Stock Compensation (ASC 718): CPA FAR Exam Guide
Master stock-based compensation accounting under ASC 718 for the CPA exam, covering stock options, restricted stock, measurement, and recognition principles.
Overview of ASC 718: Stock-Based Compensation
ASC 718 requires entities to recognize the cost of employee services received in exchange for awards of equity instruments (such as stock options and restricted stock) based on the grant-date fair value of those awards. This topic appears regularly on the CPA FAR exam, particularly in questions about measurement, recognition, and the impact on financial statements.
Types of Share-Based Payment Awards
Stock Options
Stock options give employees the right to purchase a specified number of shares at a fixed exercise price after satisfying vesting conditions. The fair value of stock options is typically estimated using an option-pricing model such as the Black-Scholes model or a lattice model (binomial model). Inputs include the stock price at the grant date, the exercise price, the expected term, expected volatility, the risk-free interest rate, and expected dividends.
Restricted Stock and Restricted Stock Units (RSUs)
Restricted stock is issued to employees subject to vesting conditions. Unlike stock options, restricted stock has value even if the stock price does not increase above the grant date price. The fair value of restricted stock is generally the market price of the shares on the grant date, reduced by any amount the employee must pay. RSUs are similar but the shares are not actually issued until the vesting conditions are met.
Performance-Based Awards
Awards with performance conditions (such as meeting a revenue target) are accounted for differently from those with service conditions. Compensation cost is recognized only when it is probable that the performance condition will be achieved. If probability changes during the vesting period, the entity adjusts compensation cost on a cumulative catch-up basis.
Market Condition Awards
Awards with market conditions (such as stock price reaching a target) incorporate the market condition into the grant-date fair value estimate. Unlike performance conditions, the market condition is reflected in the fair value measurement but does not affect whether compensation cost is recognized. Compensation cost is recognized over the vesting period regardless of whether the market condition is met, as long as the service condition is satisfied.
Measurement and Recognition
Grant-Date Fair Value
The fair value of an award is measured at the grant date and generally is not remeasured after the grant date for equity-classified awards. The grant date is the date at which an employer and an employee reach a mutual understanding of the key terms and conditions of a share-based payment award.
Recognition Over the Vesting Period
Compensation cost is recognized over the requisite service period, which is generally the vesting period. The entity may choose to recognize cost on a straight-line basis over the entire vesting period or on a graded vesting (accelerated) basis if the award has graded vesting features. The policy election must be applied consistently.
For an award with a four-year cliff vesting period and a grant-date fair value of $400,000, the entity would recognize $100,000 of compensation cost in each of the four years under the straight-line method.
Forfeitures
Entities may elect to estimate forfeitures at the grant date and revise those estimates during the vesting period, or they may elect to account for forfeitures as they occur. This is an accounting policy election. If forfeitures are estimated, a true-up is recorded when actual forfeitures differ from estimates.
Journal Entries
Annual Recognition of Compensation Cost
Debit Compensation Expense, Credit Additional Paid-In Capital (APIC) - Stock Options (or Restricted Stock, as appropriate). The credit goes to an equity account because the company is issuing equity instruments.
Exercise of Stock Options
Debit Cash (for the exercise price times the number of shares), Debit APIC - Stock Options (for the cumulative compensation cost recognized), Credit Common Stock (at par value), Credit APIC - Common Stock (for the excess over par).
Expiration of Unexercised Options
If options expire unexercised, no reversal of previously recognized compensation cost is required. The amount in APIC - Stock Options is reclassified to APIC - Expired Stock Options (or simply remains in APIC).
Modifications
When the terms of an award are modified, the entity compares the fair value of the modified award to the fair value of the original award immediately before modification. If the modification increases the fair value, the incremental compensation cost is recognized over the remaining vesting period. If the modification does not increase the fair value, the entity continues to recognize the original grant-date fair value.
Exam Preparation Tips
- Know the difference between equity-classified and liability-classified awards. Equity awards are measured once at the grant date; liability awards are remeasured each period.
- Understand how performance conditions differ from market conditions in terms of recognition and measurement.
- Practice computing annual compensation expense for stock option grants using straight-line recognition.
- Be prepared to record journal entries for the grant, vesting, exercise, and expiration of stock options.
- Remember that forfeitures of equity awards do not result in a gain; previously recognized cost is reversed.
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