires that companies recognize compensation cost using the fair value method.

The fair value method results in greater compensation costs relative to the intrinsic-value model (greater expenses).

Question 7

Stock-option plans involve two main accounting issues:

Answer 7

1. How to determine compensation expense.

2. Over what periods to allocate compensation expense.

Question 8

Determining Expense (Fair Value Method)

Answer 8

Expense based on Fair Value option + plus expense on grant date.

No adjustments occur after the grant date in response to subsequent changes in the stock price.

Question 9

Allocating compensation expense

Answer 9

A company recognizes compensation expense in the periods in which its employees perform the service (Service Period).

The company determines total compensation cost at the grant date and allocates it to the periods benefited by its employees’ services

Question 10

Allocating compensation expense

Answer 10

A company recognizes compensation expense in the periods in which its employees perform the service (Service Period).

The company determines total compensation cost at the grant date and allocates it to the periods benefited by its employees’ services

A company does not adjust compensation expense upon expiration of the options.

If an employee forfeits a stock option because the employee fails to satisfy a service requirement (e.g., leaves employment), the company should adjust the estimate of compensation expense recorded in the current period (as a change in estimate).

Question 11

Restricted Stock Plans

Answer 11

Transfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occurs.

Similar to stock options, these shares are subject to forfeiture if the conditions for vesting are not met.

The accounting for restricted stock follows the same general principles as accounting for stock options at the date of grant.

If the employee does not fulfill the vesting requirements, the company reverses the accounts that have been affected.

Question 12

Major advantages of restricted-stock plans

Answer 12

1. Restricted stock never becomes completely worthless. In contrast, if the stock price does not exceed the exercise price for a stock option, the options are worthless. The restricted stock, however, still has value.
2. Restricted stock generally results in less dilution to existing stockholders. Restricted-stock awards are usually one-half to one-third the size of stock options. For example, if a company issues stock options on 1,000 shares, an equivalent restricted-stock offering might be 333 to 500 shares. The reason for the difference is that at the end of the vesting period, the restricted stock will have value, whereas the stock options may not. As a result, fewer shares are involved in restricted-stock plans, and therefore less dilution results if the stock price rises.
3. Restricted stock better aligns the employee incentives with the companies’ incentives. The holder of restricted stock is essentially a stockholder and should be more interested in the long-term objectives of the company. In contrast, the recipients of stock options often have a short-run focus which leads to taking risks to hype the stock price for short-term gain to the detriment of the long-term.

Question 13

Employee stock-purchase plans (ESPPs)

Answer 13

Generally permit all employees to purchase stock at a discounted price for a short period of time.

These plans are considered compensatory unless they satisfy all three conditions presented below.

1. Substantially all full-time employees may participate on an equitable basis.
2. The discount from market is small. That is, the discount does not exceed the per share amount of costs avoided by not having to raise cash in a public offering. If the amount of the discount is 5 percent or less, no compensation needs to be recorded.
3. The plan offers no substantive option feature.

IFRS requires that any discount from the market price in employee stock-purchase plans be recorded as compensation expense.

Question 14

Disclosure of Compensation Plans

Answer 14

A company with one or more share-based payment arrangements must disclose information that enables users of the financial statements to understand:

1. The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders.
2. The effect on the income statement of compensation cost arising from share-based payment arrangements.
3. The method of estimating the fair value of the goods or services received, or the fair value of the equity instruments granted (or offered to grant), during the period.
4. The cash flow effects resulting from share-based payment arrangements.

Required expense recognition of compensation related to stock options and restricted stock represents a significant improvement in financial reporting.