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Equity Compensation Accounting: Common Errors Found in Details

Equity compensation can be a significant factor in attracting and retaining talent. Lately a lot of attention is being given to effective compensation strategy, investor expectations and shareholder dilution. Philosophies have evolved and rules and regulations have changed, but one thing that remains constant is that there are often surprises in the accounting for stock awards. We see start-up companies struggling to get the accounting right, and we see struggles in public companies with well-designed internal control systems, too.

What not to do

Many of these challenges can be avoided simply by paying attention to the details. Getting the paperwork right sounds easy, but you’d be surprised by what can happen. Improper accounting for stock option modifications is probably the biggest cause of error we see, and can have significant P&L impacts. Sometimes just identifying a stock option modification can be tricky—repricing an option can be obvious, but other modifications may not raise a flag, and the accounting department may be out of the loop on changes negotiated by the CEO. A stock option grant modification is any change to the terms after the stock is granted; these include changing the number of granted shares, altering vesting terms and repricing options.

A good rule of thumb is to have the accounting department analyze any potential change to stock option terms and compute the potential P&L impact before a final decision is made. The stock options may still be modified because it makes business sense, but everyone will understand the amount of the additional expense before the modifications are approved, and the proper accounting entries will be recorded.

Here are a few other errors to be on the lookout for:

  • The number of shares to be granted is a mystery, because the number of shares in the grant paperwork doesn’t agree with the number of shares approved in the board minutes.
  • There is confusion over when the employee started work. It’s not uncommon for employment start dates to be revised between the time the offer letter is sent out and the day the employee actually shows up. Granting stock to someone before he or she is an employee can cause problems; the accounting for option grants to employees is different than the accounting for option grants to nonemployees. And some stock plans prohibit granting options to nonemployees.
  • Stock is granted without proper approval. Understand (and communicate) who is authorized to grant stock or options. Having a clear stock grant policy is critical—as is making sure people understand it and follow it.

We also see data entry errors, which include the following:

  • Grant date or option strike price are entered incorrectly.
  • Vesting schedules are entered incorrectly (for example, a grant is entered as vesting ratably over four years instead of having a one-year cliff).
  • The grant is not input or is input twice.
  • Paperwork is not processed on a timely basis. This applies to inputting new grants as well as cancelling grants for terminated employees.

While these items appear rather simple, they often elude companies. The good news is that these problems can be avoided with education, discipline and communication, so use this list as a starting point to review your situation and you’ll be in much better shape when it comes to accounting for stock awards.

And bear in mind that because stock is part of employee compensation, errors are a double whammy. They can have a significant impact on employee morale and motivation, for example, if employees don’t get what they thought they were getting, or if a grant has significant tax implications for them. Errors can also impact the company financially because incorrect data can affect the computation of stock-based compensation expense.

Download my colleague’s report, Stock Options: Do You Have a Problem?, to learn more about our eight best practices for tracking and accounting for equity-based compensation: http://www.roseryan.com/reports/equity.php.

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