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Stock
Option Plan Considerations |
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Sections in this article:
Are Your Options
Compensatory or Non-Compensatory?
There are many things to consider when thinking of
using stock options. First, and foremost is the debate
as to whether the options being offered are either
compensatory or non-compensatory. The reason for
distinguishing between the two plans is the enormous
difference in how you account for the two types of
plans.
There are certain stock options and stock purchase
plans that may not be intended primarily to compensate
employees. For example, a corporation may wish to
raise capital or diversify ownership of its stock
among its employees or officers. If the difference
is no larger per share than that in an offer to all
shareholders for the purpose of raising the same
amount of money, there is no compensation involved.
Characteristics essential in Non-compensatory Stock
Options:
- Substantially all full-time employees meeting
limited employee qualifications may participate
(employees owning a specified percent of
the outstanding stock
and executives may be excluded)
- Stock is offered to eligible employees equally
or based on a uniform percentage of salary
or wages (the plan may limit the number of shares
of
stock
that an employee may purchase through the
plan)
- The time permitted to exercise the rights
is limited to a reasonable period.
- Any discount from the market price is no
greater than would be a reasonable offer of stock
to
shareholders or others.
Stock option plans that meet the requirements of
a non-compensatory plan do not require the recognition
of compensation expense by the sponsoring company.
Plans that do not contain these characteristics are
usually classified as compensatory plans and compensation
expense must be recorded. To learn how to account
for non-compensatory and compensatory stock options
see following section entitled “Accounting
Treatments for Stock-Based Compensation.”
< Back to top >
Understanding
Your Option Plan
Book
Compensatory
Options
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Non-Compensatory
Options
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The Criteria To Be Met
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Compensatory
Options
- Does not meet
all four requirements
of a Non-Compensatory
option.
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Non-Compensatory
- Substantially
all full-time
employees meeting
limited employee
qualifications
may participate.
- Stock is offered
to eligible employees
equally or based
on a uniform
percentage of
salary or wages.
- The time permitted
to exercise the
rights is limited
to a reasonable
period.
- Any discount
from the market
price is no greater
than would be
a reasonable
offer of stock
to shareholders
or others.
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Once
you have determined which
type of option you have
you must then address
the accounting and tax
implications.
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How To Account for Stock Options -
Book
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Compensatory
Two Methods:
- Intrinsic
Value Method- (APB
25) compensation
cost, (if any
is recognized
ratably over
the service period
in the income
statement), is
the excess of
the fair value
of the stock
at the measurement
date (usually
grant date) over
the amount the
employee must
pay.
Whether the
options have
intrinsic value
(whereby cost is recognized in the income
statement) or not Pro forma disclosures of
net income and earnings per share based on
the fair value method (SFAS 123) must be
included.
- Fair Value
Method-
(SFAS 123) preferable
and encouraged,
but NOT required.
Compensation
cost is based
on the fair value
of the equity
instrument awarded,
determined by
an option pricing
model (Black-Scholes),
net of any amount
the employees
must pay for
the instrument
when it is exercised.
Total cost is
allocated and
recognized ratably
over the service
period in the
income statement.
- Under either
method when booking
a deferred compensation
expense you must
recognized and
book a Deferred
Tax Asset.
For a further explanation
and a detailed example
on accounting for
stock options see
the section called “Accounting
Treatments for Stock-Based
Compensation”
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Non-Compensatory
- Recorded at
the time they
are exercised
(APB 25)
- No Income Statement
effect at grant
date
- Disclosure should
be made as to
the status of
the option or
plan at the end
of the period
of report, including
the number of
shares under
option, and option
price, and the
number of shares
as to which options
were exercisable.
No Journal Entry
at Grant Date
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Debit |
Credit |
| Journal
Entry (date
exercised) |
| Cash (option
price) |
XXX |
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| Common
Stock |
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XXX |
| Paid
In Capital |
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XXX |
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The
information above is
meant to be used in gaining
a general understanding
of how to classify and
account for stock options,
it is not inclusive or
exhausting in material
please refer to APB 25,
SFAS 123, FASB 148, for
more information. Warning
FASB has issued an Exposure
Document to amend statement
No. 123, which would
eliminate the use of
APB 25 in accounting
for stock compensation
plans.
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Understaning Your Option Plan
Tax
Compensatory
Options
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Non-Compensatory
Options
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The Criteria To Be Met
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Non-Qualified Stock Option
- Does not meet
the qualification
of an incentive
stock option
(qualified).
- Nonqualified
stock options
can be granted
to employees
and non-employees
(directors and
outside consultants)
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Qualified Stock Options
/ ISO
- Options must
be granted under
a plan established
by the company.
- Granted only
to Employees
and exercisable
only by the employee.
- Can be issued
to a selective
and discriminatory
basis.
- Options must
be granted within
10 years from
the date the
plan is adopted
and approved.
- Options must
be exercisable
within 10 years
from the date
of the grant.
- Employee, at
the time the
option is granted,
may not own more
than 10% of the
total combined
voting power
of the employer’s
stock.
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How to Account
For Stock Options - Tax(Employer) |
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Non Qualified Stock Options
- An employer
may deduct the
value of a nonqualifed
stock option
as a business
expense for the
tax year in which
the option is
includible in
the gross income
of the employee.
- Employers deduction
equals the amount
of income recognized
by employee.
- Deductible portion
is excess of
the fair market
value of the
stock received
less what the
employee paid
for the stock
(reported on
W-2) as ordinary
compensation.
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Qualified Stock Options
/ ISO
- Generally no
tax implications
to the employer.
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How to Account
For Stock Options - Tax (Employee) |
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Non-Qualified Stock Options
- Employee will
include the difference
between the exercise
price and the
fair market value
of the stock
as ordinary compensation
that will be
included in their
W-2
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Qualified Stock Options
/ ISO
- At the date
of the grant
there is no income
tax affect.
- At the date
of exercise (Assumption
is without immediate
sale) the difference
between the exercise
price and the
fair market value
of the underlying
security is a
tax preference
item for Alternative
Minimum Tax.
Therefore employee
may pay alternative
minimum tax.
- At the later
date of sale
of the stock
obtained from
option exercise
the difference
between the exercise
price and the
sales price is
recorded as a
capital gain
(subject to holding
period requirement).
There is also
available an
AMT credit for
the amount of
AMT originally
paid (if any)
when exercised.
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< Back to top >
Accounting Treatments
for Stock-Based Compensation
Once you have distinguished and classified whether
your plan is non-compensatory or compensatory you
must then measure the plan accordingly. Both plans
are accounted for in extremely different ways.
Non-Compensatory Stock Options are recorded at the
time they are exercised. No journal entries are made
when the options are granted. In relation to financial
statements, disclosure should be made as to the status
of the option or plan at the end of the period of
report, including the number of shares under option,
the option price, and the number of shares as to
which options were exercisable. As to options exercised
during the period, disclosure should be made of the
number of shares involved and the option price thereof.
Compensatory Stock Options are accounted for in a
completely different way than Non-Compensatory Stock
Options. Since the issuance of SFAS No. 123, two
methods of accounting for stock based compensation
exist.
The intrinsic value method is the method
previously used (under APBO 25), where compensation
cost is the excess of the fair value of the stock
at the measurement date over the amount the employee
must pay to exercise the option. If the intrinsic
value method is elected, then pro forma disclosures
of net income and earnings per share based on
the fair value method must be included.
The fair value method is the method
that is preferable and encouraged, but
NOT required. Compensation cost is based
on the fair value of the equity instrument awarded,
determined by an option pricing model, net of
any amount the employees must pay for the instrument
when it is exercised.
The fair value method is the preferred method because
it will always calculate some amount of compensation
expense and allocates it over the compensation (vesting)
period. Where as the (older) intrinsic value method
typically would not calculate a compensation cost
because it values’ the plan at the grant date
by excess fair value (market price) over the amount
the employee must pay. Typically with most fixed
stock option plans the amount the employee must pay
is the market price of the stock on the grant date,
thus there is no excess fair value and no compensation
costs.
The fair value method calculates the compensation
expense by using the Black-Scholes Option Pricing
Model. Which is a model that attempts to determine
the value of an option by measuring the difference
between the present value of the underlying (the
common stock that can be purchased) on the exercise
date and the present value of the option price on
the exercise date by using the following factors:
standard normal distribution, continuous compounding
at the risk-free rate, market value of the underlying
on the grant date, option price, expected life of
the option, expected dividends on the underlying,
volatility of the underling’s price.
An example of the difference between the two methods
follows:
An employee takes a position with a company and is
offered stock options that are exercisable after
he has worked 5 years with the company. Data related
to the options:
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APBO
25 |
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SFAS No. 123 |
| Fair Value (underlying plus options) at grant
date |
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$ |
140 |
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$ |
140 |
| Market value at grant date |
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100 |
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100 |
| Option Price |
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100 |
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100 |
| Market price 5 years later |
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200 |
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200 |
| Total Compentsation expense |
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*40 |
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**60 |
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| Journal entries |
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APBO 25 |
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SFAS
No. 123 |
| JE #1 (grant date) |
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| Deferred Compensation |
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40 |
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60 |
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| APIC-stock options |
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40 |
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60 |
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| JE #2-6 (end of year 1,2,3,4,5) |
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| Compensation expense |
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8 |
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12 |
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| Deferred compensation |
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8 |
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12 |
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| JE #7 |
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| Cash |
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100 |
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100 |
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| APIC - stock options |
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40 |
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60 |
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| Common stock (at
par) |
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90 |
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90 |
| Paid-incapital in
excess of par |
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50 |
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70 |
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* |
FMV of stock plus option grant date(140) - FMV
of stock at grant date (100) |
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Estimated FMV of stock at exerecise date(200)
- FMV of stock plus option at grant date (140) |
< Back to top >
Contact Nichols,
Cauley & Associates by Email, phone,
or online form
with your questions.
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