Under the fair value method, how does a corporation determine the total compensation
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Conceptual Evaluation From a conceptual standpoint, by requiring corporations to use a fair value method of accounting for their compensatory share option plans, current GAAP increases the relevance of the accounting information because it shows the fair value of the share options. Although some argue that the reliability of the accounting information is decreased because of the use of complex estimates, this is similar to using estimates for items such as depreciation, bad debts, and postemployment benefits (discussed in Chapter 19). Others argue that the reliability is increased because the result is more representationally faithful in that the accounting information better depicts the economic obligation. Use of the fair value method provides a more relevant measure of a corporation’s return on equity (ROE) and earnings per share (EPS) because compensation expense (based on fair value) is included in the corporation’s net income. Similarly, a better assessment of risk is possible because external users can evaluate the likelihood of the exercise of the share options. Finally, comparability is improved because external users can better contrast the terms of different plans with the information provided in the notes to the financial statements. On the other hand, there are several criticisms of the way the fair value method is applied in current GAAP. The fair value of the share options is measured only on the grant date using an option pricing model. This fair value is not further adjusted for changes in the variables of the model, even though some of these variables (e.g., volatility and risk-free interest rate) change with changes in the underlying economy. Not allowing adjustment of the fair value may distort reporting of the real value of the share options. However, not adjusting is consistent with generally accepted accounting principles that are based on acquisition costs for assets and original obligating amounts for liabilities. GOT IT? Under the fair value method, how does a corporation determine the total compensation cost for a share-based compensation plan? How does it recognize this amount as compensation expense? |
Here is a tip:
Various assumptions are made by a company when it uses the fair value method of accounting for the compensation expense.
Explanation
If the total compensation expense based on the per-share fair value of the options is $100,000, and the options vest at the end of the second year, the compensation expense per year is $50,000, i.e.,
\frac{\$100,000}{2}
2$100,000
.
Verified Answer
\text{Total Compensation Expense}=\text{Number of Options}\times\text{Fair Value Per Option}
Total Compensation Expense=Number of Options×Fair Value Per Option
The total compensation cost will be recognized as compensation expense for every year of the expected term.
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