Paid In Capital BREAKING DOWN Paid In Capital Paid-in capital, also referred to as contributed capital, can be compared to additional paid-in capital. and the difference between the two values will equal the premium paid by investors over and above the par value of the shares. Preferred shares sometimes have par values that are more than marginal, but most common shares today have par values of just a few pennies. Because of this, additional paid-in capital tends to be representative of the total paid-in capital figure, and is sometimes shown by itself on the balance sheet . Additional Paid-in Capital For common stock, paid-in capital consists of a stocks par value and additional paid-in capital, the amount of capital in excess of par or the premium paid by investors in return for the shares issued to them. Additional paid-in capital can provide a significant part of a companys equity capital before retained earnings start accumulating and is an important capital layer of defense against potential business losses after retained earnings have shown a deficit. Short of the retirement of any shares, the account balance of paid-in capital, specifically the total par value and the amount of additional paid-in capital, should remain unchanged as a company carries on its business. Paid-in Capital From Sale of Treasury Stock Companies may buy back shares and return some capital to shareholders. The shares bought back are listed within the shareholders equity section at their purchase cost as treasury stock, a contra-equity account that reduces the total balance of shareholders equity. If the treasury stock is sold at above its purchase cost, the gain is credited to an account called paid-in capital from treasury stock as part of shareholders equity. If the treasury stock is sold at below its purchase cost, the loss reduces the companys retained earnings. If the treasury stock is sold at equal to its purchase cost, the removal of the treasury stock simply restores shareholders equity to its pre-share-buyback level. Paid-in Capital From Retirement of Treasury Stock Companies may retire some treasury shares, which is another way to remove treasury stock other than reissuing it. The retirement of treasury stock reduces the balance of paid-in capital or the amount of total par value and additional paid-in capital, applicable to the number of retired treasury shares. Depending on whether the initial purchase cost of the treasury stock is lower or higher than the amount of paid-in capital relevant to the number of shares removed, either something called paid-in capital from retirement of treasury stock is credited to shareholders equity section, or retained earnings are debited for the additional loss of value in shareholders equity. Expensing Stock Options: A Fair-Value Approach Executive Summary Now that companies such as General Electric and Citigroup have accepted the premise that employee stock options are an expense, the debate is shifting from whether to report options on income statements to how to report them. The authors present a new accounting mechanism that maintains the rationale underlying stock option expensing while addressing critics8217 concerns about measurement error and the lack of reconciliation to actual experience. A procedure they call fair-value expensing adjusts and eventually reconciles cost estimates made at grant date with subsequent changes in the value of the options, and it does so in a way that eliminates forecasting and measurement errors over time. The method captures the chief characteristic of stock option compensation8212that employees receive part of their compensation in the form of a contingent claim on the value they are helping to produce. The mechanism involves creating entries on both the asset and equity sides of the balance sheet. On the asset side, companies create a prepaid-compensation account equal to the estimated cost of the options granted on the owners8217-equity side, they create a paid-in capital stock-option account for the same amount. The prepaid-compensation account is then expensed through the income statement, and the stock option account is adjusted on the balance sheet to reflect changes in the estimated fair value of the granted options. The amortization of prepaid compensation is added to the change in the option grant8217s value to provide the total reported expense of the options grant for the year. At the end of the vesting period, the company uses the fair value of the vested option to make a final adjustment on the income statement to reconcile any difference between that fair value and the total of the amounts already reported. Now that companies such as General Electric, Microsoft, and Citigroup have accepted the premise that employee stock options are an expense, the debate on accounting for them is shifting from whether to report options on income statements to how to report them. The opponents of expensing, however, continue to fight a rearguard action, arguing that grant-date estimates of the cost of employee stock options, based on theoretical formulas, introduce too much measurement error. They want the reported cost deferred until it can be precisely determinednamely when the stock options are exercised or forfeited or when they expire. But deferring recognition of stock option expense flies in the face of both accounting principles and economic reality. Expenses should be matched with the revenues associated with them. The cost of an option grant should be expensed over the time, typically the vesting period, when the motivated and retained employee is presumed to be earning the grant by generating additional revenues for the company. Some degree of measurement error is no reason to defer recognition accounting statements are filled with estimates about future eventsabout warranty expenses, loan loss reserves, future pension and postemployment benefits, and contingent liabilities for environmental damage and product defects. Whats more, the models available for calculating option value have become so sophisticated that valuations for employee stock options are probably more accurate than many other estimates in a companys financial statements. The final defense of the antiexpensing lobby is its claim that other financial-statement estimates based on future events are eventually reconciled to the settlement value of the items in question. For instance, estimated costs for pension and postretirement benefits and for environmental and product-safety liabilities are ultimately paid in cash. At that time, the income statement is adjusted to recognize any difference between actual and estimated cost. As the opponents of expensing point out, no such correcting mechanism currently exists to adjust grant-date estimates of stock option costs. This is one of the reasons why high-tech company CEOs such as Craig Barrett of Intel still object to the proposed Financial Accounting Standards Board (FASB) standard for grant-date accounting for stock options. A procedure that we call fair-value expensing for stock options eliminates forecasting and measurement errors over time. It is, however, easy to provide an accounting mechanism that maintains the economic rationale underlying stock option expensing while addressing critics concerns about measurement error and the lack of reconciliation to actual experience. A procedure that we call fair-value expensing adjusts and eventually reconciles cost estimates made at grant date to subsequent actual experience in a way that eliminates forecasting and measurement errors over time. The Theory Our proposed method involves creating entries on both the asset and equity sides of the balance sheet for each option grant. On the asset side, companies create a prepaid-compensation account equal to the estimated cost of the options granted on the owners-equity side, they create a paid-in capital stock-option account for the same amount. This accounting mirrors what companies would do if they were to issue conventional options and sell them into the market (in that case, the corresponding asset would be the cash proceeds instead of prepaid compensation). The estimate for the asset and owners-equity accounts can come either from an options pricing formula or from quotes provided by independent investment banks. The prepaid-compensation account is then expensed through the income statement following a regular straight-line amortization schedule over the vesting periodthe time during which the employees are earning their equity-based compensation and, presumably, producing benefits for the corporation. At the same time that the prepaid-compensation account is expensed, the stock option account is adjusted on the balance sheet to reflect changes in the estimated fair value of the granted options. The company obtains the periodic revaluation of its options grant just as it did the grant-date estimate, either from a stock options valuation model or an investment-bank quote. The amortization of prepaid compensation is added to the change in the value of the option grant to provide the total reported expense of the options grant for the year. At the end of the vesting period, the company uses the fair value of the vested stock optionwhich now equals the realized compensation cost of the grantto make a final adjustment on the income statement to reconcile any difference between that fair value and the total of the amounts already reported in the manner described. The options can now be quite accurately valued, as there are no longer any restrictions on them. Market quotes would be based on widely accepted valuation models. Alternatively, if the now-vested stock options are in the money and the holder chooses to exercise them immediately, the company can base the realized compensation cost on the difference between the market price of its stock and the exercise price of its employees options. In this case, the cost to the company will be less than if the employee had retained the options because the employee has forgone the valuable opportunity to see the evolution of stock prices before putting money at risk. In other words, the employee has chosen to receive a less valuable compensation package, which logically should be reflected in the companys accounts. Some advocates of expensing might argue that companies should continue to adjust the grants value after vesting until the options are either forfeited or exercised or they expire unexercised. We feel, however, that the companys income-statement accounting for the grant should cease at the time of vesting or almost immediately thereafter. As our colleague Bob Merton has pointed out to us, at the time of vesting, the employees obligations regarding earning the options cease, and he or she becomes just another equity holder. Any further transactions on exercising or forfeiture, therefore, should lead to adjustments of the owners-equity accounts and the companys cash position, but not the income statement. The approach we have described is not the only way to implement fair-value expensing. Companies may choose to adjust the prepaid-compensation account to fair value instead of the paid-in capital option account. In this case, the quarterly or annual changes in option value would be amortized over the remaining life of the options. This would reduce the periodic fluctuations in option expense but involve a slightly more complex set of calculations. Another variant, for employees doing research and development work and in start-up companies, would be to defer the start of amortization until the employees efforts produce a revenue-generating asset, such as a new product or a software program. The great advantage of fair-value expensing is that it captures the chief characteristic of stock option compensationnamely that employees are receiving part of their compensation in the form of a contingent claim on the value they are helping to produce. During the years that employees are earning their option grantsthe vesting periodthe companys expense for their compensation reflects the value they are creating. When employees efforts in a particular year yield significant results in terms of the companys share price, net compensation expense increases to reflect the higher value of those employees option-based compensation. When employees efforts do not deliver a higher share price, the company faces a correspondingly lower compensation bill. The Practice Lets put some numbers into our method. Assume that Kalepu Incorporated, a hypothetical company in Cambridge, Massachusetts, grants one of its employees ten-year stock options on 100 shares at the current market price of 30, vesting in four years. Using estimates from an option pricing model or from investment bankers, the company estimates the cost of these options to be 1,000 (10 per option). The exhibit Fair-Value Expensing, Scenario One shows how the company would expense these options if they end up being out of the money on the day they vest. In year one, the option price in our scenario remains constant, so only the 250 amortization of prepaid compensation is recognized as an expense. In year two, the options estimated fair value decreases by 1 per option (100 for the package). Compensation expense remains at 250, but a 100 reduction is made to the paid-in capital account to reflect the decline in the options value, and the 100 is subtracted in the calculation of year twos compensation expense. In the following year, the option revalues by 4, bringing the grant value up to 1,300. In year three, therefore, the total compensation expense is the 250 amortization of the original grant, plus an additional option expense of 400 due to the revaluation of the grant to a much higher value. Fair-value expensing captures the chief characteristic of stock option compensationthat employees receive part of their pay in the form of a contingent claim on value they are helping to produce. By the end of year four, however, Kalepus stock price plummets, and the fair value of the options correspondingly falls from 1,300 to just 100, a number that can be precisely estimated because the options can now be valued as conventional options. In the final years accounting, therefore, the 250 compensation expense is reported along with an adjustment to paid-in capital of minus 1,200, creating a total reported compensation for that year of minus 950. With these numbers, the total paid compensation over the whole period comes out to 100. The prepaid-compensation account is now closed out, and there remains only 100 of paid-in capital in the equity accounts. This 100 represents the cost of the services rendered to the company by its employeesan amount equivalent to the cash the company would have received had it simply decided to write the options, hold them for four years, and then sell them on the market. The 100 valuation on the options reflects the current fair value of options that are now unrestricted. If the market is actually trading options with exactly the same exercise price and maturity as the vested stock options, Kalepu can use the quoted price for those options instead of the model on which that quoted price would be based. What happens if an employee holding the grant decides to leave the company before vesting, thereby forfeiting the unvested options Under our approach, the company adjusts the income statement and balance sheet to reduce the employees prepaid-compensation asset account and the corresponding paid-in capital option account to zero. Lets assume, for example, that the employee leaves at the end of year two, when the option value is carried on the books at 900. At that time, the company reduces the employees paid-in capital option account to zero, writes off the 500 remaining on the prepaid-compensation balance sheet (after the year-two amortization had been recorded), and recognizes a gain on the income statement of 400 to reverse the two prior years of compensation expenses. In this way, Kalepu trues up the total reported equity-based compensation expense to the realized value of zero. If the option price, instead of declining to 1 at the end of year four, remains at 13 in the final year, the companys year-four compensation cost equals the 250 amortization, and the total compensation cost over the four years is 1,300, which is higher than had been expected at the time of the grant. When options vest in the money, however, some employees may choose to exercise immediately rather than retain the full value by waiting to exercise until the options are about to expire. In this case, the firm can use the market price of its shares at the vesting and exercise dates to close off the reporting for the grant. To illustrate this, lets assume that Kalepus share price is 39 at the end of year four, when the employees options vest. The employee decides to exercise at that time, forgoing 4 worth of benefits per option and thereby lowering the cost of the option to the company. The early exercise leads to a minus 400 year-four adjustment to the paid-in capital option account (as shown in the exhibit Fair-Value Expensing, Scenario Two). The total compensation expense over the four years is 900what the firm actually gave up by providing 100 shares of stock to the employee at a price of 30 when its market price was 39. Following the Spirit The objective of financial accounting is not to reduce measurement error to zero. If it were, a companys financial statements would consist merely of its direct cash-flow statement, recording cash received and cash disbursed in each period. But cash-flow statements do not capture a companys true economics, which is why we have income statements, which attempt to measure the economic income of a period by matching the revenues earned with the expenses incurred to create those revenues. Accounting practices such as depreciation, revenue recognition, pension costing, and allowance for bad debts and loan losses permit a better, albeit less precise, measurement of a companys income in a period than would a pure cash-in, cash-out approach. In a similar way, if the FASB and International Accounting Standards Board were to recommend fair-value expensing for employee stock options, companies could make their best estimates about total compensation cost over the vesting life of the options, followed by periodic adjustments that would bring reported compensation expense closer to the actual economic cost incurred by the company. A version of this article appeared in the December 2003 issue of Harvard Business Review . Robert S. Kaplan is a senior fellow and the Marvin Bower Professor of Leadership Development, Emeritus, at Harvard Business School. He is a coauthor, with Michael E. Porter, of 8220How to Solve the Cost Crisis in Health Care8221 (HBR, September 2011). Krishna G. Palepu (kpalepuhbs. edu ) is the Ross Graham Walker Professor of Business Administration at Harvard Business School. They are coauthors of three previous HBR articles, including 8220Strategies That Fit Emerging Markets8221 (June 2005). This article is about ACCOUNTINGEmployee Stock Compensation Learning Objective Explain how employee stock options work and how a company would record their issue Key Points Options, as their name implies, do not have to be exercised. The holder of the option should ideally exercise it when the stock s market price rises higher than the options exercise price. When this occurs, the option holder profits by acquiring the company stock at a below market price. An ESO has features that are unlike exchange - traded options, such as a non-standardized exercise price and quantity of shares, a vesting period for the employee, and the required realization of performance goals. An options fair value at the grant date should be estimated using an option pricing model, such as the BlackScholes model or a binomial model. A periodic compensation expense is reported on the income statement and also in additional paid in capital account in the stockholder s equity section. The fixed price at which the owner of an option can purchase (in the case of a call) or sell (in the case of a put) the underlying security or commodity. A payment for work done wages, salary, emolument. A period of time an investor or other person holding a right to something must wait until they are capable of fully exercising their rights and until those rights may not be taken away. A company offers stock options due in three years. The stock options have a total value of 150,000, and is for 50,000 shares of stock at a purchase price of 10. The stocks par value is 1. The journal entry to expense the options each period would be: Compensation Expense 50,000 Additional Paid-In Capital, Stock Options 50,000. This expense would be repeated for each period during the option plan. When the options are exercised, the firm will receive cash of 500,000 (50,000 shares at 10). Paid-In capital will have to be reduced by the amount credited over the three year period. Common stock will increase by 50,000 (50,000 shares at 1 par value). And paid-in capital in excess of par must be credited to balance out the transaction. The journal entry would be:Cash 500,000 Additional Paid-In Capital, Stock Options 150,000 Common Stock 50,000 Additional Paid-In Capital, Excess of Par 600,000 Definition of Employee Stock Options An employee stock option (ESO) is a call (buy) option on the common stock of a company, granted by the company to an employee as part of the employees remuneration package. The objective is to give employees an incentive to behave in ways that will boost the companys stock price. ESOs are mostly offered to management as part of their executive compensation package. They may also be offered to non-executive level staff, especially by businesses that are not yet profitable and have few other means of compensation. Options, as their name implies, do not have to be exercised. The holder of the option should ideally exercise it when the stocks market price rises higher than the options exercise price. When this occurs, the option holder profits by acquiring the company stock at a below market price . General Foods Common Stock Certificate Publicly traded companies may offer stock options to their employees as part of their compensation. Features of ESOs ESOs have several different features that distinguish them from exchange-traded call options: There is no standardized exercise price and it is usually the current price of the company stock at the time of issue. Sometimes a formula is used, such as the average price for the next 60 days after the grant date. An employee may have stock options that can be exercised at different times of the year and for different exercise prices. The quantity of shares offered by ESOs is also non-standardized and can vary. A vesting period usually needs to be met before options can be sold or transferred (e. g. 20 of the options vest each year for five years). Performance or profit goals may need to be met before an employee exercises her options. Expiration date is usually a maximum of 10 years from date of issue. ESOs are generally not transferable and must either be exercised or allowed to expire worthless on expiration day. This should encourage the holder to sell her options early if it is profitable to do so, since theres substantial risk that ESOs, almost 50, reach their expiration date with a worthless value. Since ESOs are considered a private contract between an employer and his employee, issues such as corporate credit risk, the arrangement of the clearing, and settlement of the transactions should be addressed. An employee may have limited recourse if the company cant deliver the stock upon the exercise of the option. ESOs tend to have tax advantages not available to their exchange-traded counterparts. Accounting and Valuation of ESOs Employee stock options have to be expensed under US GAAP in the US. As of 2006, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agree that an options fair value at the grant date should be estimated using an option pricing model. The majority of public and private companies apply the BlackScholes model. However, through September 2006, over 350 companies have publicly disclosed the use of a binomial model in Securities and Exchange Commission (SEC) filings. Three criteria must be met when selecting a valuation model: The model is applied in a manner consistent with the fair value measurement objective and other requirements of FAS123R is based on established financial economic theory and generally applied in the field and reflects all substantive characteristics of the instrument (i. e. assumptions on volatility. interest rate. dividend yield. etc.). A periodic compensation expense is recorded for the value of the option divided by the employees vesting period. The compensation expense is debited and reported on the income statement. It is also credited to an additional paid-in capital account in the equity section of the balance sheet . Want access to quizzes. flashcards. highlights. and more Access the full feature set for this content in a self-guided course
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