Accounting for Stock Options

How do you account for the issuance of stock options to the employees of a company

Well, to start with, stock options are, in essence, a form of compensation

You are awarding this option to the employee such that in the future they can exercise that option

and purchase on ownership interest in the company. Well, the interesting thing about stock options is that they are issued at their

current value meaning that the current value of stock that's the value at which the stock options are issued

so in essence it has no value at the moment that is unless the value of the stock goes up

the value of the stock option remains the same or or has no value whatsoever because it's just a right to purchase the stock

at that given price now at the fee in the future when the value of the stock

rises and you still have the ability to purchase the stock at that lower amount that is identified

in the stock option, now the stock option has become valuable. So in the future, the value of the

option will be based upon the value of the stock. Now, it's not always easy to determine the value

of the underlying stock. You tend to have to hire specialized practitioners, accounting firms that

can value the company so that you can understand the value of those options in the future Oftentimes they use complicated methods like the Black Shoals option method to determine value

or it could be a revenue based or market-based valuation method. So, but anyway, with that being said, at the time of vesting, that is the stock option is

awarded at one point in time, but it does not vest. The ownership interest does not become the employees

until some point in the future. Okay, that's called the vesting period. So at that point in the future, the

employee then owns that stock option. At that point in time, that's when the company has to record

the value exchanged in the transaction. And so assuming that the value is changed, at that point in time

let's assume it's gone up, the company would debit a compensation expense. Now, this is on the income

statement, right? This compensation expense and in some income statements that are further

segmented would identify this expense as part of cost of goods sold for the development of

the or the manufacturer of the item. It would, it could be recorded as R&D if you are paying

individuals to develop the product or it could just be a general operating expense if it were

just part of the company's general manufacturing. So any of these things

things are subcategories that you could allocate this expense to Now on the balance sheet because once again you are you are reducing the retained earnings when the when the options vests because you are

compensating individuals based upon the rise in value of the option above the stock

price, it will reduce the retained earnings of the company on the balance sheet. So you

would have to debit the retained earnings account. Now, you would to make the equation balance on the balance sheet, you would also have to credit

the additional paid in capital account. And what you would accredit for is the value above whatever the face value or the strike

price is on the option. So if the option strike price is $10, meaning when it was issued, the underlying stock was

valued at $10, so you could purchase stock at $10. Now the value of the stock has risen to $15

Well, the additional paid in capital, the amount above the face value

you would credit that for that difference, $5 per option. Okay, now fast forward into the future again

the holder of the stock option exercises that stock option. Now, how do you account for that

Well, you have to reverse some of the transactions. Well, you would definitely

assets because you getting cash from the exercise So when it was exercised the employee has to pay in right to purchase stock that let say it still worth would have to pay in and we get stock worth

$15. So you debit cash because that goes up. Now, because the additional paid in capital

account was credited at previously at the additional value of the stock option

above the stocks the options strike price you now have to reverse that so you

would also you would then debit the additional paid-in capital account okay now

because these are two debits to make the balance sheet balance you have to add a

credit so what do you credit you add up the additional cash brought in from the

from the exercise of the option and you would add up whatever is paid out in terms of or whatever value is it attributed to the additional

value above the strike price and you would credit common stock in the additional paid-in capital

If you do this, it makes the accounts balance. So basically what you're doing is undoing your original entries from the vesting transaction

and then you're finalizing it at the time of exercise. So, in summary, that's how you account for the award vesting and exercise of stock options