What is Stock Based Compensation?
Under US GAAP, stock based compensation (SBC) is recognized as a non-cash expense on the income statement. Specifically, SBC expense is an operating expense (just like wages) and is allocated to the relevant operating line items:
- SBC issued to direct labor is allocated to cost of goods sold.
- SBC to R&D engineers is included within R&D expenses.
- SBC for management and those involved in selling and marketing is included in SG&A and other operating expenses.
The consolidated income statement will often not explicitly identify SBC on the income statement, but it’s there, inside the expense categories. In fact, footnotes in financial filings will often detail the allocation by expense category.
Stock Based Compensation Accounting Journal Entries
There are two prevailing forms of stock based compensation: Restricted stock and stock options. GAAP accounting is slightly different for both. We’ll start with an example with restricted stock and then proceed to stock options.
Restricted Stock Example
- On January 1, 2018, Jones Motors issued 900,000 new shares of restricted stock to employees
- Jones Motors current share price is $10 per share
- Employees cannot sell their shares for a “service period” of 3 years
- Vesting occurs only if employees stay with the company for 2 years; otherwise the shares are forfeited
The restricted stock accounting journal entries are as follows:
January 1, 2018 – The grant date
|Contra-equity – Unearned (deferred) Compensation 1||$9.0 million|
Common Stock & APIC – Common Stock2
1The unearned compensation account is simply a contra-equity account to make the balance sheet balance. It will be reduced as the employees earn their awards.
2Calculated as [900,000 shares * $10 per share].
First, notice that nothing really happened. An equity account was created and was exactly offset by a contra-equity account. Also notice that there is no income statement impact and no stock based compensation expense has been recognized yet. It will only be recognized once it’s earned (i.e. vested). Also notice that the value of each share of restricted stock recognized by Jones Motors on its balance sheet is equal to its current share price. That’s not the case with stock options as we’ll see shortly.
January 1, 2019 – After one year
|Retained earnings – SBC expense||$3.0 million|
Contra-equity – Unearned (deferred) Compensation
The same thing will happen on January 1, 2020 and again one final time on January 1, 2021.
So that’s the basic accounting for restricted stock under GAAP. The key takeaways are:
- Common stock and APIC is impacted immediately by the entire value at grant date but is offset by a contra-equity account, so there is no net impact.
- The value recognized for each restricted share is the same as its current share price (for non-dividend paying stock).
- Restricted stock is recognized on the income statement over the service period
Once the restricted stock is vested, the employees that own them can trade them and do whatever they want with them. However, if an employee leaves prior to vesting, the stock based compensation expense is reversed via the income statement. In our example, had the employees left after 1 year, the restricted stock would be forfeited and the following journal entries would need to be made:
January 1, 2019 – Employees forfeit their restricted stock
|Contra-equity – Unearned (deferred) Compensation 1||$3.0 million|
Retained earnings – SBC expense
We now turn to the accounting and journal entries for stock options, which are a bit more complicated.
Stock options example
- On January 1, 2018, Jones Motors issued 900,000 stock options to employees
- The exercise price of the options is $10 per share.
- Jones Motors current share price is $10 per share.
- The fair value of each stock option is determined by Jones Motors to be $5 using the Black-Scholes option pricing model.
- The stock options will vest over 3 years: 33% on January 1 of each over the next 3 years.
The stock options accounting journal entries are as follows:
January 1, 2018 – The grant date
Nothing happens at the grant date. Unlike restricted stock, there are no offsetting journal entries to equity at the grant date. The stock options do not impact the common stock and APIC balance at the grant date.
January 1, 2019 – After a year of vesting
|Retained Earnings – SBC Expense1||$1.5 million|
APIC – Stock Options2
1Calculated as 300,000 shares * $5 per share. This is an expense recognized on the income statement. It reduces retained earnings.
2To balance the balance sheet, APIC for stock options increases
The same thing will happen on January 1, 2020 and again one final time on January 1, 2021. Now unlike restricted stock, once stock options vest, they still need to be exercised in order to become shares. So assume the following:
- On January 2, 2021, the day after all the stock options vest, all option holders exercise their options
- Jones Motors share price on the exercise date (January 2, 2021) is $20 per share.
January 2, 2021 – Upon the exercise of options
|Asset (Cash) – Option Proceeds1||$9.0 million|
|APIC – Stock Options2||$4.5 million|
Common Stock & APIC – Common Stock
1Calculated as 900,000 shares * $10 per share.
2Calculated as 900,000 shares * $5 per share. As options are exercised and become common stock, the APIC – Stock Options account is reversed and transferred into this Common Stock & APIC – Common Stock account below.
Notice that the net increase to equity on the balance sheet at the exercise date is simply the amount of option proceeds. When building financial statement models, the fact that there is actually a transfer from the APIC – Stock Options account to the Common Stock & APIC – Common Stock account is ignored and only the net effect is modeled. Notice also that the market price of Jones Motors stock price is irrelevant in the journal entries.
Stock Based Compensation Conclusion
So far, we have described the GAAP accounting treatment of stock based compensation. In practice, many analysts actually ignore the stock based compensation expense entirely when calculating EPS or when calculating EBITDA or when valuing companies . We discuss the wisdom of these approaches separately in those individual articles.
Thanks for the article! In the last entry, I was wondering do we also credit the treasury stock account if it has debit balance to show net dilution?
Yes, we would if the reissuance of shares for options happened out of the treasury stock account.
Thanks this brings clarity!
If SBC is provided to management based on services they perform for foreign affiliates, can the foreign affiliates get a share of the costs?
Hi, Martin, Presumably, the accounting at the level of the foreign affiliates would have to recognize that expense, and the affiliate income of the company providing the services would then be altered accordingly. But if the companies were not consolidated, then presumably there would be ‘services’ revenue line item for… Read more »
Hi. In the case of when all employees forfeit their options before vesting, what happens to the Equity reserve that has been built up over time? Do we have to reverse this APIC balance? Or will it forever remain on the balance sheet?
Forfeited options or restricted stock will trigger a reversal of the original addition of stock based comp to APIC.
Upon the exercise of the option, why is the debit to the APIC – Stock Options account $4.5 million (or 900,000 * $5 per share)? Namely, where does the $5 per share come from? Thank you.
The options were originally valued at $5 per option and expensed accordingly for a total of $4.5mm, which needs to be reversed.
May I know what is the accounting treatment if the market price at actual date is lower than the exercised price and employees didn’t exercise the option？
This is a bit beyond our scope but the accounting would still be the same as the options probably won’t have expired yet. If they expire without being exercised then the previously taken expense will be reversed.
It will fortift the option
That is correct. If the options expire out of the money, they will be forfeited and the expense will be reversed.
Question here. What if restricted stock isn’t provided to an employee, but rather an early customer in a startup? Let’s say we have a contract with a customer that lasts 2 years and we are also granting them stock in the company. During their 2 year contract, the shares are… Read more »
Unfortunately, that is well beyond the scope of our article. However, this link might help with regards to restricted stock to non-employees: http://sos-team.com/pdfs/Accounting_Nonemployee_RSUs.pdf
Thanks, Jeff! I knew it was a bit on the fringe of the article, but this is excellent 😉 Thanks for the direction!
At the end of the vesting period, when employees have exercised their rights and shares have been issued i.e. converted to ordinary shares, will there be a journal entry to transfer from Share based premium reserve to Issue capital
Yes, which we illustrate in our last journal entry example.
Hi – can you walk me through what happens to the 3 financial statements? For example if I have stock based compensation of $10 –> P&L – stock based compensation is an expense, net income drops with $10 * (1-t), say t=40%, net income drops with ($6) Cash flow statement:… Read more »
The offset is in APIC/Equity.
Hi Jeff Thanks for the reply. Would it then be Assets: Cash +$4 Liabilities: Retained earnings ($6), APIC + $10 –> So total equity is +$4. Just a bit confused in your article there is no mentioning of retained earnings being in play at all when calculating the equity on… Read more »
Yes, that is correct.
On restricted stock. I understand the journal entries. But, i can’t understand how to show it in the Statement of Stockholders’ Equity 2018 and 2019. Could you help me?
There is no actual impact on Shareholders’ Equity (in other words, everything held constant and equal, there would be no change in Equity.
anybody knows the accounting entry for a liability award?
Wouldn’t it be debit expense, credit liability?
On Retricted Stock: Upon vesting your are recording the compensation on the Balance Sheet to Retained Earnings instead of Stock Based Compensation which would be on the P&L Statement. I don’t understand why you are charging Retained Earnings instead of Stock Based Comp on the P&L. Are you assuming the… Read more »
Yes, it’s a little confusing at first glance but when we debit retained earnings we are also saying it runs through SBC on the income statement: Retained earnings – SBC expense $3.0 million.
Thank you. I’m still trying to figure out the entries when the stock is sold to the employees via a Founder’s Restricted Stock Purchase Agreement.
When it’s sold versus the Founder just receiving the share(s)?
Jeff, In this situation, Upon incorporation, the Restricted shares were sold to the employees at the same time as they were issued. Usually the shares are given to the employees and not sold to them. Using the entries in the article, the restricted stock is recorded as Dr. Unearned Deferred… Read more »
Interesting. That is definitely beyond my accounting knowledge!
Thank you. I feel much better now.
I’d love to hear what you found and how you desided to record the Purchased Restricted Shares Agreement.
Is it just the: Dr. to Cash and Cr. to Stock?
And if the employee terminates early the company purchases back the unvested shares at the purchase price?
Quick questiob regarding the section “Upon exercise of the stock option”. Is this example assuming a no par stock? If there is par value would we still need the fair value to record the entry or symply can we use the par value and the excess? Thanks in advance
Yes, technically the par value and the APIC would be separated in the journal entries. We were simplifying the entries for student clarity.