Accounting for Stock-Based Compensation (#293)
/In this podcast episode, we discuss the accounting for stock-based compensation. Key points made are noted below.
The Nature of Stock-Based Compensation
What we’re talking about is how to account for various types of stock grants made to employees, which might be in the form of an outright grant of stock, or as a stock option, which gives an employee the right to buy company shares at a later date, and at a specific price. In either case, the essential accounting is to recognize the cost of the related employee services as they’re received by the company, at their fair value.
The accounting is based on three concepts. The first is the grant date, which is the date when the award is approved, usually by the Board of Directors. There are some variations on this, but the grant date usually corresponds to the approval date. The second concept is the service period, which is usually the vesting period. So, if you’re granted 10,000 shares after three years of service have passed, then the vesting period is three years. And the final concept is the performance condition, which is the goal that has to be achieved in order to obtain the compensation.
Stock-Based Compensation Accounting Rules
The basic approach is to accrue the service expense related to the stock-based compensation over the service period, based on the probable outcome of the performance condition. For example, a board of directors grants stock options to the company president that have a fair value of $80,000. The options will vest in either four years or when the company achieves 20% market share in a new market. Since there’s no way to tell when 20% market share will be achieved – if ever – we throw out that performance condition and go with the four year vesting period instead, which is pretty certain. So, with a service period of four years, we accrue compensation expense of $20,000 per year for the next four years, so that $80,000 of compensation expense has been recorded by the time the president is fully vested in the stock options.
In that example, what if the president managed to achieve the 20% market share performance condition in just two years? In that case, the first $20,000 compensation accrual would have already taken place at the end of Year 1, so you would accrue the remaining $60,000 of compensation expense as soon as the market share goal was reached in Year 2.
What about a case when the performance condition is not completed? In that case, the company reverses any compensation expense that’s already been recognized. To go back to the earlier example, the company president resigns after three years. Because he didn’t complete the performance condition, he won’t receive the stock options. Up to that point, $60,000 of compensation expense had already been recognized, so that $60,000 expense is reversed as soon as the president resigns.
What happens to the accounting if the terms of the underlying grant arrangement are changed? Then you have to match the accounting to the new deal. For example, a board of directors issues stock options to the sales manager that have a fair value of $100,000, and which will vest over the next four years. Based on this information, the controller starts to accrue $25,000 of compensation expense in each of these years. But at the end of Year 2, the sales manager has done such a great job that the Board accelerates the vesting, so that it’s completed at the end of Year 2. Based on this revision, the controller accrues $75,000 of compensation expense in Year 2, which completes all recognition of the stock option fair value.
What happens if the fair value of the stock-based compensation declines over time? In short, it doesn’t matter. The fair value is set as of the grant date, even though the associated equity might not be issued until years later. However, when it’s not possible to estimate fair value at the grant date, then you can continue to remeasure the award at each successive reporting date until the award has been settled.
Now, what if those stock grants are being made to parties who are not employees? This usually happens when a small company is trying to conserve cash, and so pays its suppliers with shares instead. In this case, there are two rules to follow. The first is that you recognize the fair value of the equity instruments issued or the fair value of the consideration received, whichever can be more reliably measured.
The second rule is to recognize the asset or expense related to the goods or services being provided in the same period. For example, if the supplier being paid with shares is providing the company with production equipment, then the debit is to the fixed assets account. If the supplier is providing raw materials for the company’s production operations, then the debit is to the raw materials inventory account. It just depends on the nature of the transaction.
There are a couple of other rules relating to these stock grants to outsiders. If the company is issuing stock that’s fully vested and can’t be forfeited, then the entire fair value of the stock has to be recognized right away. In this case, if the supplier hasn’t delivered on its side of the deal yet, then the prepaid expenses asset account is debited. For example, an outside attorney demands $10,000 of stock in exchange for his services, to be paid in advance. In this case, the company hands over the shares and charges $10,000 to its prepaid expenses account. As the attorney provides services, this asset is gradually charged to legal expense.
When granting stock to outside parties, the company recognizes the payment as of a measurement date. This is usually the date when the recipient’s performance is complete, though it can be earlier, depending on the situation. This is different from grants to employees, which are as of the grant date, rather than the performance date.