What is the Accounting for Stock-Based Compensation?
A company may compensate its employees with shares in the business. The intent is to align their interests with those of the business in enhancing the share price. When these payments are made, the essential accounting is to recognize the cost of the related services as they are received by the company, at their fair value. The offset to this expense recognition is either an increase in an equity or liability account, depending on the nature of the transaction. Employee services are not recognized by the employer before they are received. The following issues relate to the measurement and recognition of stock-based compensation.
A key concept is the grant date. This is the date on which a stock-based award is granted, and is assumed to be the date when the award is approved under the corporate governance requirements. The grant date can also be considered the date on which an employee initially begins to benefit from or be affected by subsequent changes in the price of a company’s stock, as long as subsequent approval of the grant is considered perfunctory.
Another key concept is the service period. The service period for a stock-based award is considered to be the vesting period, but the facts and circumstances of the arrangement can result in a different service period for the purpose of determining the number of periods over which to accrue compensation expense. This is called the implicit service period.
Costs to be Recognized
Expense accrual. When the service component related to a stock issuance spans several reporting periods, accrue the related service expense based on the probable outcome of the performance condition, with an offsetting credit to equity. A performance condition is a condition that affects the determination of the fair value of an award. Thus, always accrue the expense when it is probable that the condition will be achieved. Also, accrue the expense over the initial best estimate of the employee service period, which is usually the service period required in the arrangement related to the stock issuance.
Service rendered prior to grant date. If some or all of the requisite service associated with stock-based compensation occurs prior to the grant date, accrue the compensation expense during these earlier reporting periods, based on the fair value of the award at each reporting date. When the grant date is reached, adjust the compensation accrued to date based on the per-unit fair value assigned on the grant date. Thus, the initial recordation is a best guess of what the eventual fair value will be.
Service rendered prior to performance target completion. An employee may complete the required amount of service prior to the date when the associated performance target has been achieved. If so, recognize the compensation expense when it becomes probable that the target will be achieved. This recognition reflects the service already rendered by the employee.
Service not rendered. If an employee does not render the service required for an award, the employer may then reverse any related amount of compensation expense that had previously been recognized.
Employee payments. If an employee pays the issuer an amount in connection with an award, the fair value attributable to employee service is net of the amount paid.
Non-compete agreement. If a share-based award contains a non-compete agreement, the facts and circumstances of the situation may indicate that the non-compete is a significant service condition. If so, accrue the related amount of compensation expense over the period covered by the non-compete agreement.
Expired stock options. If stock option grants expire unused, do not reverse the related amount of compensation expense.
Subsequent changes. If the circumstances later indicate that the number of instruments to be granted has changed, recognize the change in compensation cost in the period in which the change in estimate occurs. Also, if the initial estimate of the service period turns out to be incorrect, adjust the expense accrual to match the updated estimate.
Fair value determination. Stock-based compensation is measured at the fair value of the instruments issued as of the grant date, even though the stock may not be issued until a much later date. The fair value of a stock option is estimated with a valuation method, such as an option-pricing model.
Fair value of nonvested shares. The fair value of a nonvested share is based on its value as though it were vested on the grant date.
Fair value of restricted shares. A restricted share cannot be sold for a certain period of time due to contractual or governmental restrictions. The fair value of a restricted share is likely to be less than the fair value of an unrestricted share, since the ability to sell a restricted share is sharply reduced. However, if the shares of the issuer are traded in an active market, restrictions are considered to have little effect on the price at which the shares could be exchanged.
Stock Based Compensation is the expense in the income statement which the company uses its own stock to reward the employees. It usually provides to the key management such as CEO, CFO, and other Executives. The stock that company provides to the employee is the option stock which gives the holder the right to buy and sell at the agreed price and date, it is not the obligation.
Instead of using cash to compensate employees, company uses the stock option to motivate them. It is a form of performance bonus that company provides to employee. The employee will not be able to collect cash immediately, it usually spend several years of the vesting period.
Stock Based Compensation is beyond the normal cash motivation such as salary and bonus. It aligns the company and employee’s interests together. It will push the employee to work harder for the best interest of shareholders as they also have a chance to be the shareholders. They will treat the company the same as the owners. They will push the company forward in order to receive better compensation which depends on share price.
Stock Based Compensation Journal Entries – Restrict Share Option
- To record the issue of stock compensation
- To record compensation expense after vested period. The company record journal entry by debit compensation expense and credit contra equity.
- To reverse the stock if the employee resigns before the vested period. The company need to reverse the first transaction by debit common stock, paid-in capital and credit contra equity.
Stock Based Compensation Example – Restrict Share Option
Company ABC provides stock options to CEO to compensate for his hard work. He receives 10,000 stock options which will be vested after 3 years. Company share is trading at $ 8 per share and par value of $1.
Stock Based Compensation (also called Share-Based Compensation or Equity Compensation) is a way of paying employees, executives, and directors of a company with equity in the business. It is typically used to motivate employees beyond their regular cash-based compensation Compensation Compensation and salary guides for jobs in corporate finance, investment banking, equity research, FP&A, accounting, commercial banking, FMVA graduates, (salary and bonus) and to align their interests with those of the company’s shareholders. Shares issued to employees are usually subject to a vesting period before they are earned and can be sold.
Types of Equity Compensation
Compensation that’s based on the equity of a business can take several forms.
Common types of compensation include:
- Restricted Share Units (RSUs)
- Stock Options
- Phantom Shares
- Employee Stock Ownership Plan (ESOP)
How it Works
Companies compensate their employees by issuing them stock options Stock Option A stock option is a contract between two parties which gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a specified time period. A seller of the stock option is called an option writer, where the seller is paid a premium from the contract purchased by the stock option buyer. or restricted shares. The shares typically vest over a few years, meaning, they are not earned by the employee until a specified period of time has passed. If the employee quits the company before the shares have vested, they forfeit those shares. As long as the employee stays long enough with the company, all of their shares will vest. They can hold the shares indefinitely, or sell them to convert them into cash.
Stock-Based Compensation Example
The easiest way to understand how it works is with an example. Let’s look at Amazon’s 2017 annual report and examine how much they paid out in equity to employees, directors, and executives, as well as how they accounted for it on their financial statements.
As you can see in the cash flow statement below, net income must be adjusted by adding back all non-cash items, including stock-based compensation, to arrive at cash from operating activities.
In 2017, Amazon paid $4.2 billion of share-based compensation to its employees.
Since the company has approximately 560,000 employees, that works out to about $7,500 per employee on average.
Advantages of Stock Based Compensation
There are many advantages to this type of remuneration, including:
- Creates an incentive for employees to stay with the company (they have to wait for shares to vest)
- Aligns the interests of employees and shareholders – both want to see the company prosper and the share price rise
- Doesn’t require cash
Disadvantages of Share Based Compensation
Challenges and issues with equity remuneration include:
- Dilutes the ownership of existing shareholders (by increasing the number of shares outstanding)
- May not be useful for recruiting or retaining employees if the share price is decreasing
Implications in Financial Modeling & Analysis
When building a discounted cash flow (DCF) model DCF Model Training Free Guide A DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow to value a business, it’s important to factor in share compensation. As you saw in the example from Amazon above, the expense is added back to arrive at cash flow, since it’s a non-cash expense.
While the expense does not require any cash, it does have a capital structure impact on the business, since the number of shares outstanding increases.
Analysts need to decide how to address this issue, and there are two common solutions:
- Treat the expense as a cash item (don’t add it back).
- Add it back and increase the number of shares outstanding by the number of shares awarded to employees (both vested and non-vested).
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- Financial Modeling Guide Free Financial Modeling Guide This financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more
- Investment Banking Salary Guide Investment Banking Salary Guide Our investment banking salary guide covers several jobs in the investment banking sector and their corresponding ranges of salaries for 2018. There are three main areas in an investment bank: investment banking division, sales and trading, and asset management.
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Many tech companies compensate employees using stock-based compensation (SBC) models, allowing employees to share in the potential upside [or downside] of an emerging growth company. However, depending on the nature and characteristics of the model, such financial instruments may be classified as either equity or liability. For unprofitable start-ups needing to comply with debt covenants, determining the correct classification and structuring compensation accordingly is an important goal.
Stock-based compensation includes stock options, shares (both restricted and non-restricted), and other financial instruments that convert to shares or cash over time as the employee becomes vested in the instrument. Stock-based compensation consists of many different financial instruments that allow employees the right to enjoy the gains in a company’s stock price, whether by purchasing the stock through options, receiving a fixed amount of shares of restricted stock which vest over time or receiving a fixed cash amount of stock after meeting vesting criteria. Issuing options, warrants, and other instruments can be complex and the classification of the instrument as debt or equity will depend on the features and characteristics of the instrument.
Contact our Professionals to discuss planning ideas applicable to your situation.
Determining Liability or Equity Classification
The specific terms and timing of SBC awards are critical factors in determining whether or not stock-based compensation should be classified as equity or liability.
With respect to terms, stock-based compensation that is settled in a fixed amount of dollars is usually classified as a liability while awards settled in a fixed number of shares is classified as equity. In simpler terms, when a company’s stock-based compensation is ultimately settled in stock, rather than cash, the award is classified as equity.
Example 1: Company A awards an employee $50,000 worth of stock as compensation. Because the nature of the award is a cash obligation, this award is classified as a liability.
Example 2: Company B awards an employee 50,000 shares of stock as compensation. Because the nature of the award is an equity stake of fluctuating dollar value, this award is classified as equity.
Additionally, awards that are indexed to a factor other than the common criteria of performance, market and service conditions are also usually classified as liabilities.
With respect to timing, the events that determine the vesting and settlement of a stock-based award also affect the award’s balance sheet classification. Awards that are mandatorily redeemable or certain to become mandatorily redeemable for the issuer are classified as liabilities because they represent the equivalent of a future obligation for the payment of cash.
Awards that only become mandatorily redeemable based on a contingent event that is possible, but not certain to occur are considered contingently redeemable. These awards are classified as equity but must be reevaluated each reporting period to determine if the contingency is no longer applicable and the award represents one that is now mandatorily redeemable. When a redeeming event becomes certain to occur, companies must reclassify the awards as liabilities, as it becomes certain that the entity has an obligation to settle the award in cash.
Oftentimes, stock-based compensation is redeemable at the employee’s or employer’s option. Stock-based compensation that is redeemable at the employee’s option is a considered an employer obligation, and thus a liability while awards that are redeemable at the employer’s option are classified as equity. When terms are less clear, if the company’s history suggests that stock-based compensation is usually settled at the employee’s discretion, or is usually settled in cash, the stock-based compensation would be classified as a liability. Companies with a history of awards being settled in stock at the employer’s discretion would usually classify such compensation as equity.
Why Stock-Based Award Classification Matters
Many technologies and emerging growth companies are often unprofitable and compensate employees with stock and options to give those employees a stake in the future upside potential of the company. Cash-strapped companies need to be aware of how such compensation is structured. Equity-classified awards may be advantageous in cases when liability-classified awards could put companies dependent on loans and lines-of-credit out of compliance with debt covenants. Company owners concerned with diluting ownership stakes may prefer liability-based awards that are settled in cash rather than stock. Companies need to evaluate their goals and priorities when creating stock-based compensation plans to determine if liability or equity-based compensation is most advantageous to their financial and management situations.
The information contained herein is not necessarily all-inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriately qualified professionals.