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Share-based compensation also called stock-based compensation refers to the rewards given by the company to its employees by way of giving them the equity ownership rights in the company with the motive of aligning the interest of the management, shareholders and the employees of the company.
Stock-Based Compensation is a way companies use to reward their employees. Stock-based compensation is also popularly known as stock options or Employee stock options (ESOPS). Stock Options are given to the employees to retain them or attract them and to make them behave in certain ways so that their interests are aligned with that of all the shareholders of the company.
The above chart compares stock-based compensation as a percentage of Total Assets of three companies – Facebook, Box Inc and Amazon. Box Inc has the highest Stock-Based Compensation as a percentage of Total Assets at 15.88%. Amazon and Facebook, on the other hand, have this ratio at 4.95% and 3.57%.
What does this mean for Box? How does Share-based compensation flow affect the Financial Statements – Balance Sheet, Income Statement, and Cash Flows?
In this article, we look at Stock options and Share-based compensation in detail –
- Introduction of Stock-Based Compensation
- How a Stock options Agreement works
- Taxability of Stock options
- The Controversy over Expensing Stock options
- Effect on the Financial Statements
Introduction of Stock-Based Compensation
Stock options allow the company’s employee to buy specific amount of shares at a predetermined price. Stock options are allotted to specific employees. Stock options are different from other options which are available for the investor to buy and sell on exchange platforms, the difference being that a stock option is not available for investors and is not traded on exchange platforms. As noted earlier, stock options are given or rewarded to specific employees of the company. One of the reasons behind giving a stock option to employees is to retain them or attract them and to make them behave in certain ways so that their interests are aligned with that of all the shareholders of the company.
The employee of the company must wait for a specific period before he/she can exercise this option to buy the company’s share at a predetermined price. This waiting period is also called vesting period. The vesting period also motivates the employee to stay with the company till the vesting period is over.
How a Stock options Agreement works
Let’s take an example of a top executive of the company to whom the company has rewarded with stock options of around 1,000 shares. The company allows its top executive to exercise his option only after 3 years. This shows how a company can use the waiting period or vesting period as a motivation for its employees to stay with the company.
Reasons behind vesting before an employee can exercise his/her options:
The reason behind the waiting is to align the interest of the company’s employee and the shareholders. Any shareholder or investor in the company wants the share price of the company to increase. Therefore, rewarding the options to employees while the share price increases, keeps the interests of both employees and the shareholders in alignment. This waiting period for the employee also ensures that he/she is not able to sell the shares immediately after buying and if the majority of the options are immediately exercised and sold, it can put a pressure on the stock of the company which might lead to the downfall of the stock. This downfall of the stock might not stop if the investors realize that the reason behind this downward pressure is that the company’s employees are increasingly selling their options which can lead to panicking and huge selling from the investor’s side also.
Below table provides details of Facebook Options Outstanding and Options exercisable along with its exercise prices.
source: Facebook 10K Filings
Taxability of Stock options
To understand the tax aspect of stock options we need to understand the types of stock options which are Taxable.
There are majorly 2 types of stock options viz. Non-Qualified Stock Options and, Incentive Stock Options.
#1 – Non-Qualified Stock Options
These stock options are sometimes referred to as Non-Statutory Stock Options. These options are open for taxability. In other words, Non-Qualified Stock Options are taxable. When exercised, the owner of these options has to pay tax on the difference between the predetermined price and the price at which the option holder exercises his/her option. If the share after exercise is held for more than a year, long term capital gain tax is levied.
Non-Qualified Stock Option Example
Let’s assume that an employee gets Non-Statutory Stock options (NSO) or Non-Qualified Stock options (NQO). The option allows him to buy 100 shares of his employer at a predetermined price of $25. Now, the day the employee exercises his/her option, he/ she will be eligible for tax. Let’s take the market price to be $30 at the time of exercise. Now, the tax will be levied on the difference between the predetermined price and the price at which the option holder exercises the option. In this case it is $(30-25)*100 = $500. Assuming that the employee has exercised all his options in one go.
If the option holder, after exercising the option, sells those shares, short term capital gain tax will be applicable. If the employee decides to hold the shares and sell after one year, long term capital gain tax would be applicable.
#2 – Incentive Stock Options
Incentive Stock Options (ISO) are also referred as Incentive Share Options or Qualified Stock options. These options get tax benefit. This means no tax is applicable on these options at the time of exercise unlike the Non-Qualified Stock Options where the owner of the option has to pay the ordinary income tax at the time of exercise as discussed above. None the less, when the option holder after exercising the option decides to sell the shares after one year, long term capital gain tax will be applicable, which is much lower than ordinary income tax.
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There are several conditions, which have to be met before a stock option can qualify as an Incentive Stock Option (ISO). These conditions include:
- The option can only be granted to a current employee. The employee should exercise during his/her tenure in the company or within 3 months after the termination of the employment.
- The option must be granted under a written plan (i.e.) a document specifying all the necessary terms and conditions related to the option.
- The document should also contain all the conditions which an employee should fulfil. The conditions required under Incentive Stock Option (ISO).
- The option should be granted before 10 years after taking Shareholder’s approval.
- The ISO document must state that the option is not transferable to anyone except under extraordinary conditions (i.e.) death of the option holder, in this case, the option will be transferred to the legal heir of the deceased.
- The employee must not own more than 10% of the voting stock of the company at the time of the grant.
Also, check out Restricted Stock Units
The Controversy over Expensing Stock options
Before studying the impact on Financial Statements of the company when it grants stock options to employees, we need to look at the controversy over option expensing.
Stock Option Expense Controversy:
The controversy over option expensing has been there since the time options were used as a compensation for the company’s employees. As discussed above, the stock options are used as compensation for employee retention as well as aligning employee’s interests with that of company’s Shareholders.
This has helped the companies in such a way that its top executives do not merely look for short term profits and target completion, but also need to stay with the company for the long term if they want to benefit from owning the options. The management of the company is then motivated to stay with the company on a long-term basis with their vested interests aligned with those of the shareholders who want to see the company grow over the years.
For instance, Financial Reporting Standards Board (FASB) requires stock options to be expensed unlike International Accounting Standards Board (IASB). Since 2004, with some political pressure of converging U.S. GAAP and IFRS, the IASB (the standard rule-setting body for IFRS (International Financial Reporting Standards)), now requires companies to expense it.
Arguments against Expensing Stock options
FAS-123 requires a disclosure but not recognition. This means that the options’ cost estimates must be disclosed in the footnotes to the Financial Statements, but it does not have to be recognized as an expense in the Income Statement. This will not affect Income Statement and the Net Income would be overstated if the options are not expensed. Also, the EPS (Earning per Share) would also be overstated as the exercised options would not be recognized as an expense.
Arguments for Expensing Stock Options
Some believe that the arguments against expensing stock options are still unfounded. Some people say that the stock option does not represent a real cost incurred to the company, others believe that options result into a transfer of value, even though in some methods there is no exchange of cash. Additionally, option grants carry an opportunity cost. The issuer forgoes the opportunity to receive cash if the issuer were to sell it to an investor. The failure to include option costs leads to the understatement of compensation costs. This can mislead an analyst or an investor trying to compare the financial characteristics of companies with the varying compensation schemes. Some also argue that there are Option Pricing Models, which can be used to value a stock option; this statement comes in retaliation against a statement, which argues that because the stock options are illiquid, we cannot estimate its value.
Still, others contend that stock option costs are already adequately disclosed in the footnotes of financial statements which we have already discussed above. However, some think that footnote disclosures often misrepresent company economics and thus bring into question the quality of the date presented in the footnotes as well as the Financial Statements.
The final argument is that expensing stock options hurts entrepreneurial companies that do not have the cash to attract and retain talent to which some say that such a claim overlooks the choice companies have of issuing options to investors, as discussed in the above section, rather than employees in order to raise money for cash compensation. Some scholars are of the opinion that the implementation of new public policies allowing stock options to be expensed would likely support the strong entrepreneurial companies to become even stronger and more competitive.
The companies also get the benefit of issuing stock option grants in the later periods after their issuance. These benefits keep on accruing because of the incentive effect of the stock options on employee motivation and retention, which increasingly generates higher cash flows. However, if we try to estimate the benefits, it is likely to lead to material measurement error and biased estimates.
The debate gets deeper and complex to understand as both sides show us the valid points of whether the companies should expense the stock options or not. Whilst the arguments, the companies today fail to show the options costs in the Income Statement because of which the Net Income is overstated.
Facebook accounts for stock-based compensation plans under the fair value provision of GAAP.
source: Facebook 10K Filings
Now, let’s see the impact on the Financial Statements if we consider stock options as an expense.
Effect on the Financial Statements
If we consider the stock options as an expense, we would definitely have to recognize it. After we recognize the stock options in the Income Statement, the Net Income will come down for that specific amount and it will also impact the EPS calculations.
Impact on the Income Statement:
Share-based compensation affects the Income Statement in two ways
#1 – Decreased Net Income
Let us have a look at Facebook Income Statement. Here the cost and expenses include the share-based compensation expense. This expense reduces the Net Income.
Also, note that Facebook has provided the breakup of Stock-based compensation included under each cost and expense item. Overall, in 2016, Facebook included $3,218 million worth stock-based compensation.
source: Facebook 10K Filings
#2 – Diluted Earnings Per Share
When we calculate Diluted EPS, we take the impact of the stock options exercised by the option holders. When stock options are exercised, the company needs to issue some additional shares in order to compensate the employees or investors who have exercised them. Due to this, the total number of outstanding shares increases resulting in a lower EPS.
As we see from below, Facebook Employee stock options increase the total number of outstanding shares thereby reducing the Earnings Per Share.
source: Facebook 10K Filings
Overall, the impact of stock options on the income statement is to increase the expenses, reduce the net income and increase the number of outstanding shares, all of which result into a smaller EPS.
Learn the calculation of Impact of Stock Options on Diluted EPS from this detailed article – Treasury Stock Method
Impact on the Balance Sheet
There are several ways a company can compensate its stock option holders. Here, we will consider the following two ways for explanation purpose:
First- The Company can pay the difference between the predetermined price and the price on the date of exercise.
Second- The Company has an option to issue additional shares in lieu of the stock options outstanding for the year.
If the company goes by the second option, the company will increase its paid-up capital in lieu of issuing the additional shares.
Impact on the Cash Flow Statement
Again consider the two ways of compensating the stock option holders as discussed above. If the company goes for the first option (paying the difference in cash), then it will have to record a cash outflow from Financing Activities in Cash Flow Statement. Thus, the Cash Flow from Financing Activities will be reduced by the same amount as the Cash on the Asset side of the Balance Sheet.
If the company goes for the second option of issuing shares instead of paying cash, then we there will be no impact on the Cash Flow Statement as no cash flow will happen.
Employee Stock Options Video
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Stock-based compensation is a kind of compensation given by companies to its employees in the form of equity shares. This type of compensation is very commonly given by start-up companies in order to lock-in its executives for minimum number years. The executives who are given stock based compensation can get the benefit of it only if they serve the company for the specified period of time.
The most common type of stock-based compensation is employee stock options (ESOPS). These options may have tax implications depending upon whether they are Non-Qualified Stock Options or Incentive Stock Options. The companies can either show the costs associated to ESOPS in their Income Statements or in the footnotes.
If expensed and reported in the Income Statement, the exercising of the ESOPS by the employees results in a reduction in EPS. And if the company actually pays the difference between stock price and exercise price the option holders, it results in a reduction in Owners’ Equity and Cash on the Balance Sheet and a reduction in Cash from Financing Activities on the Cash Flow Statement. And if the company compensates the option holders totally in terms of additional shares, the paid-up capital increases on the Balance Sheet while there will be no impact on the Cash Flow Statement.