How Companies Account for Employee Stock Compensation

Think about being offered employment where the terms of the offer are that your base salary will be $120,000 and, in addition, there are stock options that might be worth many thousands more in the future.

The salary component is straightforward. The firm pays the money to you and recognizes the expense. But how do the stock options work? Does the company record an expense even though it hasn’t paid you any extra cash?

The answer is yes, and the accounting can get surprisingly complicated.

Companies offering stock-based compensation generally have to recognize its value as an expense under US accounting rules. This applies to startups trying to attract employees without spending too much cash, as well as established businesses offering stock awards as part of executive compensation.

Here’s how the process works and why getting the numbers right matters.

Why Stock Compensation Counts as an Expense

Stock options allow the employee the option of buying shares in the company at a set price, whereas RSUs (restricted stock units) involve the delivery of shares only after the fulfillment of certain criteria.

Although these arrangements work differently, both can represent compensation for an employee’s services.

Think about it from the company’s perspective. If a business pays someone $10,000 in cash for their work, that amount is recorded as a compensation expense. Paying someone partly through company equity doesn’t eliminate the cost of employing them.

This principle is covered by Accounting Standards Codification Topic 718 (ASC 718), which governs stock-based compensation under US Generally Accepted Accounting Principles (GAAP).

According to the Securities and Exchange Commission (SEC), recognizing stock compensation at fair value gives investors more complete and comparable financial information.

How Companies Calculate Stock Compensation Expenses

Stock compensation can be more complex to account for than a cash salary. Under ASC 718 reporting, companies must determine the fair value of stock awards and recognize the associated compensation expense over the period in which employees earn the award.

Take a look at how companies calculate stock compensation expenses.

Step 1: Determine the Fair Value of the Award

Equity-based rewards are valued by corporations at fair value on the grant date when the employer and employee agree on the essential features of the reward.

On the other hand, valuing RSUs is fairly simple. In the case of publicly traded companies, the valuation is typically done on the basis of the price of the stock in the market. It is adjusted, wherever appropriate, according to the award’s terms.

Stock options require more work because their value depends on several assumptions, including:

Current share price and exercise price
Expected stock price volatility
Expected time until exercise
Risk-free interest rate
Expected dividends

Firms often use valuation models, like Black-Scholes, in estimating their option prices. This is important due to the impact that an alteration of any kind will have on the compensation expense recognized.

Step 2: Recognize the Expense Over the Vesting Period

Employees do not necessarily get their full stock awards all at once. Many firms make them wait for a number of years until their awards vest.

This creates an important accounting distinction.

Suppose a startup grants an employee 4,000 stock options with a grant-date fair value of $5 per option. The total compensation value is $20,000.

If those options vest after four years of continued employment, the company would generally recognize $5,000 in compensation expense annually under a straight-line approach.

That works out to approximately $1,250 per quarter.

The employee hasn’t necessarily exercised any options, and the company hasn’t paid out that amount in cash. Nevertheless, the expense appears in its financial statements as the employee provides the required service.

Please note that this is a simplified example and actual expense recognition depends on the award’s vesting terms and applicable accounting policies.

Step 3: Account for Employees Who Leave

What happens when an employee resigns before their stock options vest?

Companies must account for awards that employees forfeit. Under ASC 718, businesses can generally choose to estimate forfeitures in advance or recognize them as they occur.

The choice affects when adjustments appear in financial statements.

Now, think of an individual who quits employment at the midpoint of a four-year vesting plan. If the unvested options are canceled due to forfeiture, then the organization tends to reverse its previously recorded compensation expense.

Where Stock Compensation Appears in Financial Statements

What is the actual destination for the stock compensation expense when computed by the firm? All three important financial statements get to see a piece of the action in their own way.

The Income Statement: Operating Expenses

The starting point for analysis would be the income statement.

Stock-based remuneration does not appear as an independent entry towards the end of the statement. Rather, it appears in conjunction with salaries, depending on the job performed by the individual.

For instance, if an engineer receives stock options, then the expense appears in the research and development section. If a sales executive gets such an option, the expense appears in the selling and administration category.

This reduces reported operating income and net income, reflecting the true cost of human capital.

The Balance Sheet: Equity vs. Liabilities

On the balance sheet, the accounting treatment hinges on how the award is classified:

Equity-classified awards: For standard stock options and RSUs, each dollar of the expense recorded on the income statement is matched by a credit against additional paid-in capital (APIC). This maintains the accounting balance sheet without affecting any cash flows.
Liability-classified awards: If an equity award allows settlement in cash or has redemption provisions, such a transaction is regarded as a liability. An organization has to adjust the fair value of the liability at the end of each period until its settlement. This creates potential volatility on the balance sheet.

The Cash Flow Statement: Non-Cash Adjustments

The cash flow statement clears up a potential point of confusion for investors. Because stock compensation is a non-cash expense, companies using the indirect method add the entire expense back to net income in the operating activities section.

However, even though there was a decrease in net income, there was no cash actually taken out of the bank. However, just because it is a non-cash expense does not mean that equity is free. Issuing new shares dilutes existing shareholders, and recording the expense permanently impacts bottom-line earnings.

What This Means for Employees and Investors

Employees should understand that the expense their employer records isn’t necessarily the amount they’ll eventually receive.

An option valued at $5 on its grant date could ultimately become more valuable, less valuable, or worthless, depending on the company’s performance and the exercise price.

Investors, meanwhile, should pay attention to stock compensation when evaluating profitability. A company can report significant noncash compensation expenses while preserving cash for operations.

Neither number tells the complete story on its own.

The lesson for business is quite straightforward: providing equity rather than money can make a difference in attracting and keeping employees but does not relieve any financial reporting burden. Understanding that cost from the beginning makes compensation decisions easier to evaluate and financial statements more reliable.

This post may contain affiliate links.

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Kevin is an attorney and the blogger behind Financial Panther, a blog about personal finance, travel hacking, and side hustling using the gig economy. He paid off $87,000 worth of student loans in just 2.5 years by choosing not to live like a big shot lawyer.

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