Employee stock options give an employee of a company the right to buy the company’s stock at a fixed price, called the exercise price. An employee can profit from the stock options if the stock’s price increases above the exercise price. A company grants stock options to an employee as part of a compensation package and as an incentive for the employee to help the company succeed in its business and increase its stock price. The company must record a compensation expense in its records to account for granting employee stock options.
1. Determine from your records the number of stock options you granted to employees during the year, the fair value of each stock option and the vesting period of the stock options. The vesting period is the period of time over which an employee earns the right to use all of the options by working for the company. For example, assume you granted 1,000 stock options with a fair value of $4 per option and a vesting period of two years.
2. Estimate the forfeiture rate of the stock options, which is the percentage of the stock options you expect will not be used by employees for various reasons, such as leaving the company or violating an employment agreement. In this example, assume that in past years, about 3 percent of employee stock options have been forfeited. Assume that you expect this forfeiture rate will be the same going forward.
3. Multiply the number of stock options granted by the fair value per option to determine the total value of the options granted. In this example, multiply 1,000 by $4 to get $4,000.
4. Subtract the forfeiture rate from 1. Multiply your result by the total value of the options. In this example, subtract 3 percent, or 0.03, from 1 to get 0.97. Multiply 0.97 by $4,000 to get $3,880.
5. Divide your result by the vesting period to calculate the compensation expense for the first year. In this example, divide $3,880 by 2 to get a first-year compensation expense of $1,940.
6. Debit the account called “compensation expense” in a journal entry in your records by the amount of the first-year compensation expense. Do this at the end of the first year in which you granted the options. This increases the compensation expense account, which reduces your profit. In this example, debit the account by $1,940.
7. Credit the account called “paid-in capital - stock options” in the same journal entry by the same amount of the first-year compensation expense. In this example, credit this account by $1,940.
- Creatas/Creatas/Getty Images