Accounting for Stock Options & Equity Compensation Plans

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  • 0:03 Why Stock Options?
  • 1:01 Important Dates
  • 1:49 Accounting for Stock Options
  • 4:30 Stock Appreciation…
  • 6:04 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

In this lesson, we'll explore the world of stock options. A simple example will be used to illustrate the accounting and journal entries for them. We'll also cover SARs, another form of employee participation in the appreciation of share prices.

Why Stock Options?

Future Ride is a cutting-edge technology company that is developing a line of replacement parts for self-driving vehicles. Future Ride is growing fast, and the board of directors has decided to hire a businessperson for the new Chief Executive Officer (or CEO) position since the current management team is heavy on techs. They decide that part of the new boss's compensation will come in the form of stock options. Tina, the head of HR suggested this:

''It will give the new person incentive to make the stock price go up; that is the only way he or she will get paid with stock options.''

Stock options give the option holder the right to buy shares of company stock at some date in the future at a prearranged, specified price. If today's stock price is used as that price, the only way the option holder can profit is if the stock price goes up. If it goes down, the option will be worthless. Tina is going to work up the specifics and present her plan to the board for a vote.

Important Dates

There are important dates to remember with stock options since they determine when accounting needs to be done. They are:

  • Grant date: The day the options are given to the employee.
  • Exercise date: The day the options are used to buy shares at the specified exercise price.
  • Vesting date: The first day the employee can exercise or use the option to buy shares.
  • Expiration date: The day the options expire and can no longer be used.

Tina is proposing that the new CEO be granted 5,000 options to buy company stock at its current price of $30 per share at the end of a two-year period. They will be granted January 1, 2018, and vest on December 31, 2019. The options will expire on January 31, 2020.

Accounting for Stock Options

Two important rules need to be remembered when accounting for stock options:

  1. Stock options are valued under the rules of Generally Accepted Accounting Principles (or GAAP) at fair market value. That is easy if the options are traded on an exchange; you can just look up the price. Otherwise, the value can be calculated with complicated pricing techniques, like the Black-Scholes model. Tina will get a good number to use from the finance department.

  2. Stock options are compensation expense to the company. This expense is recognized as the employee earns service time and works up the vesting date.

Now Tina is ready to go and see Al, the head of the accounting department. She needs to show the board what the journal entry for that compensation expense will look like. The finance people tell her to use $10 per option as a fair market value. Al multiplies the $10 times 5,000 options to get a total of $50,000, which is the total compensation expense. No entries are required at grant date if the exercise price is the same as the stock price. The journal entries will be required at the end of both years and will look the same. The entries are as follows:

item Debit Credit Explanation
Compensation expense $25,000 Total compensation expense of $50,000 divided by 2 since there are two years before the options vest. This will show on the current period's income statement.
Additional paid in capital for stock options $25,000 Stock options use equity accounts rather than liability accounts since they will be settled with stock.

The same entry is made at the end of year two to account for all of the compensation expense.

Exercising the Options

Al joins Tina in front of the board to make the presentation. Mr. Bartholomew has a question for Tina and Al.

''What if the stock price is $50 at the end of 2 years? Does that mean we are going to have to recognize even more compensation expense?''

''Not at all,'' says Al.

He explains what the journal entries will look like if all of the options are exercised on December 31, 2019, and the stock has a par value of $2.

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