Effects of Accounting for Stock Grants and Stock Options

A company might grant stocks to employees either outright, with restrictions, or contingent on performance.

1. Outright Grants

As the wording suggests, outright grants are stocks awarded to employees outrightly, without any conditions. Compensation expense is reported based on the stock’s fair value (the market value) on the grant date.

The shares are fully vested, and the company allocates the compensation expense over the service period, which is presumed to be the current period, unless other requirements are in place.

2. Restricted Stock

Restricted stock requires the employee to return the shares to the issuing company if they do not meet certain conditions. For example, a new employee might be granted 100 shares of stock vested over three years. This implies that the employee retains the stock only after three years of working there. If they happen to quit after one or two years, they automatically relinquish their right to the shares.

Compensation expense is reported on the fair value of the stock on the grant date.

The company allocates the compensation expense over the service period.

3. Performance Shares

Performance shares are granted after employees meet specific targets. The amount of the grant is contingent on measures other than the change in stock price, such as the return on assets generated in the preceding financial year. Performance measures other than the change in share price usually determine the amount of these grants.

Compensation expense is reported on the fair value of the stock on the grant date.

The company allocates the compensation expense over the service period.

Stock Options

Stock options work by a company granting its employees a certain number of stock options at a set price. Just like with stock grants, both IFRS and US GAAP require that compensation expenses related to option grants be reported at fair value. In both cases, accounting rules require the valuation of options using appropriate accounting models.

The fair value of stock options is always an estimate based on a specified valuation technique or pricing model. This makes stock options different from stock grants, whose fair value is based on the market value at the grant date.

The valuation technique, or option pricing model, that a company uses the valuation technique or pricing model used is a crucial determinant of the fair value attached to options. Popular choices include the Black-Scholes option pricing model and the binomial model.

Key Features of Appropriate Grants

• Consistent with fair value measurement.
• Based on principles of financial economic theory.
• Reflect all substantive characteristics of the award.

Option Valuation Assumptions/Inputs

• The exercise price.
• Stock price volatility.
• Estimated life of each award.
• The estimated number of options that are forfeited.
• Dividend yield.
• The risk-free rate of interest.

Some inputs, such as stock price volatility and the estimated life of stock options, are highly subjective. They can cause a significant change to the estimated fair value and, consequently, the compensation expense.

Inputs that increase estimated fair value include:

• Higher volatility.
• A longer estimated life.
• A higher risk-free interest rate.

A higher assumed dividend yield decreases the estimated fair value and thus lowers option expense. The converse is also true.

The fair value of stock options can be significantly affected by combining different assumptions with alternative valuation models.

The recognition of option expense has no net impact on total equity. Considering that since a company recognizes option expense over the relevant vesting period, the impact on the financial statements is to ultimately reduce retained earnings.

The offsetting entry is an increase in paid-in capital.

Example: Option Valuation Assumptions 

ABC is a US-based hypothetical company that offers its employees a defined pension plan and stock options as part of its compensation package.

Assumptions relating to option valuation are as per the table below:

$$\begin{array}{l|c|c|c} {} & \bf{2018} & \bf{2017} & \bf{2016}\\ \hline\textbf{Expected life} & 7.0 \text{ years} & 6.5 \text{ years} & 7.0 \text{ years}\\ \hline\textbf{Risk-free rate} & 5.4\% & 4.3\% & 3.4\%\\ \hline\textbf{Dividend yield} & 1.0\% & 0.0\% & 0.0\%\\ \hline\textbf{Expected volatility} & 35\% & 37\% & 39\%\\ \end{array}$$

Based solely on expected volatility estimates, the company’s 2018 compensation expense relative to 2016 was most likely:

     A. Higher.

     B. Lower.

     C. Unchanged.

Solution

The correct answer is B.

ABC would most likely have reported a lower compensation expense in 2018. The expected volatility was higher in 2016 than in 2018. A higher volatility assumption increases the fair value of the stock option and, consequently, the compensation expense. This ultimately reduces net income.

Question

Which of the following resulted in a positive effect on earnings in 2018 relative to prior years?

A change in:

    A. Expected life.

    B. Dividend yield.

    C. Risk-free rate.

Solution

The correct option is B.

A higher assumed dividend yield decreases the estimated fair value of options and thus lowers the options expense. The lower option expense leads to higher earnings. Higher expected lives and risk-free rates increase the fair value of options and, consequently, the compensation expense, resulting in lower earnings.

Reading 12: Employment Compensation: Post-Employment and Share-Based

LOS 12 (h) Explain how accounting for stock grants and stock options affects financial statements and the importance of companies’ assumptions in valuing these grants and options.