Stock Based Compensation (SBC)

Stock Based Compensation: Accounting Journal Entries

There are two prevailing forms of stock based compensation:

1. Restricted Stock
2. 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

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

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

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

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 

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.

How to Model Stock Based Compensation

Treatment of SBC Expense on Financial Statements

Prior to 2006, FASB’s view on this issue was that companies can ignore recognizing issuing stock based compensation as an expense on the income statement as long as exercise price is at or above current share price (restricted stock and in the money options had to be recognized but at the money options became common partly because they could stay off the income statement).

This was controversial because it clearly violated the accrual concept of the income statement.  That’s because even if a Google employee received Google options that are exactly at the current share price, these options are still valuable because they have “potential” value (i.e. if Google’s share price rises, the options become valuable). Until 2006 FASB’s view on this was “that value is difficult to quantify, so companies are allowed to keep it off the income statement.”

However, starting in 2006, FASB changed their mind on this and essentially said “actually, you really should need to recognize an expense lust like cash compensation on the income statement. And you should do this by using an options pricing model to value the options.” Since 2006, there is now an incremental operating expense that captures. Current period GAAP net income is lower because of this expense. Learn more about the accounting for stock based compensation here.

Why Does Stock Based Compensation Belongs on the Income Statement?

The accounting treatment of stock based compensation is consistent with accrual accounting guidelines and makes complete sense if your goal is to put together an accrual-based income statement.

In short, imagine two technology companies, identical in every way, except one decided this year to start hiring better engineers. Instead of mid-tier engineers that both companies have attracted to date, one of the two companies decided to start hiring top-tier employees.

The plan for attracting and recruiting the higher caliber talent involved sweetening salaries with stock options to new comp packages. The company hopes that better engineers will improve their products and thus grow the company’s market share and competitive position in the future. You’re giving employees better wages now – even if it isn’t in cash and your accrual based net income should be lower as a result.

And yet still, analysts often exclude it when calculating earnings per share (EPS). Another trend has been to exclude it from EBITDA. The reason is often simply that analysts are lazily trying to make accrual profit measures a hybrid between pure accrual and cash flows.

Complexities in Valuation: SBC Expense

A more interesting issue is whether stock based compensation should be ignored when valuing companies. Analysts care about EPS because it gives a rough gauge of value.

Specifically, many analysts use price to earnings (PE ratios) to compare companies. The idea being two comparable companies should trade at similar PE ratios. If one of those companies is trading at a higher relative PE ratio it could either be because:

1. The high-PE company is legitimately more valuable (i.e. It’s future growth prospects and returns on capital are higher, its risk profile is lower, etc).
2. The high-PE company is relatively overvalued.

Getting back to our example, let’s assume that the market thought the benefits to future growth due to better engineers is exactly offset by the extra dilution required to achieve it. As a result the share price of the better-hire company didn’t change.

If the stock analyst uses GAAP net income for calculating EPS (i.e. doesn’t exclude SBC), a higher PE multiple will be observed for the better-hire company than the no-SBC company.

This reflects the fact that lower current income to shareholders due to dilution from stock based compensation is offset by future growth.  In other words, current earnings are lower, but they will grow a lot more than the higher earnings of the no-SBC company. On the other hand, excluding the SBC from net income would show identical PE ratios for both companies.

So which is better?

When comparing companies that generally have compensation patterns (similar amounts of SBC relative to cash compensation), excluding SBC is preferable because it will make it easier for analysts to see PE differences across comparable companies that are unrelated to SBC.

This also helps to eliminate the impact of a company’s accounting assumptions for how it calculates SBC on earnings. These are the main reasons analysts in the tech space ignore SBC when valuing companies.

On the other hand, when companies have significant differences in SBC (as is the scenario we posed), using GAAP EPS which includes SBC is preferable because it clarifies that lower current income is being valued more highly (via a high PE) for companies that invest in a better workforce.

Modeling Stock Based Compensation (SBC) in DCF Valuation

In summary, most of the time analysts exclude (add back) SBC when calculating FCFs in a DCF and this is wrong.

Analysts will argue that this is appropriate because it’s a non-cash expense.

The problem is there is obviously a real cost—as we discussed earlier—in the form of dilution which is ignored when this approach is taken. Indeed, ignoring the cost entirely while accounting for all the incremental cash flows presumably from having a better workforce leads to overvaluation in the DCF.