Does Stock-Based Compensation Affect Net Income? A Look
Explore the subtle ways non-cash employee incentives influence a company's bottom-line performance.
Stock-based compensation (SBC) is a form of non-cash payment where employees receive equity or equity-linked instruments in their company. This method has become common in corporate compensation strategies, particularly for attracting and retaining talent without immediately impacting cash reserves. Companies use SBC to align employee interests with shareholder interests, motivating employees to contribute to the company’s long-term success.
What Is Stock-Based Compensation
The most common types of stock-based compensation include Restricted Stock Units (RSUs), Stock Options, and Employee Stock Purchase Plans (ESPPs). RSUs represent a promise to grant employees a specific number of shares after certain conditions are met, typically a vesting period based on continued employment. Employees do not pay to receive RSUs; they simply own the shares once vested.
Stock options, on the other hand, give employees the right to purchase company stock at a predetermined price, known as the exercise or strike price, within a specified timeframe. Employees only gain ownership if they choose to exercise their options and pay the strike price. ESPPs allow employees to purchase company stock, often at a discounted price, through payroll deductions. These various forms of SBC serve as powerful tools for companies to attract and retain skilled individuals while aligning employee incentives with overall business performance.
How Stock-Based Compensation Is Accounted For
Under Generally Accepted Accounting Principles (GAAP), specifically Accounting Standards Codification (ASC) 718, stock-based compensation is recognized as an expense on the income statement. This accounting standard requires entities to measure the cost of services received in exchange for an equity award at its fair value. The fair value of these awards is determined at the grant date; for stock options, this involves using option pricing models that consider factors like expected term, volatility, strike price, interest rate, and dividend yield. For RSUs, the fair value is the market price of the underlying stock on the grant date.
This determined fair value is then recognized as compensation expense over the vesting period, which is the time frame during which employees earn the right to the compensation. For instance, if an award vests over four years, the total fair value is expensed proportionally each year. The expensing of SBC is a non-cash transaction, meaning it reduces a company’s reported net income without an actual outflow of cash from the business. This treatment reflects the economic cost of providing equity to employees, even if no cash changes hands at the time of expensing.
The Impact on Financial Statements
Stock-based compensation directly affects a company’s net income by reducing it. The fair value of the equity awards, as determined under ASC 718, is recorded as an expense on the income statement over the vesting period. This expense appears within operating expenses or as a separate line item. The recognition of this non-cash expense lowers reported profits, consequently impacting earnings per share (EPS).
On the cash flow statement, the non-cash nature of stock-based compensation means it is added back to net income in the operating activities section when using the indirect method. This adjustment is necessary because the expense reduced net income but did not involve an actual cash outflow. For example, if a company reports $10 million in stock-based compensation expense, this amount is added back to net income to arrive at the cash flow from operations, reflecting that the company’s cash position was not directly affected by this expense.
The balance sheet also reflects the impact of stock-based compensation. When equity awards are granted, an increase in “additional paid-in capital” or a similar equity account occurs, representing the value of the shares issued or to be issued. As the compensation expense is recognized over time, accumulated deficits from reduced net income can lead to a decrease in retained earnings, a component of shareholders’ equity.