Companies may choose two vesting schedules for employee stock options: cliff or ratable vesting. The latter, commonly called graded vesting, allows employees to receive a certain percentage of vesting rights over a period of time until fully vested. A company must expense the cost of stock options over participants’ service periods. A company using a ratable vesting schedule may record compensation expense using the straight-line or accelerated method. Organizations should understand how to record compensation expenses to remain in compliance with the Financial Accounting Standard Board.
Definition of a Stock Option
Companies use employee stock option plans as incentives. An ESOP represents a contract between the employer and employee to buy the company’s stock at a certain time for a pre-determined price. Companies establish vesting periods, which require employees to wait a period of time before purchasing stock. With a four-year, ratable vested stock option, the company may set the rate at 25 percent. This means an employee is 25 percent vested after the first year, 50 percent vested after the second year, 75 percent vested after the third year and fully vested after the fourth year.
Determining Fair Value
Companies incur a cost for offering stock options to employees. In 2004, the FASB revised the rules requiring companies to expense the cost of stock options. The cost is expensed according to the fair value of the stock option on the grant date. A company may use several option models to estimate the fair value. Companies commonly use the Black-Scholes — or lattice-based — model. The FASB does not prefer a particular model over another. However, it requires the model include the exercise price of the option, the option’s term, expected risk-free rate, the current market price of the stock and the stock’s expected volatility.
The straight-line method amortizes compensation expense at the same amount for the vested period. For example, if the compensation expense for a five-year, ratable vested option equals $30,000, then the company records compensation expense for $6,000 annually. The company accounts for compensation expense by recording a debit to paid-in capital stock options for $6,000 and a credit to compensation expense for $6,000.
The accelerated method treats the vesting period as a separate award. If the company’s vesting period is five years, then the accelerated method accounts for five separate vesting amounts. Suppose, for example, the compensation expense for a company’s four-year vested stock option equals $50,000. The company may calculate the compensation expense to reflect $20,000 for the first year, $15,000 for the second year, $10,000 for the third year and $5,000 for the fourth year.
- Comstock/Comstock/Getty Images