Stock options require an employee to perform services for a period of time (the vesting period) to have the right to purchase a company's stock. Options must be exercised on a certain date (exercise date) and the underlying stock can be purchased at a specified price (exercise, target or option price). After stock options are issued, annual journal entries will allocate the costs of the options throughout the employee’s vesting period. This annual expense is reported on the income statement and under stockholder’s equity on the balance sheet. When the options are exercised or expire, the related amounts will be reported in accounts that are part of the stockholder’s equity section of the balance sheet.
Record the periodic cost allocation of the stock option. The periodic cost is the value of the stock options divided by the number of service years. Record a journal entry that debits “compensation expense” (this expense is reported in the income statement) and credits “additional paid in capital – stock options” (a stockholder’s equity account reported in the balance sheet). Record this cost annually throughout the employee’s vesting period.
Record the exercise of the stock option. When the exercise date arrives, the employee can exercise the option and purchase the company's common stock at the exercise price. Common stock is valued at par, a designated dollar amount used to value each share of common stock on the balance sheet. When common stock is sold or repurchased, it is usually for a price above the par value, so the excess amount over par is credited to an “additional paid in capital” account. The journal entry to record the exercise of the option involves debiting “cash” for the number of shares purchased multiplied by the exercise price. In addition, debit “additional paid in capital – stock options” for the balance accumulated in the account over the vesting period and credit “common stock” for the number of shares purchased multiplied by the stock’s par value. The remaining credit is made to “additional paid-in capital in excess of par (common stock)” for the amount needed to balance the journal entry.
Record the expiration of the options, if applicable. If a stock option is not exercised on its exercise date, it will expire or sometimes only some of the shares offered by the option are purchased. If the options expire, the balance in the “additional paid in capital – stock options” account needs to be transferred to “additional paid in capital – expired stock options” account. By debiting the stock options account and crediting the expired stock options account, the cost is reclassified within the stockholder’s equity section of the balance sheet. When a portion of the option shares are exercised and a portion expire, allocate the costs as explained in steps 2 and 3 based on the number of shares purchased and the remaining value of the option that expired.