On December 31, 2019, some of Corrigan Corporation’s key executives were granted the option to buy 100,000 shares of the firm’s $5 par common stock at an option price of $15 per share. According to the Black-Scholes model, the total compensation expense associated with the options is $375,000. These options represent compensation for services provided over a four-year period beginning on January 1, 2020, and they become exercisable on that date. As of December 31, 2020, none of the executives had chosen to exercise their options. If Corrigan uses the fair value method, how will the executives’ stock options affect the firm’s net income for 2020?

They will lead to a $93,750 decrease in net income.  

Explanation:

Under the fair value method, a firm determines total compensation cost at the grant date, then evenly allocates it to the periods benefited by an employee’s service. Here, the total cost is $375,000 and the service period is 4 years, so the compensation expense per year is $375,000/4 = $93,750. Even though the option was not exercised, the firm must still record these costs and the resulting decrease on net income, per GAAP.    

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