FASB ASC 718 (formerly FASB 123R) — ACCOUNTING FOR STOCK OPTIONS
I.
General Principles:
A.
Company must estimate the value of options awarded to employees as of the
award date
B.
Option value times the number of options expected to be awarded must be
accounted for as compensation expense
C.
Compensation expense is spread over the vesting period
D.
Accounting treatment follows hypothetical transaction as follows:
i.
Options treated as if issued to employees for cash in amount of their
estimated values:
Cash
Additional paid-in capital, options
ii.
Cash deemed to have been raised is then paid out to employees as
compensation expense:
Compensation expense
Cash
E.
Expected tax benefits must also be recorded over the same period as
compensation expense is recognized—tax benefit is equal to compensation cost
times corporate tax rate:
Deferred tax asset
Tax expense
Note that no expected tax benefit is recorded for qualified options (because no
deduction is likely to be available).
F.
A change in the estimated number of options to be exercised is accounted for as
a change in estimate, with the cumulative effect recorded in the year of the
change.
II.
Accounting Treatment when Options are Exercised:
A. When options are exercised, the company receives cash from each employee who
exercises an option. Cash received is equal to exercise price of the option.
B. Company credits the amount of cash received, plus cumulative amount previously
credited to additional paid-in capital, to common stock:
Cash
Additional paid-in capital, options
Common stock
C. Company must also account for tax benefits received at this time.
i.
If the options are not qualified stock options, the company is entitled to a
deduction at date of exercise, equal to difference between exercise price
and actual stock price.
ii.
If the options are qualified stock options, company is not entitled to a
deduction, and no deferred tax asset should previously have been
recorded (because company knew exercise would not generate a tax
deduction).
D. Income taxes payable will be reduced by the amount of this deduction multiplied by
corporate tax rate. Some of this reduction will be due to deferred tax asset
previously recorded. Balance does not reduce income tax expense, because no
corresponding expenditure is recognized for book (company is presumed to have
received full value for the options when awarded, returned to employees as
compensation). Rather, tax benefits received in excess of those previously recorded,
are credited to additional paid-in capital:
Taxes payable
Deferred tax asset
Additional paid-in capital, options
E. If the options expire unexercised, no reversal of previously recorded compensation
expense is recorded. However, previously recorded deferred tax assets must be
“impaired” with reduction written off into tax expense:
Tax expense
Deferred tax asset
III.
Use of Treasury Stock to Satisfy Exercise of Options
A. General accounting for treasury stock:
i.
ii.
iii.
Treasury stock recorded at cost:
Treasury stock
Cash
Sale of treasury stock above cost—excess is credited to paid-in capital
from Treasury stock:
Cash
Treasury stock
Paid-in capital from treasury stock
Sale of treasury stock below cost—“loss” is debited first to paid in capital
from treasury stock and then to retained earnings. Assuming no paid in
capital from treasury stock:
Cash
Treasury stock
Retained earnings
B. Application of this framework to use of treasury stock to satisfy options is
straightforward:
i.
ii.
Assume options exercised to purchase 1,000 shares at $10. Options
previously valued at $2. Company purchases shares on open market at
$14 to satisfy options:
Treasury stock
Cash
$14,000
Cash
Paid-in capital, options
Retained earnings
Treasury stock
$10,000
2,000
2,000
$14,000
$14,000
To account for tax effects, the entry looks like the one for newly issued
shares. If the options are nonqualified, the company will be entitled to a
iii.
$4,000 deduction at exercise ($14 stock price less $10 exercise price
times 1,000 shares). It has previously accounted for $2,000 compensation
expense, and has recorded a deferred tax asset on this expense of $700
(35%). It will actually receive a $1,400 tax benefit (35% of the $4,000
allowable deduction). Thus, it must record the additional $700 tax benefit
as follows:
Income tax payable
$1,400
Deferred tax asset
$700
Additional paid-in capital, options $700
Note that cost to company of above transaction is $4,000—it paid
$14,000 for treasury stock that it re-issued to its employees for $10,000.
It has previously hit earnings for $2,000 (compensation cost) and now
hits retained earnings for an additional $2,000. Thus, net cost to company
has been taken from retained earnings, but not all of reduction has
flowed through income statement.