 Hello and welcome to this session in which we would look at a CPA exam simulation that deals with incentive stock option plan. This topic is challenging for students for many reasons. One, it deals with an equity section of the balance sheet, which is a little bit unusual. When we talk about stock, you would think about investments, you will think about assets. Stock options, they're going to be touching the equity section of the balance sheet. That's one. Two, stock options are not something that are intuitive for students in contrast to regular stocks. Regular stocks, we are all familiar, you buy stock, you buy stock at a certain price, you hope to go up, you sell it, this is an investment. And how to account for an investment is challenged as is. So when you include stock options, it makes it a little bit more challenging for students. Now the good news is this, I did work with stock options when I was younger, right after my undergraduate degree. I work with Merrill Lynch and I handled incentive stock option plan for various companies. So I'm familiar with this topic. I was very, very familiar with it actually in the real world, not from an accounting perspective, from a finance perspective, but able to, if I'm able to explain it to you from a finance perspective, then you'll be able to understand it from an accounting perspective. And this is what I'm going to try to do by going over the CPA simulation. Now whether you are an accounting students or a CPA candidate, I strongly suggest you check out my website, farhatlectures.com. I don't replace your CPA review course. I can't do that, you keep that. I am a useful addition to your CPA review course. My resources, my lessons can add 10 to 15 points to your CPA exam score by helping you understand the material better and which you will see in this exercise. My courses are designed to mirror image your CPA review course. So they go hand in hand. I don't intend to replace them. You need your CPA review course. And here's your risk. Your risk to try me is one month of subscription. Your potential gain is passing the exam. Are you willing to take that risk to pass your CPA exam, which you only have to pass once in your lifetime? And if not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. I do have resources for other accounting courses and CPA section. If you haven't connected with me on LinkedIn, please do so and take a look at my LinkedIn recommendation. Like this recording, share it with other, connect with me on Instagram, Facebook, Twitter, and please follow me on Reddit as I am trying to increase my followers. So let's take a look at this exercise. So we have Adam graphics offers incentive stock option plan to its district manager. On January 1st, options were granted for $56 million, $1 power value, common stock. The exercise price is on the grand date was $9 per share. Now let's stop here and make sure we understand from a business perspective what we are saying. What we are saying is this, Adam graphics, it's a company and what they did to encourage your employees to work hard for the company. They told them, we're going to give you $56 million shares. You can buy those $56 million shares at $9 per share. That's what a stock option is, giving you the option to buy it at $9. The key here is to drive the stock above $9. When the stock price is above $9, if the stock price is $12, guess what? You buy $49, you have the option to buy $49, and you make an automatic profit of $3. So this is the idea. And they granted $56 million shares. Options cannot be exercised prior to January 1st, 2023, but you have to wait. Although we're giving you the options now, you have to work at least two years for the company. And after two years, that option will last. It means you can exercise it. And you have from January 1st, 2023 till December 31st, 2027. Let's take a look at a time frame here. This is 2021. This is 2022. This is, let me put 2023 in a different color. 2023, 2024, 2025, 2026, and 2027. So first thing is you have to work those two years. You have to work those two years. Then after those two years, this is when you can, what we call, exercise the option. Okay, so the first two years, simply, I'm not going to use the word restricted. I'm not really sure if this is 100% correct. It's not vested, not restricted. The options are not vested. So the first two years, you have to work for the company. Then the years in green, you can exercise the option. So here you can buy the stock for $9, and you're hoping the stock to be $100, whatever. So that's the key. So this is the picture that you are looking at, and you are granted those options today. So the fair value of the $56 million, estimated by an appropriate option, pricing model is $1 per share. Now, they have to tell you. The problem will have to tell you whether you are an intermediate accounting students or a CPA candidate. The problem will tell you what is the cost of the option for the company. What does that mean? It means you have a CFA or a specialist or an investment banker that they will tell you the cost for the company is that much. And the cost for this company, they're telling us $1 per option times $56 million. So the cost. So the first question is, what's the compensation expense? Well, the compensation expense is $56 million for the company. The compensation expense is $56 million. And you want to take a look at this picture because I'm going to delete everything. So this is the compensation expense. So usually the first question should be given to you. It's $56 million. This is the compensation expense. If you are asked that question, now, when do you record this compensation expense? That's the question. When do you record this compensation expense? Well, let's think about it from a logical perspective. When do you record the compensation expense? You record the compensation expense when the employees are working for the company, when they are producing for the company. What's the deal with this stock option? The deal is for year 2021 and 2022. This is where the employee has to work. What does that mean? It means the $56 million has to be divided into two periods, two periods and half of $56 million, which is $28 million, half of it, half of it will be recorded in 2021 and half of it will be recorded in 2022. Although the irony here is this, really, you're not paying the employees anything in 2021 and 2022. However, you have to record the expense. Therefore, December 31st, oh, by the way, what do we record on January 1st, 2021 when we grant the options? No journal entry. So, if you're giving this on the exam day, on the grant date, the grant date is January 1st, 2021, there's no entry. Simply put, it's a contract. You just say, this is what I'm going to do. I'm going to give you those options. When does the company start to record expenses? Well, after a year, this is January 1st, there's no expense yet, but after a year, the employee work for a company, now you have a compensation expense of $28 million, you debit compensation expense. On January 1st, you'll put no entry on the grant date. Now, the credit is what? Usually, when you debit an expense, you either credit cash or you credit a payable. So usually, when you debit an expense, you credit cash or you say, I'm going to pay you later. Guess what? For stock options, you are going to credit an equity account called paid in capital stock options. You're not really paying them anything yet, but you are increasing your expenses. So notice what's going to happen. You increase your expenses and as a result, you reduced your equity. Guess what? Then you increase your equity by crediting a new account called paid in capital stock options because you are issuing stocks. You are paying them with stocks. So look, look, the net effect is zero on equity. Equity went down. Equity went down. I'm going to put equity down, although the expense is up. Equity is down because you have an expense. Then you should equity. You should stock option paid in capital. Equity is up. You really, the net is zero on equity because one equity went up, one equity went down, but you have to record the expense. Simply put, what, what gap wants you to do or FASB, they want you to record the expense on the income statement. I'll tell you, you know, a short story. Why? Because back in, when we had the dot com back in 2000, 2001, prior to that companies did not have to expense their stock options. They did not have to expense it because there was really no, there was really no expense for the company. You just granted them. When they, when they exercise those options, you sell them the stocks. What gap says, well, companies were granting options and hiding those expenses. So what they want us to do with what they want the companies to do is to show the expense. That's why we record the expense. Although we record the expense and we increase equity, nevertheless, expense would reduce your earnings. Okay. So it's a non cash expense. So what does that mean? Even from a cash perspective, this is a non cash, non cash. Good. I'm glad I remember to tell you this non cash expense. It means non cash expense. It means when you're preparing your cash flow statement, you have to add this expense to the cash. Why? Because you're going from a cruel, you're recorded an expense. Then this expense is non cash. You will add back 28 million. Okay. So just I'm glad I remember to mention this. Okay. So this is for 2021. Then a year later, they're going to work another year. Then you're going to then 2022 a year later, you would debit compensation expense again, credit paid in capital 28 million. At this point, you have recorded the compensation expense. So we did January 1, which is no entry, December 31, 2021, December 31, 2022. Those are done. Those are done. Now starting January 1, 2023, the employees, those district managers, they can exercise their option. What does that mean? It means they can buy it for $9. And look what happened. Assume 75% of the options were exercised on March 1st, on March 15th, and the market price was 10. The market price now is above water. We call it it's above water. It means it's a positive. And the district manager is going to say, you know what, we are going to exercise the option. Okay. So if they exercise the option, let's think about it. What do they have to pay the company? And the only exercised 75% of 56 million. So you have to understand that if we take 70, I'm sorry, we have to take 56 million times 0.75. They are going to buy 42 million shares, 42 million. The first thing they have to pay the company $9. So we're going to take 42 million times $9 per share. They're going to give the company 378 million. The company will debit cash 378 million because they have to pay the company this much. Now, you have to understand every time we issue stocks, every time we issue stocks, we have to credit common stock and you have to know this by heart. Common stock is credited. Here's the formula. Number of shares times the par value. What's the number of shares here? 42 million. What's the par value? Dollar. So we have to credit common stock, 42 million. So this is easy. I'm putting the easy, I'm putting the easy entries first. So this way we can put, we can fill this together. Now, also, also when we did is we have now a paid in capital stock option account. We have paid in capital stock option and we have in there 56 million, you know, this 25 and this 25. Now, as we exercise those, now we're exercising 42 million. We have to reduce it by 42 million. Therefore, we debit paid in capital stock option 42 million. Why? Because we are exercising the option. Then we credit common stock for 42 million. Now we need something for the entry to balance. That's easy. When you are issuing stocks, anything that's left is paid in capital. So this number 378 is a plug, plug, plug. Okay. So this, this number is a plug. So again, we paid $9 per share for 42 million shares. We have to pay 378 million. We have to reduce our paid in capital stock options by 42 million because we did, we did, we did exercise the options. Therefore, we reduce our stock options. We can no longer keep them. Now, it's good to know how many do we still have left. So if we take 56 minus 42, we still have 14 million. We still have a balance of 14 million in paid in capital stock options. Okay, then this is a plug. Well, we are told the remaining vested options expired without being exercised. What does that mean? It means 24, year 24, year 25, year 26, year 27. The stock never really exceeded $9 or if it exceeded, we did not exercise. So what happened is the option expired. Once the option expired, we have to remove the options. If they expired, that's good. We have to remove them. What do we do? How do we remove this? We're going to debit paid in capital stock options of 14 million. What's the credit? Well, think about it. If the, if the options went unexercised, remember, when we thought they're going to be exercised, we debited an expense of 56 million in total. Well, true 42 million occur. The remaining 14 million did not occur. Therefore, we're going to increase equity by another 14 million and the account is paid in capital, expiration and stock options for. So for them not exercising those options, kind of its increase our equity back by 14 million. Why? Because when we initially, when we initially recorded those options, we reduced our equity. Now 14 million of them were not expired. That's excellent. I'm sorry, went expired. They were not exercised. That's excellent for us. It, it gave us, it gave us back 14 million in equity back to 14 million, which is good. So simply put, let me summarize this real quick. One is no journal entry on the grand date. Then the expense has to be spread out over the period where the employees are working. And usually they tell you this, but you have to be careful in case they didn't, they didn't tell you explicitly. You, you, you expense the option over the period the employees are working two years. Then you wait until they exercise. When they exercise, they'll pay cash. You would remove paid in capital for the appropriate amount. You credit common stock and the remaining as a plug. And if anything that went unexpired, you remove it, you remove the stock option paid in capital and you credit another paid in capital, which is you increase your equity. At the end of this recording, I'm going to tell you to again, I don't replace your CPA review course. I supplement. I'm a useful addition to your CPA review course. You're going to study for your exam once. Don't short change yourself. Invest the money, invest the time, invest the effort you need to pass once, pass the exam. Good luck, study hard. And as always, stay safe.