The Stock Plans - Essay Example

Stock Plans Stock options plan is one of the widely used forms of compensation in the United States. Stock options plan significantly affects a company and its shareholders. The issuance of shares to compensate the company’s employees increases the number of total shares outstanding, hence diluting the worth of every single shared owned by shareholders. However, apart from that, stock option plan minimizes a company’s compensation expenses, saves its cash reserves (Accounting For Employee Stock Options, 2004) give the employees a right of ownership and thus instigating their personal interest in the profitability of the company. GAAP Accounting Methods For Stock Plans There happen to be two most popular methods under US GAAP to account for a company’ stock plans. These are fair value based method and intrinsic value based method (US GAAP, 2004). Under the fair value based method, an option-pricing model is used by a company to assess the fair value of the stock option at the time when the options are granted. The intrinsic value based method, on the other hand, is simply the difference between the option’s strike price and the current market value of the company’s stocks. The strike price is that particular price on which the stock is purchased whereas; the current market value is the prevailing market price of that stock. If strike price is less than the stock’s current price, the difference is the intrinsic value of the stock. Hence, the company needs to bring the intrinsic value of the stock at zero by keeping the strike price equal to or more than the current market price. Even if the company decides to use the intrinsic value based method to account for stock options, it still needs to disclose the estimated fair value in the notes to financial statement section (Accounting For Employee Stock Options, 2004). The major difference between the two accounting methods is that the intrinsic value based method overstates the income of the company. This method does not reveal the fair value of the stock, whereas the fair value based method, which is also recommended by FASB is based upon estimated fair value of the company’s stock. Amount Of Compensation Under a stock options plan, 100 shares were offered to each employee that were purchased or exercised at $45 per share i.e., the grant price. The stock options would cost them $4500 ($45x100). However, the current market price of the stock is $60, which makes $6000 ($60x100) if sold in the market. The shares would obviously be sold on the current market value and hence each employee would get the difference ($6000-$4500) between the grant price and the current market value. The total amount of compensation that each employee would get is $1500 making the total compensation of $3000 paid by the company to two employees. Recording Of Stock Options In XYZ’s books The US GAAP requires the companies to expense out the employee stock options on the fair or intrinsic value, as well as disclose it in the company’s financial statements, which is supposed to decrease the company’s earnings significantly. Therefore, an expense will be recorded in the books of XYZ Corporation against the amount of employee stock options as per the accounting practice of FASB and the corresponding expense will be disclosed in the company’s financial statements. REQUIREMENT 2 Part 1: As Sheila and Ed are willing to retain maximum influence and control in the company, they should issue preferred stock. It is because only this type of stock allows stockholders of the company to exercise limited rights and authority as owners. The other type, i.e., the common stock enables the stockholders to practice maximum control and authority over the company’s decisions. These stockholders, being the owners of the company enjoy maximum voting rights. The management always needs their permission before taking a major decision concerning the company’s affairs, excluding the payment of dividends. For instance, in case if the management decides to go for a stock split, merger activity, issuance of new shares, liquidation of assets, or election of board of directors, it will always need the shareholder’s permit through voting. Besides, it is a right of the common stockholders to investigate into the company’s books and accounts, interfere in management decision-making and also sue the management for any unfair practices on their part (Preferred Vs. Common Stock, 2003). The preferred stockholders, on the other hand, are allowed limited voting rights and authority over the management. Although they are company’s owners but they can only exercise restrained control over the company’s management. Except for a few conditions, they are not allowed to vote for or against management’s decisions. Hence, when a management decides to retain maximum control and decision-making power after the issuance of shares, it should go for preferred stock rather than common stock. Part 2 The entry for the issuance of preferred stock at $5 per share with a par value of $1 per share is as follows: Account Debit Credit Cash $1,000,000 Preferred Stock, $1 par, $200,000 Paid In Capital In Excess Of Par $800,000 To record the issuance of 200,000 preferred shares of par value $1 per share at $5 per share The cash account has been debited by the total amount received through the issuance of shares (i.e., 200,000 x $5). Total 200,000 shares of $1 par value per share are issued at the rate of $5 per share. This leads to a credit to the account of preferred stock by $200,000 with the amount of total par value (200,000 x $1). The remaining balance that exceeds the par value of the stock is credited to the account of paid in capital in excess of par (i.e., 200,000 x $4). The way this transaction would affect the Equity section of the company’s balance sheet is shown below: Shareholders’ Equity Credit Issued And Paid In Capital: Preferred Stock, $1 par, 200,000 shares issued and outstanding $200,000 Paid In Capital In Excess Of Par 800,000 Total Stockholders’ Equity $1,000,000 As illustrated above, this transaction has led to an increase in the company’s total equity by $1,000,000. The management has issued the preferred stock on premium i.e., for an amount in excess of the par value, therefore, the two accounts i.e., preferred stock and paid in capital in excess of par have also been created in this section. REQUIREMENT 3: Pension Plans: Companies use pension plans to guarantee the employees a consistent flow of income after their retirement. Pension plans are intrinsically based on accrued pension costs, expected rate of return on pension assets, and the discount rate for calculation of present value of accrued pension. The Statement number 87 issued by the Financial Accounting Standards Board allows the companies to anticipate the expected rate of return on pension plans as well as the discount rate. This happens to be a common practice among companies to use the rates that overstate their income and understate the expenses and liabilities (George, 2003). Types Of Pension Plans: There are two types of pension plans viz. the defined benefit pension plans and the defined contribution benefit plans. In defined benefit pension plans, the company guarantees the employees a certain benefits to be paid to them after the retirement on the basis of a particular formula. Under this method, the company makes its contribution to the plan and invests the funds. The annual returns from this investment are anticipated by the company as expected rate of return and used in the formula for pension benefit calculation. Also, the company bears the responsibility to pay off the benefit to the employees after retirement even if the pension plans assets are not enough to meet these promised benefits. It takes into account all the employees as a group on the basis of their age, salary etc (George, 2003) . The defined contribution pension plan implies that the company using this method discloses the amount of contribution it makes into the plan and no particular benefits are promised to the employees. This is the type where the company maintains individual pension plan accounts on the basis of each employee’s particulars (George, 2003). Pension Plans And The Company’s Financial Statements Any differences in the amount of cash contribution and expected pension costs will have a significant impact on the reporting of financial statements of XYZ Corporation. Companies in the United States are required by FASB to recognize a liability and report it in the balance sheet when the expected pension expense exceeds the amount of cash contribution by the company (Summary of Statement No. 87, 1985). In case if pension expenses are less, its impact will reduce the company’s liabilities and increase its earnings (George, 2003). In the United States, the pension plans need to be accounted and reported in the financial statements in compliance with the rules set by the FASB in the statement No. 87. According to this statement, the companies are required to report all the components of pension plans such as the compensation cost of these plans, interest costs, and annual return on investment of assets, as an aggregate net amount on the company’s financial statements. Also the company is required to recognize the pension liabilities when the promised pension benefits exceed the pension plan assets and report in the financial statements (Summary of Statement No. 87, 1985). Hence, XYZ Corporation will also have to prepare its financial statements accordingly. Reference List Accounting for Employee Stock Options (2004), CBO, [Internet] retrieved September 1, 2006 from: http://www.cbo.gov/showdoc.cfm?index=5334&sequence=2 George, Nashwa (2003), “The Impact Of Pension Accounting On Companies' Financial Statements”, Journal of the Academy of Business and Economics, [Internet] retrieved September 1, 2006 from: http://www.allbusiness.com/personal-finance/investing-retirement-funds/752305-1.html Preferred Vs. Common Stock (2003), Ameritradefinancial, [Internet] retrieved September 1, 2006 from: http://www.ameritradefinancial.com/educationv2/fhtml/stocksfunds/prevscom.fhtml Summary of Statement No. 87 (1985), Financial Accounting Standards Board, [Internet] retrieved September 2, 2006 from: http://www.fasb.org/st/summary/stsum87.shtml US GAAP (2004), CPA Class, [Internet] retrieved September 1, 2006 from: http://cpaclass.com/gaap/sfas/gaap-sfas-123R.htm Read More