Reading 22: Employee Compensation: Post-Employment and Share-

accounting, 2010, class, statements, companies

Session 6: Financial Reporting and Analysis: Post-Employment and
Share-Based Compensation and Multinational Operations
Reading 22: Employee Compensation: Post-Employment and Share-Based

LOS j: Explain the impact on financial statements of accounting for stock grants and stock options, and the importance of companies’ assumptions in valuing these grants and options.

Which of the following statements about the methods of valuing employee stock options is least accurate?

A)	With the fair value method, compensation expense is allocated in the income statement for the period between the grant date and the vesting date.

B)	With the intrinsic value method, once the options are in-the-money, compensation expense is recognized on the income statement.

C)	With either method, the offset to compensation expense recognized is an increase in paid-in capital.

With the intrinsic value method, compensation expense is recognized in the income statement only if the market price of the stock exceeds the exercise price of the option on the date the option was granted (grant date).

Compensation expense is now based on the fair value of the option on the grant date based on the number of options that are expected to vest. The vesting date is the first date the employee can actually exercise the option. The compensation is allocated in the income statement over the service period (which is the time between the grant date and the vesting date).

For any compensation expense recognized, the offset is an expense in paid-in capital, which is a stockholders’ equity account.

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Which of the following statements about stock appreciation rights, performance stock, and phantom stock is most accurate?

A)	Stock appreciation rights never have any dilution effect on the existing shareholders.

B)	Performance stock cannot be sold by the employee until vesting has occurred.

C)	Phantom stock payoffs are based on the performance of the firm’s actual shares.

With stock appreciation rights since no shares are actually issued, there is no dilution to the existing shareholders.

Performance stock is a type of stock grant. It is contingent on meeting performance goals such as accounting earnings or other financial reporting metrics like return on assets or return on equity. Unfortunately, tying performance to accounting earnings and other metrics may result in manipulation by the employee. With restricted stock, the transferred stock cannot be sold by the employee until vesting has occurred.

Phantom stock is similar to stock appreciation rights except the payoff is based on the performance of hypothetical stock instead of the firm’s actual shares.

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In determining the fair value of a stock option, which of the following statements is most appropriate?

A)	A higher than expected dividend yield will decrease the estimated fair value.

B)	Absent a market-based instrument, U.S. GAAP and IFRS prefer firms to use the Black-Scholes option-pricing model.

C)	A lower risk-free rate will usually increase the estimated fair value.

Dividends paid out reduce the value of the underlying shares and therefore, reduce the value of the option.

There is no preference of a specific option-pricing model in either IFRS or U.S. GAAP. Acceptable models include the Black-Scholes model or the binomial model.

A lower risk-free rate will usually decrease the estimated fair value of the option (Refer to Study Session 17). The sensitivity factor is “Rho” and for call options, there is a positive relationship between the risk-free rate and the estimated fair value of the option.