Case Study: Sooner And Later

On January 1, 2006 Sooner or Later Inc. granted $1,000 at-the-money employee stock options. To ensure that the company can afford to compensate their employees based on their financial performance the award will only be absolute if the revenue over the following three years is greater than 10 million dollars and if the employees are still employed with the company. Sooner or Later’s management believes that the company will have revenues in excess of 10 million dollars over the next three year period. According to FASB, Statement no. 123(R) A Corporation must use the fair value method to account for compensatory share option plans. Sooner or Later has two options: they can either use the grant date fair value of $9.00 or they can use the grant
date fair value of $6.00 determined by their valuation professionals. Our group has assumed that the grant date fair value of $9.00 is calculated without the revenue target included. The grant date fair value of $6.00 is when the revenue target is factored into the fair value assessment. As mentioned earlier, employees will only be guaranteed the awards if two criteria are present.
The first being that the employee provides services to the company for three years. The second criteria is that the company attains a revenue target of 10 million dollars cumulatively for the following three years. Sooner or Later has met both of these criteria. The revenues from 2006 to 2008 are $11 million and their employees have provided services to the company for three years. Sooner or Later should use the grant date fair value of $6 when measuring compensation cost because the revenue target is factored into the fair value and the employees would be vested the award. A second reason the company should use the $6 grant date fair value would be because, “an award’s quantity may double, or an award’s contractual term may be extended, if a company-wide revenue target is achieved. (FASB code 718-10-55-64).” This option would seem very beneficial to the employees since the company reached their revenue target. This means the award granted would double in amount and the term of the contract would be
extended. The second option Sooner or Later has would be the known option grant date fair value of $9.00. The first reason for using this amount is, “performance or service that only affect vesting are excluded from the estimate of grant date fair value, but all other performance or service conditions that affect and awards fair value are included in the estimate of grant date fair value”(FASB code 718-10-55-64). Therefore performance or services that determine whether the employees will receive the award are excluded from the estimate of the grant date fair value. Also, according to ASC 718-10-30-15,”market, performance, and service conditions may affect the award’s exercise price, contractual term, quantity or other factors that are considered in measuring an awards grant date fair value.” Therefore if the company is having a good year this could lead to longer terms and higher prices which are favorable for the employees. Based on our arguments mentioned above, our group believes that the company should use the known option grant date fair value of $9.00.
We believe this is true because as mentioned earlier, performance that affects only whether the employees are granted the award should be excluded from the fair value estimate. We also believe this because in order for the company to use the fair value determined by the valuation officials, the company must meet their revenue target in order for that value to be factored in. Although Sooner or Later was able to exceed their target by 1 million dollars for the following three years, that does not mean they will be able to achieve their goal every time. We also believe it is beneficial that performance or service conditions affect the award’s fair value because good performance can lead to extended contract term and doubled quantity. If the employees are making more money, they will be motivated to do their job and do it well. In the long run satisfied employees will help the company’s bottom line and help to generate more profits. Sooner or Later should recognize compensation costs associated with these stock options for three years, 2006-2008. According to our calculations below, $3,000 should be recognized in each of these years. | 2006 | 2007 | 2008 | Estimated Compensation ($9*1,000) | 9,000 | 9,000 | 9,000 | Fraction of year | *1/3 | *1/3 | *1/3 | Compensation expense to date | 3,000 | 6,000 | 9,000 | Previous compensation
Expense | 0 | 3,000 | 6,000 | Current compensation Expense | 3,000 | 3,000 | 3,000 |

Unearned Compensation 9000 Common Stock 9000
Respectively over 3 years (1000 x 9 x 1/3)
Compensation Expense 3000 Unearned Compensation 3000
The reason why the journal entries are as such is because it is restricted stock. There are “restrictions” to the employees that they cannot; sell, transfer, or pledge until vesting occurs. There is also a termination clause that if the employee is no longer employed then the stock is forfeited. They must also meet a certain sales goal and at Sooner or Later it is a goal of 10 Million dollars. The employees are restricted to these terms, unlike common stock. The compensation cost should be recognized over three years because that is how long the service period was.