On October 1, 2018, Farmer Fabrication issued stock options for 400,000 shares t

Question

On October 1, 2018, Farmer Fabrication issued stock options for 400,000 shares to a division manager. The options have an estimated fair value of $7 each. To provide additional incentive for managerial achievement, the options are not exercisable unless divisional revenue increases by 4% in five years. Suppose that Farmer initially estimates that it is not probable the goal will be achieved, but then after one year, Farmer estimates that it is probable that divisional revenue will increase by 4% by the end of 2020.

Required:

1. What is the revised estimate of the total compensation?

2. What action will be taken to account for the options in 2019?

3. Prepare the journal entries to record compensation expense in 2019 and 2020.

Explanation / Answer

1. The Total Compensation will be 400,000*$7 = $2,800,000

2. As the Farmer intial estimates states that it is not probable, they will defer the compensation expense till completion of five years. so, for December 31, 2018, it will record compensation expense for 3 months i.e ($2,800,000/5/12)*3 = $140,000. In the question, it says "But then After one year" it means October 1, 2019 they decided it will increase by 4% by the end of 2020. That means the remaining compensation expense should be recognized in the coming two years.

3. Journal Entry in 2019

Compensation Expense A/C       DR        $1,330,000 ({$2,800,000-$140,000}/2)

                Income Statement                               $1,330,000

   Journal Entry in 2020

Compensation Expense A/C      DR        $1,330,000

     Income Statement                                $1,330,000

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