Employee compensation and income taxes - Share-based compens...

Learning Outcomes

After reviewing this article, you will be able to explain the accounting, tax, and valuation effects of share-based compensation for employees, model its expense and dilution in financial forecasting, and evaluate how such plans alter reported earnings and shares outstanding. You will recognize the impact of share-based plans on net income, cash flow, and per-share metrics for the CFA Level 2 exam.

CFA Level 2 Syllabus

For CFA Level 2, you are required to understand how share-based compensation and taxes affect the financial statements and equity valuation. In particular, this article covers:

• Identifying and distinguishing forms of employee compensation, including share-based awards
• Explaining how share-based compensation influences income statements, balance sheets, and cash flow statements
• Forecasting share-based compensation expense and shares outstanding in financial statement models
• Assessing the dilutive effect of options and share grants on per-share calculations
• Understanding tax treatment of share-based compensation and related windfalls or shortfalls
• Describing how share-based compensation impacts valuation metrics such as diluted EPS and P/FCF

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which components of financial statements are directly affected by the grant and vesting of employee stock options?
2. How does share-based compensation create dilution for existing shareholders, and what method is used to estimate its impact on diluted EPS?
3. When does a company recognize a tax benefit (windfall) or shortfall for share-based compensation, and how is it reported?
4. True or false: Before settlement, all granted share-based awards are included in basic EPS.

Introduction

Share-based compensation is a key element in modern remuneration packages for executives and employees, commonly including stock options and share grants. Correctly accounting for and forecasting these awards is important for CFA Level 2 candidates, as these plans impact reported profits, shareholders’ equity, and per-share metrics through both expense recognition and dilution. Accurate valuations and forecasts for company shares require clear understanding of both the reporting and tax effects of such awards, as well as the calculation of potential dilution.

Key Term: share-based compensation
Compensation for employees or executives that is paid in the form of equity instruments, such as shares or options, rather than cash.

ACCOUNTING FOR SHARE-BASED COMPENSATION

Share-based compensation plans typically consist of equity-settled share options or restricted stock units (RSUs). The accounting standard requires that the fair value of these awards be measured at grant date and recognized as an expense over the vesting period.

Key Term: vesting period
The period during which an employee must work before they gain the right to receive share-based awards or benefits.

Key Term: grant date
The date when share-based compensation awards are formally promised to an employee and their fair value is measured for expense purposes.

The annual expense recognized for share-based plans reduces net income and, as with other compensation costs, is allocated to COGS, SG&A, or R&D depending on employee function. The offsetting entry is made to equity under a share-based compensation reserve (a component of contributed capital), with no net change to total equity at the grant/vesting stages.

Stock Options and RSUs Recognition

The total fair value of a share-based award is measured at grant (using an option-pricing model for options, or market price for stock grants) and amortized on a straight-line basis over the vesting period. If awards are forfeited (e.g., employees leave before vesting), expense recognition is reversed accordingly.

When stock options are exercised or shares delivered for RSUs, contributed capital increases, and the number of shares outstanding is raised. Cash proceeds from option exercises (equal to the option exercise price) are reported in financing activities.

TAX EFFECTS OF SHARE-BASED COMPENSATION

A company receives a tax deduction for share-based awards only when options are exercised or shares issued. The actual deduction is usually the in-the-money value of the awards at settlement (the difference between share price at exercise and the exercise price) for options, or the market value for stock grants.

• Tax Windfall: If the share price at settlement exceeds the grant date fair value, the tax deduction exceeds the cumulative compensation expense, creating a tax benefit (windfall).
• Tax Shortfall: If the share price at settlement is lower, a tax shortfall occurs.

Key Term: tax windfall (excess tax benefit)
The amount by which the actual tax deduction at settlement of share-based awards exceeds the cumulative compensation expense, resulting in a reported tax benefit.

Key Term: tax shortfall
The amount by which the actual tax deduction at settlement is less than the cumulative compensation expense reported, resulting in a reduction in tax benefit or an increase in tax expense.

Under IFRS, tax windfalls and shortfalls are reported directly in equity. Under US GAAP, windfalls reduce tax expense (increasing reported net income), while shortfalls increase tax expense.

Worked Example 1.1

On January 1, a company grants options to purchase 200,000 shares to employees, vesting over four years. The grant date fair value is $2 per option, and the exercise price is $15. All options are exercised after vesting, when the share price is $24. The company's tax rate is 25%. What is the tax effect?

Answer:

• Total cumulative compensation expense recognized: 200,000 × $2 = $400,000
• Actual tax deduction at exercise: 200,000 × ($24 – $15) = $1,800,000
• Tax benefit: $1,800,000 × 25% = $450,000 (compared to $400,000 × 25% = $100,000 tax benefit booked over vesting).
• Tax windfall = $450,000 – $100,000 = $350,000 benefit.
• Under IFRS: $350,000 recognized directly in equity; under US GAAP: $350,000 reduces tax expense in income statement.

DILUTION AND PER-SHARE COMPUTATIONS

Share-based compensation increases the number of shares outstanding when awards settle. Before settlement, in-the-money awards that would dilute EPS must be included in the diluted EPS calculation using the treasury stock method.

Key Term: dilution
The reduction in each existing shareholder's proportional ownership and in per-share metrics, such as EPS, due to an increase in the number of shares from share-based awards.

Key Term: treasury stock method
A method for calculating the number of new shares that would be issued if all in-the-money options and similar instruments are exercised, net of shares that could be repurchased using assumed proceeds.

Key steps:

• Calculate proceeds if options are exercised (number × exercise price)
• Add any unrecognized compensation expense
• Use both to compute hypothetical buybacks at average market price
• The net increase in shares is added to diluted shares outstanding for EPS

For unvested RSUs or restricted stock, the number of outstanding dilutive shares equals the gross granted minus hypothetical buybacks funded from unrecognized compensation expense.

Worked Example 1.2

A company has 1 million in-the-money options outstanding with a $20 exercise price. The average market price for the year is $25. There are 600,000 RSUs with unrecognized compensation expense of $2 million. Calculate the additional diluted shares from the options and RSUs.

Answer:

• Options: Proceeds = 1,000,000 × $20 = $20,000,000
• Number of shares that could be bought back: $20,000,000 ÷ $25 = 800,000
• Net dilutive shares from options: 1,000,000 – 800,000 = 200,000
• RSUs: Shares that could be "bought back" = $2,000,000 ÷ $25 = 80,000
• Net dilutive RSUs = 600,000 – 80,000 = 520,000
• Total dilution from both: 200,000 + 520,000 = 720,000 additional shares for diluted EPS

Exam Warning

Failing to adjust for dilution from in-the-money options and RSUs is a common error. For the exam, always use the treasury stock method for options and subtract hypothetical buybacks when determining dilutive shares for diluted EPS.

FORECASTING SHARE-BASED COMPENSATION EXPENSE AND DILUTION

In financial statement modeling, you should forecast share-based compensation expense based on plan terms and historical trends. This forecast should be added to SG&A/R&D/COGS as appropriate, and to equity via the compensation reserve.

When estimating future per-share metrics or valuing the firm, project the net increase in dilutive shares outstanding. Ratio-based valuation metrics like P/FCF or P/E can be distorted if share-based expense and dilution are not separately modeled.

Key Term: dilution factor
An adjustment to the assumed share count or value per share to account for expected future issuance of shares relating to share-based compensation plans.

VALUATION AND ANALYSIS CONSIDERATIONS

• Share-based compensation is a non-cash expense in the period of grant and vesting, but results in actual cash proceeds and increased shares when awards are exercised or vested.
• When comparing companies, ensure you consider differences in compensation structure; companies granting more equity awards will report higher non-cash compensation expense and likely more share dilution.
• For relative valuation, compare P/E, P/FCF, and other ratios on a fully diluted basis.

Revision Tip

When reviewing CFA questions, check whether EPS, P/FCF, or other per-share metrics are calculated on a fully diluted basis, including all in-the-money awards.

Summary

• The accounting for share-based compensation expense affects net income, equity, and taxes.
• Dilution must be modeled using the treasury stock method for per-share metrics.
• Tax windfalls/shortfalls at settlement change reported tax expense.
• For valuation and forecasting, estimate share-based expense and associated dilution directly, not just as a percent of revenue or operating cost.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the measurement and recognition of share-based compensation expense over the vesting period
• Distinguish tax windfall and shortfall effects from settlement of share-based awards
• Apply the treasury stock method to compute diluted shares for options and RSUs
• Forecast both expense and dilution effects for accurate per-share valuation modeling
• Adjust valuation ratios for share-based compensation and its dilutive impact

Key Terms and Concepts

• share-based compensation
• vesting period
• grant date
• tax windfall (excess tax benefit)
• tax shortfall
• dilution
• treasury stock method
• dilution factor