3.

Recognition – Stock Compensation

Two main accounting issues
- How to determine compensation expense
- Over what periods to allocate compensation expense

DETERMINE COMPENSATION EXPENSE

Under the fair value method, companies compute total compensation expense based on the
fair value of the options expected to vest on the date they grant the options to the employee(s)
(i.e., the grant date).

ALLOCATING COMPENSATION EXPENSE

Recognizes compensation expense in the periods in which its employees perform the service
—the service period which is the vesting period—the time between the grant date and the
vesting date. Company determines total compensation cost at the grant date and allocates it to
the periods benefited by its employees’ services.

STOCK COMPENSION EXAMPLE

Example 1
On November 1, 2019, the stockholders of Chen Company approve a plan that grants the
company’s five executives options to purchase 2,000 shares of $1 par value common stock.
The company grants the options on January 1, 2020. The executives may exercise the options
at any time within the next 10 years.
The option price per share is $60, and the market price of the stock at the date of grant is $70
per share. Assume that the fair value option-pricing model determines Chen’s total
compensation expense to be $220,000.

Solution
Assume that the expected period of benefit is 2 years, starting with the grant date
Date of grant (January 1, 2020)
No entry

Compensation Expense for 2020 (December 31, 2020)

 Compensation Expense 110,000
Paid-in Capital – Stock Options (220,000/2) 110,000

Compensation Expense for 2021 (December 31, 2021)

Compensation Expense 110,000
Paid-in Capital – Stock Options (220,000/2) 110,000

If Chen’s executives exercise 2,000 of the 10,000 options (20% of the options) on June 1, 2023
Exercise (June 1, 2023)
Cash (2,000 × $60) 120,000
Paid-in Capital - Stock Options ($220,000 x 20%) 44,000
Common Stock (2,000 × $1) 2,000
Paid-in Capital in Excess of Par - Common 162,000

If Chen’s executives fail to exercise the remaining stock options before their expiration date
Expiration (January 1, 2030)
Paid-in Capital - Stock Options 176,000
Paid-in Capital—Expired Stock Options 176,000
($220,000 x 80%)

Adjustment
A company does not adjust compensation expense upon expiration of the options.
However, if an employee forfeits a stock option because the employee fails to satisfy a
service requirement (leaves employment…), the company should adjust the estimate of
compensation expense recorded in the current period.
A company records this change
Paid-in Capital—Stock Options
Compensation Expense

Example 2
On January 1, 2021, Titania Inc. granted stock options to officers and key employees for the
purchase of 20,000 shares of the company’s $10 par common stock at $25 per share. The
options were exercisable within a 5-year period beginning January 1, 2023, by grantees still
in the employ of the company, and expiring December 31, 2027. The service period for this
award is 2 years. Assume that the fair value option-pricing model determines total
compensation expense to be $350,000.
On April 1, 2022, 2,000 options were terminated when the employees resigned from the
company. The market price of the common stock was $35 per share on this date.
On March 31, 2023, 12,000 options were exercised when the market price of the common
stock was $40 per share.
Instructions
Prepare journal entries to record issuance of the stock options, termination of the stock
options, exercise of the stock options, and charges to compensation expense, for the years
ended December 31, 2021, 2022, and 2023.
Solution
January 1, 2021
No entry

December 31, 2021

Compensation Expense 175,000
 Paid-in Capital – Stock Options 175,000
($350,000/2)

On April 1, 2022
Paid-in Capital - Stock Options 170,000
Compensation Expense 170,000
($175,000 x 2,000/20,000)

December 31, 2022

Compensation Expense 157,500
Paid-in Capital – Stock Options 157,500
($350,000/2 x 18/20)

March 31, 2023

Cash (12,000 × $25) 300,000
Paid-in Capital - Stock Options 210,000
($350,000 x 12,000/20,000)
Common Stock (12,000 × $10) 120,000
Paid-in Capital in Excess of Par - Common 390,000
Note: There are 6,000 options unexercised as March 31, 2023 (20,000 – 2,000 – 12,000)

December 31, 2027

Paid-in Capital - Stock Options 140,000
Paid-in Capital—Expired Stock Options 140,000
($350,000 – $210,000)

Quiz
1. Which order of events is accurate for most stock options?
A. Vesting, grant, exercise 
B. Grant, exercise, vesting 
C. Vesting, exercise, sale 
D. Exercise, vesting, sale
Answer: C

2. After you leave a company, what can happen to unvested stock options, and how long
will you have to exercise vested stock options before expiration?
A. Depends on the reason for leaving the company 
B. All unvested options are forfeited; you have no time to exercise them, as they expire when
you leave the company 
C. Vesting continues, and you have until the end of the option term to exercise 
D. Any of the above. You need to check your stock plan and grant agreement for the
treatment of unvested stock options and the post-termination exercise period
Answer: D

3. If an employee fails to exercise a stock option before its expiration date, the company
should NOT adjust compensation expense.
A. True
B. False
Answer: B
4. On January 1, 2020, Barwood Corporation granted 5,000 options to executives. Each
option entitles the holder to purchase one share of Barwood’s $5 par value common
stock at $50 per share at any time during the next 5 years. The market price of the stock
is $65 per share on the date of grant. The fair value of the options at the grant date is
$150,000. The period of benefit is 2 years.
Prepare journal entries for January 1, 2020.
A.
Compensation Expense 75,000
Paid-in Capital – Stock Options 75,000
B. No entry

C.
Compensation Expense 150,000
Paid-in Capital – Stock Options 150,000
D.
Paid-in Capital – Stock Options 75,000
Compensation Expense 75,000
Answer: B