Retained Earnings

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Chapter

• Retained Earnings

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Retained Earnings and Other Equity IssuesStock
Option Plains

• Corporations have programs that enable employees
  to acquire shares of stock, often at a price less
  than the current market price (at the time of
  exercising the right). These programs involve the
  issuance of warrants (rights) to the employees
  and are referred to as stock option plans.

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Stock Option Plans

• Non compensatory Stock Option Plans
• This is a plan to raise capital or to obtain
  more widespread employee ownership of the
  corporate stock rather than to provide additional
  compensation for certain employees. The following
  characteristics are essential for a stock option
  plan to be qualified as noncompensatory

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Stock Option Plans(contd.)

• 1. All full time are employees who meet limited
  employment qualification are able to participate
  in the plan.
• 2. Stock is offered on an equal basis or an a
  basis related to a uniform percentage of
  salaries.
• 3. The exercise period is reasonable.
• 4. The discount is not greater than what would be
  in an offer of stock to stockholders. If all four
  are met, no journal entry is required because no
  compensation is considered to be paid. A memo is
  required.

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Compensatory Stock Option Plans

• A stock option plan does not have all four
  characteristics listed in the preview section is
  defined as a compensatory plan. A compensatory
  stock option plan is to provide additional
  compensation to selected employees. The
  additional compensation is the difference between
  the amount of proceeds the corporation will
  receive from the issuance of the shares related
  to the stock option plan and the amount of the
  proceeds that it could receive if the stock were
  issued on the open market.

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Compensatory Stock Option Plans (Contd.)

• APB opinion no. 25 defines the total compensation
  cost related to a stock option plan as the excess
  of the quoted market price over the option price
  for the specific number of shares on the
  measurement date. (referred to as intrinsic value
  method) The measurement date is the first date on
  which both (1) the number of shares an individual
  employee is entitled to receives, and (2) the
  option (purchase) price are known. For many
  plans, both are known as the date the option is
  granted to the employee. The total compensation
  cost is recognized as an expense over the service
  period (the years in which company receives the
  benefit of the employees service).

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Compensatory Stock Option Plans (Contd.)

• Example Accounting for compensatory stock option
  plan when date of measurement is date of Grant
• Assume that on 12/31/94, a corporation grants A.
  Paul the nontransferable right to acquire 1,000
  shares of 10 par common stock for 27 per share.
  The market price on the date (12/31/94) is 29
  per share, and the service period is 4 years. The
  stock option may not be exercised until the
  service period expired and the rights terminate
  at the end of 7 years or if Paul leaves the
  corporation.

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Compensatory Stock Option Plans (Contd.)

• J.E.
• 12/31/94 Deferred Compensation 2,000 a
• Common stock option warrants 2,000
• (paid-in capital-stock options)
• a. (29-27) 1,000 2,000
• The compensation expense is recognized over next
  4 service years (95,96,97 and 98)
• J.E. for 12/31, 95,96,97 and 98Compensation
  Expense 500
• Deferred Compensation 500

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Compensatory Stock Option Plans (Contd.)

• When the option is exercised on 3/6/2000, the
  following J.E is made
• Cash (27 1,000) 27,000
• Common stock option warrants 2,000
• (Paid-in capital-stock option)
• Common Stock (101,000) 10,000
• Additional Paid-in Capital 19,000
• Disclosure on the Balance Sheet (95)
• Contributed Capital
• (paid-in Capital-stock options)
• Common stock option warrants 2,000
• Less referred compensation 1,500 500

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Compensatory Stock Option Plans (Contd.)

• Assuming 500 shares of stock options expired on
  1/1/2002, the following entry will be recorded
• Common stock option warrants 1,000
• (paid-in capital-stock options)
• Paid-in capital from expired options 1,000
• Note Even if stock options expired, the
  recognized compensation expense in the prior
  years would not be adjusted. However, if
  options are forfeited because an employee fails
  to satisfy a service requirement (i.e., leaves
  employment), the compensation expense will be
  adjusted by debit paid-in capital stock options
  and credit compensation expense.

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Fair Value Method

• SFAS No. 123 encourages but does not require
  recognition of compensation cost for the fair
  value of stock-based compensation. The fair value
  of stock-based compensation can be determined by
  using an acceptable option pricing model at the
  date of grant.

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Fair Value Method (Contd.)

• Under SFAS 123, a company can choose to use SFAS
  123, a company can choose to use either the
  intrinsic value method (I.e., APB No. 25) or fair
  value method when accounting for compensation
  cost on the income statement. However, companies
  that choose the intrinsic value method are
  required to the pro-forma (as if) net income and
  EPS, as if had used the fair value method.

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Fair Value Method (Contd.)

• When adopting the fair value method, the
  compensation cost will bee amortized (recognized)
  over the service period. The journal entries are
  similar to those of the intrinsic value method.

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Incentive Stock Option Plans Vs.Non-qualified
stock option plans

• A compensatory option plan can be an incentive
  stock option or a non-qualified stock option plan
  based on the IRS code.
• A. An Incentive Stock Option Plan
• The compensation cost id NOT deductible. Thus,
  the option price is set to equal the market price
  on the grant date. When employees exercise the
  options, employees exercise the options,
  employees can defer the tax payment till they
  sell the stock in the future.

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Incentive Stock Option Plans Vs.Non-qualified
stock option plans(Contd.)

• B. A Non-qualified Stock Option Plan
• Compensation tax is tax deductible. The option
  price can be set to below the market price on the
  grant date. The employee has to pay tax on the
  exercise date when exercise price is less than
  the market price on the exercise day (i.e., no
  tax defer).
• Under either incentive or the non-qualified stock
  option plan, the employee has to come up cash for
  the exercise of the option (or pay the tax under
  the non-qualified option plan. SAR was a creation
  to solve the cash problem for employees.

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Stock Appreciation Rights(SARs)

• SARs are rights granted to key employees that
  enable them to receive cash, stock or a
  combination of both equal to the excess of the
  exercise. According to FASB Interpretation No.
  28, the plans include SARs are similar to other
  variable term stock option plans and are
  accounted for in accordance with APB opinion 25.

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Stock Appreciation Rights(SARs) (Contd.)

• Example
• On 1/1/94, when the market price is 10 per
  share, a corp. grants stock appreciation right to
  a key executive, C. Talbert. Under the SAR Plan,
  Talbert is entitled to receive cash or stock for
  the difference between the quoted market price
  and a 10 option price for 1,000 shares of the
  company stock on the date of exercise. The
  service period is 4 year and the rights must be
  exercised in 6 years.

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Stock Appreciation Rights(SARs) (Contd.)

• The year and market prices per share are shown in
  Exhibit 1. Talbert exercises the rights to
  receive cash on 12/31/98.

a. Esti. Estimated Comp. Compensation Exp.
Expense b. (12-10) 1,000 shares
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Stock Appreciation Rights(SARs) (Contd.)

• J.E.
• 12/31/94 Compensation Expense 500
• SAR Compensation Payable 500
• 12/31/95 Compensation Expense 1,000
• SAR Compensation Payable 1,000
• 12/31/96 SAR Compensation Payable 150
• Compensation Expense 150

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Conceptual Issues

• From a conceptual point of view, measuring the
  compensation cost as the excess of the market
  price over the option price on the measurement
  date (the grant date in many cases) is in
  appropriate. This method understates (in many
  cases, significantly) the value of stock option
  and the corresponding compensation cost
  (expense). FASB is looking at this issue and has
  tentatively conclude that the fair value should
  be measured at the grant date using an option
  pricing model.
• (Variable-term Stock Option Plan)
• Accounting for Compensatory Stock Option Plans
• Date of Measurement Later than Date of Grant.

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Conceptual Issues(Contd.)
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Conceptual Issues (Contd.)

• Example Assume the same information as in the
  previous example, except that the option price is
  to be 90 of the market price on 12/31/97 (3
  years after grant). Assume that the market price
  per share0 at the end of 95, 96, and 97 is 30,
  31.5 and 32.6, receptively.

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Conceptual Issues (Contd.)

• On the date of Grant (12/31/94), only a memo is
  needed
• Memorandum Entry One thousand share of 10 per
  common stock may be acquired by A. Paul in
  accordance with the company stock option plan.
  The option price is 90 of market price on
  12/31/97. The service period is 4 years, after
  which the option may be exercised. The right
  remained at the end of 7 years or if Mr. Paul
  leaves the company.

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Conceptual Issues (Contd.)

• 12/31/95
• Compensation Expense 750a
• Common Stock Option Warrants 750

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Conceptual Issues (Contd.)

• 12/31/96
• Compensation Expense 825
• C.S. Option Warrants 825

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Conceptual Issues (Contd.)

• 12/31/97
• Compensation Expense 870
• C.S.O.W 870

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Conceptual Issues (Contd.)

• 12/31/98
• Compensation Expense 815
• C.S.O.W 815