Hello and welcome everyone. In this lesson, we will introduce two complexities when accounting for stock-based compensation for stock options. When we use these compensation plans, we are going to introduce today the graded vesting of the options and number 2, the possibility of the options to be forfeited. Instead of having the stock option plans vest, meaning being exercisable on one single date, in this lesson, we will discuss the scenario of graded vesting or the recipients gradually become eligible to exercise their options rather than all at once. Graded vesting, what do we mean when we say graded vesting? The stock option plans might vest, meaning become exercisable on one single date. For example, four years from the date of the grant. This is referred to as cliff vesting. More frequently though, a awards might alternatively specified that the recipients gradually become eligible to exercise their options rather than all at once. This is what we mean by graded vesting. For instance, a company might award stock options that vest 25 percent the first year, 25 percent the second year, and 50 percent the third year, or even maybe 25 percent each year for four years. Anyway, in each of those circumstances, it's what we mean by graded vesting. In such a case, the company can choose to account for the options, essentially the same as cliff vesting plans. Or it can estimate a single fair value for each of the options even though these vest over different time periods. With using a single weighted average expected life of the options, the company can allocate total compensation expense, which is the fair value per option times the number of options over the entire vesting period. Most companies choose a slightly more complex method because it usually results in a lower expense, which is referred to as separate valuation approach. In this approach, each vesting group or tranche is viewed separately, as if it were a separate award. At any given date, a company must have recognized at least the amount vested by that date. Another alternative also companies also can choose to use the straight-line method, which would allocate the total compensation costs equally over the vesting period. Very good. That is graded vesting. Let's go to the forfeiture of stock options. If previous experience indicates that a material number of options will be forfeited before the vest due to employee turnover or violation of other terms of the options, whatever the reason, we adjust the amount of the compensation recorded by A, estimating the for features or two buy the full feature when it actually occurs, so I have two approaches. The default approach is to estimate the percentage of options that will be forfeited and adjust the grant date calculation of the fair value of the options to reflect that expectation. If the expectation changes, a firm should adjust the cumulative amount of the compensation expense recorded to date in the year the estimate change. The other alternative is to use an alternative approach. In alternative approach, companies can elect to account for features of stock options or restricted stock when the forfeitures actually occur, rather than estimate for features that will occur during the vesting period. So rather than recording the compensation expense and the paid-in capital for the net amount of the work expected to vest, companies can choose to initially record the composition based on the total amount and then reduce the compensation expense and pay it in capital only if and when forfeiture occur. Once a forfeiture occurs, we adjust the cumulative amount of the compensation expense recorded to date in the year the forfeiture occurs and there after in a manner similar to the way estimates are adjusted. In summary, accounting for stock options will be more challenging when introducing two complexities. The first is allowing the options to vest gradually instead of all at once. In such scenario, the firm can either use the separate validation approach or the straight line method to account for these options. The other complexity that we introduced is basically the forfeitures of options. In which scenario, the firm can select to either estimate the forfeitures or account for such for forfeitures as they occur. Thank you.
