On January 2, year 1, Good Co. granted Bad Guy, its president, compensatory stoc

Question

On January 2, year 1, Good Co. granted Bad Guy, its president, compensatory stock options to buy 1,000 shares of Good's $10 par common stock. The options call for a price of $20 per share and are exercisable for three years following the grant date. Bad Guy exercised the options on December 31, year 1. The market price of the stock was $50 on January 2, year 1, and $70 on December 31, year 1. The fair value of a similar stock option with the same terms was $28 on the grant date. By what net amount should Paid in Capital Common Stock increase as a result of the grant and exercise of the options?

Explanation / Answer

At the time the options were granted, there was a difference of $30 per share between the option price of $20 and the market price of $50. This would result in compensation of $30 X 1,000 shares, or $30,000, recorded as follows:

Credit under stock option

  Plan (paid-in-capital)

When the options are exercised, the credit would be reversed, the cash would be recorded, and the shares would be issued. The entry would be:

Common stock (par)

Additional paid-in capital

Since the compensation would reduce earnings and ultimately retained earnings, the net effect on stockholders' equity would be $10,000 + $40,000 - $30,000 or an increase of $20,000.

Credit under stock option

  Plan (paid-in-capital)

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