How Do You Book Stock Compensation Expense Journal Entry?
Aug 02, 2022 | By Chris Sluty
Stock-based compensation is a common way to attract, incentivize, and retain great employees. But recording stock compensation expense accounting can be daunting!
This blog is about going back to the basics in accounting, and the objective of the post is to walk you through the correct way to book stock compensation journal entry. But first, let’s talk about stock-based compensation.
What is Stock-Based Compensation?
The intention of offering stock-based compensation is to align the interests of employees with company performance. If the company does well over the long-term, employees profit. Corporations love it because it doesn’t require dipping into cash flow, and can be much more valuable to employees and key executives over the long run than just a fatter paycheck.
There are two main types: restricted stock and stock options. Restricted stock is a grant of stock in the company that is restricted in some way to provide an incentive for continued employment or service. Stock options give the recipient an option to purchase stock in the company at a specific price at a future date. Both of these can be used to compensate non-employees as well as employees.
Benefits of Stock-Based Compensation
As we mentioned, there are several benefits to stock-based compensation that can make it beneficial for both companies and employees. An employee stock option plan or restricted stock issuance allows you to increase the total compensation while reducing compensation cost, at least in terms of cash flow. For a young company, this can be especially attractive. In those early days, cash is often hard to come by and stock-based compensation is a way of rewarding employees with future value for their present work.
Again, stock-based compensation also helps keep employees on board and invested in the success of the company—because they’re literally invested in the company. Receiving shares of stock or stock options rather than a higher cash salary can also have tax benefits for employees, who may not have to pay taxes on the value of the underlying stock until it vests or until they exercise their options.
While stock-based compensation may have less of an impact on the cash flow statement up front, it’s important to remember that it is still dilutive. When those options are exercised, the increase in outstanding shares will decrease Earnings Per Share (EPS) by slicing the Net Income pie into more pieces.
How Do You Account for Stock-Based Compensation on a Balance Sheet?
The accounting treatment of stock-based compensation varies between stock options and restricted stock and between different types of stock. Let’s take a quick look at how stock options impact the balance sheet.
First, in accordance with Generally Accepted Accounting Principles, expenses need to be recorded for the period of time they’re used for more accurate financial reporting. For instance, a stock option that vests in five years should be spread out over those years, not recorded as one lump sum expense. In that case, you would debit Compensation Expense and credit a Stock Options Equity account each of the five years for one-fifth of the value of the stock. Accounting standards require this to be recorded based on the company’s fair value calculation of their shares.
When an employee exercises stock options, you’ll credit Common Stock for the number of shares x par value, debit Cash for the number of shares x the exercise price, then debit Additional Paid-In Capital for the difference, representing the increase in value of the shares during the service period. By following this process, your financial statements always accurately reflect not only the stock issued and the related compensation expenses but also how many stock options are outstanding.
How Does Restricted Stock Work?
When an employee receives a grant of restricted stock, they are not allowed to sell it until it vests, usually over several years. If the employee leaves before the end of the vesting period, they forfeit their shares. Reasonable vesting periods encourage team members to stick around and help build a strong company.
Let’s walk through an example. Under ABC Company’s restricted stock program, 2,000 shares will vest on December 31, 2020. On the date those shares were granted — the grant date — nothing happens on either the income statement or the balance sheet. On the vesting date, the shares have a fair value of $25 per share and a par value of $1. Here’s the entry to record that:
|12/31/20||Stock-based compensation expense||$50,000|
|Common Stock (par value)||$2,000|
Memo: To record restricted stock compensation for FY20
When the shares vest, the employee has taxable income at the market value of those shares. If this is a public company, this is the current trading value. But for private companies, an estimate of the fair value must be made. Some companies hire an outside consultant who specializes in valuation. According to IRS section 83, which governs restricted stock awards, a company must demonstrate a good faith effort to estimate the fair market value, which could be based on a formula.
At some companies, accounting policy calls for an entry to record restricted shares when they’re issued, which makes the stock-based compensation journal entries a little different. Let’s say that on December 31, 2019, ABC Company issued 4,000 shares of restricted stock to employees. These shares will vest over the next two years, 50% on December 31, 2020, and 50% on December 31, 2021. If the share price on the grant date is $25 with a par value of $1, here’s the entry to record the issuance of those shares:
|12/31/19||Contra-equity — deferred compensation||$100,000|
|Common Stock (par value)||$4,000|
Memo: To record the issuance of restricted stock compensation
Here the deferred compensation is recorded as a contra-equity account, with the offset to additional paid-in capital, resulting in a net-zero effect on the balance sheet and income statement. Ignoring any changes to the value of the stock, the following journal entry would be recorded on December 31, 2020, and again on December 31, 2021:
|12/31/2X||Stock-based compensation expense||$50,000|
|Contra-equity — deferred compensation||$50,000|
Memo: To record restricted stock compensation for FY2X
This accomplishes the same net effect in the end as the first method.
How Do Stock Options Work?
Stock options are a bit more complex than restricted stock awards. These give recipients the right to purchase a certain number of shares of company stock at a specified price — the exercise price — on or after a specific date in the future — the exercise date. To incentivize employees to stay, they can’t exercise the option right away, but must remain employed over a vesting period. At any time between the date that the options vest and they expire, the option holder can purchase stock at the exercise price. This becomes an incredibly great deal if the exercise price is less than the market value because the employee may be buying stock at a substantial discount.
Stock options clearly have value as compensation, but what is that value? Let’s say an employee is granted 1,000 options at an exercise price of $20 per share on a day that the market value is $30 per share. In that case, the intrinsic value of the option is the difference between the two, or $10 per share. If the options vested immediately, the company would record a compensation expense of $10,000 ($10 per share x 1,000 shares).
But what happens often is that the exercise price is set at the market price on the grant date. In this case, the intrinsic value of those options is now zero, so the company wouldn’t record any compensation expense. Because this distorts the actual value of compensation that employees receive, companies are required to calculate the fair value of the options at the grant date and record that in the financials. The most commonly used method is the Black Scholes option pricing model.
Some companies outsource this work to a consultant who specializes in Black Scholes valuation, other companies use cap table software with the functionality to calculate the Black Scholes model, and other companies do it all in excel. The inputs to Black Scholes are the current stock price, US Treasury risk-free rate, the volatility of comparable companies’ stock prices, and expected term of the options.
Here again, we run into trouble for non-public companies — what is the current stock price? Currently, FASB is working on a practical expedient for private companies that would align U.S. GAAP treatment to the IRS treatment under section 409A. This is the section of the IRS code that provides valuation rules for stock options for tax purposes.
Let’s work through a simple example to see how that works. On January 1, 2021, ABC Company grants an employee 1,000 options that vest in two years and expire in 10 years. Based on valuations, the company determines that the market value of company stock is $20 per share and the fair value of an option is $8. The par value of the stock is $1. The exercise price is set at the current market value of $20 per share. Multiplying the option value by the number of shares in the option grant, we get a total value for the stock options of $8,000. ABC Company will expense the compensation on a straight-line basis over the two-year vesting period. So on January 1, 2022, ABC Company will record this as a stock option expense journal entry for half of the options:
|1/1/21||Stock option compensation expense||$4,000|
|Equity APIC - stock options||$4,000|
Memo: To record stock option compensation
The same journal entry will also be recorded a year later. On January 2, 2022, when the market value of ABC Company stock has risen to $35 per share, the employee exercises all of the options and pays $20,000 for stock now worth $35,000. Here’s the journal entry to record that transaction:
|Equity APIC - Stock Options||$8,000|
|Common Stock (par value)||$1,000|
Memo: To record exercise of stock options
One of the biggest challenges of offering stock-based compensation for private companies is figuring out the value of the stock and options. Outsourcing this to a consultant who specializes in 409A valuations can be pricey, but it’s the best way to ensure an objective and fair value.
Reconciliation (CLICK HERE FOR 3 BEST PRACTICE EXCEL RECONCILIATION TEMPLATES)
- Always make sure retained earnings roll forward year over year!
- There should be line items in your equity recon for all of the stock option expense over time.
- Not getting timely 409A valuations done. This gives you your strike price if you’re not a publicly-traded company. Option strike prices should be issued in accordance with the 409A findings.
- Nonstandard option grant terms like different vesting periods for employees can make administration difficult and may even create problems for the company or employees when it comes time to pay income tax.
How Auditors Audit
Auditors will spend a lot of time on equity, especially if it’s a first-year audit. It’s advisable to work with a corporate attorney or a tax CPA prior to issuing stock as compensation. They’ll check the terms and look out to prevent future headaches.