Stock Based Compensation

Stock-based compensation, also called share-based compensation, refers to the rewards given by the company to its employees by way of giving them the equity ownership rights in the company with the motive of aligning the interest of the management, shareholders, and the employees of the company.

Stock-Based Compensation is a way companies use to reward their employees. It is also popularly known as stock options or Employee stock options (ESOP). Stock Options are given to the employees to retain or attract them and to make them behave in certain ways so that their interests align with that of all the shareholders of the company.

Stock based compensation is a kind of compensation given by companies to their employees in the form of equity shares besides the regular cash or salary and bonuses they receive. The executives who are given stock based compensation can benefit only if they serve the company for a specified period. Start-up companies very commonly give this type of compensation to lock in their executives for a minimum number of years.

Stock options allow the company's employees to buy a specific share at a predetermined price. Stock options are allotted to specific employees. Stock options are different from other options available for the investor to buy and sell on exchange platforms. The difference is that a stock option is not available for investors and is not traded on exchange platforms. As noted earlier, stock options are given or rewarded to specific employees of the company. One of the reasons behind giving a stock option to employees is to retain them or attract them and to make them behave in certain ways so that their interests align with that of all the shareholders of the company.

The company's employees must wait for a specific period before they can exercise this option to buy the company's share at a predetermined price. This waiting period is also called the vesting period. The vesting period also motivates the employee to stay with the company until the vesting period is over.

The above chart compares stock-based compensation as a percentage of the Total Assets of three companies – Facebook, Box Inc, and Amazon. Box Inc has the highest Stock-Based Compensation percentage of Total Assets at 15.88%. Amazon and Facebook, on the other hand, have this ratio at 4.95% and 3.57%.

A stock based compensation offered to employees and stakeholders is available in different forms. Some of the most common types of such compensation are:

Stock Options or Shares

This is a contract that gives the employers the right, but does not make it an obligation for them, to purchase or sell shares at a predetermined price and specific time range. If the stocks or shares made available are not sold or purchased within a given time frame and reach their expiry, the option turns invalid.

Such options are further divided into:

• Non-qualified stock option (NSO): It is the stock option where the income tax levied on the exercise price or price that is paid per share to the company is deducted from the price of options exercised. These schemes offer tax benefits to investors who do not require reporting the transaction when the options become exercisable.
• Incentive stock option (ISO): As the name suggests, it is an incentive kind of stock option offered to employees as a reward for their honest service tenure. These special stock options offer certain tax advantages, preventing employees from paying huge taxes on the shares while they purchase them.

Restricted Share Units (RSUs)

A restricted share unit is a scheme whereby employers promise and offer their employees company shares in return for their loyal service. The employees can own the shares at a future date, but only when they fulfill certain criteria as set by the organizations. As these options are conditional, i.e., on completion of their vesting period, they are termed as a restricted stock based compensation type.

Performance Shares

These share options, as the name implies, are offered to professionals at both management and executive levels, given their outstanding performance.

Employee Stock Ownership Plan (ESOP)

This is the stock based compensation expense type that allows employers to own a portion of company shares or get ownership of the entire company they work for. It is a type of succession scheme in which the organization’s control moves to employees having a maximum stake in it.

Let us consider the following examples to understand the stock based compensation meaning and also see how to calculate it:

Example 1

Jane has been employed with company XYZ for over 15 years, and she has been performing exceptionally well with whatever she has been trusted with. As a result, the company offers her a better position at the managerial level, and along with that she also receives access to the company’s performance shares option as well as the RSUs as she has completed the vesting period of 15 years. Together, the company offered access to 300 shares each worth $30.

Example 2

The technology sector has been into providing luring stock based compensation to attract talents from across the world. But the falling stock prices and rising number of stock compensations within the tech sector are raising the risk factor as returns are getting affected adversely.

When it comes to accounting for stock based compensation, there are multiple ways in which these expenses affect the financial statements. Let us study the impact of these compensation on:

Income Statement

Share-based compensation affects the Income Statement in two ways.

#1 - Decreased Net Income

Let us have a look at the Facebook Income Statement. Here the cost and expenses include the share-based compensation expense. This expense reduces the Net Income.

Also, note that Facebook has provided the breakup of Stock-based compensation included under each cost and expense item. In 2016, Facebook included $3,218 million worth of stock-based compensation.

source: Facebook 10K Filings

#2 - Diluted Earnings Per Share

When we calculate Diluted EPS, we take the impact of the stock options exercised by the option holders. When stock options are exercised, the company must issue additional shares to compensate the employees or investors who have exercised them. Due to this, the total number of outstanding shares increases resulting in a lower EPS.

As we see below, Facebook Employee stock options increase the total number of outstanding shares, thereby reducing the Earnings Per Share.

source: Facebook 10K Filings

Overall, the impact of stock options on the income statement is to increase the expenses, reduce the net income, and increase the number of outstanding shares, all of which results in a smaller EPS.

Learn the calculation of the Impact of Stock Options on Diluted EPS from this detailed article – Treasury Stock Method

Balance Sheet

There are several ways a company can compensate its stock option holders. Here, we will consider the following two ways for explanation purposes:

First- The Company can pay the difference between the predetermined price and the price on the exercise date.

Second- The Company has an option to issue additional shares instead of the stock options outstanding for the year.

If the company goes by the second option, it will increase its paid-up capital instead of issuing the additional shares.

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), it will have to record a cash outflow from Financing Activities in the Cash Flow Statement. Thus, the Cash Flow from Financing activities will be reduced by the same amount as the Cash on the Asset side of the Balance Sheet.

If the company goes for the second option of issuing shares instead of paying cash, then there will be no impact on the Cash Flow Statement as no cash flow will happen.

The most common type of stock based compensation is employee stock options (ESOPS). These options may have tax implications depending on whether they are Non-Qualified Stock Options or Incentive Stock Options. The companies can either show the costs associated with ESOPS in their Income Statements or the footnotes.

If expensed and reported in the Income Statement, the exercising of the ESOPS by the employees results in a reduction in EPS. And suppose the company pays the difference between stock price and exercise price, the option holders. In that case, it results in a reduction in Owners' Equity and Cash on the Balance Sheet and a reduction in Cash from Financing Activities on the Cash Flow Statement. And if the company compensates the option holders in terms of additional shares, the paid-up capital increases on the Balance Sheet while there will be no impact on the Cash Flow Statement.

This article has been a guide to what is Stock Based Compensation. Here, we explain the concept with examples, how it is taxed, its types, and how to record it. You may also look at the following articles for a better understanding of finance and accounting topics.

• Cash flow from Operations 
• Other Comprehensive Income Example
• Cash Flow from Investing Activities