Let's revisit our worksheet where we are performing purchase price and accounting calculations. You may want to have a look at our discussion of FIN 44 governing the treatment of options before proceeding. In summary, FIN 44 says that the fair value of stock options or awards issued by the acquirer (i.e. "replacement" awards) in exchange for outstanding awards held by the target's employees are considered part of the purchase price.
However, to the extent that continued employee service subsequent to the acquisition date is required for the replacement awards to vest, a portion of the intrinsic value (if any) of the unvested replacement awards is allocated to unearned compensation. Unearned compensation is recorded as an asset on the balance sheet and amortized as compensation expense over the remaining future vesting (service) period for accounting purposes.
We begin our calculation of unearned compensation expense with the calculation of the intrinsic value of TargetCo's options. Note that intrinsic value is different from the Black-Scholes fair value we have already calculated.