Stock-Based Compensation (ASC 718)
Stock-based compensation is a high-frequency topic on the FAR section of the CPA exam. ASC 718 requires entities to recognize compensation cost for all share-based payment transactions with employees based on the grant-date fair value of the awards.
Types of Share-Based Awards
- Stock options: Give employees the right to purchase shares at a specified exercise (strike) price. Fair value is typically estimated using the Black-Scholes or lattice (binomial) model.
- Restricted stock awards (RSAs): Shares issued subject to vesting conditions. Fair value equals the share price on the grant date.
- Restricted stock units (RSUs): Promise to deliver shares (or cash) upon vesting. Fair value equals the share price on the grant date. No shares are actually issued until vesting.
- Stock appreciation rights (SARs): Pay the employee the appreciation in share price. Liability-classified if settled in cash; equity-classified if settled in shares.
- Employee stock purchase plans (ESPPs): Allow employees to purchase shares at a discount, often through payroll deductions. Compensatory if the discount exceeds 5% or there is a look-back feature.
Measurement and Recognition
Key principles under ASC 718:
- Measurement date: The grant date - the date the employer and employee agree to the terms. Fair value is fixed at this date for equity-classified awards.
- Recognition period: Compensation cost is recognized over the requisite service (vesting) period, typically on a straight-line basis for awards with only service conditions.
- Forfeitures: Entities may elect to estimate forfeitures at the grant date or recognize them as they occur (ASC 718-10-35-3).
- Modifications: If an award is modified, the entity recognizes at minimum the original grant-date fair value, plus any incremental fair value resulting from the modification.
For awards with performance conditions, compensation cost is recognized only when it is probable the condition will be achieved. For awards with market conditions (e.g., stock price targets), the fair value at grant date incorporates the market condition, and cost is recognized regardless of whether the market condition is met - only service period completion is required.
Journal Entries for Stock Options
Over the vesting period, recognize compensation expense:
Dr. Compensation Expense Cr. Additional Paid-in Capital (APIC - Stock Options)
Upon exercise:
Dr. Cash (exercise price × shares) Dr. APIC - Stock Options Cr. Common Stock (par) Cr. APIC - Common Stock
If options expire unexercised, the APIC - Stock Options balance remains in equity and is not reversed to income.
Earnings Per Share (ASC 260)
EPS is a required disclosure for public entities and a heavily tested CPA exam topic. ASC 260 requires presentation of both basic and diluted EPS on the face of the income statement.
Basic EPS
Basic EPS = (Net Income − Preferred Dividends) / Weighted-Average Common Shares Outstanding
- Preferred dividends are subtracted only for cumulative preferred stock (regardless of whether declared) and for noncumulative preferred stock only when declared.
- Weighted-average shares are adjusted for stock dividends and stock splits retroactively to the beginning of the earliest period presented.
- Shares issued mid-year are weighted by the fraction of the year they were outstanding.
Diluted EPS
Diluted EPS assumes that all potentially dilutive securities are converted or exercised. Two primary methods are used:
Treasury Stock Method (Options, Warrants, RSUs)
Assumes options/warrants are exercised at the beginning of the period and the proceeds are used to repurchase shares at the average market price:
- Calculate shares issued upon exercise
- Calculate shares repurchased = (Exercise Price × Shares) / Average Market Price
- Incremental shares = Shares Issued − Shares Repurchased
- Add incremental shares to the denominator (no numerator adjustment)
Options and warrants are dilutive only when the exercise price is below the average market price (they are "in the money").
If-Converted Method (Convertible Bonds, Convertible Preferred)
Assumes conversion occurred at the beginning of the period (or issuance date, if later):
- Convertible bonds: Add back interest expense (net of tax) to the numerator; add shares that would be issued upon conversion to the denominator.
- Convertible preferred stock: Do not subtract preferred dividends from the numerator; add converted shares to the denominator.
A potentially dilutive security is anti-dilutive if including it would increase EPS or decrease loss per share. Anti-dilutive securities are excluded from diluted EPS.
CPA Exam EPS Calculation Steps
- Calculate basic EPS
- Rank all potentially dilutive securities from most dilutive to least dilutive
- Incorporate each security one at a time and recalculate EPS
- If incorporating a security increases EPS (anti-dilutive), exclude it and all less dilutive securities
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