Stock option expensing is a method of accounting for the value of share options, distributed as incentives to employees within the profit and loss reporting of a listed business. On the income statement, balance sheet, and cash flow statement the loss from the exercise is accounted for by noting the difference between the market price (if one exists) of the shares and the cash received, the exercise price, for issuing those shares through the option.
Opponents of considering options an expense say that the real loss – due to the difference between the exercise price and the market price of the shares – is already stated on the cash flow statement. They would also point out that a separate loss in earnings per share (due to the existence of more shares outstanding) is also recorded on the balance sheet by noting the dilution of shares outstanding. Simply, accounting for this on the income statement is believed to be redundant to them.
Methods
The two methods to calculate the expense associated with stock options are the "intrinsic value" method and the "fair-value" method. Only the fair-value method is permissible under U.S. GAAP and IFRS. The intrinsic value method, associated with Accounting Principles Board Opinion 25, calculates the intrinsic value as the difference between the market value of the stock and the exercise price of the option at the date the option is issued (the "grant date"). Since companies generally issue stock options with exercise prices which are equal to the market price, the expense under this method is generally zero.
The fair-value method uses either the price on a market or calculates the value using a mathematical formula such as the Black–Scholes model, which requires various assumptions as inputs. This method is now required under accounting rules.
In 2002, another method was suggested: expensing the options at the difference between the market price and the strike price when the options are exercised, and not expensing options which are not exercised, and reflecting the unexercised options as a liability on the balance sheet. This method, which defers the expense, was also requested by companies. A method to eventually reconcile the grant date fair-value estimates with the eventual exercise price was also proposed.
Stock options under International Financial Reporting Standards are addressed by IFRS 2 Share-based Payments. For transactions with employees and others providing similar services, the entity is required to measure the fair value of the equity instruments granted at the grant date. In the absence of market prices, fair value is estimated using a valuation technique to estimate what the price of those equity instruments would have been on the measurement date in an arm's length transaction between knowledgeable, willing parties. The standard does not specify which particular model should be used.
Fair-value method journal entries for stock option compensation
Grant date (if warrants are not vested when granted) No journal entry
Reporting dates, until vested (if warrants are not vested when granted) Debit compensation expense. Credit paid in capital – stock warrants. If the warrants eventually vest, the overall total compensation expense to recognize equals the fair value of the warrants on the grant date. The fair value of the warrants on the grant date is determined from the market or the Black-Scholes model. The expense is allocated to each income statement reporting period in proportion to the number of days in that period which are within the vesting period.
Grant date (if warrants are vested when granted) Debit compensation expense. Credit paid in capital – stock warrants. The fair value of the warrants on the grant date is determined from the market or the Black-Scholes model.
Exercise of warrants
Debit cash. Debit paid in capital – stock warrants. Credit common stock – par value. Credit paid in capital – common stock in excess of par value. Cash is being collected from warrant holders. The related warrants being exercised are cleared out of the account for warrants outstanding. As stock is issued, common stock is put on the books -- affecting the accounts for common stock at par value, and the contributions for common stock that are in excess of the par value.
Cancellation or expiration of warrants
Debit paid in capital – stock warrants. Credit paid in capital – expired stock warrants.