At the beginning of its first year of operations, the Barker Co. grants non qual

Question

At the beginning of its first year of operations, the Barker Co. grants non qualified options on 5,000 of its $1 par common stock. The exercise price of each option is $30. The fair market value of each option on the grant date is $6 and the options vest after 4 years. The fair market value of each common share on the grant date is $29. The tax rate is 20% in all years.

1. How much is the book value of common stock issued if all the options are exercised when the fair market value of each common share is $40 ?

Answers, $5,000: $200,000, $55,000, $195,000 and all other regarding this question on chegg are WRONG. I need to figure out how correctly solve this problem. Please help.

2. Barker's pre-tax income is $300,000 in the period when the options are exercised. The fair market value of each share on the exercise date is $40. How much is taxable income in that period?

Answer: $272,500 is WRONG

Explanation / Answer

1. Fair market value of options is the amount of Compensation expense company is required to book until the options are exercised. This means that $6 per options value multiplied by 5000 options is the compensation expense to be booked.

Journal Entry

a. Booking the expense

Compensation Expense....Dr. 30,000

TO Paid in capital warranty stock......30,000

b. Entry on the date of exercise of options.

Cash (30 x 5000)....................................Dr. 150,000

Paid in capital warranty stock.................Dr. 30,000

TO Common stock at par value............................5,000

TO Excess of paid in capital over par value.........175,000

In the given case, excess paid in capital warranty stock is reversed on the exercise date as the same was liability for the company each year when it was booking corresponding expense. This means that company has issued stocks at ($30 + $6) = $36 per share to it's employees, in which $6 will be borne by the company.

Total Book Value = Common stock at par value + Excess of paid in capital over par value

= 5,000 + 175,000 = $180,000

2. At the time of grant of options, non-qualified options are not taxable event. However, on the date of exercise of the options, the bargain element in the options is taxable as ordinary income of the company.

Bargain Element = Fair market value on the date of exercise - exercise price of options.

= $40 - $30 = $10 per share

Taxable Income of Barker = 300,000 + ($10 x 5,000 options) = $350,000

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