How to Account for Stock Based Compensation

Stock-based compensation aligns employee and executive interests with shareholder value. It involves granting employees equity, motivating them beyond cash salaries. This fosters ownership and encourages long-term commitment. Accurate accounting ensures the true cost of employee compensation is reflected in financial statements.

Key Characteristics of Stock-Based Compensation

Stock-based compensation incentivizes employees through company equity. Plans involve a grant date (when the award is given) and a vesting period (time to gain full ownership). During this vesting period, employees provide services for the compensation. Fair value, the monetary worth of the award, is central to all stock-based compensation.

Common types of stock-based compensation include:
Stock options
Restricted stock units (RSUs)
Stock appreciation rights (SARs)
Employee stock purchase plans (ESPPs)

Stock options give employees the right to buy company shares at a predetermined exercise price at a future date. Employees profit if the market price of the shares rises above this exercise price after the options vest. Restricted stock units (RSUs) promise to issue company stock or its cash equivalent after vesting. Unlike options, RSUs do not require an exercise price, and their value is tied to the stock’s market price.

Stock appreciation rights (SARs) allow employees to receive the appreciation in value of shares, often settled in cash or shares. Phantom shares offer a cash bonus equal to the value of shares at a later date. Employee stock purchase plans (ESPPs) enable employees to buy company stock at a discounted price, often through payroll deductions. These plans are designed for all employees and can be qualified under IRS Section 423 for favorable tax treatment.

Measuring Compensation Cost

Compensation expense for stock-based awards is based on their fair value at the grant date, as mandated by U.S. GAAP ASC 718. For equity-classified awards, such as stock options and restricted stock units, this fair value is fixed on the grant date. The objective is to measure the cost of services received in exchange for the equity instruments issued.

Valuation models calculate fair value, with the Black-Scholes-Merton model used for stock options. This model considers the current stock price, the option’s strike price, the time remaining until expiration (expected term), the risk-free interest rate, and the stock’s expected volatility. Expected dividends are considered, as a higher expected dividend yield can reduce an option’s fair value. For restricted stock units, the fair value is the market price of the underlying stock on the grant date.

In contrast to equity-classified awards, liability-classified awards, such as cash-settled SARs, require a different measurement approach. Their fair value is re-measured at each financial reporting date until the award is settled. This re-measurement reflects changes in the underlying stock price, resulting in variable compensation cost recognition. Companies must classify awards to ensure appropriate measurement and accounting treatment.

Recognizing Compensation Expense Over Time

Once the total compensation cost for stock-based awards is measured, it is recognized as an expense over the service or vesting period. This approach aligns the expense with the period in which the company benefits from the employee’s efforts. The common method for recognizing this cost is straight-line amortization.

For awards with time-based vesting conditions, the total fair value is spread evenly over the vesting period. A portion of the total compensation cost is recognized as an expense in each reporting period until the award is fully vested. When awards have performance-based vesting conditions, the expense is recognized only when it is probable that the performance conditions will be met. Adjustments are made if the probability of achieving these conditions changes over time.

Accounting for forfeitures, where employees leave before vesting, impacts expense recognition. Companies may estimate forfeitures at the grant date and adjust the compensation expense accordingly over the vesting period. Alternatively, companies may account for forfeitures as they occur, reversing any previously recognized expense for forfeited awards. This ensures that the expense recognized reflects only the awards expected to or actually vest.

Preparing Journal Entries

Journal entries record the financial impact of stock-based compensation. When an equity-classified award is granted, no journal entry is made on the grant date, but the fair value is disclosed in footnotes. The compensation expense is then recognized incrementally over the vesting period. Compensation Expense is debited, and Additional Paid-in Capital – Stock Options or RSUs is credited. This entry increases expenses and equity.

Upon forfeiture of unvested awards, the previously recognized expense and related equity are reversed. This involves debiting Additional Paid-in Capital – Stock Options or RSUs and crediting Compensation Expense. This adjustment removes the cost associated with awards that will not vest. The reversal ensures that only the cost of awards actually earned by employees remains on the books.

When stock options are exercised, cash received is debited, and Additional Paid-in Capital – Stock Options is debited to remove the option’s value. Common Stock is credited for the par value of the shares issued, and any remaining amount is credited to Additional Paid-in Capital – Common Stock. For restricted stock units, upon vesting and settlement, Additional Paid-in Capital – RSUs is debited, and Common Stock and Additional Paid-in Capital – Common Stock are credited.

For liability-classified awards, such as cash-settled SARs, adjustments are made at each reporting date to reflect changes in fair value. This re-measurement involves debiting or crediting Compensation Expense and crediting or debiting a Liability for Stock-Based Compensation. This ensures the liability and related expense accurately reflect the current obligation.

Financial Statement Presentation

Stock-based compensation impacts a company’s financial statements, requiring specific presentation and disclosures. The compensation expense is reported on the income statement within operating expenses, such as selling, general, and administrative expenses or cost of goods sold, depending on the employee’s function. This expense reduces net income.

On the balance sheet, equity-classified awards affect equity accounts. Additional Paid-in Capital – Stock Options or RSUs increases as compensation expense is recognized. Liability-classified awards, settled in cash or redeemable, are presented as liabilities on the balance sheet. The increase in outstanding shares due to vested equity awards is reflected in the equity section, specifically in common stock and additional paid-in capital.

The cash flow statement treats stock-based compensation expense as a non-cash item. It is added back to net income when calculating cash flow from operating activities, similar to depreciation. This adjustment is made because no actual cash outflow occurs when the compensation is granted or expensed.

Companies must provide disclosures in the footnotes to their financial statements. These disclosures include a description of the stock-based compensation plans, the types of awards granted, and the vesting conditions. Assumptions used in fair value measurements, such as volatility and risk-free interest rates, are disclosed. Companies report the total compensation cost recognized, information about unvested awards, and the intrinsic value of options exercised, providing transparency to financial statement users.