Are you considering employee stock options for your company? Many business owners and startup founders do. These can be an important part of your compensation strategy. But what is the proper accounting for employee stock options?

You need to make sure your accounting is done right because it’s very necessary. It helps you stay compliant, keep reports reliable, and support good decisions.

In this blog post, we will go through the basics of accounting for employee stock options and how the Financial Accounting Standards Board (FASB) rules under ASC 718 apply.

What Is the Proper Accounting for Employee Stock Options?

First, let us start with learning what Employee Stock Options (ESOs) are.

Employee stock options give your team a chance to get company shares at a fixed price, called the exercise or strike price. This is done once their vesting period is over.

These options help you motivate, keep, and attract employees by giving them a stake in the company's success.

If you are starting a new business, choosing stock options or another structure can affect your taxes and compliance, just like deciding between an S-Corp vs. LLC comparison.

Understanding ASC 718: The FASB Standard

There’s a rulebook for stock-based pay, including employee stock options. It’s called ASC 718, and it comes from FASB.

Under ASC 718, companies must record the cost of employee services in exchange for stock options according to their worth on the grant date.

Having knowledge of what is the proper accounting for employee stock options helps companies follow these rules correctly.

Key Components of ASC 718:

1. Fair Value Measurement

Companies measure the cost of stock options by using their fair value, often with Black-Scholes or binomial models.

2. Vesting Period

This is the period over which the employee can use the right to exercise the stock options. The related compensation cost is recorded during this period.

3. Requisite Service Period

It is the time an employee needs to work at the company before their stock options actually become theirs. It is often the same as the vesting period.

4. Exercise Price

This is the set price an employee pays to buy the company’s stock.

5. Market Value of the Stock

This is the current trading price of the company's stock, which can influence the fair value of the options.

A Guide to Accounting for Employee Stock Options

1. Find Out the Value of the Options

You need to figure out the value of the stock options using a pricing method on the grant date. This value shows the total compensation cost to record over the vesting period.

2. Count it as Compensation Expense

Spread the total value of the options as a compensation cost over the employee’s service period. This cost is shown on the income statement and affects the company’s earnings per share (EPS).

3. Adjust for Forfeitures

If employees lose their options before they vest, adjust the recorded compensation expense. This way, only the cost for options that actually vest is counted.

You must do careful tracking to prevent errors and help you avoid IRS red flags during tax filings.

4. Account for Tax Effects

Taxes on stock options can work differently depending on the situation. For example, ASC 718 says companies should account for any tax effects at the same time they record the stock-based compensation cost.

If you want to learn more about handling taxes on stock-based compensation, we provide guidance on taxes on stocks and bonds to help you manage them easily.

Restricted Stock Units (RSUs) vs. Stock Options

Stock options are common, but many startups also use Restricted Stock Units, or RSUs. RSUs promise to give employees shares in the future, usually once they’ve vested. Unlike stock options, employees don’t have to buy the shares. They get them automatically after vesting.

From an accounting point of view, RSUs are handled much like stock options under ASC 718. Knowing what is the proper accounting for employee stock options helps ensure the company records the compensation expense correctly over the vesting period based on the shares’ fair value.

Mistakes You Must Watch Out For

You Are Doing Wrong Valuation Models:
- Using the wrong method can give you the wrong value for the options.
You Are Not Recording Expenses Correctly:
- Your financial statements can give a misleading picture if you don’t spread the compensation expense over the vesting period.
You Are Ignoring Tax Effects:
- Not paying attention to the tax impact can cause compliance problems and make your financial reports inaccurate.

Starting with a clear plan early for your startup can prevent many problems, just like careful tax planning with our S-corp tax preparation services.

Impact on Financial Reporting

Keeping accurate records of employee stock options makes sure your financial statements show the true cost of stock-based compensation.

This clarity is important for investors, auditors, and anyone else who uses your financial reports to understand how your company is doing.

In Conclusion

Understanding what is the proper accounting for employee stock options is really important for you if your business offers equity-based compensation. Following ASC 718 rules will help you stay compliant, keep your finances in order, and make wise decisions.

At Skyline Financial Management, we can help you set up or review your stock option accounting with expert guidance from professionals who know ASC 718.

Contact us today to get started. We make sure your stock-based compensation is handled correctly from day one!

FAQs About Employee Stock Options

Employee stock options let employees buy company shares at a set price, while RSUs give them the shares after vesting. Both are stock-based compensation, but have different accounting and tax rules.
The compensation cost is based on the fair value of the stock options at the grant date. It is recognized over the requisite service period or vesting period on the income statement.
3. Are compensation expenses for stock options recorded immediately?
The exercise price and ongoing market value of the stock on the grant date evaluate the value of the stock options. This value affects the compensation expense recorded on the income statement.

How to Properly Account for Employee Stock Options (Guide for Businesses & Startups)