Stock Based Compensation Complete Guide for Accounting and Finance

Stock based compensation is a popular way for companies to attract and retain top talent. This type of compensation is tax-deductible for the employer, which can be a significant cost savings.

Stock options are a type of stock based compensation that give employees the right to buy company stock at a predetermined price. This can be a highly motivating form of compensation for employees.

The value of stock options is determined by the difference between the exercise price and the market price of the stock. This can be a significant amount of money for employees who hold onto their options long enough to see the stock price rise.

Stock options can be granted to employees in various forms, including incentive stock options (ISOs) and non-qualified stock options (NSOs).

Stock-based compensation is a form of employee compensation that can be tricky to model, but it's essential to capture its value somehow.

In the software industry, it's common to exclude stock-based compensation expense from earnings per share (EPS), treating it as a non-recurring item. However, this approach ignores the real cost of dilution, which can lead to overvaluation in discounted cash flow (DCF) models.

To accurately model stock-based compensation, consider the transfer of value from current equity owners to employees when companies issue stock options or restricted stock. This transfer of value needs to be captured in some way, but the question is how.

Analysts argue that stock-based compensation is a non-cash expense, but experts suggest that it's essential to model SBC in DCF valuations since it impacts the company's future cash flow and valuation.

Stock based compensation is a form of employee compensation that can be tricky to model. It's a non-cash expense, but that doesn't mean it's not important.

Stock options and restricted stock are a transfer of value from the current equity owners to employees, making it necessary to capture this transfer somehow. Analysts will argue that this is appropriate because it's a non-cash expense.

The rationale behind excluding SBC expense from earnings per share (EPS) is that it's a non-recurring item. However, this doesn't mean it's not relevant to the company's financial health.

Companies issue stock based compensation to attract and retain employees, making it a valuable form of compensation. Employees certainly prefer a salary of $50,000 + options over a salary of $50,000 with no stock options.

Restricted Stock: These are common shares with selling restrictions that typically come with voting rights and dividends. Once vested, the recipient can freely sell these shares.

Stock Options give employees the right to purchase or sell a stock at a predetermined price and date. They are generally issued at the market price on the grant date and can be exercised if the share price exceeds the strike price after vesting and before expiry.

Stock Appreciation Rights (SARs) give employees the right to the increase in the value of a designated number of shares. This benefit can be paid in cash or stock.

Restricted Stock Units (RSUs) represent a promise to employees to grant them shares or cash at a future date. Unlike actual stock, RSUs are not directly tied to the price of company shares and do not have voting rights.

Here are some common types of stock-based compensation:

Employee Stock Ownership Plan (ESOP) provides employees with shares of the company that represent ownership in the business. It's a qualified plan that offers numerous tax advantages to everyone involved.

Shares are fractional ownership interests in a company. For certain businesses, shares are a kind of financial instrument that allows for the equitable distribution of any declared residual earnings in the form of dividends.

Prior to 2006, companies were not required to recognize stock-based compensation as an expense on the income statement, as long as the exercise price was at or above the current share price. This was a controversial decision, as it clearly violated the accrual concept of the income statement.

Companies were allowed to keep stock options off their financial statements because the value was considered difficult to determine. However, this changed in 2006, when FASB required companies to use an options pricing model to value the options and recognize an expense on the income statement.

The expense is calculated based on the fair value of shares when they are granted, and is spread out over the vesting period. For example, if a company granted an employee stock options with a fair value of $100,000 that vests over five years, the company would recognize a $20,000 expense annually for five years.

Here's a breakdown of how stock-based compensation impacts the income statement:

The expense recognized on the income statement reduces net income, making it lower than it would be without the stock-based compensation. For example, Facebook paid out $3,218 million in stock-based compensation in 2016, which decreased their net income.

Stock-based compensation is recorded on the income statement because it's a form of compensation that's given to employees, just like cash wages. This compensation has a potential value that's difficult to quantify, but it's still valuable to the employees.

The accounting treatment of stock-based compensation is consistent with accrual accounting guidelines. This means that the expense is recognized on the income statement as it's earned, rather than when it's paid.

The company grants share-based compensation, which recognizes the fair value of the award as a compensation expense on the income statement. This expense is spread out over the vesting period of the award.

For instance, if a company granted an employee stock options with a fair value of $100,000 that vests over five years, the company would recognize a $20,000 expense annually for five years. This reduces the net income of the company.

Here's a breakdown of the impact of stock-based compensation on the income statement:

This accounting treatment makes complete sense if your goal is to put together an accrual-based income statement. It's a way to accurately reflect the value of the compensation that's being given to employees.

The most aggressive Street approach ignores the cost associated with SBC, only counting actual shares, vested restricted shares, and vested options. This approach completely misses the impact of future dilution.

The most conservative Street approach, on the other hand, reflects the cost of SBC via SBC expense, counts actual shares, all in-the-money options, and all restricted stock. This approach has a more realistic view, as it reflects the dilutive effect of future stock issuances as an expense that reduces cash flow.

Damodaran's approach is another method used to calculate pre-existing expense. It reflects the cost of SBC via SBC expense and values options via a reduction to equity value for option value, counting only actual shares and restricted stock. This approach is more aligned with the rest of the valuation's forecasts for growth.

Here's a comparison of the three approaches:

Calculating equity value per share in a DCF model can be tricky, especially when considering stock-based compensation. The problem is that ignoring the cost of dilution can lead to overvaluation.

Ignoring the cost of dilution entirely while accounting for all the incremental cash flows from having a better workforce leads to overvaluation in the DCF. This is because companies that issue a lot of stock-based compensation packages can attract top employees, but at the cost of significant future dilution to current shareholders.

Approach #1 in DCF models, which treats stock-based compensation as essentially cash compensation, is difficult to justify, especially for companies that regularly issue options and restricted stock. This approach can lead to overvaluation of companies that issue a lot of stock-based compensation.

Before 2006, companies weren't required to add stock-based compensation as an expense to their financial statements under GAAP. However, with the introduction of FASB guidelines, companies are now required to list stock-based compensation in their financial statements.

Companies must determine the value of stock options using valuation methods like the Black-Scholes model, and list SBC as an operating expense. This change has significant implications for financial reporting.

Here's a breakdown of the impact of stock-based compensation on financial statements:

Journal Entries are a crucial part of financial reporting and tax treatment, and they can be a bit tricky to understand. They are used to record the impact of stock-based compensation on a company's financial statements.

The journal entries for restricted stock and stock options differ slightly. For restricted stock, the journal entry on the grant date is to record the fair value of the shares in a contra-equity account, which is offset by a common stock and APIC account. This has no net impact on the balance sheet.

When restricted stock vests, the journal entry includes debiting stock-based compensation and crediting common stock and APIC. This is repeated for each vesting period until all shares are vested. If an employee leaves before vesting, the previously recorded expense is reversed.

For stock options, the journal entry on the grant date is to disclose the fair value of the shares in the footnotes, but no journal entry is recorded. On the vesting date, the journal entry includes debiting stock-based compensation and crediting equity APIC payable. This is repeated for each vesting period until all options are vested.

Here's a summary of the journal entries for restricted stock and stock options:

These journal entries are critical in accurately reporting the impact of stock-based compensation on a company's financial statements.

Before we dive into the impact of stock-based compensation on valuation, let's quickly review the changes in accounting rules. Prior to 2006, FASB's view on stock-based compensation was that companies could ignore recognizing it as an expense on the income statement as long as the exercise price was at or above the current share price. However, starting in 2006, FASB changed their mind and required companies to recognize an expense for stock-based compensation using an options pricing model.

This change in accounting rules has a significant impact on valuation. Analysts use price to earnings (PE) ratios to compare companies, but the inclusion of stock-based compensation expense can skew these ratios. If one company has a higher PE ratio, it may be because it's more valuable or because it's overvalued.

To illustrate this, let's consider an example. If a company has a higher PE ratio due to stock-based compensation, it may be because its future growth prospects are higher, but the extra dilution required to achieve it is offset by the potential value of the options. In this case, the PE ratio may be higher, but the company's true value may not be.

Here's a summary of the impact of stock-based compensation on valuation:

By understanding the impact of stock-based compensation on valuation, investors and analysts can make more informed decisions about company valuations.

Share-based compensation is a common practice in many companies, but did you know that its financial reporting and tax treatment can differ significantly?

For financial reporting, expense is recognized over the vesting period based on grant-date fair value.

The timing and amount of the deduction for tax purposes often differs from the expense recognized in financial reporting.

If the share price at settlement is higher than at the grant date, a tax windfall occurs, reducing taxable income and tax expense.

However, if the share price at settlement is lower than at the grant date, a tax shortfall occurs, increasing both taxable income and tax expense.

Under IFRS, tax windfalls and shortfalls from share-based compensation are treated differently than under US GAAP.

IFRS recognizes windfalls (gains) and shortfalls (losses) directly in equity, while US GAAP reflects them in income tax expense on the income statement.

This difference results in volatility in the effective tax rate under US GAAP.

Stock-based compensation can have a significant impact on a company's income statement and balance sheet. Prior to 2006, companies were not required to include stock-based compensation as an expense on their income statement, but this changed with the introduction of new accounting standards. Companies are now required to list stock-based compensation as an operating expense on their financial statements.

The value of stock options is determined using valuation methods like the Black-Scholes model, and the expense is calculated based on the fair value of the shares when they are granted. For instance, if a company granted an employee stock options with a fair value of $100,000 that vests over five years, the company would recognize a $20,000 expense annually for five years.

Stock-based compensation can also result in an increase in the "additional paid-in capital" account on the balance sheet. When the award is granted, a "share-based compensation reserve" is increased, reflecting the future obligation. As the award vests, this reserve is decreased, and the "common stock" and "paid-in capital" accounts are adjusted.

Here are some key facts about the impact of stock-based compensation on the income statement and balance sheet:

* AccountImpactIncome StatementDecreased Net IncomeBalance SheetIncreased "additional paid-in capital" account

Facebook, for example, included stock-based compensation expenditure in their cost and expenses, which decreased their Net Income. They also disclosed the breakdown of stock-based compensation for each cost and expenditure category, with $3,218 million paid out in 2016.

The accounting treatment of stock-based compensation is consistent with accrual accounting guidelines and makes complete sense if your goal is to put together an accrual-based income statement.

Stock-based compensation has its fair share of benefits. It encourages workers to remain with the firm while they wait for their shares to vest, aligning the interests of shareholders and workers alike.

One of the main advantages is that it doesn't require a cash payment, making it a cost-effective option for companies. This can be a huge plus for businesses looking to save on expenses.

However, there are also some drawbacks to consider. Increasing the number of outstanding shares can dilute the ownership of current shareholders, which might not be ideal for those who have invested in the company.

If the share price is falling, hiring or keeping personnel might not be the most helpful strategy. This can lead to a decrease in the value of the company's stock, which can be a major concern for shareholders.

Accounting for share-based compensation is a bit different from typical salaries.

The value of share-based awards is based on the fair market value at the grant date, and this valuation remains consistent regardless of future share price fluctuations.

Vesting conditions can be tied to an employee's service duration, which means they have to stick around the company for a certain amount of time before they can claim their shares.

Awards that have not vested by the time an employee leaves the company are forfeited, which can be a big motivator for employees to stay on board.

The value of these awards is not affected by future share price fluctuations, so employees are not benefiting from short-term gains in the company's stock price.

Stock-based compensation can be a great way to motivate employees and align their interests with the company's goals. Here are some of the pros and cons of using this type of compensation.

One of the main benefits of stock-based compensation is that it encourages workers to remain with the firm while they wait for their shares to vest. This can be a win-win for both the employee and the company. By providing employees with a vested interest in the company's success, they are more likely to stay with the company and work towards its growth.

Stock-based compensation can also align the interests of shareholders and workers, who both want the business's success and an increase in share value. This alignment of interests can lead to a more cohesive and motivated team.

However, stock-based compensation also has some drawbacks. One of the main disadvantages is that it increases the number of outstanding shares, diluting the ownership of current shareholders. This can be a significant issue for investors who are already holding shares in the company.

If the share price is falling, offering stock-based compensation can be less effective in recruiting and retaining talent. In such cases, the perceived value of the stock-based compensation may not be as high as the actual value.

Here are some of the key pros and cons of stock-based compensation: