Why is stock based compensation an expense?
Under US GAAP, stock based compensation (SBC) is recognized as a non-cash expense on the income statement. Specifically, SBC expense is an operating expense (just like wages) and is allocated to the relevant operating line items: SBC issued to direct labor is allocated to cost of goods sold.
What is stock based compensation?
Stock Based Compensation (also called Share-Based Compensation or Equity Compensation) is a way of paying employees, executives, and directors of a company with equity in the business.
How is stock based compensation expense calculated?
Total stock compensation expense is calculated by taking the number of stock options granted and multiplying by the fair market value on the grant date.
What is stock based compensation expense cash flow?
In accounting terms, stock based compensation expense represents a non-cash expense. And in the cash flow statement, accounting adds the expense to operating cash flow. Taking a similar route as depreciation and adding it back improves the operating cash flow because the cash expense is not “actually” paid out.
Is stock based compensation deductible?
Stock-based compensation also has tax implications for employers. Under financial accounting rules, employers generally deduct the fair market value of stock-based compensation when it is granted to calculate book income (what is reported on a firm's financial reports to shareholders).
Do you pay taxes on stock based compensation?
Upon a sale of the stock, the recipient receives capital gain or loss treatment. Any dividends paid while the stock is unvested are taxed as compensation income subject to withholding. Dividends paid with respect to vested stock are taxed as dividends, and no tax withholding is required.
What kind of account is APIC?
Additional paid-in capital (APIC) is an accounting term referring to money an investor pays above and beyond the par value price of a stock.
Is compensation expense a liability?
In simpler terms, when a company's stock-based compensation is ultimately settled in stock, rather than cash, the award is classified as equity. Example 1: Company A awards an employee $50,000 worth of stock as compensation. Because the nature of the award is a cash obligation, this award is classified as a liability.
Why is stock based compensation added to net income?
The reason that non-cash expenses like Depreciation and Amortization and Stock Based Compensation are added to Net Income to create Cash Flow from Operations is because these expenses don't represent literal cash coming from a business.
How does stock based comp affect balance sheet?
It is shown as a part of the owner's equity in the liability side of the company's balance sheet. read more increases resulting in a lower EPS. As we see from below, Facebook Employee stock options increase the total number of outstanding shares, thereby reducing the Earnings Per Share.
Why is stock based compensation added back in cash flow?
The approach which starts from cash flows, if you look at your cash flow statement, you always add back these things like stock-based compensation because it's a non-cash expense. And so, it systematically makes this free cash flow higher.
Types of Equity Compensation
Compensation that’s based on the equity of a business can take several forms.
How it Works
Companies compensate their employees by issuing them stock options Stock Option A stock option is a contract between two parties which gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a specified time period.
Stock-Based Compensation Example
The easiest way to understand how it works is with an example. Let’s look at Amazon’s 2017 annual report and examine how much they paid out in equity to employees, directors, and executives, as well as how they accounted for it on their financial statements.
Implications in Financial Modeling & Analysis
When building a discounted cash flow (DCF) model DCF Model Training Free Guide A DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow to value a business, it’s important to factor in share compensation.
Additional Resources
Thank you for reading CFI’s guide to Stock Based Compensation. To continue learning and advancing your career, these CFI resources will be helpful:
Stock based compensation journal entries
There are two prevailing forms of stock based compensation: Restricted stock and stock options. GAAP accounting is slightly different for both. We’ll start with an example with restricted stock and then proceed to stock options.
Restricted stock example
On January 1, 2018, Jones Motors issued 900,000 new shares of restricted stock to employees
Stock options example
On January 1, 2018, Jones Motors issued 900,000 stock options to employees
What is Stock Based Compensation Expense?
First, we have to know that SBC is not something we can just ignore just because it is a “non-cash expense”.
Why You Should NOT Add Stock Based Compensation back to FCF
Returning back to the financials, the reason that stock based compensation can often be forgotten is because it can often get lost with the other moving pieces of the cash flow statement.
Issued, Vested, and Unvested Stock
One additional key detail about stock based compensation expense is that not all of the SBC expense in the cash flow statement represents the total potential dilution to shareholders.
What Is Stock Compensation?
Stock compensation is a way corporations use stock options to reward employees. Employees with stock options need to know whether their stock is vested and will retain its full value even if they are no longer employed with that company.
How Stock Compensation Works
Stock compensation is often used by startup companies since they typically do not have the cash on hand to pay employees competitive rates. Executives and staff may share in the company’s growth and profits that way.
Example of Stock Compensation
For example, assume that an employee is given the right to purchase 2,000 shares of stock at $20 per share. The options vest 30% per year over three years and have a term of five years. The employee pays $20 per share when buying the stock, regardless of the stock price, over the five-year period.
Types of Stock Compensation
There are different types of stock compensation, such as non-qualified stock options (NSOs) and incentive stock options (ISOs). ISOs are only available to employees and not non-employee directors or consultants. These options provide special tax advantages.
Exercising Stock Options
Stock options may be exercised by paying cash, exchanging shares already owned, working with a stockbroker on a same-day sale, or executing a sell-to-cover transaction. However, a company typically allows only one or two of those methods.
What is the Accounting for Stock-Based Compensation?
A company may compensate its employees with shares in the business. The intent is to align their interests with those of the business in enhancing the share price. When these payments are made, the essential accounting is to recognize the cost of the related services as they are received by the company, at their fair value.
Essential Concepts
A key concept is the grant date. This is the date on which a stock-based award is granted, and is assumed to be the date when the award is approved under the corporate governance requirements.
Costs to be Recognized
Expense accrual. When the service component related to a stock issuance spans several reporting periods, accrue the related service expense based on the probable outcome of the performance condition, with an offsetting credit to equity. A performance condition is a condition that affects the determination of the fair value of an award.
Valuation Concepts
Fair value determination. Stock-based compensation is measured at the fair value of the instruments issued as of the grant date, even though the stock may not be issued until a much later date. The fair value of a stock option is estimated with a valuation method, such as an option-pricing model.
SBC Expense
Q: I was just told that it is common in the software industry to exclude stock-based compensation (SBC) expense from earnings per share (EPS), effectively treating it as a non-recurring item. I understand that stock based compensation is a non cash expense but so is depreciation and we don’t remove depreciation from EPS. So what’s the rationale?
Stock based compensation expense belongs on the income statement
Prior to 2006, FASB’s view on this issue was that companies can ignore recognizing issuing stock based compensation as an expense on the income statement as long as exercise price is at or above current share price (restricted stock and in the money options had to be recognized but at the money options became common partly because they could stay off the income statement)..
Stock based compensation expense is more complicated in valuation
A more interesting issue is whether stock based compensation should be ignored when valuing companies. Analysts care about EPS because it gives a rough gauge of value. Specifically, many analysts use price to earnings (PE ratios) to compare companies. The idea being two comparable companies should trade at similar PE ratios.
SBC in DCF Valuation
In a separate post, I wrote extensively on the issue of SBC in DCF valuation, but will summarize here: Most of the time analysts exclude (add back) SBC when calculating FCFs in a DCF and this is wrong. Analysts will argue that this is appropriate because it’s a non-cash expense.
Stock Based Compensation Example – Restrict Share Option
Company ABC provides stock options to CEO to compensate for his hard work. He receives 10,000 stock options which will be vested after 3 years. Company share is trading at $ 8 per share and par value of $1.
Stock Based Compensation Journal Entries – Share Option
Stock option is a type of stock compensation when the company gives the right to the employee to purchase common stock at a specific price in the future. Similar to restrict share, it requires the vested period from the grant date and exercise date. The employee has the right, not the obligation, to exercise the right.
Stock Option Example
Company XYZ provides 1,000 stock options to the CFO, it allows him to purchase the stock at $10 per share in the next two years. The fair value of the option is $ 8 per share based on company calculation.
Benefit of Stock Based Compensation
Does not require cash: As we know cash is very important for the business to expand the operation. While using the stock for compensation, the company will be able to use cash for other purposes such as investments and R&D which will help to grow the business.
Disadvantage of Stock Based compensation
Dilute share equity: By allowing the employee to purchase new share, it will decrease the ownership of existing shareholders.
Impact of Stock-Based Compensation on Income Statement
- Share-based compensation affects the Income Statement in two ways. You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked For eg: Source: Stock Based Compensation(wallstreet…
Impact on The Balance Sheet
- There are several ways a company can compensate its stock option holders. Here, we will consider the following two ways for explanation purpose: First-The Company can pay the difference between the predetermined price and the price on the date of exercise. Second- The Company has an option to issue additional shares in lieu of the stock options outstanding for th…
Impact on The Cash Flow Statement
- Again consider the two ways of compensating the stock option holders as discussed above. If the company goes for the first option (paying the difference in cash), then it will have to record a cash outflow from Financing ActivitiesFinancing ActivitiesThe various transactions that involve the movement of funds between the company and its investors, owners, or creditors in order to achi…
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Types of Equity Compensation
How It Works
- Companies compensate their employees by issuing them stock optionsor restricted shares. The shares typically vest over a few years, meaning, they are not earned by the employee until a specified period of time has passed. If the employee quits the company before the shares have vested, they forfeit those shares. As long as the employee stays long enough with the company, …
Stock-Based Compensation Example
- The easiest way to understand how it works is with an example. Let’s look at Amazon’s 2017 annual reportand examine how much they paid out in equity to employees, directors, and executives, as well as how they accounted for it on their financial statements. As you can see in the cash flow statement below, net income must be adjusted by adding back all non-cash items…
Advantages of Stock Based Compensation
- There are many advantages to this type of remuneration, including: 1. Creates an incentive for employees to stay with the company (they have to wait for shares to vest) 2. Aligns the interests of employees and shareholders – both want to see the company prosper and the share price rise 3. Doesn’t require cash
Disadvantages of Share Based Compensation
- Challenges and issues with equity remuneration include: 1. Dilutes the ownership of existing shareholders (by increasing the number of shares outstanding) 2. May not be useful for recruiting or retaining employees if the share price is decreasing
Implications in Financial Modeling & Analysis
- When building a discounted cash flow (DCF) modelto value a business, it’s important to factor in share compensation. As you saw in the example from Amazon above, the expense is added back to arrive at cash flow, since it’s a non-cash expense. While the expense does not require any cash, it does have a capital structure impact on the business, since the number of shares outstanding …
Additional Resources
- Thank you for reading CFI’s guide to Stock Based Compensation. To continue learning and advancing your career, these CFI resources will be helpful: 1. Financial Modeling Guide 2. Investment Banking Salary Guide 3. Financial Analyst Salary Guide 4. Investment Banking Job Description