pacmandefense

Jason Johnson, CFA, is a principal of a large private equity firm in New York. One of the associates in his firm has identified a potential investment opportunity for the firm. Gasline, Inc. is a major producer of pipeline used in the production of natural gas in the Southwest United States.
Of particular concern to Johnson is Gasline’s numerous, complicated transactions related to the company’s various stock-based compensation plans.
For example, the CEO of Gasline was awarded a stock option package at the beginning of 2006, which could ultimately have a significant impact on the company’s future earnings. Details of the CEO’s stock option grant are outlined below.

CEO Options (grant date January 1, 2006)

Strike price	$37.00
Current market price	$35.00
Number of options	100,000
Option period	4 years
Vesting period	25% per year

For the valuation of the CEO’s stock options granted on January 1, 2006, Gasline estimated a fair value of $100,000 by using Monte Carlo simulation. In accordance with SFAS No. 123(R), which of the following statements is most accurate? Gasline's accounting treatment of the options is:

A) in compliance because the firm can elect to use either the intrinsic value model or the fair value model in the valuation of stock option plans.

B) in compliance because a Monte Carlo simulation is an acceptable method of valuing options in the absence of a market-based instrument.

C) not in compliance because the fair value must be established by using the Black-Scholes option pricing model.

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Under SFAS No. 123(R), firms are required to use the fair value method of valuing stock option plans. In the absence of a market-based instrument, firms may select and use an option-pricing model such as the Black-Scholes, the binomial model or Monte Carlo.

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Assume that the CEO of Gasline exercises 25,000 of his options on December 31, 2006, and the market price of the stock on that date is $39.50. Calculate the total compensation expense for the year ending 2006 that Gasline should recognize in association with the CEO option grant.

A) $25,000.

B) $62,500.

C) $100,000.

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Under the fair value method, as required by SFAS No. 123(R), Gasline will recognize compensation expense over the 4 year vesting period. For the year ending 2006, Gasline will recognize $25,000 (= $100,000 / 4 years) in compensation expense. Compensation expense is not affected when options are exercised.