Complete Guide on Stock Based Compensation (SBC) in Accounting

Introduction

These days, it’s common for employees to come across stock based compensation (SBC) during salary negotiations. Businesses are increasingly embracing the practice of issuing stocks to their employees to encourage a culture where employees are incentivized to work towards meeting the company’s business goals. 

Offering stock based compensation, while highly beneficial for businesses, also increases complexity when it comes to accounting practices. 

In this blog, we are going to understand what stock based compensation is, its types, benefits, how to do accounting journal entries for SBC, and their impact on financial statements.

What is Stock Based Compensation?

Stock based compensation is the practice of rewarding employees by issuing them shares of the company as part of their compensation. SBC, or equity compensation, can be stock options or restricted stocks and are often vested, i.e.,the employees earn the right to exercise the shares only after a certain time period (vesting period) has passed.

Initially, corporations issued stocks to high-level executives so their interests would be aligned with the company’s growth. Over time, SBC has increasingly become a standard component in the compensation package (CTC) of employees at various other levels as well.

There are two major types of SBC: 

1. Restricted stock units (RSUs): RSUs are granted to employees under certain conditions. The stocks are issued at the full value of the company shares and have a vesting period. Once the vesting period is completed, employees can exercise their right over the shares. 
2. Stock options: With stock options, employees get an option to purchase shares of the company at a predetermined price (strike or exercise price) on or after a specific date in the future. In case the market price of the share increases, employees can then sell their shares for a profit.

Stock Based Compensation: Accounting Journal Entries

While SBC is a highly attractive option for both the company and the employees, the accounting for SBC can be tricky. Under Generally Accepted Accounting Principles (GAAP), the process of recording journal entries varies slightly for RSUs and stock options. To understand it better, let’s take examples of the two types of SBC. 

Accounting journal entries for restricted stock units

Let’s suppose:

• ABC company grants 1000 RSUs to one of their employees on January 1, 2024 
• The fair value of each of the shares granted is $10
• The RSUs will start vesting after a year, evenly over a period of 4 years. That means 25% of RSUs will vest on January 1 for the next 4 years starting from January 1, 2025 
• If the employee leaves before the vesting period is complete, they forfeit the RSUs. 

Journal entry on grant date (January 1, 2024)

There will be no journal entry on the grant date as the stocks are not exercisable and there’s no actual cash outflow. The company, however, is required to note the fair value of the shares in the footnotes. 

Journal entry on the vesting date (January 1, 2025)

On the vesting date, 25% of the 1000 RSUs will vest, and the following journal entry will be recorded. The journal entry will include common stock journal entry, SBC entry, and additional paid-in capital (APIC) journal entry.

Calculation: 25% of 1000 (RSUs granted to the employee) * $10 (fair value of the stock)

The same entry will be recorded for the next 3 years as well, i.e., until all the granted RSUs are vested. This is in case the employee remains at the company during the entire vesting period. 

At the end of the four year vesting period, which is January 1, 2028, the same journal entry will be recorded, and the employee will become eligible to exercise their rights over the shares going forward. 

Journal entry if the employee leaves before the vesting period (December 31st, 2024)

If the employee leaves before the vesting period is completed, say on December 31st, 2024, they forfeit their shares. The company will then record the following journal entry to reverse the previously recorded expense. 

Accounting journal entries for stock options

As mentioned before, the journal entries for stock options differ from those for RSUs. The journal entries for stock options are recorded according to the fair value of the options. 

Let’s suppose:

• ABC company grants 1000 stock options to their new employee on January 1, 2024 
• The exercise or strike price of each share is $20
• The current market price of each share is $20
• The company will determine the fair value of the stock options using a valuation method. Let’s say that the fair value is determined to be $5 per share option. 
• The shares will vest evenly over a period of 4 years and have a cliff of 1 year. So, 25% of stock options granted will vest on each anniversary date. 

Journal entry on the grant date (January 1, 2024)

The ABC company does not need to make a journal entry for stock options on the grant date. They should only disclose the fair value of the shares in the footnotes. 

Journal entries on the date of vesting (January 1, 2025)

25% of the shares out of 1000 stock options will vest on this date, and ABC company will record the following journal entries. Unlike RSUs, common stock journal entries are not added along with APIC entries.  

Calculation: 25% of 1000 (number of stock options granted) * $5 (fair value of an option)

The same entry will be recorded on the vesting date for the next 3 years according to the fair value of the stock. 

Journal entries on the exercise date (January 1, 2028)

Now that the stock options of the employee have vested, they are eligible to exercise their rights over these stock options. Let’s say the employee exercises all their shares (1000 stock units) at the current market price of $20. The company will receive $20,000 in cash which they would then need to  pay out to the employee. Also note, common stock journal entry is added for stock options only when the employee exercises their stocks. 

Here’s what the journal entry for this will look like:

Benefits of Stock Based Compensation

As it can be seen, employees stand a good chance to benefit from SBC. But how exactly do businesses profit from granting stock to their employees? Let us understand the key benefits of SBC:

1. Alignment of employees with business goals: By providing employees with SBC, businesses can align employee interests with business goals.. This ensures that the employee will be motivated and automatically work towards the greater good, which in this case is the financial growth of the company, if they want to benefit from SBC. 
2. Effective employee retention strategy: Compensating employees with stocks in addition to cash payments is a good way to retain top-tier talent. Since there’s a specific time period after which employees can exercise their shares, this might incentivize them to stay at the company for a longer period of time. 
3. Optimize cash flow: Businesses can optimize their cash flow by including an SBC component in the CTC instead of paying higher cash salaries. This can be especially helpful for startups, as they might have limited cash flow in the initial years of the business.

Treatment of SBC Expense on Financial Statements

Before 2006, companies were not expected to add stock based compensation as an expense to their financial statements under GAAP. In the case of RSUs, the exercise price and current market price were not relevant as  employees get the stocks based on a set value after the vesting period. 

However, when it comes to stock options, things get complex. The employees stand to profit if the market price of the shares rises over the market price at which the stocks were granted. Stocks essentially have a ‘potential value’ which was considered difficult to determine. Owing to this companies were allowed to  keep stock options off their financial statements.

But now, under Financial Accounting Standards Board (FASB) guidelines, companies are required to list stock based compensation in their financial statements. They should ideally determine the value of stock options using valuation methods like Black-Scholes model. So, companies now list SBC as an operating expense on their financial statements. 

Impact of SBC on the income statement and the balance sheet

• When RSUs are granted, they are recorded on the balance sheet resulting in an increase in additional paid-in capital. As they vest, an expense is recognized on the income statement, reducing net income. 
• Stock options create an expense on the income statement during the vesting period, which results in reduced net income. 
• For stock options, the expense is calculated on the basis of the fair value of shares when they are granted.

Why to Model Stock Based Compensation in DCF Model

There’s been some discussion about whether stock based compensation expense should be modeled in the discounted cash flow (DCF) valuation due to the fact that it’s a non-cash expense. But experts suggest that it’s important to model SBC in DCF valuation since it impacts the company’s future cash flow and hence the valuation. The problem with not accounting for stock based compensation expense in the valuation is that it shows an inflated value of the company share. 

Stocks are a dilutive asset. When a company compensates employees with stocks, they are creating more shares, impacting the value of shares held by other stakeholders. Also, granting SBC to employees instead of more cash doesn’t mean that there is no real cost to the company. It’s just a trade-off for future payments. The more equity a company offers, the more dilutive their shares become. So, with SBC as well, there is a cost that the company is paying.   

Considering all this, analysts should include SBC in DCF valuations to arrive at a fair value of the company’s shares.

Conclusion

Stock based compensation accounting is difficult as there are different norms being practiced by different companies. On top of this, different entries need to be recorded for different types of SBC. In such a scenario, companies need to capture all their entries related to SBC properly and in a detailed manner. Furthermore, they need to keep track of employees who have forfeited their SBC and employees who will exercise their shares. This will ensure that SBC related expenses are listed on financial statements properly.

Considering the complexity of SBC journal entries, companies will benefit from using accounting software. Automated accounting software makes things easier by capturing all the relevant information and also flag any anomalies or errors. Therefore, the manual efforts related to SBC accounting may reduce significantly with the use of a robust accounting software.

About HighRadius: Record to Report Suite

HighRadius offers a cloud-based Record to Report Suite that helps accounting professionals streamline and automate the financial close process for businesses. We have helped accounting teams from around the globe with month-end closing, reconciliations, journal entry management, intercompany accounting, and financial reporting.

Our Financial Close Module is designed to create detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30%. The workspace is connected and allows users to assign and track tasks for each close task category for input, review, and approval with the stakeholders. It allows users to extract and ingest data automatically, and use formulas on the data to process and transform it. 

Our Account Reconciliation Module provides an out-of-the-box formula set that can configure matching rules and match line-level transactions from multiple data sources and create templates to automate various transaction processing required for month-end close. Our solution has the ability to prepare and post journal entries, which will be automatically posted into the ERP, automating 70% of your account reconciliation process. 

Our AI-powered Anomaly Management Module helps accounting professionals identify and rectify potential ‘Errors and Omissions’ throughout the financial period so that teams can avoid the month-end rush. The AI algorithm continuously learns through a feedback loop which, in turn, reduces false anomalies. We empower accounting teams to work more efficiently, accurately, and collaboratively, enabling them to add greater value to their organizations’ accounting processes.

FAQs

Q1. Is stock based compensation an operating expense?

Yes, a stock based component is a form of employee compensation and comes under operating expenses on financial statements much like all the other core operating expenses of a business. The accounting treatment for the SBC component in the CTC is similar to that of the cash component. 

Q2. Is stock based compensation tax deductible?

The employer can take a tax deduction on RSUs in the year the shares are transferred to the employees after the vesting period. The employer, however, cannot take the deduction when RSUs are granted. With stock options, the employer can claim a tax deduction when the employee receives their shares after the vesting period. 

Q3. Is stock based compensation a cash expense?

No, stock based compensation is a non-cash expense on the income statement as per the GAAP accounting standards. This is because the company doesn’t need to use cash flow for the SBC component, i.e., when it’s granted. It’s reflected in the cash flow statement if the company needs to pay cash once the shares are exercised. 

Q4. Where is stock based compensation on an income statement?

Stock based compensation expense is recorded in the same income statement line or lines as the cash compensation the company is paying to its employees. Typically, companies record it under certain functional expense categories, depending on the role of the employee who is rewarded with SBC. 

Q5. How does stock based compensation affect cash flow?

SBC doesn’t affect cash flow, but it does affect the capital structure of the business as the number of outstanding shares increases. There is no cash inflow or outflow with SBC when it’s granted. But when employees are compensated with cash when the share price increases, the amount is shown in the cash flow statement.