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Stock Based Compensation

Last Updated June 15, 2023

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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:

  1. SBC issued to direct labor is allocated to cost of goods sold.
  2. SBC to R&D engineers is included within R&D expenses.
  3. 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

Debits Credits
Contra-equity – Unearned (deferred) Compensation 1 $9.0 million

Common Stock & APIC – Common Stock2

$9.0 million

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

Debits Credits
Retained earnings – SBC expense $3.0 million

Contra-equity – Unearned (deferred) Compensation

$3.0 million

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:

  1. 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.
  2. The value recognized for each restricted share is the same as its current share price (for non-dividend paying stock).
  3. 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

Debits Credits
Contra-equity – Unearned (deferred) Compensation 1 $3.0 million

Retained earnings – SBC expense

$3.0 million

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

Debits Credits
Retained Earnings – SBC Expense1 $1.5 million

APIC – Stock Options2

$1.5 million

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 

Debits Credits
Asset (Cash) – Option Proceeds1 $9.0 million
APIC – Stock Options2 $4.5 million

Common Stock & APIC – Common Stock

$13.5 million

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.

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Fidel
November 29, 2023 11:31 am

Hi Brad, I’m hoping you can help me. I’m hoping to calculate share dilution over a 5 year period. Let’s say the company in question is engaging in share repurchasing, stock splits, stock based compensation, common share issues, and convertibles. The shares outstanding for the period will be muddied by… Read more »

Brad Barlow
November 29, 2023 9:08 pm
Reply to  Fidel

Hi, Fidel, Do you mean is there a reported metric that you can look at? I doubt most companies will show it that straightforwardly. What you are doing is probably the best estimate you can come up with, because you typically limit yourself to what can be foreseen and is… Read more »

Samiksha
May 24, 2023 4:36 am

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?

Brad Barlow
May 26, 2023 11:29 pm
Reply to  Samiksha

Hi, Samiksha,

Yes, we would if the reissuance of shares for options happened out of the treasury stock account.

BB

Samiksha
May 27, 2023 12:38 am
Reply to  Brad Barlow

Thanks this brings clarity!

Martin Christson
December 21, 2022 1:06 pm

If SBC is provided to management based on services they perform for foreign affiliates, can the foreign affiliates get a share of the costs?

Brad Barlow
December 27, 2022 9:53 pm

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 »

Nathan
September 1, 2022 11:42 am

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?

Brad Barlow
September 1, 2022 7:43 pm
Reply to  Nathan

Hi, Nathan,

Forfeited options or restricted stock will trigger a reversal of the original addition of stock based comp to APIC.

BB

Tito
August 24, 2022 1:25 pm

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.

Brad Barlow
August 24, 2022 11:17 pm
Reply to  Tito

Hi, Tito,

The options were originally valued at $5 per option and expensed accordingly for a total of $4.5mm, which needs to be reversed.

BB

Yibo
January 12, 2022 12:22 am

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?

Jeff Schmidt
January 12, 2022 10:01 am
Reply to  Yibo

Yibo:

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.

Best,
Jeff

Raje
July 30, 2022 4:37 am
Reply to  Yibo

It will fortift the option

Brad Barlow
August 1, 2022 10:07 pm
Reply to  Raje

Hi, Raje,

That is correct. If the options expire out of the money, they will be forfeited and the expense will be reversed.

BB

Samantha
August 12, 2021 10:29 pm

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 »

Last edited 2 years ago by Samantha
Jeff Schmidt
August 13, 2021 9:44 am
Reply to  Samantha

Samantha:

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

Best,
Jeff

Samantha
August 13, 2021 9:56 am
Reply to  Jeff Schmidt

Thanks, Jeff! I knew it was a bit on the fringe of the article, but this is excellent 😉 Thanks for the direction!

Raj
July 3, 2021 9:43 pm

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

Jeff Schmidt
July 4, 2021 11:39 am
Reply to  Raj

Raj:

Yes, which we illustrate in our last journal entry example.

Best,
Jeff

CFS
March 10, 2021 3:34 pm

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 »

Jeff Schmidt
March 10, 2021 4:54 pm
Reply to  CFS

Cheryl:

The offset is in APIC/Equity.

Best,
Jeff

CFS
March 10, 2021 5:04 pm
Reply to  Jeff Schmidt

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 »

Jeff Schmidt
March 10, 2021 5:06 pm
Reply to  CFS

Cheryl:

Yes, that is correct.

Best,
Jeff

Jeff Schmidt
February 26, 2021 3:46 pm

Sean: Do you have a specific, easy-to-read resource on this? There is no actual gross-up to equity in this journal entry as they both offset within equity. Are you saying that expense associated with restricted share issuances are recognized when earned and there should be no initial impact to the… Read more »

Ignacio Moreno
June 26, 2020 4:42 pm

Hi,

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?

Thanks!

Jeff Schmidt
June 26, 2020 6:20 pm
Reply to  Ignacio Moreno

Ignacio:

There is no actual impact on Shareholders’ Equity (in other words, everything held constant and equal, there would be no change in Equity.

Best,
Jeff

Mike Smith
January 4, 2021 1:02 am
Reply to  Jeff Schmidt

anybody knows the accounting entry for a liability award?

Jeff Schmidt
January 4, 2021 11:03 am
Reply to  Mike Smith

Mike:

Wouldn’t it be debit expense, credit liability?

Best,
Jeff

BARBARA GREEN
June 3, 2020 11:20 am

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 »

Jeff Schmidt
June 3, 2020 11:34 am
Reply to  BARBARA GREEN

Barbara:

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.

Best,
Jeff

BARBARA GREEN
June 3, 2020 12:27 pm
Reply to  Jeff Schmidt

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.

Jeff Schmidt
June 3, 2020 1:36 pm
Reply to  BARBARA GREEN

Barbara:

When it’s sold versus the Founder just receiving the share(s)?

Best,
Jeff

BARBARA GREEN
June 3, 2020 4:27 pm
Reply to  Jeff Schmidt

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 »

Jeff Schmidt
June 3, 2020 4:51 pm
Reply to  BARBARA GREEN

Barbara:

Interesting. That is definitely beyond my accounting knowledge!

Best,
Jeff

BARBARA GREEN
June 3, 2020 8:38 pm
Reply to  Jeff Schmidt

Thank you. I feel much better now.

Jack Sez
August 11, 2020 6:44 pm
Reply to  BARBARA GREEN

Barbara,
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?

Ramon Abreu
May 25, 2020 12:15 pm

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

Jeff Schmidt
May 25, 2020 1:26 pm
Reply to  Ramon Abreu

Ramon:

Yes, technically the par value and the APIC would be separated in the journal entries. We were simplifying the entries for student clarity.

Best,
Jeff

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