Chapter 19: Share-Based Compensation and Earnings Per Share

Chapter 19: Share-Based Compensation and Earnings Per Share

Overview

• Share-based compensation is a means used by companies to compensate employees.

• Different formats for share-based compensation:

  • Stock award plans

  • Stock option plans

  • Stock appreciation rights

Valuation and Expense Recognition

• Fair value is used for measuring share-based compensation in each reporting period.

• Expense allocations will be detailed through examples.

Restricted Stock Plans

Types of Restricted Stock Plans

1. Restricted Stock Award

   • Shares awarded to employees but come with certain restrictions.

   • Possible forfeiture if conditions are not met (e.g., failure to complete the vesting period).

2. Restricted Stock Units (RSUs)

   • Entitles the employee to receive shares upon meeting conditions but does not grant share ownership until vesting.

Key Concepts

• Restricted Term: implies that the employee must wait for shares to vest before ownership is granted.

• Valuation for restricted stock is determined based on fair market value on the grant date.

• Expense recognition aligns with the service period of the employee.

Example: Universal Communication - Restricted Stock Awards

• Par value per share: $1

• Total shares for award: 5,000,000 shares

• Market value on grant date: $12 per share

• Total fair value of share-based compensation:
  $12 imes 5,000,000 = 60,000,000$

• Vesting period: 4 years, meaning compensation expense allocated annually:
  $rac{60,000,000}{4} = 15,000,000$

General Journal Entry for Restricted Stock Award

• Total compensation expense incurred: $60,000,000

• Common stock recognition: $5,000,000 (5,000,000 shares at $1 par)

• Paid-in capital in excess of par:
  $(12 - 1) imes 5,000,000 = 55,000,000$

• Counter equity account setup to reflect deferred compensation.

Restricted Stock Units

• Similar to restricted stock awards but no shares are issued at the grant date; just a promise of future shares.

• Fair market value also maintained at $12 per share for RSUs.

• Total compensation expense similar to the stock award: $60,000,000, allocated as:
  $rac{60,000,000}{4} = 15,000,000$

Key Differences from Restricted Stock Awards

• No journal entry at grant: just an acknowledgment of a future promise.

• Compensation expense recognized as it is earned, without needing a counter equity account initially.

Difference in Journal Entries

1. For Restricted Stock Awards:

   • Credit to common stock, paid-in capital in excess of par, and deferred compensation as equity.

2. For Restricted Stock Units:

   • Credit to paid-in capital account specific for RSUs when recognizing compensation expense.

Stock Option Plans

• Stock options are a popular compensation plan in many companies, especially in Silicon Valley.

• Options give employees the right to purchase stock at a fixed price, called the exercise price, regardless of current market price.

• Must be exercised within a certain time frame.

Key Components

• Fair market value is based on the option pricing model at the grant date.

• Total compensation expense calculated based on the fair value of the options.

Example: Universal Communication - Stock Options

• Grant of 10,000,000 options with an exercise price of $35/share.

• Fair value per option: $8

• Total compensation expense =
  $10,000,000 imes 8 = 80,000,000$

• Annual allocation for four years:
  $rac{80,000,000}{4} = 20,000,000$

Journal Entries for Stock Options

• No entry at grant; recognition only happens when the service period elapses:

  • Debit compensation expense and credit paid-in capital in stock options instead.

Forfeiture Rates in Stock Options

• Forfeiture rates affect the estimated compensation expense.

• If the forfeiture rate is 5%, then the expected total expenses adjust accordingly.

• During forfeiture, re-evaluation and potential reversal of expenses might occur.

Vesting Structures

• Two common forms of vesting:

  1. Cliff Vesting: full access after a specific duration.

  2. Graded Vesting: multiple partial vesting dates, typically scheduled at specific intervals.

Performance Conditions

• Performance conditions may require adjustments in recognized compensation expense based on the likelihood of meeting performance targets.

  • If initially expected to meet a condition changes, entries need immediate correction.

Conclusion

• Frequent complexities arise in recognizing share-based compensation.

• Recommended to review textbook materials, work through exercises, and clarify questions in next class.