ESOs: Accounting For Employee Stock Options.
Relevance above Reliability.
We will not revisit the heated debate over whether companies should "expense" employee stock options. However, we should establish two things. First, the experts at the Financial Accounting Standards Board (FASB) have wanted to require options expensing since around the early 1990s. Despite political pressure, expensing became more or less inevitable when the International Accounting Board (IASB) required it because of the deliberate push for convergence between U. S. and international accounting standards. (For related reading, see The Controversy Over Option Expensing .)
As of March 2004, the current rule (FAS 123) requires "disclosure but not recognition". This means that options cost estimates must be disclosed as a footnote, but they do not have to be recognized as an expense on the income statement, where they would reduce reported profit (earnings or net income). This means that most companies actually report four earnings per share (EPS) numbers - unless they voluntarily elect to recognize options as hundreds have already done:
2. Pro Forma Diluted EPS.
A key challenge in computing EPS is potential dilution. Specifically, what do we do with outstanding but un-exercised options, "old" options granted in previous years that can easily be converted into common shares at any time? (This applies to not only stock options, but also convertible debt and some derivatives.) Diluted EPS tries to capture this potential dilution by use of the treasury-stock method illustrated below. Our hypothetical company has 100,000 common shares outstanding, but also has 10,000 outstanding options that are all in the money. That is, they were granted with a $7 exercise price but the stock has since risen to $20:
Basic EPS (net income / common shares) is simple: $300,000 / 100,000 = $3 per share. Diluted EPS uses the treasury-stock method to answer the following question: hypothetically, how many common shares would be outstanding if all in-the-money options were exercised today? In the example discussed above, the exercise alone would add 10,000 common shares to the base. However, the simulated exercise would provide the company with extra cash: exercise proceeds of $7 per option, plus a tax benefit. The tax benefit is real cash because the company gets to reduce its taxable income by the options gain - in this case, $13 per option exercised. Why? Because the IRS is going to collect taxes from the options holders who will pay ordinary income tax on the same gain. (Please note the tax benefit refers to non-qualified stock options. So-called incentive stock options (ISOs) may not be tax deductible for the company, but fewer than 20% of options granted are ISOs.)
Pro Forma EPS Captures the "New" Options Granted During the Year.
First, we can see that we still have common shares and diluted shares, where diluted shares simulate the exercise of previously granted options. Second, we have further assumed that 5,000 options have been granted in the current year. Let's assume our model estimates that they are worth 40% of the $20 stock price, or $8 per option. The total expense is therefore $40,000. Third, since our options happen to cliff vest in four years, we will amortize the expense over the next four years. This is accounting's matching principle in action: the idea is that our employee will be providing services over the vesting period, so the expense can be spread over that period. (Although we have not illustrated it, companies are allowed to reduce the expense in anticipation of option forfeitures due to employee terminations. For example, a company could predict that 20% of options granted will be forfeited and reduce the expense accordingly.)
Our current annual expense for the options grant is $10,000, the first 25% of the $40,000 expense. Our adjusted net income is therefore $290,000. We divide this into both common shares and diluted shares to produce the second set of pro forma EPS numbers. These must be disclosed in a footnote, and will very likely require recognition (in the body of the income statement) for fiscal years that start after Dec 15, 2004.
There is a technicality that deserves some mention: we used the same diluted share base for both diluted EPS calculations (reported diluted EPS and pro forma diluted EPS). Technically, under pro forma diluted ESP (item iv on the above financial report), the share base is further increased by the number of shares that could be purchased with the "un-amortized compensation expense" (that is, in addition to exercise proceeds and the tax benefit). Therefore, in the first year, as only $10,000 of the $40,000 option expense has been charged, the other $30,000 hypothetically could repurchase an additional 1,500 shares ($30,000 / $20). This - in the first year - produces a total number of diluted shares of 105,400 and diluted EPS of $2.75. But in the forth year, all else being equal, the $2.79 above would be correct as we would have already finished expensing the $40,000. Remember, this only applies to the pro forma diluted EPS where we are expensing options in the numerator!
Expensing options is merely a best-efforts attempt to estimate options cost. Proponents are right to say that options are a cost, and counting something is better than counting nothing. But they cannot claim expense estimates are accurate. Consider our company above. What if the stock dove to $6 next year and stayed there? Then the options would be entirely worthless, and our expense estimates would turn out to be significantly overstated while our EPS would be understated. Conversely, if the stock did better than expected, our EPS numbers would've been overstated because our expense would've turned out to be understated.

Accounting entry when stock options are exercised

All other stock option plans are assumed to be a form of compensation, which requires recognition of an expense under U. S. GAAP. The amount of the expense is the fair value of the options, but that value is not apparent from the exercise price and the market price alone. Option valuation is a finance concept, and it generally relies on the Black-Scholes method, which is beyond the scope of this article.
The expense is recorded equally throughout the entire vesting period , which is the time between the date the company grants the options and when the individual is allowed to exercise the option. In other words, U. S. GAAP considers the options “earned” by the employee during the vesting period. The entry credit is to a special additional paid-in capital account. Let’s take a look at an example.
Friends Company, a fictitious entity, grants its CEO 5,000 stock options on January 1, 20X4. Each option allows the CEO to purchase 1 share of $1-par-value stock for $80 on December 31, 20X7. The current market value of the stock is $75. The fair market value of one stock option is $10. Each year, the company will record the following compensation entry.
Additional paid-in capital – stock options.
The total value of the options is $50,000 (5,000 x $10), and the vesting period is 4 years, so each year the company will record $12,500 of compensation expense related to the options. If the options are exercised, the additional paid-in capital built up during the vesting period is reversed. The stock’s market value is irrelevant to the entry – the credit to additional paid-in capital (common stock) is to balance the entry and is not related to market value.
Additional paid-in capital – stock options.
Additional paid-in capital – common stock.
If the options are not used before the expiration date, the balance in additional paid-in capital is shifted to a separate APIC account to differentiate it from stock options that are still outstanding.

How to Do Accounting Entries for Stock Options.
Because stock option plans are a form of compensation, generally accepted accounting principles, or GAAP, requires businesses to record stock options as compensation expense for accounting purposes. Rather than recording the expense as the current stock price, the business must calculate the fair market value of the stock option. The accountant will then book accounting entries to record compensation expense, the exercise of stock options and the expiration of stock options.
Initial Value Calculation.
Businesses may be tempted to record stock award journal entries at the current stock price. However, stock options are different. GAAP requires employers to calculate the fair value of the stock option and record compensation expense based on this number. Businesses should use a mathematical pricing model designed for valuing stock. The business should also reduce the fair value of the option by estimated forfeitures of stock. For example, if the business estimates that 5 percent of employees will forfeit the stock options before they vest, the business records the option at 95 percent of its value.
Periodic Expense Entries.
Instead of recording the compensation expense in one lump sum when the employee exercises the option, accountants should spread the compensation expense evenly over the life of the option. For example, say that an employee receives 200 shares of stock valued by the business at $5,000 that vests in five years. Each year, the accountant debits compensation expense for $1,000 and credits the stock options equity account for $1,000.
Exercise of Options.
Accountants need to book a separate journal entry when the employees exercise stock options. First, the accountant must calculate the cash that the business received from the vesting and how much of the stock was exercised. For example, say the employee from the previous example exercised half of his total stock options at an exercise price of $20 a share. Total cash received is $20 multiplied by 100, or $2,000. The accountant debits cash for $2,000; debits a stock options equity account for half of the account balance, or $2,500; and credits the stock equity account for $4,500.
Expired Options.
An employee may leave the company before the vesting date and be forced to forfeit her stock options. When this happens, the accountant must make a journal entry to relabel the equity as expired stock options for balance sheet purposes. Although the amount remains as equity, this helps managers and investors understand that they won't be issuing stock to the employee at a discounted price in the future. Say that the employee in the previous example leaves before exercising any of the options. The accountant debits the stock options equity account and credits the expired stock options equity account.
References.
About the Author.
Based in San Diego, Calif., Madison Garcia is a writer specializing in business topics. Garcia received her Master of Science in accountancy from San Diego State University.
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Q&A Forum.
Stock Option Exercise on the Grant Date.
A private California corporation granted stock options to its executive team that were exercised on the same day as grant (83bs have been filed), with a 4-year vesting period. The exercise was paid for with a promissory note. Does this transaction eliminate the need to record compensation expense and APIC-Options (and also the deferred tax entry)? I was just planning to record the notes receivable, common stock and interest.
Company: Growth Accelerator.
Let me ask a clarifying question. the options were granted at-the-money? The stock, not the option, is what vests? So you *essentially* sold the stock to the exec's in question at market value? If you can treat it that way, I believe you're in the clear. however;
Even an "at the money" option has value; I believe that the grant in and of itself is compensation, and would have to have been treated as such at the time of grant.
I'm *reasonably* sure that the proper way to have done this is to issue an SPR for an at-market purchase (or something similar) that doesn't have intrinsic value. I'd be hesitant to say that this (as described) isn't compensation expense.
The other piece to this is the promissory note. First, it is a related-party transaction loaning money to Execs, and I'd consult a tax expert to make sure that this doesn't fall afoul of deferred comp and other rules. Second, depending on the terms of the promissory note, it could look very artificial, in as much as the transaction could be said not to have ever happened. Again, that would need to be cleared with a tax attorney as I can see it going wrong.
Thanks Keith! Yes grant price=fmv=exercise price. Private company. The stock was sold at market value. Does that negate the "compensation" component of the options since they were immediately purchased as restricted stock?
Company: Stock & Option Solutions.
Actually, you do not escape expense this way, you value the shares in the same way, record a Deferred Tax Liability for the total expense and then book the expense and write off the DTL as the expense is recorded. I am NOT an expert on the JEs for this, but I do know for certain that early exercise does not remove the need to expense the options.
From the PwC "Guide to Accounting for Stock-based Compensation":
If an employee makes an IRC Section 83(b) election, the company measures the.
value of the award on the grant date and records a deferred tax liability for the.
value of the award multiplied by the applicable tax rate, reflecting the fact that the.
company has received the tax deduction from the award before any compensation cost has been recognized for financial reporting purposes. In this case, the deferred tax liability offsets the current tax benefit the company is entitled to by virtue of the employee’s IRC Section 83(b) election. As the company recognizes book compensation cost over the requisite service period, the deferred tax liability will be reduced (in lieu of establishing a deferred tax asset since the tax deduction has already occurred). If an IRC Section 83(b) election is made by an employee for an equity-classified award, there will not be a windfall or shortfall upon settlement because the tax deduction equaled the grant-date fair value. If, however, an IRC Section 83(b) election is made for liability-classified restricted stock, a windfall or shortfall likely would occur at settlement because the tax deduction is measured at the grant date, whereas the book compensation cost for a liability award is remeasured through the settlement date.
This section actually refers to restricted stock, but the same applies to options.
Thanks Elizabeth! For clarification purposes, what event are you referring to when you say "settlement date"? Yes this is restricted stock.
Company: Stock & Option Solutions.
I don't see a way to reply to the reply from 1/7, so I'm replying to my own answer:
Settlement is the event that ends the life of the grant. For options, exercise (though it can also be expiration) for Restricted Stock (not RSUs) it is the vesting. (For RSUs it is the release of the shares, but that is not relevant here since no 83(b) election can be filed on RSUs.)
Settlement can also be thought of as the event that provides the tax deduction to the company OR eliminates the possibility of a future tax deduction (like option expiration). The windfall/shortfall calculation is performed at settlement.
FORFEITURE is different, however, that is cancellation pre-vest when expense is reversed for the grant and generally shortfall/windfall calculations are not performed. Likewise for an option exercised before vest, if the grant were cancelled before vest, the Deferred Tax Liability would also be reversed.
Company: Windes & MCClaughry.
How can you exercise an unvested option?
As already mentioned, you book the compensation expense for granting the option, regardless of when exercised. Since grantees couldn't fully exercise until vested, this sounds like an issuance of restricted stock, not a stock option, although then I'm not sure why 83(b) election would be made.
Depending on what was issued, you could avoid comp expense/APIC. I would recommend googling "restricted share units" "form 10-k - investor relations" to see some financial statement examples if this is not an actual stock option.
Yes it is restricted stock. Why do you think an 83(b) is not required?
Company: Stock & Option Solutions.
Exercising unvested stock options is actually fairly common in private companies, especially in the Silicon Valley.
I'm always relieved to find when companies don't do it, since it complicates taxation and tax accounting considerably and many (most? all?) systems that provide accounting for stock plans / stock options do not support "early exercise" correctly for accounting at least.
Company: Stock & Option Solutions.
You absolutely can allow "exercise before vest" or "early exercise" on stock options. See Section 2.4 of "The Stock Options Book" (13th edition) which covers 83(b) elections on options exercised prior to vesting. But one caution, the elections don't "work" on ordinary income for ISOs - you can file them, but you don't get the improved tax consequences. It may be beneficial for AMT, however.
If I understand the situation correctly, you have issued restricted stock to employees at FMV on grant date. This eliminates any income to the employee (and tax deduction to the employer) if 83(b) elections are made timely. Since there is no compensaton expense to the corporation under this scenario, I don't believe their is a deferred tax liability as Elizabeth lays out above from the PWC Guide (again since there isn't any compensation expense under ABP 25 or 123R). Again, my interpretation might be off, but I believe I am correct on that. Good luck.. a call to your auditors also will be helpful.
Company: Growth Accelerator.
Ted, I think the clarifying point here is that these were done as options, not SPRs. As Jeff noted, the grant is the trigger for the expense, regardless of exercise timing.
I think Jeff's suggestion is the right one: sell restricted stock at value directly, don't mess with options or 83(b)s and you have a much cleaner deal (except the loan. where you need to be careful).
Sorry, but I believe this was done as restricted stock grants. please see the response to Jeff Fisher. Otherwise the situation that is being described doesn't make any sense. (An option you exercise for stock that is restricted?)
The most common scenario I have seen is a grant of restricted stock with the strike price at FMV. The loan is made from the company to pay the exercise cost and the restrictions lapse over 4 years. You would file the 83(b) to avoid picking up income as the grantee as the restriction lapses. There is some goofiness that occurs with the loan whether it is forgiven by the company or paid back by the employee, but I don't believe this changes the FAS123r accounting on it.
Company: Stock & Option Solutions.
You absolutely can allow "exercise before vest" or "early exercise" on stock options. See Section 2.4 of "The Stock Options Book" (13th edition) which covers 83(b) elections on options exercised prior to vesting. But one caution, the elections don't "work" on ordinary income for ISOs - you can file them, but you don't get the improved tax consequences. It may be beneficial for AMT, however.
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