Accounting for stock-based compensation
This article digs into the concept of stock-based compensation accounting and the pros and cons of stock-based compensation.
When a firm wants to incentivize its workers and better align the interests of management, investors, and employees, it may offer them stock-based compensation in the form of equity ownership rights in the company. Stock-based compensation is widely used to recruit, motivate, and retain high-quality personnel. Yet, accounting for stock-based compensation can take much work to document. The key accounting for stock-based compensation is to record the expense of the relevant services when the firm receives them at their fair value. Depending on the kind of transaction, the rise in an equity or liability account that results from this expenditure recognition will serve as a counterbalance. The company does not pay employees in advance for their efforts.
This article digs into the concept of stock-based compensation accounting, types of stock-based compensation, and the pros and cons of stock-based compensation.
Stock-based compensation and accounting
Stock-based compensation is widely used to recruit, motivate, and retain high-quality personnel. Yet, accounting for stock-based compensation may take a lot of work to document. Accounting equity compensation is a must for every business that provides stock-based compensation as it impacts your income statement, balance sheet, and cash flow statement. Let’s understand all of this in detail.
What is stock-based compensation?
A business’s executives, directors, and employees are paid with the company’s stock via stock-based compensation, share-based compensation, or equity compensation. It is often used to incentivize workers in addition to their normal cash-based pay and to match their objectives with those of the business’s shareholders. Employee stock awards often have a vesting time before they become earned and marketable.
Types of stock-based compensation
Different types of compensation based on a company’s equity are possible. Typical forms of stock-based compensation include:
- Restricted share units (RSU) – Before the RSU are released to the employees, they must satisfy a few requirements set by the employer.
- Stock options – The employee is given the right, but not the commitment, to purchase or sell a stock at a predetermined price and date.
- Employee stock ownership plan (ESOP) – An employee benefit plan that provides employees with shares of the company that represent ownership in the business. Its a qualified plan since it offers numerous tax advantages to everyone involved.
- Shares – Shares are fractional ownership interests in a company. For certain businesses, shares are a kind of financial instrument that allows for the equitable distribution of any declared residual earnings in the form of dividends. A stock with no dividend payments does not distribute its income to its shareholders.
- Phantom shares – Provides senior management and other chosen workers all of the advantages of stock ownership without actually transferring any firm shares to them.
Pros and cons of stock-based compensation
This kind of compensation has a lot of benefits, such as:
- Encourages workers to remain with the firm while they wait for their shares to vest.
- Align the interests of shareholders and workers, who want the business’s success and an increase in share value.
- Doesn’t need payment in cash to be made.
Stock-based compensation also comes with its own set of disadvantages. The main disadvantages are:
- Increases the number of outstanding shares, diluting the ownership of current shareholders.
- If the share price is falling, hiring or keeping personnel could not be helpful.
What is accounting for stock-based compensation?
The fundamental accounting principle for stock-based compensation is to record the expense of any linked services at the fair value at which the firm acquires them. Based on the type of the agreement, a rise in an equity or liability account will be used to balance this expenditure realization. Before being received, employee services are not acknowledged by the employer.
The essential concept of stock-based compensation
The grant date is an important concept. A stock-based compensation is awarded on this day, the day the award is presumed to have received corporate governance approval. As long as future grant approval is seen as merely ceremonial, the grant date may also be regarded as the day an employee starts to profit from or be impacted by shifts in the value of a company’s shares.
The service period is another important principle. A stock-based compensation’s service duration is often thought of as the vesting period, although depending on the facts and conditions of the agreement, a different service period may be used to calculate the number of intervals during which compensation expenditure will be incurred.
Recognizable costs for stock-based compensation accounting
The expenses related to stock-based compensation must be recorded in many situations. Here are some of the recognizable costs that are needed when you are handling the accounting of your stock-based compensation:
- Expense Accrual – Accrue the service charge connected to a stock issue across numerous reporting periods depending on the likely performance status, with an equivalent credit to equity. Performance factors impact award fair value. Thus, accumulate the expenditure when it is likely to be met. Accrue the expenditure over the first best estimate of the employee service time, generally the service length specified under the stock issue agreement.
- Service Rendered Before Grant Date – If part or all of the required service for stock-based compensation happens before the grant date, accumulate the compensation cost for these previous time frames relying on the award’s fair value at every reporting date. The per-unit fair value given on the grant date should be used to modify the compensation earned. Thus, the original recordation represents the best approximation of the future fair value.
- Service Rendered Before Performance Target Completion – Accumulate the compensation cost for the earlier periods using the award’s fair value at each initial recognition if all or part of the necessary service for stock-based compensation occurs before the grant date. The compensation received so far should be adjusted using the per-unit fair value provided on the award date. Therefore, the initial recordation is the most accurate estimate of the future fair value.
- Service not Rendered – The employer may then overturn any associated amounts of compensation expenditure previously recorded if an employee does not provide the service necessary for an award.
- Employee Payments – The fair value due to employee service is net of any sum an employee pays the issuer in conjunction with an award.
- Non-Compete Agreement – The characteristics and circumstances of the situation may show that a non-compete clause in stock-based compensation is a substantial service condition. If so, add the corresponding compensation expenditure throughout the non-compete agreement’s applicable time frame.
- Expired Stock Options – Refrain from reversing the associated amount of compensation expenditure if stock option awards expire unused.
- Subsequent Changes – Recognize the variation in compensation expense when the modification in projection occurs if subsequent circumstances show that the number of instruments to be given has changed. Additionally, if the original estimate of the service time proves to be off, change the accrual of expenses to reflect the new estimate.
Valuation Principles for Stock-Based Compensation
The list below includes some valuation principles connected to accounting for stock-based compensation:
- Determine the fair value – Even if the equity may not be awarded until much afterwards, accounting for stock-based compensation is assessed at the fair value of the given securities as of the grant date. With a valuation approach like an option-pricing model, the fair value of a stock option is calculated.
- Fair value of non-vested shares – A nonvested share’s fair value is determined by treating it as if it had vested on the grant date.
- Fair value of restricted shares -Due to contractual or statutory limitations, a restricted share cannot be traded for a certain time. Due to the severely limited capacity to market a restricted share, the fair value of a restricted share is expected to be lower than the fair value of an unrestricted share. However, limits are thought to have minimal impact on the price at which the shares might be exchanged if the issuer’s shares are traded in a crowded market.
Impact of stock-based compensation
Accounting for stock-based compensation is necessary as it significantly impacts your income statement, balance sheet, and cash flow statement. Let’s understand how.
Impact on Income Statement
There are two ways that stock-based compensation impacts the income statement, as listed below:
Decreased Net Income
Let’s check the income statement for Facebook. Stock-based compensation expenditure is included in the cost and expenses in this case. This cost decreases the Net Income. Also, take notice of the breakdown of stock-based compensation that Facebook has disclosed for each cost and expenditure category. Facebook paid out $3,218 million in stock-based compensation in 2016.
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Diluted Earnings Per Share
We account for the effect of stock options that option holders have exercised when calculating diluted earnings per share (EPS). The corporation must issue new shares with rewarding workers or investors who exercise stock options. Consequently, there are more outstanding shares overall, which lowers EPS.
As we can see here, the number of outstanding shares rises due to Facebook employee stock options, which lowers earnings per share.
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Impact on balance sheet
A corporation may reward the holders of its stock options in several ways. Here, we’ll focus on the two approaches that follow for clarification:
- The Business may first pay the difference between the cost on the exercise date and the price at the designated price.
- Second, the business can issue more shares than the existing stock options for the year.
If the business chooses the second course of action, it will enhance its paid-up capital rather than release the extra shares.
Impact on cash flow statement
Think about the two payment options for stock option holders again from the previous discussion. The Cash Flow Statement will need to reflect a cash outflow from financing activities if the firm chooses the first option. As a result, the Cash on the Asset side of the Balance Sheet will decrease by the same amount as the Cash Flow from Financing Activities.
The Cash Flow Statement won’t be affected if the corporation chooses the second option, issuing shares rather than paying cash since there won’t be any cash flow.
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