Stock option compensation is a form of equity based compensation in which a business rewards key personnel by granting them the rights to purchase shares in the business in return for their services.
A stock option, sometimes referred to as a share option, is a contract between a buyer and a seller which gives the buyer the right to buy a stock at a specified price (referred to as the exercise or strike price) on or before a specific date, and the seller the obligation to complete the transaction by selling the stock.
The stock option lasts from a period of time (the life of the option) and will expire after that date and have no value.
A stock option only exists because the underlying stock exists. A stock option therefore derives from the underlying stock and is a form of derivative.
Types of Stock Option
There are two types of stock option.
- Put option – Option to sell at an agreed price on or before a specific date.
- Call option – Option to buy at an agreed price on or before a specific date .
An employee stock option is a type of call option granted by a business to an employee giving them the right to buy stock in the business at an agreed price on or before a specific date. The right to buy price is usually lower than the market price and is treated as part of the compensation of the employee.
When dealing with stock option compensation accounting there are three important dates to consider.
- Grant date: The date on which the stock options are granted.
- Vesting date: The date on which the rights to exercise the option are obtained. The time between the grant date and the vesting date is known as the vesting period.
- Exercise date: The date on which the stock options are exercised and shares are purchased.
Stock Option Compensation Accounting Treatment
The granting of stock options is a form of compensation given to key personnel (employees, advisers, other team members etc.) for providing their services. Like any other form of compensation, such as the cash payment of wages and salaries or fees to advisers, it is a cost to the business. In the case of stock option compensation the amount is ‘paid’ in the form of stock options instead of cash.
Amount
Like any cost, the cost of compensating the key personnel for their services if the fair value of the service they provide.
If for example an employee is paid a salary then the amount paid is regarded as a reflection of the fair value of the service provided. Likewise for stock option based compensation the fair value of the options granted can be used as an indication of the fair value of the service provided and therefore the cost to the business.
Stock Option Vesting Period
The vesting period is important in stock option compensation accounting as it sets the time period over which the cost of compensating the option holder is treated as an expense in the income statement.
The purposes of granting stock options is to enable a business, particularly a startup business, to recruit, reward, and retain key personnel.
To ensure a employee does not immediately exercise their newly granted options and leave the business before the task they were employed for is complete, it is normal to have a vesting period. Consequently the vesting period is the period of time between the grant date and the vesting date at which the option holder receives the rights to exercise the option and purchase shares in the business. The diagram above illustrates the vesting period. As an illustration an employee might be granted 20,000 options but only receives the right to exercise then over a 4 year period at the rate of 5,000 options each year.
In addition a business will often have a requirement that if an employee leaves within a certain time period, for example one year, then they forfeit the right to excise any options and therefore leave without any shares in the business. The date before which the employee loses all rights to exercise the options is referred to as a cliff.
Stock Option Compensation Example
As an illustration suppose at the start of the year a business grants five key personnel 300 stock options each. Additionally the fair value (FV) of each option at the date of grant is 7.00. The options vest at the end of a 3 year period at which point the option holders can exercise their options.
The exercise (strike) price is the same as the share price at the date of grant which is 20.00 and the nominal par value of each share is 1.00.
During the Vesting Period
During the vesting period the business needs to expense the total stock option compensation cost of the employees providing the service. Accordingly the total cost is the fair value of the service which is represented by the fair value of the options granted in return for the service. In this example the cost is 7.00 for each option granted.
Year 1
The calculation of total expected stock option compensation cost over the 3 year vesting period is as follows.
Options expected to vest = Options x EmployeesOptions expected to vest = 300 x 5 = 1,500Stock option compensation cost = Options x Fair value of option at grantStock option compensation cost = 1,500 x 7.00 = 10,500
Since the vesting period is three years and one year of the service period has now been completed the business calculates the stock option compensation expense for the year as follows.
Total stock option compensation = 10,500Vesting period = 3 yearsService period completed = 1 yearCumulative expense at end of year 1 = Total cost x Service period / Vesting periodCumulative expense at end of year 1 = 10,500 x 1/3 = 3,500Previously recognized expense = 0Stock option compensation expense for year 1 = 3,500
The stock option expense for year 1 (3,500) is the difference between the cumulative expense at the end of year 1 (3,500) and the cumulative expense previously recognized (0).
Stock Option Journal Entries – Year 1
The stock option expense journal entry for the year is as follows.
| Account | Debit | Credit |
|---|---|---|
| Stock option compensation expense | 3,500 | |
| APIC – Stock options | 3,500 | |
| Total | 3,500 | 3,500 |
The stock option compensation is an expense of the business and is represented by the debit to the expense account in the income statement. The other side of the entry is to the additional paid in capital account (APIC) which is part of the total equity of the business.
Year 2
In year 2 suppose one employee leaves the business and forfeits their stock option rights.
The calculation of the total expected stock option compensation cost is as follows.
Options expected to vest = 300 x 4 = 1,200Stock option compensation cost = 1,200 x 7.00 = 8,400
Since two years of the service period have now been completed the business calculates the stock option compensation expense for the year as follows.
Expected total stock option compensation = 8,400Vesting period = 3 yearsService period completed = 2 yearsCumulative expense at end of year 2 = 8,400 x 2/3 = 5,600Previously recognized expense = 3,500Stock option compensation expense for year 2 = 2,100
The stock option expense for year 2 (2,100) is the difference between the cumulative expense at the end of year 2 (5,600) and the cumulative expense previously recognized in year 1 (3,500).
Stock Option Journal Entries – Year 2
The stock option expense journal entry for the year is as follows
| Account | Debit | Credit |
|---|---|---|
| Stock option compensation expense | 2,100 | |
| APIC – Stock options | 2,100 | |
| Total | 2,100 | 2,100 |
Year 3
In year 3 suppose another employee leaves the business and forfeits their stock option rights.
The calculation of the total expected stock option compensation cost is as follows.
Options expected to vest = 300 x 3 = 900Stock option compensation cost = 900 x 7.00 = 6,300
Since three years of the service period have now been completed the business calculates the stock option compensation expense for the year as follows.
Expected total stock option compensation = 6,300Vesting period = 3 yearsService period completed = 3 yearsCumulative expense at end of year 3 = 6,300 x 3/3 = 6,300Previously recognized expense = 5,600Stock option compensation expense for year 3 = 700
The stock option expense for year 3 (700) is the difference between the cumulative expense at the end of year 3 (6,300) and the cumulative expense previously recognized in year 2 (5,600).
Stock Option Journal Entries – Year 3
The stock option expense journal entry for the year is as follows
| Account | Debit | Credit |
|---|---|---|
| Stock option compensation expense | 700 | |
| APIC – Stock options | 700 | |
| Total | 700 | 700 |
The table below summarizes the stock option compensation expense for the three year vesting period.
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| Number of options | 1,500 | 1,200 | 900 |
| FV of options at grant | 7.00 | 7.00 | 7.00 |
| Expected total cost | 10,500 | 8,400 | 6,300 |
| Service period | 1/3 | 2/3 | 3/3 |
| Cumulative expense | 3,500 | 5,600 | 6,300 |
| – Previous expense | 0 | 3,500 | 5,600 |
| Compensation expense | 3,500 | 2,100 | 700 |
The total stock option compensation expense is 6,300 (900 x 7.00), and this has been allocated to the income statement over the vesting period in the following amounts, year 1 (3,500), year 2 (2,100) and finally year 3 (700).
Exercise of Stock Option
After the options have vested the employees have the right to exercise their options and purchase shares in the business at the exercise (strike) price of 20.00.
Assuming all the options are exercised the increase in capital is calculated as follows.
Number of options exercised = 900Exercise price / share = 20.00Amount paid for shares = 900 x 20.00 = 18,000
The stock based compensation journal entries are as follows.
| Account | Debit | Credit |
|---|---|---|
| Cash | 18,000 | |
| Common stock | 900 | |
| APIC – Common stock | 17,100 | |
| Total | 18,000 | 18,000 |
The employees exercise their options and purchase the shares at the exercise price of 20.00 a share. The business receives cash of 18,000 and since the par value of the shares is 1.00 allocates 900 to common stock and the balance 17,100 to additional paid in capital (APIC).
Intrinsic Value of Stock Option
If the market value of each share at the exercise date is say 30.00 then the intrinsic value of the shares is calculated as follows.
Number of shares sold = 900Market value / share = 30.00Exercise price / share = 20.00Market value = 900 x 30.00 = 27,000Exercise price = 900 x 20.00 = 18,000Intrinsic value = Market value - Exercise priceIntrinsic value = 27,000 - 18,000 = 9,000
Last modified October 27th, 2022 by Michael Brown
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.
You May Also Like
Posted By: Michael Brown Balance Sheet, Income Statement, Tutorials
October 27, 2022
Capital
As an expert and enthusiast, I have a wide range of knowledge on various topics, including stock option compensation. I can provide information and insights on the concepts used in the article you mentioned.
Stock option compensation is a form of equity-based compensation in which a business rewards key personnel by granting them the rights to purchase shares in the business in return for their services. A stock option is a contract between a buyer and a seller that gives the buyer the right to buy a stock at a specified price (exercise or strike price) on or before a specific date, and the seller the obligation to sell the stock. Stock options are a form of derivative and only exist because the underlying stock exists.
There are two types of stock options:
- Put option: This gives the buyer the right to sell the stock at an agreed price on or before a specific date.
- Call option: This gives the buyer the right to buy the stock at an agreed price on or before a specific date.
Employee stock options are a type of call option granted by a business to an employee, giving them the right to buy stock in the business at an agreed price on or before a specific date. The right to buy price is usually lower than the market price and is treated as part of the employee's compensation.
When dealing with stock option compensation accounting, there are three important dates to consider:
- Grant date: The date on which the stock options are granted.
- Vesting date: The date on which the rights to exercise the option are obtained. The time between the grant date and the vesting date is known as the vesting period.
- Exercise date: The date on which the stock options are exercised and shares are purchased.
The vesting period is important in stock option compensation accounting as it sets the time period over which the cost of compensating the option holder is treated as an expense in the income statement. It is common to have a vesting period to ensure that employees do not immediately exercise their options and leave the business before completing their tasks. During the vesting period, the business needs to expense the total stock option compensation cost of the employees providing the service.
After the options have vested, employees have the right to exercise their options and purchase shares in the business at the exercise price. The increase in capital is recorded through journal entries, with cash received from the exercise of options allocated to common stock and additional paid-in capital (APIC).
The intrinsic value of a stock option is the difference between the market value of the shares at the exercise date and the exercise price. If the market value is higher than the exercise price, the option has intrinsic value.
Please note that the information provided above is based on general knowledge and understanding of stock option compensation. For specific details and accounting treatment, it is always recommended to consult with a qualified accountant or financial professional.
Let me know if there's anything else I can help with!
