Since stock option plans are a form of compensation, generally accepted accounting principles, or GAAP, requires businesses to record stock options as compensation expense for accounting purposes. Rather than recording the expense as the current stock price, the business must calculate the fair market value of the stock option.
Basics of accounting for stock options
Now here is where things get difficult. What do we enter for the term? Often, you will see 10 years entered. Click here to learn more about this method. Using it, we get a term of 6. Myron Scholes and Robert C.
Fischer Black died in and was therefore ineligible as Nobel Prizes may not be awarded posthumously. Another tricky input is Volatility. If we are a public company, this is as straightforward as looking up our trading history on finance. The last input needed is the Risk-Free Rate. This is the interest rate at which you can lend money at with an almost perfect certainty of being repaid. Because the United States Government has never defaulted on its debt, it is a standard industry practice to use the interest rates on US Treasury Bonds as a proxy for the risk-free rate.
These rates are updated daily on the US Treasury website. We now have all five inputs to enter into the Black-Scholes Model. Now that we know the value per share, we are ready to record the expense. The expense is recorded over the useful economic life of the grant. What is the useful economic life of an option grant? After 4 years, she is able to exercise all of her options as they are fully earned.
The most common way to allocate the expense over the 4 year is in even increments — this is called the Straight-Line Allocation Method — but an accelerated method somewhat analogous to double declining appreciation can be used. At year-end, the grant is 6 months or Using this straight-line method, it is easy to see how much expense will be recorded at the end of each year:.
If she quits her job on December 31, , she does not have This begs the question of whether we should even record an expense in or if we should just wait until the options have vested? The answer is that we should still record the expense in , but the expense is not final until the options have vested.
Rather than recording the expense as the current stock price, the business must calculate the fair market value of the stock option. The accountant will then book accounting entries to record compensation expense, the exercise of stock options and the expiration of stock options.
Businesses may be tempted to record stock award journal entries at the current stock price. However, stock options are different. GAAP requires employers to calculate the fair value of the stock option and record compensation expense based on this number.
Businesses should use a mathematical pricing model designed for valuing stock. The business should also reduce the fair value of the option by estimated forfeitures of stock. Accounting manager, self employed Sep 25, Ask a question Can be anonymous.
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Let’s take a look at an example. Friends Company, a fictitious entity, grants its CEO 5, stock options on January 1, 20X4. Each option allows the CEO to purchase 1 share of $1-par-value stock for $80 on December 31, 20X7. The current market value of the stock is $ The fair market value of one stock option is $ First, the experts at the Financial Accounting Standards Board (FASB) have wanted to require options expensing since around the early s. By David Harper Relevance above ReliabilityWe will not revisit the heated debate over whether companies should "expense" employee stock options. Stock Option and Stock Purchase Plans, Accounting Research Bulle-tin No. 43 (), Chapter 13B. 2. That treatment was established in by FASB’s predecessor, the Accounting Principles Board, in its Opinion No. 25, Accounting for Stock Issued to Employees (referred to hereafter as Opinion 25).