Chapter 19, Problem 19.6P

(1)

To determine

Stock options: Stock options are the stock-based compensation plans provided in the form of an option to buy certain number of shares for a certain price during certain period.

To determine: The compensation cost of stock options

Explanation of Solution

Compute the total compensation cost of stock options.

$\begin{array}{c}\begin{array}{l}\text{Total compensation }\\ \text{cost of stock options}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Estimated fair market value of the option × }\\ \text{Number of options granted}\end{array}\right\}\\ \text{= \$6 × 6,000,000 shares}\\ \text{= \$36,000,000}\end{array}$ (1)

(2)

To determine

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

To journalize: The entry for compensation expense on December 31, 2016, 2017, and 2018

Explanation of Solution

Prepare journal entry for compensation expense on December 31, 2016.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2016
December	31	Compensation Expense		12,000,000
		Paid-In Capital–Stock Options			12,000,000
		(To record compensation expense)

Table (1)

• Compensation Expense is an expense account. Since expenses decrease stockholders’ equity, and a decrease in stockholders’ equity is debited.
• Paid-in Capital–Stock Options is a stockholders’ equity account. Since stock options are considered as earned by the employee, stockholders’ equity increased, and an increase in equity is credited.

Working Notes:

Compute the compensation cost allocated each year.

$\begin{array}{c}\text{Expense allocated each year =}\frac{\text{ Total compensation cost of stock options}}{\text{Vesting period}}\\ \text{=}\frac{\text{\$36,000,000}}{\text{3 years}}\\ \text{= \$12,000,000}\end{array}$ (2)

Note: Refer to Equation (1) for the value and computation of compensation cost.

Prepare journal entry to record the tax effect of compensation expense on December 31, 2016.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2016
December	31	Deferred Tax Asset		4,800,000
		Income Tax Expense			4,800,000
		(To record income tax expense)

Table (2)

• Deferred Tax Asset is an asset account. Since the stock options are not qualified as incentive plans, tax expense is recorded on compensation expense for which the tax deduction is available in future. To record this tax benefit, which is accounted as the tax expense payment in advance, this account is debited.
• Income Tax Expense is an expense account. Since tax expense is reduced for accounting purposes, tax expense is credited.

Working Notes:

Compute the deferred tax asset amount allocated.

$\begin{array}{c}\text{Deferred tax asset =Compensation expense}\times \text{Tax rate}\\ \text{=\$12,000,000}\times \text{40\%}\\ \text{= \$4,800,000}\end{array}$ (3)

Note: Refer to Equation (2) for the value and computation of compensation expense.

Prepare journal entry for compensation expense on December 31, 2017.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2017
December	31	Compensation Expense		12,000,000
		Paid-In Capital–Stock Options			12,000,000
		(To record compensation expense)

Table (3)

• Compensation Expense is an expense account. Since expenses decrease stockholders’ equity, and a decrease in stockholders’ equity is debited.
• Paid-in Capital–Stock Options is a stockholders’ equity account. Since stock options are considered as earned by the employee, stockholders’ equity increased, and an increase in equity is credited.

Note: Refer to Equation (2) for value and computation of compensation expense.

Prepare journal entry to record the tax effect of compensation expense on December 31, 2017.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2017
December	31	Deferred Tax Asset		4,800,000
		Income Tax Expense			4,800,000
		(To record income tax expense)

Table (4)

• Deferred Tax Asset (DTA) is an asset account. Since the stock options are not qualified as incentive plans, tax expense is recorded on compensation expense for which the tax deduction is available in future. To record this tax benefit, which is accounted as the tax expense payment in advance, this account is debited.
• Income Tax Expense is an expense account. Since tax expense is reduced for accounting purposes, tax expense is credited.

Note: Refer to Equation (3) for value and computation of deferred tax asset.

Prepare journal entry for compensation expense on December 31, 2018.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Compensation Expense		12,000,000
		Paid-In Capital–Stock Options			12,000,000
		(To record compensation expense)

Table (5)

• Compensation Expense is an expense account. Since expenses decrease stockholders’ equity, and a decrease in stockholders’ equity is debited.
• Paid-in Capital–Stock Options is a stockholders’ equity account. Since stock options are considered as earned by the employee, stockholders’ equity increased, and an increase in equity is credited.

Note: Refer to Equation (2) for value and computation of compensation expense.

Prepare journal entry to record the tax effect of compensation expense on December 31, 2018.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2018
December	31	Deferred Tax Asset		4,800,000
		Income Tax Expense			4,800,000
		(To record income tax expense)

Table (6)

• Deferred Tax Asset (DTA) is an asset account. Since the stock options are not qualified as incentive plans, tax expense is recorded on compensation expense for which the tax deduction is available in future. To record this tax benefit, which is accounted as the tax expense payment in advance, this account is debited.
• Income Tax Expense is an expense account. Since tax expense is reduced for accounting purposes, tax expense is credited.

Note: Refer to Equation (3) for value and computation of deferred tax asset.

(3)

To determine

To journalize: The exercise of options

Explanation of Solution

Journalize the entry for options exercised.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
August	21	Cash		132,000,000
		Paid-in Capital – Stock Options		36,000,000
		Common Stock			6,000,000
		Paid-in Capital–Excess of Par			162,000,000
		(To record options exercised by stock option holders)

Table (7)

• Cash is an asset account. Since cash is received, asset value increased, and an increase in asset is debited.
• Paid-in Capital–Stock Options is a stockholders’ equity account. Since stock options are exercised and shares are issued, stock options value is decreased, and a decrease in equity is debited.
• Common Stock is a stockholders’ equity account. Since stock options are exercised and shares are issued, common stock value increased, and an increase in equity is credited.
• Paid-in Capital–Excess of Par is a stockholders’ equity account. Since stock options are exercised and shares are issued, excess of par value increased, and an increase in equity is credited.

Working Notes:

Compute cash received by Corporation J.

$\begin{array}{c}\text{Cash received = Number of shares × Exercise price}\\ \text{= 6,000,000 shares × \$22}\\ \text{= \$132,000,000}\end{array}$ (4)

Compute the paid-in capital of stock options amount.

$\begin{array}{c}\begin{array}{l}\text{Paid-in capital }\\ \text{amount}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Estimated fair market value of the option × }\\ \text{Number of options granted}\end{array}\right\}\\ \text{= \$6 × 6,000,000 shares}\\ \text{= \$36,000,000}\end{array}$ (5)

Compute the common stock amount.

$\begin{array}{c}\text{Common stock amount= }\left\{\begin{array}{l}\text{Par value per share × }\\ \text{Number of shares}\end{array}\right\}\\ \text{= \$1 × 6,000,000 shares}\\ \text{= \$6,000,000}\end{array}$ (6)

Compute the paid-in capital–excess of par amount.

$\begin{array}{c}\begin{array}{l}\text{Paid-in capital–}\\ \text{excess of par value}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Cash received + }\\ \text{Paid-in capital of stock options value – }\\ \text{Common stock value}\end{array}\right\}\\ \text{= \$132,000,000 + \$36,000,000 – \$6,000,000}\\ \text{= \$162,000,000}\end{array}$ (7)

Note: Refer to Equations (4), (5), and (6) for all the values.

Journalize the entry for tax effect if all the options are exercised.

Date		Account Titles and Explanation	Post Ref.	Debit ($)	Credit ($)
2020
August	21	Income Taxes Payable		12,000,000
		Income Tax Expense		2,400,000
		Deferred Tax Asset			14,400,000
		(To record income taxes payable)

Table (8)

• Income Taxes Payable is a liability account. Since the tax expense is recognized in advance, the future tax liability is reduced, and a reduction in liability is debited.
• Income Tax Expense is an expense account. Since DTA is recognized, the future tax benefit is recorded.
• Deferred Tax Asset (DTA) is an asset account. Since the tax expense which is paid in advance is recognized on exercise date, asset is reduced and a reduction in asset is credited.

Working Notes:

Compute income taxes payable amount.

$\begin{array}{c}\text{Income taxes payable = }\left\{\begin{array}{l}\left(\text{Market price – Exercise price}\right)\text{ × }\\ \text{Number of shares × Tax rate}\end{array}\right\}\\ \text{= }\left(\text{\$27–\$22}\right)\text{ × 6,000,000 shares × 40\%}\\ \text{= \$12,000,000}\end{array}$ (8)

Compute DTA for the years 2016 and 2017.

$\begin{array}{c}\text{DTA = }\left\{\begin{array}{l}\text{Deferred tax asset amount for 1 year × }\\ \text{Number of years}\end{array}\right\}\\ \text{= \$4,800,000 × 3 years}\\ \text{= \$14,400,000}\end{array}$ (9)

Compute paid-in capital.

$\begin{array}{c}\begin{array}{l}\text{Paid-in capital–tax }\\ \text{effect of stock options}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Deferred tax asset for 3 years–}\\ \text{Income taxes payable}\end{array}\right\}\\ \text{= \$14,400,000–\$12,000,000}\\ \text{= \$2,400,000}\end{array}$

Note: Refer to Equations (8), and (9) for the value and computation of income taxes payable and DTA.