Accounting for Stock (or Share) Based Compensation
- A frequent component of corporate executive compensation is stock or share based.
- Stock based compensation can take the form of: stock grants, stock options, stock appreciation rights (SARs), or phantom stock.
- GAAP and IFRS require that share-based compensation is expensed on the basis of fair value.
- Stock Grants: the employing company gives shares to employees.
Stock Grant Expense = the fair value of the stock on the grant date recognized over period in which the company benefitted from the employee’s service.
-
Stock Options: this form of compensation gives the employee the right to by a specific numbers of shares, at a specific exercise price, within an established period of time.
-
GAAP and IFRS require companies to use the fair value method to account for stock options.
-
The compensation cost is measured on the on the date the options are awarded, based on market prices or by using an options valuation model such as Black-Scholes or the binomial model.
-
The compensation cost is allocated to the service period and this is typically the timeframe between the grant date and the date when the employee can exercise the options (the vesting date).
Management Assumptions and Stock Option Compensation Accounting
-
When a company compensates with stock options, certain valuation assumptions must be employed in order to account for the compensation expense.
-
Assumptions that must be made include: stock price volatility, the expected risk free interest rate, and future dividend payments.
-
Even small changes to the values of these assumptions can have significant impact on the value of the options (and consider that a company may issue hundreds of thousands to executives).
-
Both stock option and defined benefit retiree compensation plans bring subjective elements into the financial reporting process. A well-trained financial analyst will understand how to spot, interpret, and adjust for management accounting choices in order to derive the true economic picture.