 Hello, and welcome to the session in which we will discuss stock options. What is the big idea of stock options? Stock options are simply giving the employees the option, not the obligation, the option, whether they want to exercise or not, to buy the stock at a certain price over a period of time. Simply put, the company would say, you have the right, if you choose, to buy the stock at a certain price. And usually that price is fixed. Simply put, what does that mean? It means if the price of the stock rises, you can buy the stock price at a certain price, and the difference is a profit to you. Now, why do companies give those options? Well, many reasons. One is to retain valuable employees. What does that mean? It means they want to keep you as an employee, so they will entice you. They would say, okay, we're going to give you a certain number of stock options. And as a result, to have those options vested, you have to work for a certain years. What's going to happen by working certain years, they retain you. It's also used as a compensation. So, for example, when you get a job, part of your compensation plan, part of what they pay you is a stock option. The best way to illustrate this concept is to show you my wife work at Johnson & Johnson, so I can show you their brochure, because she qualifies for stock options. And this is the brochure for Johnson & Johnson. And basically, this section is award options. An option gives you the right to buy a share of Johnson & Johnson stock at the market price on the grand date. So, what does that mean? For example, if you were granted an option with the market price of our stock at $100, so let's assume when they gave you this option, the market price was $100. Then eventually, you can exercise this option when it's vested. Vested, it means you can exercise the option. You will be able to buy a share for $100, no matter what the price of the stock is. So, my wife was granted the stock today, the stock options today, and the stock for Johnson & Johnson happens to be $100. Three years later, my wife can buy the stock at $100, regardless of J&J stock price. So, if the stock is $130, she will make a profit of $30, and that's obviously a pre-tax profit. So, there is a vesting period. And the vesting period is what? Is how long do you have to wait? So, the vesting period is three years. The exercise period is different. The exercise period is once the option vests, which is after three years, my wife will have seven years to exercise the option, so she can keep it. And the higher Johnson & Johnson stock gets, the more profit she will make. And obviously, there's an expiration date that expires 10 years later, which is three years vested. And the vesting period is what? Obviously, there's an expiration date that expires 10 years later, which is three years vested, seven years to exercise total of 10 years. So, this is what a stock option looks like, and this is from an actual company. And by the way, notice here the brochure. It says English. And the reason I wanted to point this out, because Johnson & Johnson, they operate all over the world. They have people in Germany. They have people in Asia. They have people in Japan. They have people all over the world. So, they exercise stock option. Therefore, this brochure happens to be in English. And the reason I want to mention this, because my first job after college, my second job after college, after I studied finance, was working in Merrill Lynch Employee Stock Option Plan. So, I used to handle those stock options for executives. For example, if somebody worked, I remember I used to handle Intel, PepsiCo, and Tyco, those three companies with Merrill Lynch. I used to be part of that team handling, exercising option. So, I'm very familiar with stock options. These days, you don't need a customer service back then, because the internet was not as common. Now, employees like, for example, my wife can go online and check her options, exercise them, or whatever she wants to do with them. But back then, employees and executives would have to call us and we'll handle their options. Let's go back to our presentation. So, part of it is compensation. Part of it, why they give you stock option, is to connect the performance of the employee to the company's performance. Simply put, for example, for talking about my wife, now her wealth is connected to Johnson & Johnson. What does that mean? It means, if Johnson & Johnson do well as a stock price, she does well, because for every, let's assume they gave her 100 options, or 1,000 options. For every stock, for every dollar the stock price goes up. If they gave her 1,000 option, she can profit for 1,000 dollars. So, her performance is connected to the company's stock performance. And we assume that the company's stock performance, the company's stock is connected to the company's performance. Also, stock options, they help recruit new employees. And this happens during, this was a major event in the years, in 98 till 2001. And the reason is, this was called the dot com error, dot com error. You may not be familiar with this, but I lived this period. And during this period, the internet was just starting to be a common thing. And many companies, like Amazon, this is when it started. And many other companies, when they started, they did not have cash. So, what did they do to compensate you to help, to ask you to join them? I said, we can't pay you, but we're going to give you 10,000 or 100,000 options. If the stock price goes up, you can exercise those options and make a profit. And back then, this is why we had a bubble, and the bubble burst during the dot com is, company's stocks were going higher and higher and higher, and eventually they collapsed. And only a few companies survived, notably Amazon is one of them. But many other companies that you don't know about, they just went bankrupt, because they did not survive. So also, when you want to recruit new employees, you give them stock options. Basically, you make them part of the company. Now, let's go back to the accounting part. The option is valued using fair value method. What does that mean? It means when the company grant you an option, they have to determine, they have to determine the expense. Although they're not really incurring any expense now, the company based on gap, you have to expense something because it's part of your compensation. You are rewarding the employees. You have to expense something. Well, the way they expense it, it's used the fair value method. Don't worry about what does that mean? Fair value method basically means the expense will be giving. You will have a CFA or an actuarial scientist. They will determine the expense and they will tell you you should expense this much. Then the company will have to allocate the expense. Once you know the expense, and this is the accounting part over the time, the employee perform the service. For example, the options for my wife. If she works there three years, her options are vested. Well, guess what? Let's assume for the sake of simplicity, whatever they granted her, I'm going to make it 9000 divisible by three. The company will divide 9000 by three and every year they will expense as my wife is working for J&J. They will expense $3000 per year. The best way to illustrate this is to look at a complete example showing you from the grand date to the expiration date. But before we do so, I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website, farhatlectures.com. I don't replace your CPA review course if you're studying for your CPA. I don't replace your accounting course. 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Let's take a look at this example to show you how the journal entries and what do we have to do on certain dates when it comes to stock options? On January 1st, 20x3, the Board of Directors of Farhat Lectures approve. It means they grant a stock option to grant the employees two executives option to purchase 1000 shares of the company $1 par value stock at a price of 50. Simply put, Farhat Lectures has two executives. And I gave each executive, let's assume I am the owner of the company, 1000 options, the option to buy the share at $50. And then we're going to assume my company is publicly traded. Yeah, right. But it's a dream, but that's okay. On January 1st, 23, the market price of the stock is 38. Well, what we can say is the option is underwater, because no one in the right mind will exercise the option if they can buy it at 38. I told them they can buy it at 50. So they will not do it now. So I consulted with the CFA or Actuarial Scientist and they estimated the fair values using something called the black shawl method, the option to be 200,000. It means my expense based on this grant is 200,000. And the expected service period of the two executives is two years. So I expect those two executives to work for me two years. Once they work two years after that date, they have the option to buy the stock at 50. And I'm going to give them 10 years after that. So anytime 10 years after two years, they can buy it at 50. So what entries do we have to make on the grand date? So the grand date is January 1st. The grand date, no entry. I don't have to do anything on the grand date. I decided to give them the options. Then I have to wait. I'm going to see whether they're going to stay with the company or not. And indeed they stayed. So on December 31st, 20x3. So by the end of the year, I debit an expense called compensation expense. Notice I granted January 1st and it's for two years. So since they work the first year, I debited an expense 100,000. And I credit an equity account called paid in capital stock options. Notice what happened? My expense went up. Paid in capital stock options is equity. My equity went up as well. I'm sorry. My expense went up. It means if expense went up, it means equity went down. And I increased paid in capital equity. Notice no change to my equity. Equity went down. Equity went up. The net effect is zero on the balance sheet. However, my income statement got hit with 100,000. So this is the entry that I make in year one. For year two, if the executives kept working for me until year, at the end of year two, I debit compensation expense. Again, 100,000. I credit paid in capital stock options 100,000. What does that mean? It means over the period of two years, I expense the options. And now I have what's called additional paid in capital stock options of 200,000 in total. So now what's going to happen is now I have 200,000 paid in capital stock options on March 1st, 20X5. Now this is now the options have vested. The two executives exercised 60% of the option when the stock price reached 80. So now the stock price is $80. They find out, well, it's a good deal. They can buy it at 50. So they went ahead and they purchased the stock at $50. At $50. And they exercised 60%. Remember, I gave them 2000 in total, times 60%. They are going to buy 1,200 stock at $50 each. So the company would receive $60,000 in cash. I will debit paid in capital 120,000. That's 60% of that because now they're exercised. I'm issuing common stock. I'm issuing 1,200 common stock. The par value is a dollar. Therefore, I credit common stock 1,200. And the remainder will be paid in capital 178,000. You might be saying, hold on a second. What is the benefit to the executives? They had to pay $60,000. Yes, they can buy it today at 50 and sell it at 80 if they choose and they make $30 profit. So really, if you want to think about it, just from the executive's perspective, they're pre-tax profit because this is obviously taxable. And if you don't know how it's taxable, go to my income tax course on farhatlectures.com. If you take 80 minus 50, they made, oh, sorry, 80 minus 50. They made $30 per share. And if they sold those shares, their profit is $36,000. Now, let's assume by the end of 20x5, the stock of farhat lecture started to deteriorate and fell below 50. For somehow, the company went downhill and it kept down downhill for the next 10 years. As a result, the remaining stock option expired because at the price below 80, the executives, they have no incentive of exercising their option. Now, remember here, I still have 80,000 sitting in my paid-in-capital stock options. If those options expired, I have to reverse my entry. I have to debit. I have to debit this account 80,000 to make sure it's go down to zero and I transfer it into an account called paid-in-capital expired stock option, which is an equity account. So here's what I want you to notice. Notice we did not reverse. We did not adjust compensation expense. What does that mean? It means when this 80,000 expired, I did not go back and reduce my compensation expense by 80,000. Okay, because that's what technically happened because they did not really, that 80,000 was not really in expense. All I did is I increased my equity by 80,000. Now, if the two executives failed to meet the service period requirement, if they left before the period was, let's assume in year two, after I recorded 80,000, they left, then you can adjust compensation expense. But once they are recorded and the year is closed, you would just reverse the stock option. That's it. And you will increase an equity account. Now, the best way to learn about stock options is to work additional multiple choice questions and look at additional resources at my website, foreheadlectures.com. Don't shortchange yourself. My investment is nominal. Try it. You see if it's helping you, you keep it. If it's not helping you, you cancel. It's as simple as that. Good luck, study hard. And of course, stay safe. The CPA exam is worth it.