Accounting for Stock Appreciation Right
Stock appreciation right is a type of incentive that company provides to the employee by linking with the stock price. Employees will receive the incentive when company’s stock price increase within a period of time.
The stock appreciation right will ensure company and employees are working to achieve the same goal which is to maximize shareholders’ wealth. When the company performing well and hit the target profit, the share price will increase. It will increase the share price which benefits both shareholders and employees.
The employees will receive incentive which equals the portion of the share price increase. The company will set the exercise price as the minimum, so employees will receive the portion of share price that increases over the exercise price. They also have the option to convert this incentive to the common share base on the market share.
The employees do not need to own the share to receive the reward, they just work hard to ensure company success and increase share price.
Stock appreciation rights (SARs) are a type of stock-based compensation plan in which employees are awarded the right to receive cash or shares based on the appreciation of company stock. SARs can be an effective way to motivate and retain employees, as they provide a direct financial incentive for improved performance. In addition, SARs can help to align employee and shareholder interests, as both parties benefit from increases in the company’s stock price. While there are some risks associated with SARs, such as fluctuations in the value of company stock, these plans can be an important tool for employers to attract and retain top talent.
Stock Appreciation Right Example
On Jan 202X, Company ABC offers share appreciation rights to the top management to encourage them to work hard for the company. The current share price is $ 170, shareholder design this reward to push management to make attractive strategies to increase share price.
Share appreciation right detail as below:
- Number of share appreciation right = 1,000 SAR
- Exercise price = $ 200 per share
- Vesting date: 31 Dec 202X+4 ( 5 years)
It means the company will provide compensation to top management when the share price increase higher than exercise price ($ 200). Compensation expense will equal to share price at the end of 4th year minus exercise price and multiply by 1,000 SAR. The employee has the option to have SAR settle in cash or company stock on the vesting date.
How do we account for share appreciation right?
First, we need to calculate the incentive expense which is the different between share price at the end of each year and the exercise price.
| 202X | 202X+1 | 202X+2 | 202X+3 | 202X+4 | |
|---|---|---|---|---|---|
| Year-end share Price | 180 | 218 | 230 | 240 | 270 |
| Exercise Price | 200 | 200 | 200 | 200 | 200 |
| Compensation per share | 0 | 18 | 30 | 40 | 70 |
| Total Compensation | 0 | 18,000 | 30,000 | 40,000 | 70,000 |
| Number of years | 5 | 4 | 3 | 2 | 1 |
| Accumulated Compensation Exp | 0 | 0 | (4,500) | (13,000) | (26,500) |
| Current Year Expense | 0 | 4,500 | 8,500 | 13,500 | 43,500 |
- At the end of 202X, share price increase to $ 180 per share, but it is below exercise price, so the company does not expect to pay any compensation to SAR.
- At the end of 202X+1, share price increase to $ 218, so the company expect to pay a compensation expense of $ 18,000. However, this expense needs to divide into the remaining 4 years. The current year compensation expense is only $ 4,500 ($ 18,000/4 years).
- At the end of 202X+2, share price increase to $230, the company expect to pay a compensation expense of $ 30,000. But company already records expenses of $ 4,500, so only $ 25,500 needs to divide into the remaining 3 years. Current year compensation expense is $ 8,500 ($ 25,500/3 years).
- At the end of 202X+3, share price increase to $240, the company expect to pay compensation expense of $ 40,000. Current year compensation expense is $ 13,500 [($40,000-$13,000)/2 years].
- At the end of 202X+4, share price increase to $270, the company need to pay compensation expense of $ 70,000 but company already record expense $ 26,500 from year 1 to year 4. So only an expense of $ 43,500 ($70,000-$26,500) needs to record into the system. We record the whole amount as it is the last year.
We can see that the compensation expense fluctuates from year 1 to year 5. It is the estimated accounting in which company relies on the year-end share price. When the share price fluctuates, it will impact the compensation expense. However, the total expense must equal the difference between exercise price and market price on the vesting date.
Stock Appreciation Right Journal Entry
Company needs to make a journal entry to record the compensation expense and share appreciation right liabilities.
- First Year, Company does not need to make a journal entry as the share price is still below the exercise price.
- The second Year, company needs to make a journal entry by debiting compensation expense $ 4,500 and credit SAR liability $ 4,500.
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 4,500 | |
| SAR Liabilities | 4,500 |
The transaction will increase the compensation expense on the income statement and the liabilities on the balance sheet.
- The third Year, company needs to make a journal entry by debiting compensation expense $ 8,500 and credit SAR liability $ 8,500.
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 8,500 | |
| SAR Liabilities | 8,500 |
- The fourth Year, company needs to make a journal entry by debiting compensation expense of $ 13,500 and credit SAR liability $ 13,500.
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 13,500 | |
| SAR Liabilities | 13,500 |
- The fifth Year, company needs to make a journal entry by debiting compensation expense of $ 43,500 and credit SAR liability $ 43,500.
| Account | Debit | Credit |
|---|---|---|
| Compensation Expense | 43,500 | |
| SAR Liabilities | 43,500 |
Compensation expense will be recorded into each year’s income statement, it will reduce the company’s net profit. SAR liabilities will be recorded into the balance sheet as long-term liabilities, and they will settle on the vesting date. At the end of the 5th year, the total SAR liabilities equal $ 70,000.
We assume 500 SAR will be settled by cash and 500 SAR will be settled by common share on 31 Dec 202X+4.
- 50% of top management require to settle SAR in cash. The company makes journal entry by debiting SAR Liabilities $ 35,000 ($ 70,000 * 50%) and credit cash to employees.
| Account | Debit | Credit |
|---|---|---|
| SAR Liabilities | 35,000 | |
| Cash | 35,000 |
- 50% of top management require to settle SAR in company common share which has par value of $ 1 per share. They need to make journal entry by debiting SAR Liabilities $ 35,000 and crediting common share $ 500, Additional paid-in capital $ 34,500.
| Account | Debit | Credit |
|---|---|---|
| SAR Liabilities | 35,000 | |
| Common Share | 500 | |
| Additional paid-in capital | 34,500 |
Advantage
- To motivate employees: this type of incentive will help to encourage staff to work for the best interest of the company which is to maximize shareholders’ wealth. Incentives are designed to encourage employees to work hard and achieve specific goals. When it comes to business, one of the most important goals is to increase shareholder value. This type of incentive will help to encourage staff to work for the best interest of the company which is to maximize shareholders’ wealth.
- Flexible: The company can use the SAR to manage the performance bonus for the employees. It is very flexible as they can set vesting dates and the exercise price to impact the incentive package.
- No impact on the equity: The company can set the condition to allow the employees to redeem the cash. It will not impact the equity as well as the company’s capital structure.
Disadvantage
- Share dilution: It can happen when the employee decides to redeem share instead of cash. It will decrease the current shareholders’ ownership. When the company increases the number of shares, the overall value of each existing share is diluted. This happens because the total market value of all shares outstanding is spread over more shares. While this may seem like a bad thing for shareholders, it’s not always the case.
- Huge cash paid: when the share price increase too high, it will impact cash paid on the vesting date. It can lead to cash shortage as company needs to pay a huge amount in a short time. When the share price of a publicly traded company increases too rapidly, it can have a negative impact on the cash paid out to employees on the vesting date. This is because the company will be required to pay a larger amount of money in a shorter period of time, which can lead to a shortage of cash.
Conclusion
Stock appreciation is a part of the compensation that employees receive from their employer. This type of compensation is given to employees based on the increase in the value of the company’s stock. Stock appreciation can be used as a bonus, or it can be used to purchase shares of the company’s stock.
In addition, stock appreciation gives employees an incentive to help the company succeed by working hard and meeting their goals. This type of compensation helps to attract and retain talented employees who are essential for a company’s success. Consequently, stock appreciation is an important part of many employers’ compensation plans.