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ACCT 5341 Examination 2


Part 1

Dr. Jensen

Spring 2002

 

Students may use any reference materials available in the Trinity Library and on the Web.

 

Students may not obtain help from any person other than Dr. Jensen.  His help is limited to clarification questions regarding what is required for a given question or problem.

Part 1 ESO Tax Benefits

The starting point for Part 1 is Appendix A of a letter written by Professor Jensen to Senator Charles E. Schumer.  An Appendix B has been added to Professor Jensen’s original letter, and the letter has not yet been mailed.  The purpose of Part 1 of this examination is to compare how you would write an Appendix B that addresses the tax benefit controversy of employee stock options (ESOs).  The letter of Walter Schuetze to Senator Schumer,  The primary documents useful to this examination are as follows:

1.      “Accounting for Tax Benefits of Employee Stock Options and Implications for Research,” Accounting Horizons, Vo. 16, No. 1, March 2002, pp. 1-16.

2.      Chapter 11 of Business Analysis & Valuation, by K.G. Palepu, P.m. Healy, and V.I. Bernard (South-Western Publishing, 2000, ISBN 0-324-02002-3).

3.      FAS 123 entitled “Accounting for Stock-Based Compensation.”  This standard is available from the Financial Accounting Standards Board at http://accounting.rutgers.edu/raw/fasb/
Trinity University students may find the document on the path J:\courses\acct5341\ExamHints\Fas123

4.      On March 25, 2002, Walter P. Schuetze, former Chief Accountant of the Securities and Exchange Commission, wrote Senator Schumer a letter that leaves no doubt that he opposes booking of employee stock options when they vest. That letter is now on the Web at http://www.trinity.edu/rjensen/theory/sfas123/schuetze01.htm

5.      Bob Jensen’s reply that points out some opposing arguments. The initial reply is on the Web at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Initially, the above document contains an incomplete Appendix B that is Part 1 of this examination.  You are prepare an answer key for this examination.  That key will complete the Appendix B.

Required:

1.      You are to fill in the cells that have been blanked out below.  Please enter your results in the Excel spreadsheet that accompanies this examination.  That spreadsheet can be downloaded from the exam02q.xls file on the path http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/
Warning:  Since you will be asked what happens when the tax rate varies, it is best to derive your spreadsheet answers in such a way that you can easily derive different outcomes with each change in the tax rate.

2.      A copy of Hanlon and Shevlon (2002) cited above is provided in this examination.  You are to use this paper for guidance in completing the spreadsheet required above. 

3.      Fill in all the table blanks and answer the questions on the following pages.  Assume that ESO tax benefits arise only when stock options are exercised.  Initially assume that the options in Appendix B can only be exercised at the end of Year 5.

4.      When you are asked to value these companies at the beginning of Year 1, pretend that the revenue and expense cash flows are estimates.  For guidance on the valuation calculations, to the Excel workbook on the path J:\courses\acct5341\ExamHints\FAS123\Appendices.xls

 

Part 1.1 (40 Points)
Fill in the blanks below after filling in the yellow cells of the Part 1 spreadsheet in the Exam3q.xls file.  The accounting is to proceed according to APB 25 procedures (see Hanlon and Shevlon (2002)).

 

Year 5 After Exercise of Options

Nobel Cash Company

Nobel Option Company

Operating  revenue

$320,000

$320,000

Interest revenue

$12,367

$23,424

Labor expense

$160,000

$0

Net profit before income tax (NBOT)

$172,367

$343,424

Income tax expense

$51,710

$103,027

Net profit

$120,657

$240,397

Cash

$244,329

 

Capital

($10,000)

 

Retained earnings

($234,329)

 

Number of shares

10,000

 

Earnings Per Share

$12.07

 

Value of options before exercised

$0

 

Value of options after exercised

 

 

Book Value Per Share

$24.43

 

 

 

 

 

 

 

 

 

Nobel Option Reconciliation of Cash in Year 5

 

Appendix A Cash without interest and taxes =

$780,000

 

Interest revenue =

 

 

Less Income Taxes Payable paid in cash =

 

 

Appendix B Cash With Taxes =

 

 

 

 

 

 

Nobel Option Reconciliation of Capital in Year 5

 

Appendix A Capital without taxes =

($160,000)

 

Additional paid-in capital from ESO tax benefit =

 

 

Appendix B Capital With Taxes =

 

 

 

 

 

 

Nobel Option Reconciliation of Retained Earnings in Year 5

 

Appendix A Retained Earnings without interest and taxes =

($620,000)

 

Interest revenue =

 

 

Less Income Tax Expense in financial statements =

 

 

Appendix B Retained Earnings With Taxes =

 

Comment:  Normally the tax payable exceeds the tax overstatement

 

due to ESO benefits.  If not, this example assumes that the

 

company has neither a tax refund nor a tax loss carry-forward.  If the

 

ESO tax benefit exceeds the Income Tax Expense account, the credit

 

to the Capital account for the ESO tax benefit is limited to the Income

 

Tax Expense value before deducting the ESO tax benefit.

 

 

 

 

 

 

 

Initial Investment and Net Profits

Nobel Cash Company

Nobel Option Company

0

$7,700

$10,000

1

$7,700

$14,700

2

$15,239

$29,729

3

$30,306

$59,810

4

$60,427

$119,997

5

$120,657

$240,397

NPV =

$166,254

$324,096

Cost of Capital =

10.00%

10.00%

Dividend Cash Flow Valuation

 At the beginning of Year 1 = $151,709

 

Residual Income Model Valuation

At the beginning of Year 1 = $151,709

 

FCF Flow Valuation

 At the beginning of Year 1 = $151,709

 

 

 

 

Dividend Cash Flow Valuation

Nobel Cash Company

Nobel Option Company

Cost of Capital =

10.0000%

10.0000%

Year t

Dividend Cash Flows

Dividend Cash Flows

1

$0

$0

2

$0

$0

3

$0

$0

4

$0

$0

5

$244,329

 

ESO New Equity Investment in Year 5 =

$0

 

Dividend Est. Value of Firm at Time 0

At the beginning of Year 1 = $151,709

 

Dividend Est. Value Per Share at Time 0

$15.17

 

 

 

 

 

 

 

Residual Income Valuation

 

 

 

 

 

Residual Income Valuation