Accounting For Stock Compensation

So far I wrote about accounting for debt, leases and taxes. You can find them all here. Companies pay its employees using cash and stocks. All cash payments made to employees are shown as expenses in the income statement. But when it comes to stock compensation things are not that straightforward. Companies pay its employees using restricted stocks and stock options and the accounting treatment for both of them is very different. In this post, I will try to unravel the accounting for stock compensation.

1. Common Stock, APIC, and Treasury Stock

In order to understand stock based compensation, you need to know few basic things about common stocks. I will explain them by using a fictitious company called TestCo. On 01-Jan-2014, TestCo issued 10,000 shares of $1 par value for proceeds of $10 per share. The company received $100,000 as proceeds from the public. Given below is the journal entry for this transaction.

01-Jan-2014  Dr. Cash     $100,000                   [10,000 shares * $10]
              Cr. Common stock               $10,000 [10,000 shares * $1 par value]
              Cr. Additional paid in capital $90,000 [$100,000 - $10,000]

The journal entry increases its cash asset by $100,000. For the balance sheet to balance the company makes two entries on the liability side. The first entry is called as common stock. What does this mean? Before the advent of computers, stocks were issued in physical certificates. On each certificate the face value (also known as par value) of the stock will be displayed. This refers to the amount at which a stock is issued or can be redeemed. Thanks to status quo, even today the concept of par value is used. In this example the par value is $1 and for 10,000 shares, the total value for common stocks comes to $10,000. Any amount received in excess of par value is kept in additional-paid-in-capital (APIC). In this case it comes to $90,000. At this point the total number of stocks issued by the company is 10,000 and the total number of stocks outstanding with the public is 10,000.

On 01-Jan-2015, TestCo buys back 1,000 of its common stock at a price of $12 per share. The journal entry for this transaction is given below. This entry decreases cash asset by $12,000. For the balance sheet to balance the company makes a liability entry for $12,000 which is kept in an account called as treasury stock. A depreciation account decreases the value of fixed assets. Similarly treasury stock account reduces the value of total equity. Treasury stock does not have voting rights nor receive any dividends. They remain dormant until the company retires or reissues them. After the buyback the total number of stocks issued by the company is still 10,000 and the total number of stocks outstanding with the public is 9,000.

01-Jan-2015  Dr. Treasury stock $12,000   [1,000 shares * $12]
                       Cr. Cash  $12,000  [1,000 shares * $12]

On 01-Mar-2015, TestCo decides to reissue 1,000 shares to public from treasury stock account at a price of $15 per share. The journal entry for this transaction is given below. This entry increases the cash asset by $15,000. For the balance sheet to balance the company makes two entries on the liabilities side. The stocks sold from the treasury account comes out at $12; original price paid by the company. The remaining $3,000 is stored in additional-paid-in-capital (APIC). This gain of $3,000 is never shown in the income statement. Why is that? If this was allowed, under the influence of incentive caused bias, every company will engage in trading its own stock in the market instead of running its business. Had TestCo reissued treasury stock at some price less than $12 then the difference will be subtracted from APIC. At this point the total number of stocks issued by the company is 10,000 and the total number of stocks outstanding with the public is 10,000.

01-Mar-2015  Dr. Cash       $15,000                   [1,000 shares * $15]
               Cr. Treasury Stock             $12,000 [1,000 shares * $12]
               Cr. Additional paid in capital $3,000  [$15,000 - $12,000]

The table given below shows the effects of all three journal entries. Spend some time to make sure you really understand this.

Armed with the basic understanding of common stocks, let us look at Amazon’s 2013 balance sheet given below. From this you can see that Amazon (1) issued 5 million additional shares in 2013 (2) didn’t buyback any shares as treasury stock remained the same in 2012 and 2013 (3) additional 5 million share issues resulted in APIC increasing by $1,226 million. Spend some time to go through the annotations I made in the balance sheet.

2. Paying Employees With Restricted Stock

A company can pay its employees using restricted stock. The stock is called as restricted because the employee cannot sell the stock right away and needs to wait for some period, also called as vesting period, before selling. Let us understand this with an example. On 05–Mar-2015, TestCo grants 500 shares to its CEO as compensation. On the grant date the stock price is $18. The stock vests after two years and the par value is $1. The journal entry for this transaction is given below. As the company issued 500 new shares to its CEO, it records $500 in common stock and the balance $8,500 in APIC. For the balance sheet to balance it records $9,000 in deferred compensation expense which will get expensed over the two years vesting period using straight line method. Also the total number of shares issued and outstanding goes up by 500.

05-Mar-2015 Dr. Deferred compensation expense  $9,000     [500 shares * $18 per share]
                    Cr. Common Stock                 $500 [500 shares * $1 par value]
                    Cr. Additional paid in capital $8,500 [$9,000 - $500]

On 05-Mar-2016, TestCo recognizes $4,500 as compensation expense and the other half will be recognized on 05-Mar-2017. The journal entries for these transactions are given below.

05-Mar-2016  Dr. Compensation Expense  $4,500            [$9,000 / 2]
                Cr. Deferred compensation expense $4,500 [$9,000 / 2]

05-Mar-2017  Dr. Compensation Expense  $4,500            [$9,000 / 2]
                Cr. Deferred compensation expense $4,500 [$9,000 / 2]

3. Paying Employees With Stock Options

A company can pay its employees using stock options. For a long time, I was assuming that options are stocks. But they are not. Options become stocks at some point in future when the market price of the stock is higher than the exercise or strike price. Let us understand this with an example. On 01-Feb-2015, TestCo grants 100 options to its CFO with an exercise price set to market price of $13. The options vest after two years and expire after 10 years. The fair value of the option is $10 per share at the grant date. The last couple of sentences contains some new terminologies which needs more explanation.

The date on which the options are granted to an employee is called as grant date. In this case it is 01-Feb-2015. On the grant date the exercise price of the option is set to the market price. In this case it is set to $13. What does this mean? This means that in future, the CFO can convert these options into stocks by paying $13 for a stock. How long should he wait for this conversion to happen. He needs to wait until the vesting period is over. In this case it is two years. The CFO can convert these options into stocks between 01-Feb-2017 and 31-Jan-2025 after which the options expire. In 2005, SEC came out with a rule, rightly so, for expensing the stock options in the income statement. This means that companies needs a way to value the options. Some of the popular valuation methods are Black Scholes and Binomial Models.

In our example the fair value of the option is set to $10. Why is the fair value of the option less than the market price of $13? Options have value only when the strike price is greater than the market price after the vesting period. There is a likelihood of this not happening in the future. This uncertainty leads to lower price for options. The total value of the stock options comes to $1,000 (100 options * $10 fair value). TestCo will expense this as compensation expense over the vesting period of two years using straight line method. The journal entries for these transactions are given below. For the balance sheet to balance, APIC goes up by $500 each year.

01-Feb-2016 Dr. Compensation expense $500            [$1,000 / 2]
                Cr. Additional paid in capital $500  [$1,000 / 2]

01-Feb-2017 Dr. Compensation expense $500            [$1,000 / 2]
               Cr. Additional paid in capital $500   [$1,000 / 2]

Let us assume that on 02-Mar-2017, the CFO exercises his 100 options by paying $13. At the time of exercise the market price of the stock is $20. The journal entries for these transactions are given below. If the market price is $20 who sells shares to the CFO at $13? TestCo sells those shares. But from where does it gets these shares from? It gets these from its treasury stock. For this example let us assume that $12 is the average buyback price of treasury stocks. For the balance sheet to balance the difference between the exercise price and buyback price is added to APIC.

02-Mar-2017 Dr. Cash $1,300 [100 shares * $13]
              Cr. Treasury Stock $1,200 [100 shares * $12]
              Cr. Additional paid in capital $100 [$1,300 - $1,200]

The current market price of $20 is not relevant for this journal entry. But TestCo will get a tax deduction for $700 [ ($20 – $13) * 100 shares ] when its CFO sells his shares. Note that in stock options the capital stock account never went up. Why is that? The company never issued new shares. All it did was to reissue the stocks from its treasury account. After this transaction the total shares issued remains the same and shares outstanding goes up by 100.

4. Amazon’s Stock Compensation

Any changes that happen to shareholders equity is captured in statement of shareholders equity. Take a look at Amazon’s 2013 shareholders equity. From this we can see that (1) it didn’t buyback any stocks in 2013 (2) issued restricted stocks for $1,149 million and APIC went up by that amount (3) some stock options there were issued long back got exercised and APIC went up by that amount (4) also it did not issue any new stock options.

5. Is stock compensation really an expense?

Until 2005 companies were issuing stock options to its employees and never recognized it as an expense. Why would they do that? The rule did not require them to. Also the top management’s pay check depended on showing more profits. If you pay your employees in stock options and not recognize it as an expense then profits will go up along with their pay check. In 1994, FASB wanted to change this rule and treat stock based compensation as an expense. But companies fought against this rule by lobbying and made the senate to condemn the proposal. Buffett stood on the side of FASB but things did not change. In 2005, after a decade, law was passed to treat stock option as an expense.

Whatever the merits of options may be, their accounting treatment is outrageous. Think for a moment of that $190 million we are going to spend for advertising at GEICO this year. Suppose that instead of paying cash for our ads, we paid the media in ten-year, at-the-market Berkshire options. Would anyone then care to argue that Berkshire had not borne a cost for advertising, or should not be charged this cost on its books? … The role that managements have played in stock-option accounting has hardly been benign: A distressing number of both CEOs and auditors have in recent years bitterly fought FASB’s attempts to replace option fiction with truth and virtually none have spoken out in support of FASB. Its opponents even enlisted Congress in the fight, pushing the case that inflated figures were in the national interest. – Buffett; 1998 letter

The law fixed one problem. But corporate executives are smart and they have figured out another way to manage investors expectations. Along with GAAP earnings companies report something called as adjusted EBITDA. What does this mean? You show profits by not counting depreciation and stock based compensation as an expense. To me this is nonsense. If stock based compensation is not an expense then what the hell are they?

A few years ago we asked three questions to which we have not yet received an answer: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?” – Buffett; 1998 letter

As long as investors are gullible, executives can paint whatever investors want to see. Investors who believe in adjusted EBITDA reminds me of a joke told by Charlie Munger – I tell about the guy who sold fishing tackle. I asked him, “My God, they’re purple and green. Do fish really take these lures?” And he said, “Mister, I don’t sell to fish.”

Closing Thoughts

I learned these concepts by reading the book shown below. Also I took the Financial Accounting course from coursera. I would highly recommend this course for anyone who wants to know how the financial statements are put together.