Option 3 March 12th Payment

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Stock option compensation is a form of equity based compensation in which a business rewards key personnel by granting them the rights to purchase shares in the business in return for their services.

A stock option, sometimes referred to as a share option, is a contract between a buyer and a seller which gives the buyer the right to buy a stock at a specified price (referred to as the exercise or strike price) on or before a specific date, and the seller the obligation to complete the transaction by selling the stock.

The stock option lasts from a period of time (the life of the option) and will expire after that date and have no value.

A stock option only exists because the underlying stock exists. A stock option therefore derives from the underlying stock and is a form of derivative.

Types of Stock Option

There are two types of stock option.

  1. Put option – Option to sell at an agreed price on or before a specific date.
  2. Call option – Option to buy at an agreed price on or before a specific date .

An employee stock option is a type of call option granted by a business to an employee giving them the right to buy stock in the business at an agreed price on or before a specific date. The price is usually lower than the market price and is treated as part of the compensation of the employee.

When dealing with stock option compensation accounting there are three important dates to consider.

  1. Grant date: The date on which the stock options are granted.
  2. Vesting date: The date on which the rights to exercise the option are obtained. The time between the grant date and the vesting date is known as the vesting period.
  3. Exercise date: The date on which the stock options are exercised and shares are purchased.

Stock Option Compensation Accounting Treatment

The granting of stock options is a form of compensation given to key personnel (employees, advisers, other team members etc.) for providing their services. Like any other form of compensation, such as the cash payment of wages and salaries or fees to advisers, it is a cost to the business. In the case of stock option compensation the amount is ‘paid’ in the form of stock options instead of cash.

Amount

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Like any cost, the cost of compensating the key personnel for their services if the fair value of the service they provide.

If for example an employee is paid a salary then the amount paid is regarded as a reflection of the fair value of the service provided. Likewise for stock option based compensation the fair value of the options granted can be used as an indication of the fair value of the service provided and therefore the cost to the business.

Vesting Period

The vesting period is important in stock option compensation accounting as it sets the time period over which the cost of compensating the option holder is treated as an expense in the income statement.

The purposes of granting stock options is to enable a business, particularly a startup business, to recruit, reward, and retain key personnel.

To ensure a employee does not immediately exercise their newly granted options and leave the business before the task they were employed for is complete, it is normal to have a vesting period. The vesting period is the period of time between the grant date and the vesting date at which the option holder receives the rights to exercise the option and purchase shares in the business. This is shown in the diagram above. So for example an employee might be granted 20,000 options but only receives the right to exercise then over a 4 year period at the rate of 5,000 options each year.

In addition a business will often have a requirement that if an employee leaves within a certain time period, for example one year, then they forfeit the right to excise any options and therefore leave without any shares in the business. The date before which the employee loses all rights to exercise the options is referred to a cliff.

Stock Option Compensation Example

At the start of the year a business grants five key personnel 300 stock options each. The fair value (FV) of each option at the date of grant is 7.00. The options vest at the end of a 3 year period at which point the option holders can exercise their options.

The exercise (strike) price is the same as the share price at the date of grant which is 20.00 and the nominal par value of each share is 1.00.

During the Vesting Period

During the vesting period the business needs to expense the total stock option compensation cost of the employees providing the service. The total cost is the fair value of the service which is represented by the fair value of the options granted in return for the service. In this example the cost is 7.00 for each option granted.

Year 1

The total expected stock option compensation cost over the 3 year vesting period is calculated as follows.

Since the vesting period is three years and one year of the service period has now been completed the business calculates the stock option compensation expense for the year as follows.

The stock option expense for year 1 (3,500) is the difference between the cumulative expense at the end of year 1 (3,500) and the cumulative expense previously recognized (0).

Stock Option Journal Entries – Year 1

The stock option expense journal entry for the year is recorded as follows.

Stock option expense journal entry – Year 1
AccountDebitCredit
Stock option compensation expense3,500
APIC – Stock options3,500
Total3,5003,500

The stock option compensation is an expense of the business and is represented by the debit to the expense account in the income statement. The other side of the entry is to the additional paid in capital account (APIC) which is part of the total equity of the business.

Year 2

In year 2 suppose one employee leaves the business and forfeits their stock option rights.

The total expected stock option compensation cost is now calculated as follows.

Since two years of the service period have now been completed the business calculates the stock option compensation expense for the year as follows.

The stock option expense for year 2 (2,100) is the difference between the cumulative expense at the end of year 2 (5,600) and the cumulative expense previously recognized in year 1 (3,500).

Stock Option Journal Entries – Year 2

The stock option expense journal entry for the year is recorded as follows

Stock option expense journal entry – Year 2
AccountDebitCredit
Stock option compensation expense2,100
APIC – Stock options2,100
Total2,1002,100

Year 3

In year 3 suppose another employee leaves the business and forfeits their stock option rights.

The total expected stock option compensation cost is now calculated as follows.

Since three years of the service period have now been completed the business calculates the stock option compensation expense for the year as follows.

The stock option expense for year 3 (700) is the difference between the cumulative expense at the end of year 3 (6,300) and the cumulative expense previously recognized in year 2 (5,600).

Stock Option Journal Entries – Year 3

The stock option expense journal entry for the year is recorded as follows

Stock option expense journal entry – Year 3
AccountDebitCredit
Stock option compensation expense700
APIC – Stock options700
Total700700

The table below summarizes the stock option compensation expense for the three year vesting period.

Stock option compensation expense summary
Year 1Year 2Year 3
Number of options1,5001,200900
FV of options at grant7.007.007.00
Expected total cost10,5008,4006,300
Service period1/32/33/3
Cumulative expense3,5005,6006,300
– Previous expense03,5005,600
Compensation expense3,5002,100700

The total stock option compensation expense is 6,300 (900 x 7.00), and this has been allocated to the income statement over the vesting period in the following amounts, year 1 (3,500), year 2 (2,100) and finally year 3 (700).

Exercise of Options

Option

After the options have vested the employees have the right to exercise their options and purchase shares in the business at the exercise (strike) price of 20.00.

Assuming all the options are exercised the increase in capital is calculated as follows.

The stock based compensation journal entries are as follows.

Option 3 March 12th Payment Online

Increase in capital on exercise of the options
AccountDebitCredit
Cash18,000
Common stock900
APIC – Common stock17,100
Total18,00018,000

Option 3 March 12th Payment 2020

The employees exercise their options and purchase the shares at the exercise price of 20.00 a share. The business receives cash of 18,000 and since the par value of the shares is 1.00 allocates 900 to common stock and the balance 17,100 to additional paid in capital (APIC).

Intrinsic Value

If the market value of each share at the exercise date is say 30.00 then the intrinsic value of the shares is calculated as follows.

About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.