Companies pay its employees using cash and stocks. All cash payments made to employees are shown as expenses in the income statement. In this post, I will try to unravel the accounting for stock compensation. I will explain them by using a fictitious company called TestCo. Given below is the journal entry for this transaction. The first entry is called as common stock. What does this mean?
Before the advent of computers, stocks were issued in physical certificates. On each certificate the face value also known as par value of the stock will be displayed. Thanks to status quo , even today the concept of par value is used. At this point the total number of stocks issued by the company is 10, and the total number of stocks outstanding with the public is 10, The journal entry for this transaction is given below.
A depreciation account decreases the value of fixed assets. Similarly treasury stock account reduces the value of total equity. Treasury stock does not have voting rights nor receive any dividends. They remain dormant until the company retires or reissues them. After the buyback the total number of stocks issued by the company is still 10, and the total number of stocks outstanding with the public is 9, For the balance sheet to balance the company makes two entries on the liabilities side.
If this was allowed, under the influence of incentive caused bias , every company will engage in trading its own stock in the market instead of running its business. Spend some time to make sure you really understand this. Spend some time to go through the annotations I made in the balance sheet.
A company can pay its employees using restricted stock. Let us understand this with an example. Also the total number of shares issued and outstanding goes up by A company can pay its employees using stock options. For a long time, I was assuming that options are stocks.
But they are not. Options become stocks at some point in future when the market price of the stock is higher than the exercise or strike price. The options vest after two years and expire after 10 years. The date on which the options are granted to an employee is called as grant date. In this case it is Feb On the grant date the exercise price of the option is set to the market price.
How long should he wait for this conversion to happen. He needs to wait until the vesting period is over. In this case it is two years.
The CFO can convert these options into stocks between Feb and Jan after which the options expire. In , SEC came out with a rule, rightly so, for expensing the stock options in the income statement. This means that companies needs a way to value the options. Options have value only when the strike price is greater than the market price after the vesting period. There is a likelihood of this not happening in the future.
This uncertainty leads to lower price for options. TestCo will expense this as compensation expense over the vesting period of two years using straight line method. The journal entries for these transactions are given below. TestCo sells those shares. For the balance sheet to balance the difference between the exercise price and buyback price is added to APIC.
Note that in stock options the capital stock account never went up. The company never issued new shares. All it did was to reissue the stocks from its treasury account. After this transaction the total shares issued remains the same and shares outstanding goes up by Any changes that happen to shareholders equity is captured in statement of shareholders equity.
Until companies were issuing stock options to its employees and never recognized it as an expense. Why would they do that? The rule did not require them to. In , FASB wanted to change this rule and treat stock based compensation as an expense. Buffett stood on the side of FASB but things did not change. In , after a decade, law was passed to treat stock option as an expense. Whatever the merits of options may be, their accounting treatment is outrageous.
Suppose that instead of paying cash for our ads, we paid the media in ten-year, at-the-market Berkshire options. Would anyone then care to argue that Berkshire had not borne a cost for advertising, or should not be charged this cost on its books?
Its opponents even enlisted Congress in the fight, pushing the case that inflated figures were in the national interest. The law fixed one problem. You show profits by not counting depreciation and stock based compensation as an expense.
To me this is nonsense. A few years ago we asked three questions to which we have not yet received an answer: Do fish really take these lures?
I learned these concepts by reading the book shown below. Also I took the Financial Accounting course from coursera. I would highly recommend this course for anyone who wants to know how the financial statements are put together. I believe options were granted. I assume its a narrative error. For 1 that was a terrible mistake from my part. I fixed it and let me know if you still find issues.
Thanks a lot for pointing this out. Since this happens in the future and there is a likelihood of this not happening. Does stock based compensation and employee benefit stock plan line item in equity statement always refer to restricted stocks?
So to start with you increase Common stock and APIC and also the contra liability account so the net effect is zero. Over the vesting period you reduce the contra liability account and replace it with compensation expense. Thanks for your explanation. I understand that the compensation expense is charged to the income statement over the vesting period and the deferred compensation expense is reduced to zero. Please check if my entries below are correct.
So, deferred compensation expense asset gets amoritzed over vesting period and APIC and Common stock stays on the balance sheet. Your entries for Mar is correct. For the next two years, common stock and APIC will not get touched at all. Instead deferred compensation expense goes down to zero and compensation expense takes its place which in turn reduces retained earnings.
Thanks Jana for the post. Do you think a credit investor should also be worried about stock expense accounting. Cash flows do not change materially, so why bother? I mean only an equity investor who cares for the EPS number and potential equity dilution should be concerned. As we are having discussion on stock compensation, i thought it would be timely to provide the following example of stock compensation abuse by technology corporations.
Based on the following information from footnotes, You will find this trend in most of the technology companies. But would be happy to hear. Divide revenue, operating income, cash flows by total shares outstanding. So if the share count is going up then you will be able to adjust for it.
Also take a look at http: You will like what Michael Shearn is telling. Thanks for your article! What is your view on that stock based compensation are added to the operating cash flow of companies and thereby having a positive effect on free cash flow?
Jana — another great post thanks for sharing.More...