This post is the fifth in a series exploring techniques to attract and retain key employees, directors, and other service providers of privately held companies through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock or ownership interests.
Previously, I provided an overview and discussed the tax treatment of various equity compensation arrangements typically used by corporations, such as stock options, restricted stock, phantom stock, and stock appreciation rights and the tax treatment of profits interests in entities taxed as partnerships (like LLCs). In this post, we’ll briefly discuss the accounting treatment for some of these vehicles (and in particular, the effects on the company’s P&L). While the details of accounting for stock-based compensation and deferred compensation plans are complex and certainly beyond the scope of this blog post, the basic concepts are important and should be considered before such awards are made. In particular, companies considering awards will want to have an understanding of the potential expenses that will be recognized on the company’s P&L in connection with an award and how those expenses might affect financial statements and agreements with third parties (e.g. financial covenants in a loan agreement).
Thank you to Keith Johnson and Tammy Joscelyn, CPAs with Byrd, Proctor & Mills for providing the accounting expertise to write this post.
Stock Options and Restricted Stock
Within the last decade, the rules for governing the accounting treatment for stock based compensation have changed significantly and now most companies (public and private) are required to recognize an expense associated with stock options and restricted stock. This was not the case prior to some of the corporate scandals that took place in the last decade which created a growing perception that financial statements were not accurately reflecting stock based compensation. Warren Buffet stated in a 2002 New York Times article that there existed a “crisis in confidence” regarding the earnings number reported by most corporations, and he attributed much of the problem to stock option accounting and pension fund returns. In fact, he stated in the article that “the aggregate misrepresentation in these two areas dwarfs the lies of Enron and WorldCom.”
As a result of this growing concern, under 2004 Financial Accounting Standards Board Statement 123(R) (now incorporated into FASB Accounting Standards Codification Topic 718, Compensation-Stock Compensation), companies are required to recognize an expense for stock based compensation.
Without going into too much detail, the basic concepts are as follows:
For restricted stock, the value of the award at the date of grant will be recognized over the vesting period. So for example, if the company awards shares of stock worth $10,000 and the award vests over 5 years, then the company would recognize an expense of $2,000 per year. In addition, because the company gets a tax deduction when the amount is included in the income of the service provider, there is a partial offset to the expense for the value of the future tax deduction. So assuming the company is in the 35% tax bracket, it will have recognized an after-tax expense equal to $6,500 ($10,000 expense – $3,500 tax savings) when the award is fully accounted for (assuming it fully vests). Subsequent changes in the price after the date of grant do not affect the expense; however, for purposes of comparison to an example below, let’s assume the stock price doubles resulting in the service provider owning stock worth $20,000 when the award is fully vested.
Stock options are a little bit more complex and generally require the application of an option pricing model to determine the fair value of the option. Such models include “closed end” or “lattice” models, which take into account factors such as volatility of the stock, the time value of money, the option’s strike price and the dividend yield. The resulting value of the option is expensed over the vesting period and, as with restricted stock, there is a tax deduction for the amount included in the income of the service provider (for nonqualified options only; ISOs do not result in a tax deduction). Also, stock price changes after the date of grant do not affect the expense.
So for example, assume the company grants an option to purchase the same shares worth $10,000 as in the prior example. However, in this case, it’s an option (and not an outright grant of stock), so the service provider can purchase the shares for an exercise price of $10,000. In this case, there is no intrinsic value at the date of grant because the purchase price equals the value of the stock. But the option does have some value because of the chance that it could increase in value in the future. So the fact that they have value and consequently cost the company something seems intuitive, but what’s less intuitive (or perhaps not intuitive at all) is how to determine the expense.
Under current rules, the company would determine the fair value of the option (not the stock) by inputting several variables into an option model which is used to value the option based on the probability that it will be “in the money”, will vest, and will be exercised. So let’s assume the company runs this model and it tells us the option value is worth $9,000 at the date of grant. In that case, the company will recognize an expense in this amount over the vesting period (if any). Now let’s assume the stock price increases to $20,000, as in the prior restricted stock example, and is exercised at that time. In this case, the company will have recognized an expense of $9,000 and will benefit from a tax deduction of $10,000 ($20,000 value over $10,000 exercise price; and if the tax bracket is 35%, a tax savings of $3,500). So the after tax cost recognized will be $9,000 – $3,500 = $5,500 and the recipient will have received value of $10,000 ($20,000 value received less $10,000 exercise price).
Phantom Stock and Stock Appreciation Rights
Phantom Stock and Stock Appreciation Rights (SAR) (those settled in cash) are in essence deferred compensation plans and as such are subject to liability accounting (as opposed to equity accounting). As with stock based compensation, the company recognizes a P&L expense for the current value of the award at date of grant which is fully taken into account over the vesting period and which is reduced by the future tax deduction. However, unlike stock based compensation, the expense is subsequently adjusted for both vesting events and stock price changes.
Assume, for example, a phantom stock plan that provides the service provider with phantom stock award, to be settled in cash, equal to 1,000 shares of stock valued at $10 per share on the date of grant. In addition, the award vests 20% per year over five years.
In this example, the company would recognize a compensation expense in the first year equal to $2,000 if the stock price remained constant. However, unlike with stock based compensation, the company would subsequently re-value the expense based on the change in the stock price. So, in our example, if the stock price increased to $20 per share at the end of our five-year vesting period, then the company would have recognized a compensation expense equal to $20,000. In addition, when the award is paid out the company will recognize a tax deduction resulting in tax savings of $7,000 (again, assuming a 35% tax bracket (35% of $20,000)). So the after-tax expense is $13,000.
It’s interesting to note that the company comes up with very different accounting expenses based on the type of award. Notice the following based on the simple examples:
Pre-tax Value to Recipient
After-tax Cost Accounting Expenses to Service Provider
Restricted Stock Example
Stock Option Example
Phantom Stock Example
* * *
Accounting for stock based compensation and deferred compensation plans is complex, but should be taken into account by companies considering such awards. In particular, the P&L expenses that will potentially be recognized over the lifetime of the award can vary significantly based on the type of award and should be factored into the equation. A good CPA can provide this expertise.
 Buffett, Warren E. (July 24, 2002). “Warren E. Buffett, ”Who Really Cooks the Books?”, The New York Times, July 24, 2002″.
 Note that $10,000 is the pre-tax value to the service provider who would recognize $10,000 in income in this example. This example is simplified to illustrate the basic concepts. The actual accounting entries would result in a tax savings of $3,150 ($9,000 book expense x 35%) and a balance sheet entry to additional paid in capital for $350 (the excess of the amount deductible for tax purposes ($10,000) over the book expense ($9,000) multiplied by the tax rate).
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.