3. Compensatory stock option plans

All other stock option plans are assumed to be a form of compensation, which requires recognition of an expense under U.S. GAAP. The amount of the expense is the fair value of the options, but that value is not apparent from the exercise price and the market price alone. Option valuation is a finance concept, and it generally relies on the Black-Scholes method, which is beyond the scope of this article.

The expense is recorded equally throughout the entire vesting period, which is the time between the date the company grants the options and when the individual is allowed to exercise the option. In other words, U.S. GAAP considers the options “earned” by the employee during the vesting period. The entry credit is to a special additional paid-in capital account. Let’s take a look at an example.

Friends Company, a fictitious entity, grants its CEO 5,000 stock options on January 1, 20X4. Each option allows the CEO to purchase 1 share of $1-par-value stock for $80 on December 31, 20X7. The current market value of the stock is $75. The fair market value of one stock option is $10. Each year, the company will record the following compensation entry.

The total value of the options is $50,000 (5,000 x $10), and the vesting period is 4 years, so each year the company will record $12,500 of compensation expense related to the options. If the options are exercised, the additional paid-in capital built up during the vesting period is reversed. The stock’s market value is irrelevant to the entry – the credit to additional paid-in capital (common stock) is to balance the entry and is not related to market value.

If the options are not used before the expiration date, the balance in additional paid-in capital is shifted to a separate APIC account to differentiate it from stock options that are still outstanding.

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