On January 2, 2017, Dwyer Corporation granted 10,000 nonqualified stock options
ID: 2330402 • Letter: O
Question
On January 2, 2017, Dwyer Corporation granted 10,000 nonqualified stock options each to four of its key executives (40,000 options in total). Under the terms of the option plan, upon exercise, each executive will pay the exercise price of $10 per share of common stock ($1 par value). The options were exercisable after January 1, 2020, and the executives were required to be employees of Dwyer at the date of exercise. The Black–Scholes value of the option on the grant date is $12.50. Three employees exercised options for 30,000 shares of stock on January 2, 2021. Dwyer has a tax rate of 35% in all years. Relevant dates and stock prices are as follows:
Required:
Prepare the compensation expense and related tax journal entries from 2017 to 2019.
Prepare the journal entries required to record the stock option exercise on January 2, 2021. Include the journal entries to record the tax effects.
Prepare a schedule to show how the January 2, 2021, option exercise affects Dwyer’s 2021 income tax expense.
January 2, 2017 $ 10 December 31, 2017 19 December 31, 2018 28 December 31, 2019 45 December 31, 2020 26 January 2, 2021 26 December 31, 2021 25Explanation / Answer
Compensation cost is the Fair value of service represented by the fair value of the option granted in return of the service.
In this case fair value of service is the price of the share at the grant date i.e $12.50
Calculation of compensation expense for vesting period of 3 years: = Number of option * Fair value of option at grant = 40000*$12.50 = $ 500000
Compensation expense for 1 year = $500000/3= $166,667
Employee Stock option compensation expense is non cash expense and thus is not allowed as deduction for tax purposes.
Thus the difference between accounting income and Tax Income will lead to creation of deferred Tax Assets for $166667*35%= $58,333 per year
Total Deferred tax asset Created for 40,000 stocks = $58,333*3 = $175,000
Journal Entry for each year 2017- 2019
Recording Compensation expenses in books of accounts:
Stock Expense Compensation Account Dr $166,667
APIC- Stock Option Cr $166,667
APIC- Additional Paid In Capital ( Part of total Equity of business)
Recording Deferred Tax assets:
Deferred Tax Asset Dr $58,333
Income Tax Expense Cr $58,333
Calculation on Exercise Date:
No of shares exercised * exercise price = 30000* $10= $300,000
Cash Dr $300,000
Current Stock Cr $30,000
APIC-Common Stock Cr $270,000
Journal entry for Tax effect : Year 2021
Income Tax Expense Payable Dr $131,250
Deferred Tax Asset Cr $131,250
Effects on Income Tax Expenses
Deductible tax Expenes : Market value- Exercise price = $26-$10 = $16
Number of stock exercised = 30,000.
Deductible tax expense =30000* $16 = $ 480,000
Tax benefit available = $480,000*35% = 168,000
Deferred tax created in books for 30,000 Shares = ($58333*3)*30,000/40,000 = $131,250
As tax benefit available is more than the deferred tax created in books of accounts for 30,000 Stocks , Year 2021, Tax expense payable will be reduced by $131,250.
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