Stock-based compensation accounting
/What is 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. A further advantage of stock-based compensation is that the employer does not incur a cash outflow, which is quite useful for cash-strapped organizations.
What is the Accounting for Stock-Based Compensation?
When stock-based compensation 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.
Essential Concepts
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.
Related AccountingTools Topics
Costs to be Recognized
There are several scenarios in which the costs associated with stock-based compensation need to be recognized. They are noted below:
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.
Valuation Concepts for Stock-Based Compensation
There are several valuation concepts associated with stock-based compensation, as noted below:
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.