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hello and welcome to this session in which we would look at accounting for stock compensation plan under generally accepted accounting principle under GAAP well just before we proceed just want to remind you that when we left the last session we talked about stock options stock options is an example of those stock compensation plans but we do have other ones but we're gonna look at them separately so stock option planes to accounting issues to tackle when we talk about stock option plans is one is to determine the compensation expense and the other thing is to determine is how should we allocate this compensation expense so we have an a compensation expense first we need to determine the dollar amount then we need to know over how many years or how many periods we need to allocate the expense now we're gonna see this we're gonna see what do we do in a moment so we don't have to worry about this you just need to know the rules okay compensation expense how so how do you determine the expense is based on the fair value of the option expected the vest on the date that they grant the option so what's gonna happen they're gonna tell us this this option is costing the company five million dollars so this number will be given to us it's determined on the day that they grant the option how is it determined there is something called the black Scholes formula and they tell us how much a stock option would cost the company so this is the expense now when are we gonna expense this five million is it now is it in the future or are we gonna allocate it over a period of time well we're gonna recognize the compensation expense and the period in which the employee performed the service we call it the service period so let's assume this employee it's gonna this employee will that's getting the 5 million we'll service the company for five years is expected to service perform services for five years so each here will expense a million so two issues to tackle one is the total expense determined the expense which will be given to you the other issue is how to allocate the expense how do you allocate the expense over the period that's gonna benefit the company over the period that's gonna benefit now let's work an example to see how this work on November 1st the stockholder of sort of company approve a plan that grand the company's five executives options to buy 2,000 shares of its $1 par value common stock the company grant the option on January 1st we call Jenny buddy first the grand date this is the grand date the executives may exercise so this is January 1st the executive may exercise the option at any time within the next ten years so they have ten years to exercise the option this is not the benefit period they have ten years to do so the option price per share is $60 and the market price per share at the date of the grant is 17 under the fair value method the company compute the total compensation expense by applying an acceptable fair value option pricing model the fair value the fair value option pricing model determined that Cyril total compensation expense is two hundred and twenty thousand this is the first item we need to know this is the total compensation expense so this is the expense for the company so the question is how are we gonna allocate this expense how are we gonna allocate this expense okay so let's take a look at the benefit period okay here's what we're gonna assume we're gonna assume that the expected period of benefit is two years starting with the grand date so what are we saying we are saying that we give we give we gave those stock options to the executives because the executives will work for us as a form of compensation to them in the next two years but they have ten years to exercise them so the company said this is for two years but you have ten years to exercise so the period benefit is two years what does that mean it means you have to take this expense and divide it by two so each here you're gonna expense one hundred and ten although the executives even if they'll have they work two years and left the company they can still exercise their options for the next eight years so a total of ten so let's look at the journal entry that we have to make at the end of year one and at the end of year two to record the expense so at the end of year one because they work here one we assume by the end of the year remember the grant date was this January first the grand date was January 1st January first let me see yes January 1st 2014 so the executives work that first year and the company now have a compensation expense which is an expense account of one hundred and ten thousand and they will credit paid in capital stock options one hundred and ten which is an equity account so let's just examine this expenses went down equity went up so basically those two cancel each other so there's no real effect on the balance sheet because expect when the expenses went down brought equity down 110 then paid in capital brought equity up 110 so total equity is the same total net equity in 2015 when the when the executives spent the second year at the company and they completed the year we debited compensation expense credited paid in capital stock option what I want you to do is to keep track of paid in capital stock options so create a t-account paid in capital stock option and you have 110 then another 110 so you have 220 after two years and in stock option why is this relevant because when you actually stop when the executives actually start to exercise their options start to buy the stock they will we will reduce this account so let's take a look at an example when the executives actually exercise the stock so this is the eggs the exercise so now the executives gonna go ahead and buy the stock at a certain price if Cyril executives exercise 2,000 of the 10,000 options they're going to exercise 20% of the options on June 1st 2017 three years three years and five months after the grand date remember they have ten years to exercise the company record the following journal entry so what happened is this the executives wanted to buy 2000 shares 2000 shares how much can they buy it for well let's go back and see how much they can buy it for they can buy it at $60 they can buy the shares at $60 regardless of of how much the shear is trading today the share might be $100 so the executives will have to send 2,000 times 60 they'll have to send cash of 120 dollars to the company because they have to pay $60 for the stock and here we have to assume that the stock was above $60 otherwise the executives will not exercise the option that will be stupid because they can buy the stuff they can buy the stock at a cheaper price they will not exercise so we're going to debit cash 120 thousand now remember if we are issuing 2,000 shares we are issuing 2,000 shares we have to multiply this by the par value in the par value let's go back to see what the par value was the par value was $1 for this company the par value was a dollar therefore we're gonna go ahead take 2,000 times $1 gives us common stock of 2,000 this will be common start so we're gonna credit common stock whoops we're gonna credit common stock 2000 so we're gonna debit cash credit common stock now let's go back to the paid and capital M paid in capital we had two hundred and twenty thousand the total was two hundred and twenty thousand this is paid in capital stock option how much of the options are we exercising we are exercising one % so we're gonna have to reduce this account by 20 percent and 20 percent times times 220 is 44,000 now we need to reduce paid in capital 44,000 we need to debit paid in capital 44,000 which in turn reduces this amount so now we're gonna reduce the paid in capital we're gonna go from 220 minus 44,000 what were left with is 100 176 okay 176 so to complete the journal entry we're gonna debit paid in capital stock option 44,000 and anything that's left in this entry what does it go it goes into paid in capital this is the plug figure paid in capital always a plug figure so we debited cash because the executives needs to pay how much 120 thousand we credited common stock to issue the common stock then we debited paid in capital which is 20 percent of of what of two hundred and twenty thousand okay because we did we reduce the 20 percent and the remainder is paid in capital now what happen if serve executives failed to exercise failed to exercise the remaining stock option after the expiration date so what happened they waited until year ten and it seems the stock maybe the stock price went down so the executives felt that the options are worthless in other words if the stock is below sixty dollars they will not exercise so the the option will expire it basically it will go away so what happen if the option expires well if the option expires remember let's go back to this the account here whoops moving too fast if we are go back to the account if the option is no longer valuable we need to remove this one hundred and seventy six thousand therefore part of the entry will to debit 176,000 to bring this account down to zero so let's go to the entry so we're going to debit when the when the eggs when the when the options fail when the executives fail to exercise the option we're going to debit this account 176,000 which is two hundred and twenty times eighty percent because they exercise twenty and they did not exercise the remainder they should have exercised all of them when they had the chance though but they did not so we will remove the stock option paid in capital and we create a paid in capital expired the stock options this is another equity account because originally we recorded expenses and those expenses did not materialize because because in the first two years we recorded two hundred and twenty thousand in expenses and those expenses one hundred and seventy six of them did not materialize so we have to credit paid in capital expired option to increase our equity because we thought it's gonna be two twenty but the options that not cost us two twenty okay so that's why we debit in equity and credit another equity which is good this equity is good basically we made up be some of the expenses alright let's look at other form of compensation okay stock option planes adjustment a company does not adjust stock option expense upon expiration of the option so we don't go back and change the expense we don't go back to the prior year we don't go back to the prior year as you saw however if an employee forfeit a stock option because the employee fails to satisfy a service requirement for example if the employee left if the employee left in other words the employee did not stay the full year for the service the company should adjust the estimate compensation expense recorded in the current period so only change the current period and it's a change in estimate so we don't have to go back and change the prior period okay so only in that current period we'll do a change to an expense it's called we don't go back retrospectively and do anything else another form of stock compensation is called restricted stocks it's a little different than stock option so you need to know the difference between stock option and restricted stock stock options gives you the right to buy the stock at a certain price okay restricted stocks are a little bit different restricted stocks transfer shares of stocks to employees so they will give you the start you don't have to pay for them you don't have to pay a certain price not a low price not a high price just will give you the will give you the stocks it's subject to an agreement that the shears cannot be sold transferred or pledge until a vesting period has occurred so we'll give you the stocks but you can they're restricted now notice the word restricted they're restricted in terms of you selling them for a period of time so you have to hold them until they vest okay so what is the major advantage over stock options well it's the restricted stocks they don't become obsolete remember the stock options one hundred and seventy six thousand of them became obsolete so restricted stocks don't become obsolete so you are guaranteed to get the stock okay and you don't have to pay anything for them it generally results in less dilutions to existing shareholders so we don't have to give a lot of them we can give less than the stock options and better align the incentives with the company's incentive and here you don't have to do anything illegal to drive the stock price up because under the stock options executives might have the incentives to drive the stock up temporary to exercise the option they may cut do some short cuts maybe cut down on R&D cut down on maintenance to save some money to show that the company is doing better here you have no incentive for a short cut why because you're gonna get the stocks for $0 you don't have to pay anything you just have to wait a period of time so the alignment of your interest and the company's interest are better aligned they are better aligned and let's take let's take a look at an example just to see how this works okay so we have this company on January 1st Skidmore company-issued 1000 of shares that are restricted to a CEO Skidmore stock has a fair value of $20 per share on January 1st we are given additional information the service period related to the restricted stocks is five years so the executives will have to work at the company five years and they are guaranteed to get 1,000 shares right now the stock price is $20 right now the stock price is $20 okay so the vesting period a vesting occurred if if the executive stays with the company for five years so you only gonna get this if you stay with the company for five years so this way they are retained on you and the part value per stock is $1 the part value of stock is $1 so what entry do we have to make on the date of the grant on the date of the grand okay so what company does Skidmore makes well on the date of the grant what's gonna happen we're gonna have what's called an unearned compensation an unearned compensation of 20,000 which is what did the 20,000 came from it's the value of the stocks today the value of the stocks today is 20,000 which is 1,000 shares times $20 today so we debit unearned compensation well now unearned compensation is not an asset this is not an asset actually it's a component of equity it's an equity account okay now we're gonna credit common stock one Townsend credit paid in capital 1000 so we what kind of we assume that the stocks are issued but remember we bring equity up then we bring equity down so the net effect on equity is 0 why because equity went up then equity went down so there is no effect on the stock on the only overall equity of the company and just we are recording we do have a future compensation of 20,000 to account for that's all what we are doing here okay to tell the users look we granted those stock we gave those restricted stocks to the executives therefore in future years as the executive stays with the company we're gonna have what's called a compensation expense a total of 20,000 over five years but today there's really no expense and the company is not is in the end is in the same position okay so what's gonna happen notice under compensation represent the cost of service yet to be performed so there's no expense yet which is not an asset under the compensation is reported as component of stockholders equity as I told you it's an equity account now after one year what happened after one year after the executive stays with the company for one year well remember let me just kind of draw this we have unearned compensation just to kind of remind you and we have in this account 20,000 and this unearned compensation is for five years so what's gonna happen after year one the executive spent the year one with the company we are going to credit unearned compensation and now it's gonna go down to 16,000 and we're gonna debit compensation expense now we are recording the expense now the expense is being recorded as as the executives work for the company the expense is recorded now okay let me just erase this so we see this note okay Skidmore record compensation expense of 4,000 for each of the next four years 2015 2016 2017 and 2018 so this is gonna be the entry for the next five years assume in what assuming that the executive stays with the company okay assuming the executive stays with the company okay let's change the scenario a little bit and let's assume stocker leaves the company On February 3rd 2016 before an expense has been recorded for 2016 so remember this was for 2014 so we did this entry for 2014 and we're gonna do the same entry for 2015 so in 2015 we did the same entry so between 2014 and 2015 we had a compensation expense of 8,000 in total this was the compensation expense also just you want to keep track of your unearned compensation your unearned compensation was originally 20 then we debit in sorry yes was originally let me just go back here originally was at 20 yes originally 20 then for 2 years what what happened in 2 years the balance went down by 8 thousand total so twelve thousand so by 2016 we had expenses already recorded of 8,000 and we had a balance whoops a balance let me do it here let me just do the whole thing here so here's what happened unearned compensation let me just show you everything then we go over the entry was originally twenty thousand four thousand was recorded in 2014 and four thousand was recorded in 2015 to reduce it so the balance was twelve thousand the balance was twelve thousand now compensation expense the same thing was four thousand and four thousand the total was eight thousand now assume in stalker leaves the company what's going to happen is this we need to credit this account which is the compensation expense to bring it down to zero okay this is the entry right here then we need to credit compensation expense to bring it down to zero as well it's this entry right here let me go back this entry this entry in this entry that's done we also need to go back to the original entry let me go back to to the original entry and I need to remove this so I need to debit common stock and debit paid in capital so I need to debit common stock and debit paid in capital and by doing so I remove all the effect of the original entry so the original entry is gone the original entry is basically gone okay so this is the entry assuming that stocker leaves so we have to remove everything okay another another stock compensation is Employee Stock Purchase Plan it generally permit all the employee to purchase the stock at a discounted price okay plans are considered compensatory unless they satisfy all three conditions presented below substantially all full-time employees may participate on equitable basis the discount from the market is small in plant plan offers no substance substantive option feature and basically the employee stock purchase plain what happened is this you pay you pay from your paycheck so basically money deducted from your paycheck to buy stocks okay and basically if all the employees are participating so basically all employees are participating there's no there is no discrimination between employees so basically the company is raising money why because the employee pays the cash pays the cash and buy the stock we're assuming here that the discount is small okay so there is no option features here there's no option features here so when the employee pays the money they will buy the stock disclosure of compensation plan what above disclosure should the company have nature on extent of such a arrangement effect on the income statement of compensation expense method of estimating the fair value what method did we use and the cash flow effect on the company in case those in case those stock compensations are executed and to a great degree this is all what I'm gonna be covering in this session if you have any questions by all means email me or see me in class the next thing we're gonna look at is what we're gonna compute earnings per share in a simple capital structure if you have any questions by all means email me or see me in class