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.
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:
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.
Let’s suppose:
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.
Account |
Debit (Dr) |
Credit (Cr) |
Stock based compensation |
$2500 |
|
Common stock and additional paid-in-capital (APIC) |
$2500 |
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.
Account |
Debit (Dr) |
Credit (Cr) |
Common stock and equity AIPC |
$2500 |
|
Stock based compensation (unearned) |
$2500 |
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:
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.
Account |
Debit (Dr) |
Credit (Cr) |
Stock based compensation |
$1250 |
|
Equity AIPC (payable) |
$1250 |
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:
Account |
Debit (Dr) |
Credit (Cr) |
Cash |
$20,000 |
|
Equity AIPC (payable) |
$5000 |
|
Common stock & Equity APIC |
$25,000 |
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:
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.
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.
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.
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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.
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.
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.
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.
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.
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