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Example SC 2-23 further illustrates the concepts discussed in this chapter.
EXAMPLE SC 2-23
Accounting for the award using graded vesting and straight-line attribution
For simplicity, the following assumptions have been made:
  • Only annual periods are illustrated; quarterly information is not presented
  • None of the compensation cost is subject to capitalization under other GAAP
  • Income tax considerations are ignored. Refer to TX 17 for guidance on the income tax implications of stock-based compensation awards
Facts and background
  • SC Corporation is a US public company with a calendar year end
  • All of the awards granted in the following examples are equity-classified
  • SC Corporation’s common stock has a par value of $0.01 per share
  • The award is granted on January 1, 20X1 and has only a service condition
  • SC Corporation has elected to estimate forfeitures and the pre-vesting annual forfeiture assumption on the grant date is 5%
Number of options granted
100,000
Grant date
Jan. 2, 20X1
Stock price on grant date
$100
Exercise price
$100
Vesting
1/3 each year for 3 years
Contractual term
10 years
Expected term
6 years
Expected volatility of the underlying common stock
30%
Expected dividend yield on stock
0%
Risk-free interest rate (continuously compounded)
3%
Estimated fair value per option under the Black-Scholes model
$35.29
Upon termination of employment, unvested options are forfeited and the contractual term of vested options truncates to 90 days from the termination date.
Scenario 1
On January 1, 20X1, SC Corporation grants 100,000 options with an exercise price of $100. Options vest evenly over three years. The grant-date fair value is $35.29 per option. Employees are given 90 days to exercise options in the event of termination.
Under the graded vesting attribution approach, each annual vesting tranche has a different requisite service period over which employees earn the awards. At the end of 20X1, employees will have vested in 100% of Tranche 1, will have completed 50% of the requisite service period for Tranche 2 and will have completed 33% of the requisite service period for Tranche 3. SC Corporation applies an annual forfeiture rate assumption of 5% to each tranche, which means that, at the grant date, SC Corporation expects that 95% of Tranche 1, 90.25% (.95 × .95) of Tranche 2, and 85.74% (.95 × .95 × .95) of Tranche 3 will vest.
The following tables present the number of options expected to vest and the related compensation cost estimated from the grant date through the end of the requisite service period.
Proportion of grant date fair value recognized as compensation cost
Tranche
Number of options expected to vest
20X1
20X2
20X3
1
31,667
95%
2
30,083
45%
45%
3
28,579
28.6%
28.6%
28.6%
Totals
90,329
62.3%
27.2%
10.5%
Compensation cost recognized each year
Tranche
Number of options expected to vest
20X1
20X2
20X3
1
31,667
$1,117,528
2
30,083
530,815
$530,815
3
28,579
336,184
336,184
$336,184
Totals
90,329
$1,984,527
$866,999
$336,184
The following schedule summarizes option activity through 12/31/20X5, showing the number of options each year that legally vested and the number of options exercised and cancelled.
Date
Vested
Exercised
Post-vesting cancellations
12/31/20X1
31,667
12/31/20X2
30,083
12/31/20X3
28,579
12/31/20X4
(6,000)
12/31/20X5
(50,000)
Totals
90,329
(50,000)
(6,000)
Note that from 20X1 to 20X3, actual forfeitures were 5% annually, which was exactly as expected. As a result, SC Corporation did not have to adjust its expected compensation cost.
How should SC Corporation account for the awards using graded vesting attribution?
Analysis
Based on the above activity, SC Corporation would record the following journal entries.
Dr. Compensation expense
$1,984,527
Cr. Additional paid-in capital
$1,984,527
To recognize 20X1 compensation expense
Dr. Compensation expense
$866,999
Cr. Additional paid-in capital
$866,999
To recognize compensation expense in 20X2
Dr. Compensation expense
$336,184
Cr. Additional paid-in capital
$336,184
To recognize compensation expense in 20X3
On October 1, 20X4, employees with collectively 6,000 options terminated their employment. The options remain underwater through December 31, 20X4 and are then cancelled in accordance with the term truncation. Previous compensation expense is not reversed because the terminated employees completed the three-year service condition.
On December 31, 20X5, employees exercised 50,000 options when the market price of SC Corporation’s common stock was $140 per share.
SC Corporation would record the following journal entry.
Dr. Cash
$5,000,000
Cr. Common stock
$500
Cr. Additional paid-in capital
$4,999,500
To recognize the exercise of 50,000 options at an exercise price of $100
Scenario 2
Assume the same facts as Scenario 1 except that in Scenario 2 SC Corporation uses straight-line attribution.
The following table presents the number of options expected to vest and the related compensation cost.
Total
20X1
20X2
20X3
Number of options expected to vest
90,329
31,667
30,083
28,579
Compensation cost
$3,187,710
$1,117,528
$1,061,629
$1,008,553
How should SC Corporation account for the awards using straight-line attribution?
Analysis
The annual forfeiture-rate assumption is applied to each tranche to determine the total number of awards expected to vest and, therefore, the total compensation cost. As SC Corporation elected the straight-line attribution method, the total compensation cost is recognized on a straight-line basis over the requisite service period for the entire award (i.e., over 3 years—the requisite service period of the last separately vesting portion of the award). However, ASC 718-10-35-8 requires that the amount of compensation cost recognized at any date must at least equal the portion of the grant-date value of the award that is vested (i.e., the “floor”). Therefore, in the first year, the minimum amount of cost that must be recognized in this fact pattern is the amount that legally vests. Assuming the forfeiture estimate was accurate, then 95% of the cost of the first tranche of awards must be recognized, or $1,117,528. The estimate of expected forfeitures would need to be updated each period based on actual experience. Other approaches for determining and applying the forfeiture rate to the attribution approach in this scenario may be acceptable.
SC Corporation would record the following journal entries.
Dr. Compensation expense
$1,117,528
Cr. Additional paid-in capital
$1,117,528
To recognize compensation expense in 20X1
Dr. Compensation expense
$1,061,629
Cr. Additional paid-in capital
$1,061,629
To recognize compensation expense in 20X2
Dr. Compensation expense
$1,008,553
Cr. Additional paid-in capital
$1,008,553
To recognize compensation expense in 20X3
Dr. Cash
$5,000,000
Cr. Common stock
$500
Cr. Additional paid-in capital
$4,999,500
To recognize the exercise of 50,000 options at an exercise price of $100 on December 31, 20X5

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