6 Principles for Accounting for Stock-Based Compensation

For today’s blog entry, I get back to the basics in stock plan accounting. Here are six fundamental principles that govern how stock compensation is accounted for.

1. Stock Compensation Is an Expense

A fundamental principle of US GAAP is that compensation paid to employees is an expense that reduces the company’s profitability and is reported in the company’s income statement (also sometimes referred to as the “profits and loss” or “P&L” statement). For many companies, compensation is their most significant expense.

Most forms of stock compensation are compensatory in nature; as such, they result in expense that the company recognizes in its P&L. Occasionally stock compensation is not considered compensatory. These are usually plans that are broad-based, are intended to raise capital for the company or distribute stock widely among employees, and offer only a very small purchase discount. Arrangements that are noncompensatory do not result in expense for the company.

2. Awards Paid Out in Stock Are Equity Instruments

US GAAP distinguishes between equity and liability awards. Awards paid out in stock generally receive equity treatment and awards paid in cash generally are accounted for as liabilities.

With equity awards, the expense per share for the award is determined on the grant date and is not subsequently adjusted unless the award is modified (note that the aggregate expense may be adjusted for forfeitures).

In the case of liability awards, however, the company’s expense will ultimately be equal to the amount of cash paid out when the award is settled. This amount is not known prior to the settlement date, so the company will record expense for the award based on estimates until the period in which it is settled. This is sometimes referred to as marked-to-market or marked-to-fair value accounting.

3. Equity Awards Generally Involve a Grant-Date Measurement of Expense

As noted above, the expense per share for awards that receive equity treatment is determined on the date of grant. Thus, it is important to know when the grant date is considered to occur. Four conditions must exist for an award to have a grant date for accounting purposes:

• The company and the award recipient have a mutual understanding of the key terms and conditions of the award.

• The company is contingently obligated to issue equity instruments or transfer assets when the requisite services are rendered.

• The required approvals for the grant have been obtained.

The award recipient begins to benefit from, or be adversely affected by, subsequent changes in the price of the company’s equity shares.

Although there are exceptions, in many cases, the above four conditions exist on the date the award is approved by the relevant authority (board, compensation committee, or delegate). Thus, the date the award is approved is also typically the date the per-share expense for the award is determined.

4. Expense for Equity Vehicles Is the Award’s Fair Value

The expense for stock-based compensation is equal to the fair value of the arrangement. Fair value is defined as the price of a similar instrument that is traded in the securities markets. If no similar instrument is traded in the securities markets, an option pricing model can be used to determine fair value. 

For stock options and stock appreciation rights, the fair value is generally determined using an option-pricing model, such as the Black-Scholes model, since options traded in the public markets are materially different from stock options granted in a compensatory context.

The security underlying restricted stock and unit awards, however, is often the same stock that is traded in the public markets (typically the common stock of the granting corporation) and can be valued using current trading prices. Thus, the fair value of restricted stock and unit awards is generally the market value or fair value of the stock (less any amount paid for it), unless the award includes features that implicate use of a more sophisticated valuation methodology.

5. Expense Is Recognized Over the Period Services Are Performed

Another fundamental principle of US GAAP is sometimes called the “matching” principle. This principle says that expenses should be recognized over the period that they produce revenue for the company. In the context of equity awards, this means that expense for an award is recognized over the period that the employee performs the services necessary to earn the award. Those services contribute—directly or indirectly—to the company’s revenue, thus expense for the award must be “matched” to the services.

6. Expense Is Not Recognized for Awards that Are Forfeited

For grants in which vesting is contingent on continued service or performance conditions, expense is recognized only for arrangements that actually vest. Because expense is recognized only if the vesting conditions are fulfilled, the initial fair value of the grant is determined without regard to these conditions.

Expense is not reversed in any circumstances after an award vests, even for stock options that vest and subsequently expire unexercised. Likewise, expense cannot be reversed when options and awards are cancelled at the request of or with consent of the award holder. Once an option or award is granted, only forfeiture due to failure to meet vesting conditions can prevent recognition of expense for it.

There is an important exception to this general principle: market-conditioned awards. These are awards in which vesting is contingent on a market-related target, such as the company’s stock price, shareholder return, or market capitalization. These targets are incorporated into the award’s fair value. Because of this, expense is recognized for the award even if the market condition is not achieved.

Learn More

To learn more about how stock compensation is accounted for, read the article “ Accounting for Equity Compensation in the United States,” which is available on the NASPP website.

“Accounting for Equity Compensation” is also one of the six modules in our online Stock Plan Fundamentals course, which will begin on April 19 of this year. This program covers the regulatory framework and day-to-day procedures necessary to administer stock plans; it is a great program for anyone who is new to stock compensation.