pacmandefense

Which of the following is NOT an advantage of share based compensation over cash compensation?

A) Share based compensation does not require a cash outlay.

B) Share based compensation serves to align employee interest with the interests of stockholders.

C) In a share based compensation plan, expense is not recognized, unless the exercise price is set below the market price.

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Share based compensation needs to be recognized at fair value under both U.S. GAAP and IFRS. Intrinsic value does not matter. However, the expense is does not require a cash outlay and serves to align the interests of employees and stockholders.

pacmandefense

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

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

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

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

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

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

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

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Stock appreciation rights do not cause dilution to the existing shareholders since no shares are actually issued.

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 employee stock options, which of the following statements is most appropriate?

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

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

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

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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.

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.