Stock Based Compensation Accounting: Journal Entries

By using this site, you agree to the Terms of Use and Privacy Policy. The downside though, is as a consultant, you don't have the measure of control that executive employees or board members have. Despite political pressure, expensing became more or less inevitable when the International Accounting Board IASB required it because of the deliberate push for convergence between U. Basics of Accounting for Stock Options. For example, real estate is carried at historical cost because historical cost is more reliable but less relevant than market value - that is, we can measure with reliability how much was spent to acquire the property. There are no rules governing an NSO, so the option price can be lower than the fair market value of the stock on the grant date. This is a particular problem if the value of the shares subsequently drops, since there is now no source of high-priced stock that can be converted into cash in order to pay the required taxes.

Exercise of Options. Accountants need to book a separate journal entry when the employees exercise stock options. First, the accountant must calculate the cash that the business received from the vesting and how much of the stock was exercised.

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However, if an employee leaves prior to vesting, the stock based compensation expense is reversed via the income statement. We now turn to the accounting and journal entries for stock options, which are a bit more complicated. Unlike restricted stock, there are no offsetting journal entries to equity at the grant date. The stock options do not impact the common stock and APIC balance at the grant date. This is an expense recognized on the income statement. It reduces retained earnings.

The same thing will happen on January 1, and again one final time on January 1, Our hypothetical company has , common shares outstanding, but also has 10, outstanding options that are all in the money. Diluted EPS uses the treasury-stock method to answer the following question: In the example discussed above, the exercise alone would add 10, common shares to the base.

However, the simulated exercise would provide the company with extra cash: Because the IRS is going to collect taxes from the options holders who will pay ordinary income tax on the same gain. Please note the tax benefit refers to non-qualified stock options.

Let's see how , common shares become , diluted shares under the treasury-stock method, which, remember, is based on a simulated exercise. We assume the exercise of 10, in-the-money options; this itself adds 10, common shares to the base. To complete the simulation, we assume all of the extra money is used to buy back shares. In summary, the conversion of 10, options creates only 3, net additional shares 10, options converted minus 6, buyback shares.

But what do we do with options granted in the current fiscal year that have zero intrinsic value that is, assuming the exercise price equals the stock price , but are costly nonetheless because they have time value?

The answer is that we use an options-pricing model to estimate a cost to create a non-cash expense that reduces reported net income. Whereas the treasury-stock method increases the denominator of the EPS ratio by adding shares, pro forma expensing reduces the numerator of EPS.

You can see how expensing does not double count as some have suggested: While the proposed accounting rule requiring expensing is very detailed, the headline is "fair value on the grant date".

This means that FASB wants to require companies to estimate the option's fair value at the time of grant and record "recognize" that expense on the income statement. Consider the illustration below with the same hypothetical company we looked at above: However, under pro forma, the diluted share base can be different.

See our technical note below for further details. First, we can see that we still have common shares and diluted shares, where diluted shares simulate the exercise of previously granted options. Under the SFAS approach, compensation expense must be recognized for options granted, even if there is no difference between the current market price of the stock and the price at which the recipient can purchase the stock under the terms of the option.

The compensation expense is calculated by estimating the expected term of the option that is, the time period extending to the point when one would reasonably expect them to be used , and then using the current risk-free market interest rate to create a discounted present value of what the buyer is really paying for the option. The difference between the discounted price of the stock and the purchase price as listed in the option agreement is then recognized as compensation expense. Under SFAS , the present value of the stock that is to be purchased at some point in the future under an options agreement must also be reduced by the present value of any stream of dividend payments that the stock might be expected to yield during the interval between the present time and the point when the stock is expected to be purchased, since this is income forgone by the buyer.

The use of present value calculations under SFAS means that financial estimates are being used to determine the most likely scenario that will eventually occur.

One of the key estimates to consider is that not all stock options will eventually be exercised—some may lapse due to employees leaving the company, for example. One should include these estimates when calculating the total amount of accrued compensation expense, so that actual results do not depart significantly from the initial estimates.

However, despite the best possible estimates, the accountant will find that actual option use will inevitably vary from original estimates. When these estimates change, one should account for them in the current period as a change of accounting estimate. However, if estimates are not changed and the accountant simply waits to see how many options are actually exercised, then any variances from the accounting estimate will be made on the date when options either lapse or are exercised.

Incentive stock options are taxable to the employee neither at the time they are granted, nor at the time when the employee eventually exercises the option to buy stock.

If the employee does not dispose of the stock within two years of the date of the option grant or within one year of the date when the option is exercised, then any resulting gain will be taxed as a long-term capital gain.

However, if the employee sells the stock within one year of the exercise date, then any gain is taxed as ordinary income. The reduced tax impact associated with waiting until two years have passed from the date of option grant presents a risk to the employee that the value of the related stock will decline in the interim, thereby offsetting the reduced long-term capital gain tax rate achieved at the end of this period.

To mitigate the potential loss in stock value, one can make a Section 83 b election to recognize taxable income on the purchase price of the stock within 30 days following the date when an option is exercised, and withhold taxes at the ordinary income tax rate at that time. The employee will not recognize any additional income with respect to the purchased shares until they are sold or otherwise transferred in a taxable transaction, and the additional gain recognized at that time will be taxed at the long-term capital gains rate.

It is reasonable to make the Section 83 b election if the amount of income reported at the time of the election is small and the potential price growth of the stock is significant. On the other hand, it is not reasonable to take the election if there is a combination of high reportable income at the time of election resulting in a large tax payment and a minimal chance of growth in the stock price, or if the company can forfeit the options. The Section 83 b election is not available to holders of options under an NSO plan.

In essence, the AMT requires that an employee pay tax on the difference between the exercise price and the stock price at the time when an option is exercised, even if the stock is not sold at that time.

This can result in a severe cash shortfall for the employee, who may only be able to pay the related taxes by selling the stock. This is a particular problem if the value of the shares subsequently drops, since there is now no source of high-priced stock that can be converted into cash in order to pay the required taxes.

Accounting, Financial, Tax

Basics of accounting for stock options. 3. Compensatory stock option plans so each year the company will record $12, of compensation expense related to the options. If the options are exercised, the additional paid-in capital built up during the vesting period is reversed. The stock’s market value is irrelevant to the entry – the. Since companies generally issue stock options with exercise prices which are equal to the market price, the expense under this method is generally zero. Fair-value method journal entries for stock option compensation. . When dealing with stock option compensation accounting there are three important dates to consider. The date on which the stock options are exercised and shares are purchased. Stock option dates; Vesting period ↑ Grant: Stock Option Journal Entries – .