Question

Glam Time, Inc. ("Glam Time" or "the Company"), an SEC registrant, is a fashion retailer that sells men's and women's clothing and accessories. As an incentive to its employees, the Company established a compensation incentive plan granting 100,000 options on January 15, 20X0. On that date (the grant date), Glam Time's stock price was $15.00 per share. The significant terms of the incentive plan are as follows: • The options have a $15.00 "strike" or exercise price (the price the employee would pay to purchase a share of stock if the options vest). . For the options to vest, the following must occur: The employee must continue to provide service to the Company throughout the entire explicit service period of five years (i.e., a five-year "cliff-vesting" award). . The Company must achieve annual sales of at least S20 million during the fifth year of the explicit service period. The Company's share price must increase by at least 25 percent over the five-year explicit service period. • In addition, if the Company achieves sales of at least $25 million during the fifth year of the vesting period, the strike price of the options will decrease from $15 to $10. • The options expire after 10 years following the grant date. • The options are classified as equity awards. Additional Facts: • Assume it is probable that 100 percent of the employees receiving the awards will continue as employees for the entire five-year service period and that the five-year service period is determined to be the requisite service period. . On the grant date, Glam Time's management determined that it is probable that the Company's sales in year 5 will be $30 million, and therefore it is probable on the grant date that sales are greater than or equal to at least $25 million. . The grant-date fair value of the options assuming a strike price of $15 is $8 per option. The grant-date fair value assuming a strike price of $10 per option is $12 per option. Research Dimension: 1. What types of conditions are present in the plan for the vesting of the units? Are they service, performance, market, or other conditions? 2. How do the service, performance, and market conditions affect vesting of the units? Of the various conditions present in the awards which affect the vesting of the award? 3. As described above, on January 15, 20X0 (the grant date), $30 million of sales were probable for ycar 5. During years 1, 2, and 3, $30 million of sales for year 5 remained probable. At the beginning of year 4, management determines that it is probable that only $22 million of sales will occur for year 5. What are the proper accounting treatment and journal entries for each year?

Answer 1

Ethics Dimension

5.  Stock options backdating is the practice of altering the date a stock option was granted, to a usually earlier (but sometimes later) date at which the underlying stock price was lower. This is a way of repricing options to make them valuable or more valuable when the option "strike price" (the fixed price at which the owner of the option can purchase stock) is fixed to the stock price at the date the option was granted. Cases of backdating employee stock options have drawn public and media attention.

Stock options are often granted to upper management. While options backdating is not always illegal, it has been called "cheating the corporation in order to give the CEO more money than was authorized."According to a study by Erik Lie, a finance professor at the University of Iowa, more than 2,000 companies used options backdating in some form to reward their senior executives between 1996 and 2002. In an "uncanny number of cases," the "companies granted stock options to executives right before a sharp increase in their stocks."

To be legal, backdating must be clearly communicated to the company shareholders, properly reflected in earnings, and properly reflected in tax calculations.

The SEC’s opinions regarding backdating and fraud were primarily due to the various tax rules that apply when issuing “in the money” stock options versus the much different – and more financially beneficial – tax rules that apply when issuing “at the money” or "out of the money" stock options. Additionally, companies can use backdating to produce greater executive incomes without having to report higher expenses to their shareholders, which can lower company earnings and/or cause the company to fall short of earnings predictions and public expectations. Corporations, however, have defended the practice of stock option backdating with their legal right to issue options that are already in the money as they see fit, as well as the frequent occurrence in which a lengthy approval process is required

6. One of the larger backdating scandals occurred at Brocade Communications, a data storage company. It was forced to restate earnings by recognizing a stock-based expense increase of $723 million between 1999 and 2004, after allegedly manipulating its stock options grants for the benefit of its senior executives. It allegedly failed to inform investors, or account for the options expense(s) properly.

Backdating has been identified at more than 130 companies, and led to the firing or resignation of more than 50 top executives and directors of those companies. Notable companies embroiled in the scandal include Broadcom Corp., UnitedHealth Group, and Comverse Technology.

Although many companies have been identified as having problems with backdating, the severity of the problem, and the consequences, fall along a broad spectrum. Where it is clear that top management was guilty of conscious wrongdoing in backdating, attempted to conceal the backdating by falsifying documents, and where the backdating resulted in a substantial overstatement of the company's profitability, SEC enforcement actions and even criminal charges have resulted.

7. Stock option backdating isn’t necessarily illegal, where you:

• Disclose the practice to investors,
• Record the appropriate compensation expense in your company’s financial statements, and
• Report the transaction properly for tax purposes