Accounting for Employee Stock Options, Examples and Valuation Methods

International Financial Reporting Standard-2 deals with the recognition, measurement, and disclosure of Employee Stock Options. In this article, we will offer examples of accounting for Employee Stock Options. At the end of this article, we will present methods for valuing Employee Stock Options.

What is an Employee Stock Option?

A company often has the policy to make its employees the shareholders; therefore they offer a certain number of shares to eligible employees as an incentive.

To retain and motivate the workforce and sometimes to comply with the regulatory requirement, the company’s management can opt to issue share options to its employees. The Employee Stock Option plan is not meant to apply to all employees, rather to those who meet certain prescribed criteria.

Employees are normally required to meet the performance as well as service criteria to be eligible for the Employee Stock Option plan. Suppose that the management imposes a service condition of five years and an employee, Mr. A, opted for this option, then after five years of service, he would become eligible to exercise his options. The company often fixes a strike price for the option holders to exercise their rights.

Eligibility of employees

It’s up to the company’s management to decide what criteria they should use when issuing Employee Stock Options, but typically it involves the fulfillment of performance obligation and service period.

Example

Company A has offered 500 share options to each of 5 managers, subject to achievement of their sales targets and continuous services of 5 years with the company. Until these conditions are not fulfilled, the company cannot book expenses for those shares in its accounting books. When the options expire, the employees can choose to settle the transaction either in equity or in cash.

Equity-settled options

In this case, the employees reserve the right to convert their share options into equity by paying only the option exercise price. The employees then become the shareholders of the company.

Cash settled options

In this case, the company offers the employees the option of selling the shares or getting cash equivalent to the market value of those shares.

From the accounting perspective, the company has to make accounting adjustments for both the equity-settled and cash-settled transactions.

What are the concepts involved in Employee Stock Options?

There are several concepts that are crucial for employee stock options. Firstly, when a company grants ESO to its employees, it becomes the grantor. On the other hand, the employee becomes the grantee or optionee. There are several periods that play a significant role in how companies account for employee stock options.

Firstly, employee stock options have a grant date. It is the date on which the grantor presents the options to the grantee. After the grant date, there is a vesting date. The vesting date is the date on which the grantee receives the rights to exercise the option. The next date is the exercise date. It is the date on which the grantee can exercise their rights to purchase the share.

Another crucial concept in employee stock options is that of the vesting period. The vesting period is any time between the grant date and the vesting date. This period represents the length of time that grantees must wait to exercise their ESOs. In short, the vesting period is the period after which the employee would be eligible to exercise their right to purchase the common stock of the company. For the grantor, the vesting date is also crucial.

The vesting period sets the time period over which the grantor will treat the compensation cost for the option in the income statement. Since employee stock options come with conditions that grantees must meet over a time period, the grantor will have to spread the cost over those periods.

The vesting period is also critical because if the grantee does not meet the condition or leaves before the exercise date, then they will forfeit the right to exercise the option.

How to account for the Employee Stock Options in the financial statement

At the time of offering share options, the company would need to determine the fair value of options or the intrinsic value of those options. Then every year after, an expense for compensation shall be debited to the employee compensation account and credit entry shall be made in the outstanding balance for the compensation plan. The same pattern of entries shall be repeated until the completion of the vesting period.

At the end of the vesting period, the employee is offered two options: either to buy common stocks by exercising his/her options, or to get cash equivalent to the number of shares. If an employee chooses to buy shares then the balance in the outstanding account shall be debited and credit shall be made in the capital account as common stocks. If he opts for the cash option, then the outstanding account shall be debited and the cash account shall be credited.

Example

A company, Blue Co., grants ten employees 500 stock options. The fair value of each option at the grant date is $20. The exercise date for the option is after 4 years of the grant date. With this stock option, employees have the right to buy Blue Co.’s shares at $50 on the exercise date. The nominal value of the company’s stock is $10 per share.

The vesting period for the stock options is 4 years. For the first year, Blue Co. will have to recognize a cost of $25,000 (500 options x $20 fair value x 10 employees / 4 years). The accounting treatment for the first year will be as follows.

Dr Stock option compensation expense $25,000

Cr Stock Options $25,000

During the second year, two employees leave the company, therefore, forfeiting their stock options. Therefore, Blue Co. will have to calculate the fair value of its stock options for the remaining employees. The total expected cost of the stock option at the end of the second year will be $80,000 (500 options x $20 fair value x 8 employees). The total charge to the account will be $40,000 ($80,000 x 2 / 4). Since Blue Co. has already recognized $25,000 in expenses, it will recognize the difference in the amount during the 2nd year, which is $15,000 ($40,000 – $25,000).

Dr Stock option compensation expense $15,000

Cr Stock Options $15,000

For the next year, two more employees leave the company. Therefore, the total expected cost for the plan will be $60,000. The charge to the account will be $45,000 ($60,000 x 3 / 4). Since Blue Co. has already recognized $40,000 for the stock options, it will only treat the difference of $5,000 during the third year. The accounting treatment is as follows.

Dr Stock option compensation expense $5,000

Cr Stock Options $5,000

During the final year of the vesting period, only one employee leaves the company. Therefore, the total cost of the stock option plan will be $50,000. It will also be the total charge to the account. The stock options account already has $45,000 recognized over the three years. Therefore, Blue Co. will only need to recognize the remaining $5,000 during the final year, as follows.

Dr Stock option compensation expense $5,000

Cr Stock Options $5,000

At the exercise date, all five remaining employees choose to exercise the right to buying stocks on their stock option. As mentioned, they will have to pay $50 for an ordinary share. Therefore, the five employees will have to pay a total of $125,000 (500 options x $50 per share x 5 employees) to Blue Co. As mentioned, the nominal value of the share is $10.

Therefore, the accounting treatment for the exercise will be as follows.

Dr Share Options $50,000

Dr Cash $125.000

Cr Share Capital (500 shares x 5 employees x $10 nominal value) $25,000

Cr Share Premium ($125,000 + $50,000 – $25,000) $150,000

How to value Employee Stock Options

Monte Carlo and the Binomial Tree methods are the most common approaches used to price the Employee Stock Options.

 

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