Chapter 19, Problem 19.1P

Stock options; forfeiture; exercise

• LO19–2

On October 15, 2017, the board of directors of Ensor Materials Corporation approved a stock option plan for key executives. On January 1, 2018, 20 million stock options were granted, exercisable for 20 million shares of Ensor’s $1 par common stock. The options are exercisable between January 1, 2021, and December 31, 2023, at 80% of the quoted market price on January 1, 2018, which was $15. The fair value of the 20 million options, estimated by an appropriate option pricing model, is $6 per option. Ensor chooses the option to recognize forfeitures only when they occur.

Ten percent (2 million) of the options were forfeited when an executive resigned in 2019. All other options were exercised on July 12, 2022, when the stock’s price jumped unexpectedly to $19 per share.

Required:

1. 1. When is Ensor’s stock option measurement date?
2. 2. Determine the compensation expense for the stock option plan in 2018. (Ignore taxes.)
3. 3. What is the effect of forfeiture of the stock options on Ensor’s financial statements for 2019 and 2020?
4. 4. Is this effect consistent with the general approach for accounting for changes in estimates? Explain.
5. 5. How should Ensor account for the exercise of the options in 2022?

To determine

Stock options: Stock options are the stock-based compensation plans provided in the form of an option to buy certain number of shares for a certain price during certain period.

To mention: The stock options measurement date

Explanation of Solution

The compensation cost of stock options would be measured on the grant date, January 1, 2018.

To determine

The amount of compensation expense of stock options

Explanation of Solution

Determine the amount of compensation expense to be recorded by Corporation E in 2018.

Step 1: Compute the total compensation cost of stock options.

$\begin{array}{c}\begin{array}{l}\text{Total compensation }\\ \text{cost of stock options}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Estimated fair market value of the option × }\\ \text{Number of options granted}\end{array}\right\}\\ \text{= \$6 × 20,000,000 shares}\\ \text{= \$120,000,000}\end{array}$ (1)

Step 2: Compute the compensation expense of stock options allocated to each of the three vesting periods.

$\begin{array}{c}\text{Expense allocated each year =}\frac{\text{ Total compensation cost of stock options}}{\text{Vesting period}}\\ \text{=}\frac{\text{\$120,000,000}}{\text{3 years}}\\ \text{= \$40,000,000}\end{array}$ (2)

Note: Refer to Equation (1) for value and computation of total compensation cost.

Thus, compensation expense to be recorded in 2018 is $40,000,000.

To determine

The effect of forfeiture of 10% of stock options in 2019 and 2020

Explanation of Solution

Effect of forfeiture of stock options in 2019:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2019
		Compensation Expense		32,000,000
		Paid-In Capital – Stock Options			32,000,000
		(To record changes in compensation expense due to forfeiture)

Table (1)

Working Notes:

Compute the new estimated expense allocated in 2019, after the 10% forfeiture.

$\begin{array}{c}\begin{array}{l}\text{Expense }\\ \text{allocated }\\ \text{in 2019}\end{array}\}\text{ =}\left\{\begin{array}{l}\left(\begin{array}{l}\text{Total compensation cost of stock options ×}\\ \left(\text{100\%–10\% of forfeiture}\right)\text{ ×}\\ \frac{\text{}\text{Number of years completed in vesting period}}{\text{Vesting period }}\end{array}\right)\text{–}\\ \text{Original expense allocated in 2018}\end{array}\right\}\\ \text{=}\left(\text{\$120,000,000×90\%×}\frac{\text{2 years}}{\text{3 years}}\right)\text{–\$40,000,000}\\ \text{= \$32,000,000}\end{array}$ (3)

Note: Refer to Equation (1) for value and computation of total compensation cost, and Equation (2) for value of compensation expense in 2018.

Thus the forfeiture of 10% of stock options reduces the compensation expense of $40,000,000 to $32,000,000 in 2019.

Effect of forfeiture of stock options in 2020:

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
		Compensation Expense		36,000,000
		Paid-In Capital – Stock Options			36,000,000
		(To record changes in compensation expense due to forfeiture)

Table (2)

Working Notes:

Compute the new estimated expense allocated in 2020, after the 10% forfeiture.

$\begin{array}{c}\begin{array}{l}\text{Expense }\\ \text{allocated }\\ \text{in 2020}\end{array}\}\text{=}\left[\begin{array}{l}\left\{\begin{array}{l}\text{Total compensation cost of stock options ×}\\ \left(\text{100\%–10\% of forfeiture}\right)\text{ ×}\\ \frac{\text{Number of years of vesting period completed}}{\text{Vesting period }\left(\text{2018 to 2020}\right)}\end{array}\right\}\text{–}\\ \text{Original expense allocated in 2018–}\\ \text{Expense allocated in 2019}\\ \end{array}\right]\\ \text{=}\left(\text{\$120,000,000×90\%×}\frac{\text{3 years}}{\text{3 years}}\right)\text{–\$40,000,000–\$32,000,000}\\ \text{= \$36,000,000}\end{array}$

Note: Refer to Equation (1) for value and computation of total compensation cost, Equations (2), and (3) for values of compensation expense in 2018 and 2019.

Thus the forfeiture of 10% of stock options reduces the compensation expense of $40,000,000 to $36,000,000 in 2020.

To determine

To explain: If the accounting method followed for forfeiture is in consistent with the usual method applied for changes in estimates

Explanation of Solution

No, the method is inconsistent.

Generally, the revised expense for changes in estimates which would be allocated to each year would be deducted by 10%, the original expense recorded in 2018 ($40,000,000) would be reduced from the revised total cost, 90% of total compensation cost $\left(\$120,000,000\times 90\%=\$108,000,000\right)$, and the remaining balance, $68,000,000 $\left(\$108,000,000–\$40,000,000\right)$, would be re-allocated on a straight line basis for other 2 years.

To determine

To journalize: The options exercised on July 22, 2022

Explanation of Solution

Journalize the entry for options exercised in the books of Corporation E.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2022
July	22	Cash		216,000,000
		Paid-in Capital – Stock Options		108,000,000
		Common Stock			18,000,000
		Paid-in Capital–Excess of Par			306,000,000
		(To record purchase option exercised by stock option holders)

Table (3)

• Cash is an asset account. Since cash is received, asset value increased, and an increase in asset is debited.
• Paid-in Capital–Stock Options is a stockholders’ equity account. Since stock options are exercised and shares are issued, stock options value is decreased, and a decrease in equity is debited.
• Common Stock is a stockholders’ equity account. Since stock options are exercised and shares are issued, common stock value increased, and an increase in equity is credited.
• Paid-in Capital–Excess of Par is a stockholders’ equity account. Since stock options are exercised and shares are issued, excess of par value increased, and an increase in equity is credited.

Working Notes:

Compute cash received by Corporation E.

$\begin{array}{c}\text{Cash received = }\left\{\begin{array}{l}\left(\begin{array}{l}\text{Number of shares granted–}\\ \text{Number of shares forfeited}\end{array}\right)\text{ × }\\ \text{Exercise price}\times \text{Reduced exercise price percentage}\end{array}\right\}\\ \text{= }\left(\text{20,000,000 shares –2,000,000 shares}\right)\text{× \$15}\times \text{80\%}\\ \text{= \$216,000,000}\end{array}$ (4)

Compute the paid-in capital of stock options amount.

$\begin{array}{c}\begin{array}{l}\text{Paid-in capital }\\ \text{amount}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Estimated fair market value of the option × }\\ \left(\begin{array}{l}\text{Number of shares granted–}\\ \text{Number of shares forfeited}\end{array}\right)\end{array}\right\}\\ \text{= \$6 × }\left(\text{20,000,000 shares}–2\text{,000,000 shares}\right)\\ \text{= \$108,000,000}\end{array}$ (5)

Compute the common stock amount.

$\begin{array}{c}\begin{array}{l}\text{Common stock }\\ \text{amount}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Par value per share × }\\ \left(\begin{array}{l}\text{Number of shares granted–}\\ \text{Number of shares forfeited}\end{array}\right)\end{array}\right\}\\ \text{= \$1 × }\left(\text{20,000,000 shares}–\text{2,000,000 shares}\right)\\ \text{= \$18,000,000}\end{array}$ (6)

Compute the paid-in capital–excess of par amount.

$\begin{array}{c}\begin{array}{l}\text{Paid-in capital–}\\ \text{excess of par value}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Cash received + }\\ \text{Paid-in capital of stock options value – }\\ \text{Common stock value}\end{array}\right\}\\ \text{= \$216,000,000 + \$108,000,000 – \$18,000,000}\\ \text{= \$306,000,000}\end{array}$

Note: Refer to Equations (4), (5), and (6) for all the values.