 Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Come to the session, this is Professor Farhat in which we would look at an exercise or a CPA simulation that deals with stock options. On January 1st, 2021, Adam Inc. granted stock option to officers and key employee for the purchase of 40,000 shares for its $5 power value common stock at $30. Simply put, Adam Inc. allowed the certain employees and key officers to do what? To buy the shares at $30. This is the exercise price. How many shares? 40,000 shares. Let's see what the deal is. The options were exercisable within a five-year period beginning January 1st, X1. Let's take a look at a timeline here. This is important. This is 20X1. This is 20X2. Let me put 20X3 in a different color and you'll see why. 20X3. They are exercisable starting at the beginning of 20X3 and they are granted January 1st, 20X1. The options were exercisable within a five-year period beginning January 1st, 20X3. Simply put, once they become exercisable, they are available for the employees for 1, 2, 3, 4, and 5. So 20X4, 20X5, 20X6, and 20X7. That's fine. The service period for this award is two years. What does the service period means? It means the employees that got those options to earn them, to earn the right to exercise them. They have to work for the company two years, obviously starting January 1st. This is why I have the first two years in red to indicate that's the service period. Assume that the fair value of the option pricing model determines total compensation expense to be 300,000. So our total expense for this stock options for the company will be given is 300,000. What do we have to do with the 300,000? We have to expense it. How much do we expense 300,000? Over how long? Over the service period. What is the service period? I'm going to color the service period. This is the service period, the first two years. So what I'm going to do? I'm going to split the expense. I'm going to expense it over two periods. I'm going to expense 150,000 every year. So starting with January 1st, the grand date. What do I have to do on the grand date? January 1st, and the answer is nothing. There's no entry. Because what if I granted the options, then all those employees left the company before the service period ends? I have no expense. Therefore, I have to wait until they start to earn their compensation. After they work for one year, I have an expense of 150,000. So I will debit compensation expense 150, credit paid in capital stock options 150. Obviously, compensation expense is an expense. Expense went up, equity went down, and paid in capital stock options is equity, and equity went up. So notice all what we did is equity went down, equity went up. There is no effect, overall effect on the balance sheet. However, our income statement was hit with 150,000. On April 1st, so now we're looking at an April 1st, 2020, some time here, 4,000 options were canceled when employees resigned from the company. Remember, if they resigned, they no longer can exercise the option. The market price of the common stock was 35. It doesn't really matter because they're outside the period. Now the employees might negotiate with the company, asking them if they can exercise them in the real world, but that's not what we're talking about here. So now what's going to happen is this, if 4,000 were canceled, 4,000 divided by 40,000 options, it means we have to cancel 10% of the paid in capital stock options that are basically canceled. So we debit, 10% of 150 is 15,000, and we have to reverse 15,000 of the compensation expense. That's for April 1st. Then we're done with 20x2. At the end of 20x2, we have to make the same journal entry. At the end of 20x2, we have to debit compensation expense, credit paid in capital to expense the remaining 150. 150 plus 150 equal to 300,000. Now 15,000 was eliminated. Nevertheless, it was originally 300,000. Therefore, this is the entry that we make at the end of year 20x2. At this point, the company is done with their expenses. And at this point, if you work for the company, now you can leave and you have five years to exercise your options. March 31st, 20x3. So sometime here after it was, after they qualify at the end of the quarter, it seems some employee wanted to exercise their option. 24,000 options were exercised and they bought the stock at the exercise price, which is $30, but the stock price was 40. So they made an immediate profit of $10. So what is the, what are we required to do here? Well, now the employee will have to pay the company. If they're buying 24,000 shares at $30, they have to pay the company, if my math is right, $720,000. Now the company will have to issue the stocks, will have to issue 24,000 shares issuing the stock at par value, $5 per share, they have to credit common stock for 120. So this is cash, this is the amount for common stock. Now also, if we look at 24,000, 24,000 divided by 40,000, that's 60% of the stock options. So 60% of 300,000 will have to be of the paid and capital stock option. We have 300,000. 60% of them now, they're going to be gone because they're exercised. So if we take 60% times 300,000, we have to debit paid and capital stock options, 180. This is paid and capital. And anything that's left, it's going to be additional paid and capital. Let's take a look at the journal entry and review every entry separately. First the cash, the company would receive cash $720,000, which is 24,000 shares times $30. That's done. The company would receive this much in cash, they will issue the stock, the stock is issued, we have 24,000 shares times $5 par value. Then we have to debit paid and capital $180,000, which is 300,000 multiplied by 60%, because 60% were exercised and anything that's left is a plug to paid and capital. So this is basically an exercise that showed you how to account for stock options, accounting for stock options from recording the compensation expense to some employees leaving before the service period until the cash, until the some of the options were exercised. What should you do now? Go to farhatlectures.com, work additional MCQs through false exercises that's going to help you really understand this topic. Don't hesitate to contact me if you have any questions. Good luck, study hard, stay safe.