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Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281

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BuyFindarrow_forward

Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281
Textbook Problem
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Compensatory Share Option Plan

Tom Twitlet, president of Twitlet Corporation, is considering establishing a compensatory share option plan for the company’s 20 top executives. Tom wants to set the terms of the plan so that the number of options the executives can exercise increases based on a specified increase in the company’s future earnings. Tom wants to make sure that the plan cannot be manipulated but, in addition, it should properly motivate the executives to stay with the company and make it successful. Given this concern, he wants to know how the increase in earnings should be specified: Should it be a dollar amount or a percentage change, and should the change in earnings be compared to the company’s past results or against industry results? He also is interested in understanding how to determine the service period of the plan. Finally, Tom wants to understand the accounting for the plan and how it will affect the company’s financial statements.

Required:

Prepare a memo to Tom that briefly explains the issues involved in specifying the terms used in the plan and accounting for the terms of this type of compensatory share option plan.

To determine

Prepare the memo to Person T that explains the issues involved in specifying the terms used in the plan and accounting terms of this type of compensatory share option plan.

Explanation

Share option plan: This is an option given to an employee to buy a certain number of shares of stock of the company at a pre-determined price during certain period of time.

Memo

To: Person T

From: Person X

 The considered plan is known as a performance-based compensatory share option plan since the number of options that executives are entitled is built on their performance while achieving a target goal, which is the increased earnings. The issues of concern for the above-mentioned type of plan are, namely (1) what issues to address in specifying the terms of the plan and (2) how to account for the plan.

Specifying the Terms

The terms of the plan should be particular in how “earnings” are explained, how the increase in the earnings is measured/ calculated, and the duration of the period earnings.

The growth in earnings can be described in various ways. Initially, the growth can be stated in a dollar amount. However, it does not consider the increase relative to the initial base amount of earnings.  Expressing the growth in terms of a percentage of the base earnings is another method that considers the relative growth.  Lastly, if the company is in a growing market, earnings will also increase due to the overall market growth.  In this method, measuring the percentage increase in the earnings above the overall market growth is a proper technique to measure the increase in earnings. 

The duration which the earnings are measured must be related to the requisite service period.   The period, which the executives must work for the corporation to be entitled to participate in the plan, is known as the service period...

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