Smaller Corporation has been in operation for several years. Each year, around t

Question

Smaller Corporation has been in operation for several years. Each year, around the holidays, Smaller gives a cash bonus to each of its employees and records the bonuses as compensation expense. Smaller has reached the point at which it is now making a reasonable return on its shareholders' equity. At the end of the current year, the company president is considering establishing a compensatory share option plan for Smaller's key executives, instead of paying cash bonuses to any of its employees. At this time, the market price and the planned option (exercise) price of the company's common stock are the same. The plan would allocate a specified number of options to each executive based on the executive's level within the company and meeting Smaller's targeted income goals. The service period would be 3 years and the options would have to be exercised within 10 years. You are the controller for Smaller and one of the key executives who would participate in the plan. You also already own a substantial number of shares of Smaller common stock. The company president comes to you for advice about this plan and says, “If Smaller establishes this plan, it will work out for all of us. It looks like the plan is pretty valuable, since an option pricing model shows a high fair value for each option. The corporation will be saving cash because it won't have to pay bonuses to either the executives or the other employees. But executives will manage better because their share options will depend on meeting the company's targeted income. Because the market price and the option price are the same, there won't be any compensation cost or expense related to this plan. Furthermore, since no bonuses would be paid to any employees, the corporation will decrease its compensation expense. This will increase its net income and earnings per share compared to last year, as well as its return on shareholders' equity. So the stock value will go up. This seems like a win-win situation for everyone. Am I right on this?” Do you think Smaller should adopt this compensatory share option plan?

Required: From financial reporting and ethical perspectives, how would you reply to the president?

Use one academic resource to provide support for your response in APA-style

Explanation / Answer

Stock compensation plan has its own merits and demerits. All the mentioned advantages of the compensatory share option plan are true and this can be beneficial for all the parties involved. But the company must consider other side of the plan also. There may be some employees who do not want to give up cash bonus option for stock based compensation. Employees, mainly lower level, prefer immediate benefit in the form cash bonus over the deferred benefit of stock option. Further the option price is at par with the current market price so there is no additional incentive for employees to prefer compensatory share option plan over cash bonus. There is also risk of price fluctuations associated with the stock option. While in cash bonus, employees get immediate money, which can be used according to their will.

Introduction of stock based compensation will also result in the dilution of ownership which may be opposed by existing stockholders. This will also result in low earnings per share and there is no evidence that stock bonus will positively affect the net income. The result may be negative also.

So, before adoption of any such plan, the company should consider all pros and cons of any such scheme.

Yes, the executive is right with this, that it will be a good thing for both the employers and employees.

Smaller should definitely adopt this compensatory share option plan.

Some of the benefits of this plan are given below:

Tax benefits to employees

Tax benefits to employers

Reduce cost of compensation expenses given to employess with whatever name called.

Employees are motivated to work hard as they are target based.

Reduced costs resulting in higher earnings

Leads to higher value of stock.

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