At a Glance
Main Takeaway
On an income statement, stock-based compensation is recognized as a non-cash expense, just like other operating expenses such as depreciation. ASC 740 addresses how companies should account for stock-based compensation in their income tax provision.
Next Step
Learning the ins and outs of ASC 740 and its effect on stock-based compensation can help you remain compliant with GAAP (Generally Accepted Accounting Principles) reporting.
What is Stock-Based Compensation?
Stock-based compensation, sometimes called equity or share-based compensation, is a way to pay a company’s directors, executives, or employees with equity in the company. It is often used to motivate employees in ways beyond their standard cash-based compensation like salaries or bonuses.
Stock-based compensation also helps to align an employee’s interests with the interests of the company’s shareholders. Under US GAAP, stock-based compensation is seen as a non-cash expense on the income statement.
There are generally three ways to give stock-based compensation to employees:
- Incentive Stock Options (ISOs). For ISOs, a company will grant an employee the option to purchase a set number of stock shares at an exercise price. ISOs are usually subject to certain conditions like continued employment.
- Restricted Stock Units (RSUs). For RSUs, the company awards stock shares to an employee at a future date if the employee meets specific requirements, such as achieving performance goals or continued employment.
- Nonqualified Stock Options. For NQSOs, the company will grant an employee the opportunity to purchase a specific number of stock shares at an exercise price. NQSOs are often subjected to a condition of continued employment. The main difference between NQSOs and ISOs is how they are taxed.
How ASC 740 Affects Stock-Based Compensation
Accounting for stock-based compensation will depend on the type of compensation received. Compensation such as non-qualified stock options and restricted stock units are seen as temporary items and ordinarily result in an eventual tax deduction for the company.
On the other hand, incentive stock options are treated as permanent items resulting in favorable tax treatment for employees and no tax deduction to the employer. However, subtle differences in each option make them more advantageous for a particular business or employee.
Incentive Stock Options (ISOs)
In the case of an ISO, the company grants an employee the option to buy a set amount of stock shares after the vesting date at the exercise price. ISOs differ from other stock-based compensation types as the employee may be afforded capital gain tax treatment. The option must meet statutory requirements to qualify for preferential treatment and be considered an ISO.
The company will calculate the intrinsic value for the options using option pricing on the grant date. Any value is recorded as a compensation expense during the vesting period with an offsetting credit to additional paid-in capital (APIC).
The company should treat the compensation expense of an ISO as a permanent item in its tax provision. The company does not need to record a deferred tax asset because ISOs generally do not result in tax deductions.
The company will receive no deduction after exercise if the employee reaches the set goals and complies with the required holding periods. However, if they do not meet the requirements for requisite holding, a disqualifying disposition occurs, and the company will receive a tax deduction equal to the difference between the exercise price of the award on the exercise date and the fair value of the exercised awards. This tax deduction is permanent in the tax provision.
Restricted Stock Units (RSUs)
Restricted Stock Units are stock shares awarded by the company to an employee for a date in the future if the employee reaches a set of specific vesting requirements, such as achieving a set of goals or having continued employment.
Over the vesting period, the company records the RSUs as a compensation expense and marks the value of the award as of the grant date, with an offsetting credit to APIC. In anticipation of a future deduction, the company will also recognize a deferred tax asset related to the compensation expense.
The company will receive a tax deduction upon vesting that will equal the fair value of the awards. The company will reverse the deferred tax asset associated with the restricted shares upon vesting. Any shortfall or excess windfall benefit is recorded as a discrete cost or benefit in income tax expense during the period the RSU is exercised.
Nonqualified Stock Options (NQSOs)
Non-qualified stock options are granted to an employee as an opportunity to purchase a set number of stock shares after the vesting date at the exercise price. They are usually subject to a condition of continued employment.
Similar to ISOs, the company will calculate the intrinsic value of the non-qualified stock options using an option-pricing model. This allows them to record the value as a compensation expense during the vesting period, with an offsetting credit to APIC.
Anticipating a future deduction, a company will recognize a deferred tax asset for the compensation expense. The company will then receive a tax deduction upon exercise equal to the difference between the exercised awards’ fair value and the price of the award on the exercise date.
Any deferred taxes associated with the exercised option are then reversed. Similar to RSUs, the shortfall or excess windfall benefit will be recorded as a discrete cost or benefit in income tax expense during the period the NQSO was exercised.
Key Terms to Track for Stock Compensation
- Exercise Date – The date an option is exercised or purchased.
- Vesting Date – The vesting date is when an award is available for exercise (for options), or the restriction will lapse (for restricted stock units). Options will usually vest in tranches over three to four years with multiple-year exercise periods. Restricted units will usually vest on the same date after a three to four-year period. This is called a “cliff vest.”
- Grant Date – The date the company grants an award to an employee, often the day a vesting period begins.
- Vesting or Service Period – This is when the award is earned and may become available for exercise by an employee.
- Exercise or Strike Price – The price at which an option is exercisable and is set at the grant date.
Work with Windes for Professional Business Accounting Services
Windes is a professional ASC 740 advisory firm offering ASC 740-specific consulting and general business accounting services. ASC 740 is challenging for even the most proficient financial professionals to navigate. Let our team of experts help your business achieve ASC 740 compliance.