How to Account for Stock Options Expense
Accounting for employee stock options is 1 of the most controversial topics in accounting and corporate finance. A stock option is the right to buy a share of stock at a pre-set price, known as the strike price. If you own an option to buy stock in Company A for $20 per share, and the stock is trading in the open market at $50 per share, you can purchase the stock for $20, sell it for $50 and make an immediate profit of $30. During the dot-come bubble, many start-up companies issued large quantities of options to company managers as a form of compensation. In 2004, in response to widespread criticism that these companies were understating their compensation expenses by using stock options, Congress passed the Stock Option Reform Bill, which significantly changed the way companies are required to account for stock options.
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Instructions
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Obtain a list of all stock options issued to employees along with the strike prices for the options. The list should be available from the company's human resources department.
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Calculate the intrinsic value of the exercised options by subtracting the strike prices from the market price of the stock when the options are exercised. The intrinsic value is the same as the profit the option holder will make when she exercises the options and sells the shares in the open market. In the example above, the intrinsic value of Company A's options is $30.
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Enter the total intrinsic value of all options exercised in the period in the operating expenses section of the company's income statement. Continuing with the example above, if 100 of Company A's options are exercised, the total operating expense associated with the options is $30 x 100 = $3,000.
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Add the operating expense associated with the company's options back to net income on the company's cash flow statement. The cash flow statement reflects the cash inflows and outflows of the company; because stock option expenses are non-cash expenses, the expense should be added back.
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Add back the strike price of the exercised options to the company's cash flow statement. When an employee exercises his stock options, he pays the strike price of the options to the company in exchange for newly issued shares. Continuing with the example above, if 100 of Company A's options are exercised at a $20 exercise price, the company will receive a cash inflow of $20 x 100 = $2,000. This amount should be added back as a source of cash on the company's cash flow statement.
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Tips & Warnings
Rules for accounting for stock option expenses change frequently. Consult with an accountant or a lawyer before filing any financial statements that contain stock option expenses.
