section 1 asset exchanges section 1 asset exchanges

44 Pages·2004·1.54 MB·English

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SSEECCTTIIOONN 11 AASSSSEETT EEXXCCHHAANNGGEESS
In 2004, the FASB issued a new standard addressing the accounting for exchanges of
productive assets. This new standard, “Exchanges of Productive Assets: An Amend-
ment of APB Opinion No. 29,” Statement of Financial Accounting Standard (Stamford,
Conn.: FASB, 2004), is part of the FASB’s short-term international convergence project
and amends APB Opinion No. 29.
The following material should be used in place of the discussion in Chapter 10,
pages 482–487, of Intermediate Accounting, 11th Edition.
Exchanges of Nonmonetary Assets
The proper accounting for exchanges of nonmonetary assets (such as inventories and
property, plant, and equipment) is controversial.1 Some argue that the accounting for
these types of exchanges should be based on the fair value of the asset given up or the
fair value of the asset received, with a gain or loss recognized. Others believe that the
accounting should be based on the recorded amount (book value) of the asset given
up, with no gain or loss recognized. Still others favor an approach that would recog-
nize losses in all cases, but defer gains in special situations.
Ordinarily accounting for the exchange of nonmonetary assetsshould be based on
the fair value of the asset given up or the fair value of the asset received, whichever
is clearly more evident.2 Thus, any gains or losses on the exchange should be recog-
nized immediately. The rationale for this approach is that the transaction has com-
mercial substance and therefore should be recognized.
Meaning of Commercial Substance
As indicated above, fair value is the basis for measuring an asset acquired in a non-
monetary exchange, only if the transaction has commercial substance. An exchange
has commercial substance if the future cash flows change as a result of the transac-
tion. That is, if the two parties’ economic positions change, the transaction has com-
mercial substance. For example, Andrew Co. exchanges some of its equipment for
land held by Roddick Inc. It is likely that the timing and amount of the cash flows
arising from the land received in the exchange will be significantly different from
the cash flows from the equipment. As a result, both Andrew Co. and Roddick
Inc. are in different economic positions. Therefore the exchange has commercial
substance.
Even if similar assets are exchanged (e.g., an exchange of a truck for another truck),
a change in the economic position of the company can result. For example, let’s say the
useful life of the truck received is significantly longer than the truck given up. In this
case the cash flows for the trucks can be significantly different. As a result, the trans-
action has commercial substance and fair value should be used as a basis for measur-
ing the asset received in the exchange. However, if the difference in cash flows is not
1Nonmonetary assets are items whose price in terms of the monetary unit may change over
time. Monetary assets—cash and short- or long-term accounts and notes receivable—are fixed
in terms of units of currency by contract or otherwise.
2“Accounting for Nonmonetary Transactions,” Opinions of the Accounting Principles Board
No. 29 (New York: AICPA, 1973), par 18, and “Exchanges of Productive Assets: An Amend-
ment of APB Opinion No. 29,” Statement of Financial Accounting Standard (Stamford, Conn.: FASB,
2004).
UP-1
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UP-2 • Chapter 10 Update Acquisition and Disposition of Property, Plant, and Equipment
significant, then the company is in the same economic position as before the exchange
and no gain or loss should be recorded.3
As we will see in the examples below, use of fair value generally results in recog-
nition of a gain or loss at the time of the exchange. Consequently companies must care-
fully evaluate the cash flow characteristics of the assets exchanged to determine if the
transaction has commercial substance.4 Asset exchange situations and the related ac-
counting are summarized in Illustration U10-1.
ILLUSTRATION U10-1
Exchange Situation Accounting
Accounting for Exchanges
General Case
Fair values are determinable, Record at fair value asset
assuming commercial substance. received;recognize gain or
loss immediately.
Modification from the General Rule
Exchange lacks commercial Record at book value of the
substance. asset given up;no gain or
loss recognized.
To summarize, fair value is used to record an asset acquired in a nonmonetary ex-
change, if the transaction has commercial substance. Again or loss is recorded on the
exchange based on the difference between the carrying value of the asset relinquished
and the fair value of the asset received. If the exchange lacks commercial substance,
the exchange is recorded based on book values. In that case, no gains or losses are rec-
ognized on the exchange.
To illustrate the accounting for exchange transactions, we examine the following
situations:
(cid:1) Exchange with commercial substance—gain.
(cid:2) Exchange with commercial substance—loss.
(cid:3) Exchange lacks commercial substance.
Exchange with Commercial Substance—Gain
The cost of a nonmonetary asset acquired in exchange for another nonmonetary asset
is usually recorded at the fair value of the asset given up, and a gain or loss is recog-
nized. The fair value of the asset receivedshould be used only if it is more clearly ev-
ident than the fair value of the asset given up.
To illustrate, Interstate Transportation Company exchanged a number of used
trucks plus cash for vacant land that might be used for a future plant site. The trucks
have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depre-
ciation). Interstate’s purchasing agent, who has had previous dealings in the second-
hand market, indicates that the trucks have a fair market value of $49,000. In addition
3According to previous accounting standards, the primary factor in determining whether
to recognize gains on exchanges was based on whether the assets exchanged were “similar”
in nature. This approach was criticized due to the subjectivity of determining similarity in the
assets being exchanged. Adopting the commercial substance condition addresses this concern
and contributes to international accounting convergence. The FASB and the IASB are collab-
orating on a project in which they have agreed to converge around high-quality solutions to
resolve differences between U.S. GAAP and International Financial Reporting Standards
(IFRS). By adopting the commercial substance approach, U.S. GAAP and IFRS are now in
agreement.
4The determination of the commercial substance of a transaction requires significant judgment.
In determining whether future cash flows change, it is necessary to either (1) determine whether
the risk, timing, and amount of cash flows arising for the asset received is different from the cash
flows associated with the outbound asset, or (2) evaluate whether cash flows are affected with the
exchange versus without the exchange.
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Asset Exchanges • UP-3
to the trucks, Interstate must pay $17,000 cash for the land. The cost of the land to In-
terstate is $66,000 computed as follows.
ILLUSTRATION U10-2
Fair value of trucks exchanged $49,000
Computation of Land
Cash paid 17,000
Cost
Cost of land $66,000
The journal entry to record the exchange transaction is:
Land 66,000
Accumulated Depreciation—Trucks 22,000
Trucks 64,000
Gain on Disposal of Trucks 7,000
Cash 17,000
The gain is the difference between the fair value of the trucks and their book value.
It is verified as follows.
ILLUSTRATION U10-3
Fair value of trucks $49,000
Computation of Gain on
Cost of trucks $64,000
Disposal of Used Trucks
Less:Accumulated depreciation 22,000
Book value of trucks 42,000
Gain on disposal of used trucks $ 7,000
It follows that if the fair value of the trucks was $39,000 instead of $49,000, a loss
on the exchange of $3,000 ($42,000 (cid:1) $39,000) would be reported. In either case, the
company is in a different economic position and therefore the transaction has com-
mercial substance. Thus, a gain or loss should be recognized.
Exchange with Commercial Substance—Loss
To illustrate a loss situation, assume that Information Processing, Inc. trades its used
machine for a new model. The machine given up has a book value of $8,000 (original
cost $12,000 less $4,000 accumulated depreciation) and a fair value of $6,000. It is traded
for a new model that has a list price of $16,000. In negotiations with the seller, a trade-
in allowance of $9,000 is agreed on for the used machine. Based on an evaluation of
cash flows arising from the assets exchanged, management determines that this trans-
action has commercial substance. The cash payment that must be made for the new as-
set and the cost of the new machine are computed as follows.
ILLUSTRATION U10-4
List price of new machine $16,000
Computation ofCost of
Less:Trade-in allowance for used machine 9,000
New Machine
Cash payment due 7,000
Fair value of used machine 6,000
Cost of new machine $13,000
The journal entry to record this transaction is:
Equipment 13,000
Accumulated Depreciation—Equipment 4,000
Loss on Disposal of Equipment 2,000
Equipment 12,000
Cash 7,000
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UP-4 • Chapter 10 Update Acquisition and Disposition of Property, Plant, and Equipment
The loss on the disposal of the used machine can be verified as follows.
ILLUSTRATION U10-5
Fair value of used machine $6,000
Computation of Loss on
Book value of used machine 8,000
Disposal of Used
Loss on disposal of used machine $2,000
Machine
Why was the trade-in allowance or the book value of the old asset not used as a
basis for the new equipment? The trade-in allowance is not used because it included a
price concession (similar to a price discount) to the purchaser. For example, few indi-
viduals pay list price for a new car. Trade-in allowances on the used car are often in-
flated so that actual selling prices are below list prices. To record the car at list price
would state it at an amount in excess of its cash equivalent price because the new car’s
list price is usually inflated. Similarly, use of book value in this situation would over-
state the value of the new machine by $2,000. Because assets should not be valued at
more than their cash equivalent price, the loss should be recognized immediately rather
than added to the cost of the newly acquired asset.
Exchange Lacks Commercial Substance
The accounting treatment for exchanges that lack commercial substance is illustrated
in the real estate industry. In this industry, it is common practice for companies to
“swap” real estate holdings. Assume that Landmark Company and Hillfarm, Inc.
each had undeveloped land on which it intended to build shopping centers. Ap-
praisals indicated that the land of both companies had increased significantly in
value, but the cash flows arising from the land parcels to be exchanged are not sig-
nificantly different. Although the companies may wish to exchange (swap) their un-
developed land, record a gain, and report their new parcels of land at current fair
values, they are precluded from recognizing gains because the exchange lacks com-
mercial substance. That is, the companies remain in the same economic position af-
ter the swap as before. Therefore, the asset acquired should be recorded at book
value with no gain recognized.5
Let’s look at another example of an exchange that lacks commercial substance.
Davis Rent-A-Car has a rental fleet of automobiles consisting primarily of Ford Motor
Company products. Davis’s management wants to increase the variety of automobiles
in its rental fleet by adding numerous General Motors models. Davis arranges with
Nertz Rent-A-Car to exchange a group of Ford automobiles that are essentially identi-
cal to the General Motors models. The Ford vehicles to be exchanged have a fair value
of $160,000 and a book value of $135,000 (cost $150,000 less accumulated depreciation
$15,000). The GM models in the exchange have a fair value of $170,000. Davis pays
$10,000 in cash in addition to the Ford automobiles exchanged. The total gain to Davis
Rent-A-Car is computed as shown in Illustration U10-6.
ILLUSTRATION U10-6
Fair value of Ford automobiles exchanged $160,000
Computation of Gain
Book value of Ford automobiles exchanged 135,000
(Unrecognized)
Total gain (unrecognized) $ 25,000
In this case, Davis Rent-A-Car still has a fleet of cars with essentially the same cash
flows as the cars given up although different models. Therefore, the transaction lacks
commercial substance. As a result, the total gain is deferred, and the basis of the General
5Note that the asset given up may be impaired. As a result, if the book value exceeds the
fair value, an impairment is recorded, if the impairment test is met. For homework purposes, as-
sume that the impairment test is not met.
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Asset Exchanges • UP-5
Motors automobiles is reduced via two different but acceptable computations as shown
below.
ILLUSTRATION U10-7
Fair value of GM automobiles $170,000 Book value of Ford automobiles $135,000
Basis of New
Less:Gain deferred (25,000) OR Cash paid 10,000
Automobiles—Fair Value
Basis of GM automobiles $145,000 Basis of GM automobiles $145,000
vs.Book Value
The entry by Davis to record this transaction is as follows.
Automobiles (GM) 145,000
Accumulated Depreciation—Automobiles 15,000
Automobiles (Ford) 150,000
Cash 10,000
The gain that reduced the basis of the new automobiles will be recognized when
those automobiles are sold to an outside party. While these automobiles are held, de-
preciation charges will be lower, and net income will be higher in subsequent periods
because of the reduced basis.
To summarize, fair value is the basis for measuring an asset acquired in a non-
monetary exchange, if the transaction has commercial substance. A gain or loss is
recorded on the exchange based on the difference between the carrying value of the
asset relinquished and the fair value of the asset received. One other exception to the
general rules must be noted: If fair values for either the asset received or the asset
given up in the exchange are not determinable within reasonable limits, the book value
of the asset relinquished (plus any cash paid) will be recorded as the cost of the asset
received.6
For example, due to a change in its meat packing process, Jones Meat Locker Co.
trades its specialty meat-packing equipment for new equipment that can be used in its
new packing process. Because of the specialty nature of the equipment being exchanged,
the fair values of the assets being exchanged cannot be reliably determined. The used
equipment has a book value of $9,000 (original cost of $17,000 less $8,000 accumulated
depreciation). The list price of the new equipment is $21,000. The equipment vendor
gives Jones an $11,000 trade-in allowance on its old equipment. The cash payment made
for the new machine and the cost to be recorded are computed as follows.
ILLUSTRATION U10-8
List price of new equipment $21,000
Computation of Cost
Less:Trade-in allowance for used equipment 11,000
of New Machine
Cash payment due 10,000
Book value of old equipment 9,000
Cost of new equipment $19,000
The journal entry to record the exchange is:
Equipment 19,000
Accumulated Depreciation—Equipment 8,000
Equipment 17,000
Cash 10,000
As indicated, in the absence of fair values (for either the asset received or the as-
set relinquished), the company uses the book value of the asset added to cash paid in
the exchange to measure the cost of the new equipment.
6Yet another exception to the fair value rule is for an exchange that facilitates sales to cus-
tomers. An example of this situation is when a company exchanges its inventory items with in-
ventory of another company because of color, size, etc. to facilitate sale to an outside customer.
In this case, the earnings process for the inventory is not considered complete, and a gain is not
recognized.
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UP-6 • Chapter 10 Update Acquisition and Disposition of Property, Plant, and Equipment
An enterprise that engages in one or more nonmonetary exchanges during a period
should disclose in financial statements for the period the nature of the transactions, the
method of accounting for the assets transferred, and gains or losses recognized on
transfers.7
About those swaps
In a press release, Roy Olofson, former vice president of finance for Global Crossing,
accused company executives of improperly describing the company’s revenue to the
public. Olofson said Global Crossing had improperly recorded long-term sales imme-
What do the
diately rather than over the term of the contract, that the company improperly booked
numbers mean? swaps of capacity with other carriers as cash transactions, and that Global Crossing fired
him when he blew the whistle.
The accounting for the swaps is of particular interest here. The accounting for swaps
involves exchanges of similar network capacity. Companies engaged in such deals, they
have said, because it was less costly and quicker than building segments that their own
networks lacked, or because such pacts provided redundancies to make their own net-
works more reliable to customers. In one expert’s view, an exchange of similar network
capacity is the equivalent of trading a blue truck for a red truck—it shouldn’t boost a
company’s revenue.
But Global Crossing and Qwest, among others, used the transactions to do just that,
counting as revenue the money received from the company on the other end of the deal.
(In general, in transactions involving leased capacity, the companies booked the rev-
enue over the life of the contract.) Some of these companies then treated their own pur-
chases as capital expenditures, which weren’t run through the income statement. In-
stead, the spending led to the addition of assets on the balance sheet.
Both congressional and Securities and Exchange Commission investigators are seek-
ing to determine whether some of these capacity exchanges may have been a device to
pad revenue. Revenue growth was a key factor in the valuation of some of these com-
panies, such as Global Crossing and Qwest, throughout the craze for tech stocks in the
late 1990s and 2000.
Source:Adapted from Henny Sender, “Telecoms Draw Focus for Moves in Accounting,” Wall Street
Journal(March 26, 2002), p. C7.
EXERCISES
UE10-1 (Nonmonetary Exchange) Cannondale Company purchased an electric wax melter on April 30,
2005, by trading in its old gas model and paying the balance in cash. The following data relate to the purchase.
List price of new melter $15,800
Cash paid 10,000
Cost of old melter (5-year life, $700 residual value) 11,200
Accumulated depreciation—old melter (straight-line) 6,300
Second-hand market value of old melter 5,200
Instructions
Prepare the journal entry(ies) necessary to record this exchange, assuming that the exchange (a)has com-
mercial substance, and (b) lacks commercial substance. Cannondale’s fiscal year ends on December 31,
and depreciation has been recorded through December 31, 2004.
UE10-2 (Nonmonetary Exchange) Carlos Arruza Company exchanged equipment used in its manu-
facturing operations plus $3,000 in cash for similar equipment used in the operations of Tony LoBianco
Company. The following information pertains to the exchange.
7“Accounting for Nonmonetary Transactions,” op. cit., par. 28.
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Asset Exchanges • UP-7
Carlos Arruza Co. Tony LoBianco Co.
Equipment (cost) $28,000 $28,000
Accumulated depreciation 19,000 10,000
Fair value of equipment 12,500 15,500
Cash given up 3,000
Instructions
(a) Prepare the journal entries to record the exchange on the books of both companies. Assume that
the exchange lacks commercial substance.
(b) Prepare the journal entries to record the exchange on the books of both companies. Assume that
the exchange has commercial substance.
UE10-3 (Nonmonetary Exchange) Busytown Corporation, which manufactures shoes, hired a recent
college graduate to work in its accounting department. On the first day of work, the accountant was as-
signed to total a batch of invoices with the use of an adding machine. Before long, the accountant, who
had never before seen such a machine, managed to break the machine. Busytown Corporation gave the
machine plus $340 to Dick Tracy Business Machine Company (dealer) in exchange for a new machine.
Assume the following information about the machines. (The difference in expected cash flows between
the exchanged machines is significant.)
Busytown Corp. Dick Tracy Co.
(Old Machine) (New Machine)
Machine cost $290 $270
Accumulated depreciation 140 –0–
Fair value 85 425
Instructions
For each company, prepare the necessary journal entry to record the exchange.
UE10-4 (Nonmonetary Exchange) Dana Ashbrook Inc. has negotiated the purchase of a new piece of
equipment at a price of $8,000 plus trade-in, f.o.b. factory. Dana Ashbrook Inc. paid $8,000 cash and
traded in used equipment. The used equipment had originally cost $62,000; it had a book value of
$42,000 and a secondhand market value of $47,800, as indicated by recent transactions involving simi-
lar equipment. Freight and installation charges for the new equipment required a cash payment of
$1,100.
Instructions
(a) Prepare the general journal entry to record this transaction, assuming that the exchange has com-
mercial substance.
(b) Assume the same facts as in (a) except that fair value information for the assets exchanged is not
determinable. Prepare the general journal entry to record this transaction.
PROBLEMS
UP10-1 (Nonmonetary Exchanges) Susquehanna Corporation wishes to exchange a machine used in
its operations. Susquehanna has received the following offers from other companies in the industry.
1. Choctaw Company offered to exchange a similar machine plus $23,000 (exchange has commercial
substance).
2. Powhatan Company offered to exchange a similar machine (exchange lacks commercial substance).
3. Shawnee Company offered to exchange a similar machine, but wanted $8,000 in addition to Susque-
hanna’s machine (exchange has commercial substance).
Susquehanna Choctaw Powhatan Shawnee
Machine cost $160,000 $120,000 $147,000 $160,000
Accumulated depreciation 50,000 45,000 71,000 75,000
Fair value 92,000 69,000 92,000 100,000
Instructions
For each of the three independent situations, prepare the journal entries to record the exchange on the
books of each company.
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UP-8 • Chapter 16 Update Dilutive Securities and Earnings per Share
UP10-2 (Nonmonetary Exchanges) On August 1, Arna, Inc. exchanged productive assets with Bon-
temps, Inc. Arna’s asset is referred to below as “Asset A,” and Bontemps’ is referred to as “Asset B.” The
following facts pertain to these assets.
Asset A Asset B
Original cost $96,000 $110,000
Accumulated depreciation (to date of exchange) 45,000 52,000
Fair market value at date of exchange 60,000 75,000
Cash paid by Arna, Inc. 15,000
Cash received by Bontemps, Inc. 15,000
Instructions
(a) Assuming that the exchange of Assets Aand B has commercial substance, record the exchange for
both Arna, Inc. and Bontemps, Inc. in accordance with generally accepted accounting principles.
(b) Assuming that the exchange of Assets Aand B lacks commercial substance, record the exchange
for both Arna, Inc. and Bontemps, Inc. in accordance with generally accepted accounting princi-
ples.
UP10-3 (Nonmonetary Exchanges) During the current year, Garrison Construction trades an old crane
that has a book value of $80,000 (original cost $140,000 less accumulated depreciation $60,000) for a new
crane from Keillor Manufacturing Co. The new crane cost Keillor $165,000 to manufacture and is classi-
fied as inventory. The following information is also available.
Garrison Const. Keillor Mfg.Co.
Fair market value of old crane $ 72,000
Fair market value of new crane $190,000
Cash paid 118,000
Cash received 118,000
Instructions
(a) Assuming that this exchange is considered to have commercial substance, prepare the journal entries
on the books of (1) Garrison Construction and (2) Keillor Manufacturing.
(b) Assuming that this exchange lacks commercial substance for Garrison, prepare the journal entries
on the books of Garrison Construction.
(c) Assuming the same facts as those in (a), except that the fair market value of the old crane is $98,000
and the cash paid is $92,000, prepare the journal entries on the books of (1) Garrison Construc-
tion and (2) Keillor Manufacturing.
(d) Assuming the same facts as those in (b), except that the fair market value of the old crane is $87,000
and the cash paid $103,000. Prepare the journal entries on the books of Garrison Construction.
SSEECCTTIIOONN 22 SSTTOOCCKK--BBAASSEEDD CCOOMMPPEENNSSAATTIIOONN
Presented below is a discussion of a proposed standard on stock compensation plans.
The FASB announced in mid-October 2004 a six-month delay in passage of the stan-
dard. Thus, mandatory expensing of stock-based compensation would not begin until
the third quarter of 2005. Many attribute the delay to questions related to the valua-
tion models used to value stock options.
The following material provides information necessary to understand the new
standard and can be used in place of the discussion in Chapter 16, pages 781–787, of
Intermediate Accounting, 11th Edition.
STOCK COMPENSATION PLANS
Another form of warrant arises in stock compensation plans used to pay and motivate
employees. This warrant is a stock option, which gives selected employees the option to
purchase common stock at a given price over an extended period of time. As indicated
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Stock-Based Compensation • UP-9
in the opening story, stock options are very popular. For example, the following chart
shows stock options as a percentage of total compensation for 1999–2000 given to the top
200 CEOs and to 100 dot-com company CEOs.
ILLUSTRATION U16-1
200 top companies: Dot-coms:
Stock Options as a Portion
$11.3 million* $6.1 million*
$0.31 of Total Compensation
$0.43
$1.02 $0.06
Salary
Stock $2.15
Annual options
incentive $6.55 Stock options
(58%) $1.58 $5.31
Long-term
(87%)
incentive
*Values are based on Pearl Meyer estimates using a common model (the Black
Scholes model) to value stock options.
Source: Pearl Meyer & Partners
These figures show the dramatic change in the way many top executives (and for that
matter, regular employees) are compensated.
Effective compensation has been a subject of considerable interest lately. Aconsen-
sus of opinion is that effective compensation programs are ones that (1) motivate em-
ployees to high levels of performance, (2) help retain executives and allow for recruit-
ment of new talent, (3) base compensation on employee and company performance,
(4)maximize the employee’s after-tax benefit and minimize the employee’s after-tax cost,
and (5) use performance criteria over which the employee has control. Although straight
cash compensation plans (salary and, perhaps, bonus) are an important part of any com-
pensation program, they are oriented to the short run. Many companies recognize that
a more long-run compensation plan is often needed in addition to a cash component.
Long-term compensation plans attempt to develop in key employees a strong loyalty
toward the company. An effective way to accomplish this goal is to give the employees
“a piece of the action”—that is, an equity interest based on changes in long-term mea-
sures such as increases in earnings per share, revenues, stock price, or market share.
These plans, generally referred to as stock option plans, come in many different forms.
Essentially, they provide the employee with the opportunity to receive stock or cash in
the future if the performance of the company (by whatever measure) is satisfactory.
The Major Reporting Issue
Suppose that you are an employee for Hurdle Inc. and you are granted options to pur-
chase 10,000 shares of the firm’s common stock as part of your compensation. The date
you receive the options is referred to as the grant date. The options are good for 10
years. The market price and the exercise price for the stock are both $20 at the grant
date. What is the value of the compensation you just received?
Some believe you have not received anything: That is, the difference between the mar-
ket price and the exercise price is zero, and therefore no compensation results. Others ar-
gue these options have value: If the stock price goes above $20 any time over the next 10
years and you exercise these options, substantial compensation results. For example, if at
the end of the fourth year, the market price of the stock is $30 and you exercise your op-
tions, you will have earned $100,000 [10,000 options (cid:2) ($30 (cid:1) $20)], ignoring income taxes.
How should the granting of these options be reported by Hurdle Inc.? In the past,
GAAPrequired that compensation cost be measured by the excess of the market price
of the stock over its exercise price at the grant date. This approach is referred to as
theintrinsic value methodbecause the computation is not dependent on external cir-
cumstances: The compensation cost is the difference between the market price of the
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UP-10 • Chapter 16 Update Dilutive Securities and Earnings per Share
stock and the exercise price of the options at the grant date. Hurdle would therefore
not recognize any compensation expense related to your options because at the grant
date the market price and exercise price were the same.
Under previous accounting standards, companies could use eitherthe intrinsic or fair
value methods for recognizing stock-based compensation. Fair value represents the mar-
ket value of the option at the date of grant. Most companies adopted the intrinsic value
approach because it generally results in lower compensation expense. However, during
2002 a number of companies began voluntarily to switch to the fair value method for
recording compensation expense related to stock options. By March 2004 over 500 public
companies were using the fair value method. A major reason for this change was that
these companies wanted to show the investing community that they believe in fair and
transparent financial reporting, particularly in the aftermath of the many financial re-
porting scandals. Because some companies included stock-based compensation expense
in income based on fair value and others only disclosed the pro-forma effects, compara-
bility concerns were raised, and the FASB developed a new standard for stock-based com-
pensation.
The FASB now requires recognition of compensation cost for the fair value of
stock-based compensation paid to employees for their services.1The FASB position
is that the accounting for the cost of employee services should be based on the value
of compensation paid, which is presumed to be a measure of the value of the serv-
ices received. Accordingly, the compensation cost arising from employee stock op-
tions should be measured based on the fair value of the stock options granted.2 To
determine this value, acceptable option pricing models are used to value options at
the date of grant. This approach is referred to as the fair value method because the
option value is estimated based on the many factors that determine its underlying
value.3
Accounting for Stock Compensation
Stock option plans involve two main accounting issues:
OBJECTIVE U1
(cid:1) How should compensation expense be determined?
Describe the
accounting for stock (cid:2) Over what periods should compensation expense be allocated?
compensation plans
under generally Determining Expense
accepted accounting
Under the fair value method, total compensation expense is computed based on the
principles. fair value of the options expected to vest4 on the date the options are granted to the
employee(s) (i.e., the grant date). Fair value for public companies is to be estimated us-
ing an option pricing model, with some adjustments for the unique factors of employee
stock options. No adjustments are made after the grant date, in response to subsequent
changes in the stock price—either up or down.
1“Accounting for Stock-Based Compensation,” Statement of Financial Accounting Standards No.
123 (Norwalk, Conn.: FASB, 1995). “Share-Based Payment: An Amendment of FASB Statements
No. 123 and 95,” Statement of Financial Accounting Standard (Stamford, Conn.: FASB, 2004).
Note that in 2004 the International Accounting Standards Board (IASB) also issued a statement,
titled “Share-Based Payment,” which requires the expensing of stock-based compensation based on
fair values. Thus the FASB’s new standard contributes to international accounting convergence.
2Stock options issued to non-employees in exchange for other goods or services must be rec-
ognized according to the fair value method in SFAS 123.
3These factors include the volatility of the underlying stock, the expected life of the options,
the risk-free rate during the option life, and expected dividends during the option life.
4“To vest” means “to earn the rights to.” An employee’s award becomes vested at the date
that the employee’s right to receive or retain shares of stock or cash under the award is no longer
contingent on remaining in the service of the employer.