Accounting for Stock Based Compensation
Stock Based Compensation is the expense in the income statement which the company uses its own stock to reward the employees. It usually provides to the key management such as CEO, CFO, and other Executives. The stock that company provides to the employee is the option stock which gives the holder the right to buy and sell at the agreed price and date, it is not the obligation.
Instead of using cash to compensate employees, company uses the stock option to motivate them. It is a form of performance bonus that company provides to employee. The employee will not be able to collect cash immediately, it usually spend several years of the vesting period.
Stock Based Compensation is beyond the normal cash motivation such as salary and bonus. It aligns the company and employee’s interests together. It will push the employee to work harder for the best interest of shareholders as they also have a chance to be the shareholders. They will treat the company the same as the owners. They will push the company forward in order to receive better compensation which depends on share price.
Stock Based Compensation Journal Entries – Restrict Share Option
There are three transactions related to the stock compensation.
- To record the issue of stock compensation
| Account | Debit | Credit |
|---|---|---|
| Contra Equity | 000 | |
| Common Stock Equity | 000 | |
| Additional Paid-In Capital | 000 |
There is no impact on the financial statement, these three accounts will be offset in the equity section. We will not recognize the expense yet.
- To record compensation expense after vested period. The company record journal entry by debit compensation expense and credit contra equity.
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 000 | |
| Contra Equity | 000 |
We only recognize the expense after the vested period which states during the initial stage. The company will record expenses and eliminate the contra equity. So the common stock and additional paid-in capital will remain on the balance sheet.
- To reverse the stock if the employee resigns before the vested period. The company need to reverse the first transaction by debit common stock, paid-in capital and credit contra equity.
| Account | Debit | Credit |
|---|---|---|
| Common Stock Equity | 000 | |
| Additional Paid-In Capital | 000 | |
| Contra Equity | 000 |
Stock Based Compensation Example – Restrict Share Option
Company ABC provides stock options to CEO to compensate for his hard work. He receives 10,000 stock options which will be vested after 3 years. Company share is trading at $ 8 per share and par value of $1.
Stock option = 10,000 share * $ 8 = $ 80,000
The company need to debit contra equity, common stock equity and credit additional paid in capital. This transaction will impact only the quity section in balance sheet.
| Account | Debit | Credit |
|---|---|---|
| Contra Equity | 80,000 | |
| Common Stock Equity | 10,000 | |
| Additional Paid In Capital | 70,000 |
After 3rd year, CEO still work for the company and he has exercised the right, so there will be the following journal entry. We need to record debit compensation expense to income statement and credit contra equity.
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 80,000 | |
| Contra Equity | 80,000 |
Stock Based Compensation Journal Entries – Share Option
Stock option is a type of stock compensation when the company gives the right to the employee to purchase common stock at a specific price in the future. Similar to restrict share, it requires the vested period from the grant date and exercise date. The employee has the right, not the obligation, to exercise the right. He may not exercise the right if it does not provide any benefit to him.
- No recording on the grant date
- Record compensation expense base on the option valuation after the vested date.
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 000 | |
| Additional Paid-In Capital-Stock Option | 000 |
- Recording employee exercises the right:
| Account | Debit | Credit |
|---|---|---|
| Cash | 000 | |
| Additional Paid-In Capital-Stock Option | 000 | |
| Common Stock | 000 | |
| Additional Paid-In Capital | 000 |
Stock Option Example
Company XYZ provides 1,000 stock options to the CFO, it allows him to purchase the stock at $10 per share in the next two years. The fair value of the option is $ 8 per share based on company calculation.
- There is no recording of the grant date.
- At the end of 1st year: (1,000 shares * $ 8)/2
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 4,000 | |
| Additional Paid-In Capital-Stock Option | 4,000 |
- At the end of 2nd year
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 4,000 | |
| Additional Paid-In Capital-Stock Option | 4,000 |
- On the exercise date: The CFO decides to exercise the right by paying $ 10,000 to purchase 1,000 shares. Assume the share price equal to $ 20 per share.
| Account | Debit | Credit |
|---|---|---|
| Cash | 10,000 | |
| Additional Paid-In Capital-Stock Option | 8,000 | |
| Common Stock | 1,000 | |
| Additional Paid-In Capital | 17,000 |
Benefit of Stock-Based Compensation
- Does not require cash: As we know cash is very important for the business to expand the operation. While using the stock for compensation, the company will be able to use cash for other purposes such as investments and R&D which will help to grow the business.
- Motivate Employee: The employee will become a part of the company and they will treat the company as their own.
- Prevent Outstanding Staff from joining competitors: The employee needs to wait for some time before cashing the stock option. So it will lock them within the company.
- Align employee and company interests: After receiving the stock, the employee will work harder as their interests are the same as company interests. It will reduce the conflict of interest.
Disadvantage of Stock-Based compensation
- Dilute share equity: By allowing the employee to purchase new shares, it will decrease the ownership of existing shareholders.
- Not work when share price decreases: The employee will work hard to grow the business so that the share price increases and they will get more wealth. On the other hand, if the share price decreases due to any reason, the stock option will not work. It will demotivate the employees and stop them from working hard.
- Limited Liquidity for Employees: Stock options and other equity-based compensation plans often come with restrictions on when employees can sell or liquidate their shares. Even if the share price increases, employees may be unable to realize the financial gains immediately. This lack of liquidity can be frustrating for employees who may have expected more flexibility in converting their equity holdings into cash. Additionally, in the event of a downturn in the stock price, employees may face difficulties in selling their shares at a desirable value.
- Administrative Complexity: Implementing and managing stock-based compensation plans can be administratively complex. Companies need to establish fair and transparent methods for determining the value of stock options, vesting schedules, and other relevant terms. This administrative burden can be resource-intensive, requiring dedicated personnel and systems to ensure accurate tracking and compliance with regulatory requirements.
- Potential for Short-Term Focus: Employees with stock options may become overly focused on short-term stock price fluctuations, potentially at the expense of the company’s long-term goals. The desire to see immediate gains in the stock price could lead to decisions that prioritize short-term financial performance over sustainable, long-term growth strategies.