Equity Compensation

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on August 26, 2021

As a method of obtaining agreement between the personal goals of employees and the goals of the stockholders, many corporations provide their key employees with part of their compensation either in the form of equity securities or based upon the value of the firm’s stock.
Compensation can be provided through shares of stock, warrants, and stock appreciation rights. There are four criteria for determining whether the granting of the securities actually constitutes compensation. If a particular plan possesses any one of the following characteristics, it is deemed to be compensatory:

Characteristics of Equity Compensation

Characteristics Rational
1. Securities are not offered to essentially all employees. The plan is provided as special compensation
to a special group of employees for their
unique services.
2. Securities are not offered proportionally to the employees’ salaries. Same as number 1.
3. Warrants cannot be exercised within a reasonable period of time. The plan is designed to reward employees for
the length of service.
4. The discount on the price of the securities
is more than a reasonable amount.
The plan causes the firm to incur a sacrifice.

If a plan is noncompensatory, all issuances of securities are recorded normally and no compensation expense is reported. Accounting for compensatory plans raises questions of how to (1) measure the compensation, (2) assign the compensation to a period, and (3) disclose information about the situation.

Measurement of Equity Compensation

The preferable measure of compensation would be the market value of the options. However, no market typically exists for these warrants because they are usually not transferable and frequently are subject to other restrictions. If a quoted market price for the stock is not available, an estimate should be used.
Another substantive measurement issue involves identifying the date on which the amount is to be determined. Because market value can change significantly, the date selected can produce substantial differences in the amount reported. The approach is consistent with historical cost measurement in that the date used is the one on which the firm is committed to making the sacrifice of foregoing alternative uses of the stock. That is, the approach holds that expense is incurred (and best measured) when the corporation effectively gives up its right to issue its shares elsewhere
The measurement date is the one on which both the number of shares and the price are established. In many cases, the measurement date is the same date on which the employee is granted the right to obtain the shares. In other situations, the measurement date follows the grant date because the plan is variable, such that either the number of shares or the option price or will not be known until future events occur. This postponement of the measurement date, however, does not preclude reporting estimated compensation expense in the periods between the granting and measurement dates. The mechanics of these procedures are demonstrated in the following section.

Assignment of Expense to Time Periods

As with other expenses, compensation costs should be assigned to the time period in which the firm receives the benefit from the sacrifice. If compensation for past or current services is paid with equity securities, the expense should be recorded and reported in the current period. If the compensation will not be earned until future periods, the expense should be reported in those periods. If a present sacrifice is made to secure those future services, a Deferred Compensation Expense account should be created and amortized as the services are performed. The entries for recognizing compensation expense under several example situations are explained below.

Measurement on Grant Date

Perhaps the simplest situation occurs when an employee is compensated for past service with an outright grant of shares of stock. Assume that, on December 31, 2018, the Sample Company gives a group of executives 10,000 shares of its $20 par value common stock for services rendered in 2018. On the date of grant, which is also the measurement date, the stock has a listed market value of $75 per share. This entry would be recorded:
Equity Compensation Journal Entry
The equity accounts arc credited just as if the stock were sold for cash. The situation is slightly more complicated if the executives are allowed to purchase the share at 80 percent of the market value. That is, the compensation for past services equals only 20 percent of $75 value of the stock ($15 per share). To summarize the facts for this example:
Equity Compensation Journal Entry
This journal entry would be recorded:
Equity Compensation Journal Entry
Deferred realization
A more typical arrangement calls for warrants to be exercisable only after future services are rendered. This postponement is intended to encourage the employees to take steps to increase the market value of the stock. Assume that the Sample Company grants warrants for 10,000 shares on December 31, 20×1. The warrants require the executives to pay in 80 percent of the present market value of $75 per share, but cannot be exercised until January 2, 20×6. It is clear from the arrangement that the compensation is for the next four years’ services. This summary presents the basic facts:
Equity Compensation Journal Entry
The significant difference in this case is that the present sacrifice is made for future benefits. Matching the expense with the periods requires it to be deferred and amortized over the next four years. For this example the annual expense equals $37,500 ($150,000 / 4 years). On the date of the grant, this journal entry would be recorded:
Equity Compensation Journal Entry
The Deferred Compensation Expense account should be reported as contra to the Warrants Outstanding account in the stockholders’ equity rather than as an asset. The apparent reason for this treatment is that the firm has not yet paid for the services and has not yet received them. On December 31 of each year from 2018 through 2022, this journal entry would be recorded:
Equity Compensation Journal Entry
Thus, the balance of the deferred account will be reduced to zero on December 31, 2022. If the warrants are exercised on January 2, 2023, this entry would be recorded:
Equity Compensation Journal Entry
It should be noted that the entry is made without considering the stock’s market value on the exercise date.
Measurement date after grant date
The calculations become more complex when the arrangement does not fix either the number of shares or the price per share or both until some date following the date of grant. According to good income reporting practice, the uncertainty should not preclude charging the periods of service with estimated amounts of compensation expense. The total amount should be based on the value of the stock at the end of each year until the date of measurement is reached. Any changes in the estimated total are to be included in the current and future years rather than retroactively.
This situation can be demonstrated by modifying the Sample Company’s arrangement such that the option price on the 10,000 shares is stated as 80 percent of the market value on December 31, 2021, instead of December 31, 2018. This new date is the measurement date because it is the first day on which both the quantity and price are fixed. The facts are summarized below:
Equity Compensation Journal Entry
The following example shows the calculation of the estimated total and annual compensation expense. The total is estimated at the end of 2019 by using the current market value. Only one fourth is assigned as the expense to that year. The total is again estimated at the end of 2020, but reduced by the amount previously recognized in 2019 before being spread over the three years. At the end of 2021, the total can be calculated without estimation. This balance is reduced by the prior years’ expenses and is amortized over 2021 and 2022. No new calculations are needed for 2022.
Equity Compensation Example
It should be observed that this approach could result in a negative expense In later years if the market value first increased and then declined so far such that prior years’ charges exceeded the total compensation. In this case, no entry is made in the Deferred Compensation Expense account until the measurement date is reached. As a practical matter, the omission also simplifies the accommodation of changes in the estimate. Thus, there would be no entry recorded by Sample Company on the date of grant (December 31, 20×1). At the end of 20×2, this journal entry would be recorded:
Equity Compensation Journal Entry
The following year would require this entry:
Equity Compensation Journal Entry
The amount includes the adjustment for the inaccuracy in 20×2’s estimated expense. At the end of 20×4, the total expense can be determined and adjusted to compute the amount to be amortized in 20×4 and 20×5. The year-end entry also recognition of the deferred compensation expense because the measurement date has been reached. The journal entry would be:
Equity Compensation Journal Entry
At this point, the balance in the Warrants Outstanding account is $176,000, which is the sum of the three credit entries ($37,500 + $14,500 + $97,000). The increase in owners’ equity is this balance less the deferred compensation expense ($48,500), or $127,500. This amount also equals the three years’ expenses ($37,500 + $41,500 + $48,500).
At the end of 20×5, this journal entry is recorded to amortize the reminder of the deferral:
Equity Compensation Journal Entry
The equity account reflects a sale for $88 per share.
Equity Compensation Journal Entry
Recording lapsed warrants
If warrants granted under a compensatory plan are not exercised, the treatment of the lapsing depends on the reason for their not being used. If the employee fails to meet the requirements of the agreement (such as not remaining employed), the Warrants Outstanding and Deferred Compensation Expense accounts be closed. Any difference between the balances of those two accounts should be credited to Compensation Expense. For example, if $25,000 of warrants are forfeited when an employee quits and the balance of Deferred Compensation Expense is $10,000, this entry would be made:
Equity Compensation Journal Entry
This procedure is used because the firm did not receive the service for which it was paying. If, on the other hand, the employee chooses not to exercise the right, the Warrants Outstanding and Deferred Compensation Expense accounts are closed. Any difference is credited to Additional Paid In Capital. If $25,000 of warrants are lapsed for this reason, and the balance of the Deferred Compensation Expense is $10,000, this entry is made:
Equity Compensation Journal Entry
This procedure is used because the firm actually did receive the services but did not have to pay for them.
In addition to the items presented on the income statement and balance sheet, additional disclosures are required when the firm uses equity securities to compensate its employees. Disclosure should be made as to the status of the (compensatory) plan at the end of the period, 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, disclosures should be made of the number of shares involved and the option price thereof.
When a variety of plans operate at the same time, the disclosures can be fairly complex. For firms registering with the SEC, even more information must be provided.

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