# Compensation expense relative to stock options

I was doing a mock exam, which used the following formula to calculate the compensation expense relative to stock options:

Compensation expense=(number of options granted)*(option price)*(time from grant date to fiscal year end)/(service period in years)

Everything makes sense to me in the formula above, except the (time from grant date to fiscal year end). If a stock option is issued mid-year, I understand that for that specific year, the expense would only over half year, and so you would have to adjust for this. However the formula above implies that if you issue a stock option mid-year, with a service period of 5 years, you would multiply everything by 1/2. Why should this be the case?

I had in my notes from an older mock I recently did that it was

compensation exp= [# of stock options granted x fair value of stock OPTIONS at grant date] divided by average life of options and THEN if your fiscal year is Jan to Dec, and this was granted on July 1st, then you would also divide by 2, as you only want to recognize half the year’s worth of this expense

THEN

I saw in another mock, by using the above formula, that I was wrong. The above mock was from a 2011 mock I believe and the question I just did is for the 2013 morning mock, question 40. They have it as

compensation exp= [# of stock options granted x fair value of stock options at grant date] divided by VESTING PERIOD (years from grant date until you can exercise)

Can anyone confirm which one it is? I hate the CFAI, and I hate spending 3 hours on a problem because I refuse to look at the answer and then I realize 3 hours later it’s on their errata, fml, if I fail level 2 in 3 days, I swear…

Remember an ESOP plan’s options have very different “lives” than the options from the derivatives section. The company sets the terms. In the past, circa Y2k, lots of executives used to grant options, and then go backdate them and change the exercise price to make them already deep in they money. They basically bypassed the income statement entirely. It happened more than you’d imagine.

IFRS 2, which is similar to US GAAP here, you expense the fair value (price) of the instruments granted, along the vesting period, which is usually a few years. It could be option premiums (cheaper route) or the full share price of restricted stock. You always use the price on the day they were granted. Market price / years till earned. Done. There’s also stuff about if there’s no marketable stock price or what to do if people quit/get fired, etc., but don’t worry about that.

It looks like IASB wants the company’s to show half the expense every 6 months, so it’s not a big surprise to shareholders at the end of the year. But year end (audited) financials would have the full yearly expense. That’s what matters.

I was also confused by that, but I think it’s just that the expense spread over 5 years would be 1/2 of the yearly expense in year 1 (because granted on July 1), full yearly expense years 2-5, 1/2 yearly expense in H1 of year 6. So no, I’m pretty sure the mock solution stated that only half the expense is recognized in the year end financials of that first year.

Anybody know if this kind of treatment applies to stock grants? multiplies the expense by .5 if the grant date was july 1st.?

Yes any kind of share-based compensation. FV at the grand date and amortize over vesting. If they’re for work that employees already did, it’s expensed immediately at t=0. Obviously if it’s a mid-year 7/1/20xx grant date, the year’s expense is half for the first and last years but full in between. Performance factors don’t change this for the most part. IFRS and GAAP are pretty much convergent on this, too.

And any kind of share-based payments for inventory don’t recognize the expense until inventory is used, I believe? In doubt, just follow the underlying economics.