Answered Essay: Smaller Corporation has been in operation for several years. Each year, around the holidays, Smaller gi

Smaller Corporation has been in operation for several years. Each year, around the holidays, Smaller gives a cash bonus to each of its employees and records the bonuses as compensation expense. Smaller has reached the point at which it is now making a reasonable return on its shareholders’ equity. At the end of the current year, the company president is considering establishing a compensatory share option plan for Smaller’s key executives, instead of paying cash bonuses to any of its employees. At this time, the market price and the planned option (exercise) price of the company’s common stock are the same. The plan would allocate a specified number of options to each executive based on the executive’s level within the company and meeting Smaller’s targeted income goals. The service period would be 3 years and the options would have to be exercised within 10 years.

You are the controller for Smaller and one of the key executives who would participate in the plan. You also already own a substantial number of shares of Smaller common stock. The company president comes to you for advice about this plan and says, “If Smaller establishes this plan, it will work out for all of us. It looks like the plan is pretty valuable, since an option pricing model shows a high fair value for each option. The corporation will be saving cash because it won’t have to pay bonuses to either the executives or the other employees. But executives will manage better because their share options will depend on meeting the company’s targeted income. Because the market price and the option price are the same, there won’t be any compensation cost or expense related to this plan. Furthermore, since no bonuses would be paid to any employees, the corporation will decrease its compensation expense. This will increase its net income and earnings per share compared to last year, as well as its return on shareholders’ equity. So the stock value will go up. This seems like a win-win situation for everyone. Am I right on this?” Do you think Smaller should adopt this compensatory share option plan?

Required:

From financial reporting and ethical perspectives, how would you reply to the president?

Expert Answer

 

Smaller Corporation

Theory:

From long term perspective, Employee Stock Option Plan is considered as a good management tool for retention of human resources.

Under this scheme, employees are provided stake in the company in the form of shares / options at reduced price than what prevails in the market.
As a founder, you would always want to hire the best of resources for your startup, but the problem is that the best has cost attached to it, which a startup may not be able to afford initially.
Thus, Employee Stock Option Plan (ESOPs) gives a solution to the founders, by which they can look to instill founder’s motivation among their founding team by offering stake in the business by way of ESOPs.

Accounting Treatment of ESOPs:

The total compensation cost is the fair value of the instruments issued multiplied by the number of instruments that actually vest.
This cost is recognized over the requisite service period with a corresponding credit to Employee Stock Options Outstanding account.

Concept Example Given Case (hypothetical)
Particulars $ per stock $ per stock Remarks
Market Value of stock 50 10
Fair value of option 32 10
No. of options 1000 1000
Total Amortized employee stock compensation expenses 18,000.00 0.00 To be amortised over service period
No of options X (Mkt value – fair vale of option)
Service period 3.00 3.00
Yearly amortised esop expense 6,000.00 0.00
Conclusion:

Since the company will not be paying its cash in the form of bonuses, it will be saving the sum of money and will be utilising it better for carrying out its operations effectively
Nil amortisation expense reported in profit and loss account as (Mkt value of stock=fair value of option). Hence, improving the profitability.
Win-win situation for key executives as well as they will be eventually benefitted in the form of increase in market value of stock.
This will also keep them motivated to work towards achieving more of company’s target
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