Stock-based Compensation Expense
Accounting for stock-based compensation expense is similar under the two most commonly used accounting methods; IFRS and U.S. GAAP. On this page, we discuss how stock options, stock grants, stock appreciation rights, and phantom stock can be used to compensate personnel.
In the case of stock options, compensation expense will be based on the fair value of the options on the grant date based on the number of options that are expected to vest. The vesting date is defined as the first date the employee can actually exercise the options that he or she was granted.
The compensation expense is allocated in the company’s income statement over the service period. The service period is defined as the time between the grant data and the vesting date. Recognition of compensation expense will always decrease net income and retained earnings: however, paid-in capital is increased by an identical amount. This results in no change in total equity. At the same time, this will increase the number of shares outstanding and thus dilute shareholders’ equity stake.
The fair value of the option is based on the observable market price of a similar option if one is available. Absent a market-based instrument, companies will typically use an option-pricing model such as the Black-Scholes model or a binomial model. There is no preference for a specific model in either IFRS or U.S. GAAP. Both can be used to value the option.
Compensation expense for stock granted to an employee is based on the fair value of the stock on the grant date. The compensation expense is allocated to the income statement over the employee’s service period.
A stock grant can have many forms. A stock grant can involve an outright transfer of stock without conditions, restricted stock, and performance stock.
- In the case of restricted stock, the transferred stock cannot be sold by the employee until vesting has occurred.
- Performance stock is contingent on meeting performance goals, such as accounting earnings or other financial reporting metrics like return on assets or return on equity. Unfortunately, tying performance to accounting earnings and other metrics has the disadvantage that it may incentivize employees into manipulating the accounting metric used.
Stock appreciation rights
The difference between a stock appreciation right and an option as discussed earlier is the form of payment. A stock appreciation gives the employee the right to receive compensation based on the increase in the price of the firm’s stock over a predetermined amount.
With stock appreciation rights, employees have limited downside risk and unlimited upside potential, thereby limiting the risk aversion among executives to take risk. An advantage of this approach is that, since no shares are actually issued, there will be no dilution to existing shareholders. A disadvantage of stock appreciation rights is that they require current period cash outlays.
The last kind of stock compensation we discuss is phantom stock.It is similar to stock appreciation rights, except the payoff is based on the performance of hypothetical stock instead of the firm’s actual shares. Phantom stock can be used in privately held firms and firms with highly illiquid stock.
We discussed the impact of stock-based compensation expenses for a company’s cash flows and equity outstanding.