101 Concepts for the Level I Exam

# Essential Concept 25: Stock Options

Compensation expense related to stock options is reported at fair value. The fair value has to be estimated using an appropriate valuation model.

The fair value of stock options is sensitive to inputs and assumptions of the valuation model:

• Exercise price up  ?  value of option down
• Stock price volatility up  ?  value of option up
• Estimated life of each award  ?  value of option up
• Estimated dividend yield up  ?  value of call option down
• Risk free rate up  ?  value of call option up

In accounting for stock options, there are several important dates, including the grant date, the vesting date, the exercise date, and the expiration date.

• The grant date is the day that options are granted to employees.
• The vesting date is the date that employees can first exercise the stock options.
• The exercise date is the date when employees actually exercise the options and convert them to stock.
• If the options go unexercised, they may expire at some pre-determined future date, commonly 5 or 10 years from the grant date.

The compensation expense is allocated over the service period.

Example:

A company awards 1,000,000 stock options to its executives on 1 July 2015. The estimated cost of each option is $0.50. The options require a service period of 4 years after the grant date before vesting. What is the stock option expense for 2015? Solution: Total expense = 1,000,000 x 0.5 =$500,000

Expense per year = 500,000 / 4 = $125,000 Expense for 2015, from 1 July 2015 to 31 Dec 2015 i.e half a year = 125,000 / 2 =$62,500