Accounting for Stock Based Compensation

Granting stock is an effective way to attract and retain employees. When a company grants stock awards or options to employees as a form of compensation or as payment for outside services, the fair market value of the compensation must be recorded on the company’s books as an expense over the periods in which related services are performed and reported to the IRS as taxable income to the recipient. Determining the fair value of the compensation and expensing that compensation satisfies FASB’s Accounting Standards Codification Topic 718 (formerly FAS 123R) Compensation-Stock Compensation requirements. When granting stock, a company should also be concerned with satisfying the fair market value requirements of IRC Sec. 409A.  A reasonable valuation method is to consider the following factors:
• The value of tangible and intangible assets (present value of future cash flows)
• The market value of comparable businesses, public and private
• Other relevant factors such as control premiums or discounts for lack of marketability
• Whether the valuation method is used consistently for other corporate purposes

This article illustrates the three most common types of stock based compensations:
1. Stock Awards
2. Stock Options
3. Shares Purchase Plans

Stock Awards (Restricted Shares Units or RSUs)
Stock awards is the granting of shares of the company’s stock.  This should not be confused with stock options, which is the granting of options to purchase the company’s stock. Shares are restricted (non-vested) and typically tied to continued employment. The awards are forfeited if employment is terminated within some specified number of years from grant date. Shares cannot be sold during the restriction period between grant and vesting date. The compensation is the market price of the stock at grant date. Compensation is recorded as expense over the service period, usually from grant date to vesting date.

Example 1 Stock Award JE

Stock Options
Stock option plans give employees the option to buy (1) a specific number of the company’s stock (2) at a specified time (3) during a specified period of time. The fair value is recorded as compensation expense over the service period for which participants receive the options, usually from the date of the grant to when the options become exercisable, the vesting date. Fair value is estimated on grant date using an option pricing model that takes into consideration the following:

1. Exercise price of the option
2. Expected term of the option
3. Current market share price
4. Expected dividends to be paid on the underlying shares during the term of the option
5. Risk-free Interest Rate during the term of the option
6. Expected volatility of the stock

Example 2 - Stock Options JE

Shares Purchase Plan (Employee Stock Purchase Plan/ESPP)

Employee stock purchase plans permit employees to buy shares directly from the employer at a discount. Money for purchases is usually collected via payroll deductions and shares are typically purchased at set intervals. Plans are usually considered compensatory and compensation expense is recorded. Example 3 - ESPP JEFor tax purposes, plans can either be an “incentive stock option” (Qualified) or “Unqualified” under the IRS Tax Code.

Qualified Plans
-Exercise price equals the market price at the grant date
-Recipient pays no income tax until acquired shares are sold
-Employer gets no tax deduction

Non-Qualified Plans
-Employee must pay income on the difference between market value and exercise price at time of exercise; can’t delay paying income tax, which requires employers to withhold taxes at time of purchase
-Employer can deduct the difference between the exercise price and market price at the exercise date