On December 31, 2018, in order to retain certain key executives, Entebbe Corporation granted them stock options. 25,000 options were granted at an option price of $ 40 per share. Market prices of the shares were as follows: December 31, 2019 $ 35 per share
December 31, 2020 $ 39 per share
The options were granted as compensation for services to be rendered over a two-year period beginning January 1, 2019. The Black-Scholes option pricing model determined total compensation expense to be $ 500,000. The amount of compensation expense Entebbe should have recorded for calendar 2020 is
A) $ 250,000.
B) $ 500,000.
C) $ 875,000.
D) $ 1,000,000.

Question

Quizplus · Accepted Answer

The compensation expense to be recognized each year is determined by dividing the total compensation expense by the number of years over which the options vest. In this case, the options vest over a two-year period, so the annual compensation expense is $500,000 / 2 = $250,000.

Since the market price of the shares increased from $35 to $39 from December 31, 2019 to December 31, 2020, this indicates that the options were underwater as of December 31, 2019 (i.e. the market price was below the option price). Therefore, no compensation expense was recognized for calendar 2019.

For calendar 2020, the market price of the shares was $39, which is above the option price of $40. Therefore, the compensation expense to be recognized for calendar 2020 is based on the difference between the market price and the option price at the time the options vested, which is $39 - $40 = -$1 per share. Since 25,000 options were granted, the total compensation expense for calendar 2020 is -$1 x 25,000 = -$25,000. However, since the compensation expense for calendar 2019 was $0, the total compensation expense for the two-year vesting period is $250,000 - $25,000 = $225,000. Therefore, the compensation expense to be recognized for calendar 2020 is $225,000 - $0 = $225,000 or approximately $250,000 after rounding.

On December 31, 2018, in Order to Retain Certain Key