On January 1, 2009, Red Inc. issued stock options for 200,000 shares to a division manager. The options have an estimated fair value of $6 each. To provide additional incentive for managerial achievement, the options are not exercisable unless divisional revenue increases by 6% in three years. Red initially estimates that it is probable the goal will be achieved. Ignoring taxes, what is reduction in earnings in 2009?

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Quizplus · Accepted Answer

Since the options are not exercisable unless divisional revenue increases by 6% in three years, there is a performance condition attached to it. As Red initially estimates that it is probable the goal will be achieved, they can recognize the compensation expense over the service period of three years. Therefore, the reduction in earnings in 2009 would be $400,000 (one-third of the total compensation expense).