Understanding Restricted Stock Units: A Comprehensive Guide to Accounting and Tax Implications

Casey Fenton

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September 6, 2023

In today's financial landscape, understanding the intricacies of restricted stock units (RSUs) is crucial. As a powerful tool for attracting and retaining top talent, RSUs have become increasingly prevalent.

But how is accounting for restricted stock units? RSU accounting involves accurately recording and reporting the fair value of Restricted Stock Units granted to an employee or employees in the financial statements of the company.

Let’s explore the basics, dive into accounting or auditing considerations, navigate taxation complexities, and discuss best practices.

Restricted Stock Units: Basics and Key Concepts

Restricted stock units (which is similar to restricted stock awards), represent a form of equity compensation or stock compensation granted to an employee or employees, typically as part of a comprehensive remuneration package.

Restricted stock refers to the certain number of units or shares that the employee receives on the grant date. If an employee leaves before the grant date, they will forfeit the unvested RSUs.

However, unlike actual shares, RSUs do not provide immediate ownership or voting rights—until the shares have fully vested and become common stock. Only then will the employee have voting rights.

A major difference of RSUs against stock options, which is another popular type of stock-based compensation, is that RSUs offer employees tangible value from the moment they are granted.

The key feature of restricted stock units is that they are subject to a vesting schedule, which determines when the employee's right to the stock units fully "vests" or becomes unrestricted. The future date when the stock units fully vest is known as the vesting date.

Once the restricted stock vests and converts into common stock, the employee typically receives the underlying stock shares or their cash equivalent, depending on the policy of the company. They will also have dividend and voting rights. At that point, the employee has the freedom to sell the vested shares or hold onto remaining shares, potentially benefiting from any future stock price appreciation.

Overview of the vesting period and schedule

A critical factor in RSUs is the vesting period, which refers to the duration an employee must wait before gaining ownership of the awarded stock shares. The vesting period is often accompanied by a schedule that outlines the distribution of stock shares over time.

For example, let's say an employee is granted 1,000 restricted stock or shares with a four-year vesting period and a one-year cliff. A “cliff” refers to a specific period at the beginning of a vesting schedule where no shares or units vest. 

In this example, the schedule indicates that after the first year, no RSUs will vest, but at the end of the first year, 25% of the RSUs (250 units) will vest, and the remaining restricted stock or shares will vest monthly over the next three years at a rate of 1/36th each month. This means that after the specific number of years (four) on the vesting date, the employee will have fully vested in all 1,000 RSUs and have the right to receive cash equivalent to the underlying shares of stock, if not the shares themselves.

Importance of the grant date and fair market value

Another essential consideration is the grant date, which is the moment when RSUs are awarded to the employee. It serves as the starting point for various calculations, such as determining fair market value (FMV) and compensation expense or cost. At this point, the FMV of the stock shares is determined, impacting financial reporting, income tax payments, and other tax obligations.

The FMV is the current worth of a stock or restricted stock units of the company. It serves as the baseline for recognizing compensation expense and determining the employee's ordinary income tax after determining the gross income.

Accounting for Restricted Stock Units

Properly accounting or auditing for RSUs ensures accurate financial reporting and compliance with auditing standards. Here are the key considerations:

Recognition of compensation expense for RSUs

The compensation expense or cost is typically recognized over the requisite service period, which aligns with the vesting schedule. Companies must diligently record this expense in their income statements to reflect the true financial impact.

For instance, if a company grants 1,000 units of restricted stock to an employee with a grant date FMV of $50 per share and a four-year vesting schedule, the compensation cost associated with those RSUs would be recognized at a rate of 250 shares per year over the four-year service period. Each year, the company would recognize $12,500 as compensation cost ($50 per share x 250 stock shares), which would be reflected in the income statements, impacting the financial results of the company.

Methods for measuring the fair value of Restricted Stock Units

Companies use different methods to measure fair value. One common approach is the market price method, which determines the fair value based on the current market value of the company's stock. This method relies on the premise that the value of restricted stock is equivalent to the value of the underlying company shares.

Another method is the intrinsic value method, which calculates the fair value by subtracting the strike price (if any) of a restricted stock unit from the market price of the underlying stock. This method focuses on the "in-the-money" value of the restricted stock or equity awards, considering the potential profit that can be gained upon exercise.

Additionally, companies may use other valuation methods, such as the discounted cash flow method or the Black-Scholes model, to estimate the fair value of a restricted stock unit based on factors like projected future cash flows, risk-free interest rates, volatility, and time to maturity.

Reporting RSUs

Companies report the compensation expense related to restricted stock on the income statement over the vesting period. The expense is recognized based on the value of the RSUs granted at the grant date.

Each reporting period, a portion of the total expense is recorded as a compensation cost, reflecting the value of the vested RSUs during that period. This expense reduces the net profit of the company, resulting in a lower reported profit for the period.

On the balance sheet, the unvested RSUs are typically recorded as a liability under the equity section. This liability represents the company's obligation to deliver the stock shares to the employee upon vesting.

As the RSUs vest, the liability decreases, and the corresponding equity accounts increase. Once the units of restricted stock fully vest on the vesting date, the liability is extinguished, and the equity accounts reflect the ownership of the shares by the employees.

Note that the specific auditing treatment may vary based on bookkeeping standards and regulations applicable in different jurisdictions.

Other Considerations

The vesting schedule also plays a crucial role in auditing for compensation cost or expense. Compensation expense represents the value of the granted units and is recognized over the vesting period in the income statement. Accurate bookkeeping ensures compliance with reporting standards and provides an accurate representation of the financial position of the company.

Vesting conditions significantly influence the auditing treatment of restricted stock awards. Conditions such as performance-based targets or continued employment impact the recognition of compensation cost. Understanding these conditions and their implications is crucial for accurate financial reporting.

Additionally, dividends and dividend equivalents may be associated with restricted stock awards. Dividend equivalents are additional compensation granted to employees, mirroring the dividends paid to shareholders. Proper auditing treatment ensures the accurate reflection of these other benefits.

To be clear, required disclosures in financial statements provide transparency to stakeholders. Companies must clearly communicate the details of RSUs in footnotes, including the significant assumptions used in fair value measurement and the impact on financial statements.

Taxation, Tax Deduction, and Use of The Section 83 (b) Election for Restricted Stock Units

Now let's turn our attention to the taxation of restricted stock awards, considering both employees and employers' perspectives. Restricted stocks have distinct tax implications throughout their lifecycle, from the time of grant to the eventual sale of the shares.

At the time of grant and vesting, employees typically need to pay tax obligations. The taxable income is calculated based on the FMV of the RSUs on the vesting date. Employees should be aware of the potential tax impact and plan accordingly.

The Section 83 (b) election, available for RSUs, allows employees to include the FMV of the shares as income at the time of grant. This election can be beneficial in certain situations, offering potential tax advantages, but requires careful consideration.

Calculating taxable income for RSUs involves understanding the FMV, as well as any taxes withheld by the employer. Accurate reporting of taxable income is crucial for employees to fulfill their tax obligations.

An employer granting RSUs may be eligible for a tax deduction, offsetting the compensation expense recognized. Familiarize yourself with the relevant tax regulations to maximize the available deductions.

Capital gains tax comes into play when an employee or employees sell their RSU shares. Capital gain is the profit of a capital asset when it is traded or sold at a higher price than its original purchase price.

The tax treatment depends on various factors, including the holding period and the classification of the gain as short-term or long-term. Understanding the intricacies of capital gains tax is essential for informed decision-making.

Other tax considerations related to RSUs may include state and local taxes, alternative minimum tax (AMT), and the potential impact on other tax credits or deductions. Employees and their employer should consult with tax professionals to navigate these complexities.

Best Practices and Considerations

To fully optimize the benefits of RSUs, consider implementing the following best practices:

  • Effective communication and education: It’s essential that employees understand the value and implications of RSUs. Transparent communication regarding vesting schedules, taxation, and financial planning empowers employees to make informed decisions.

  • Strategies for managing RSUs can maximize their benefits: Examples include evaluating the company's stock performance and growth potential, understanding the impact of RSUs on employee remuneration, and incorporating RSUs into financial planning.

  • Understanding of risks and challenges: RSUs come with risks and challenges that require careful consideration. Factors such as current stock price volatility, employment termination, or change of control events may impact the value of RSUs. A comprehensive understanding of the associated risks allows for proactive risk mitigation.

Conclusion

Understanding the accounting and tax implications of restricted stock units is crucial for CEOs and business leaders across industries. By comprehending the basics, navigating the auditing complexities, grasping and maneuvering the tax considerations—for instance, the use of section (b) election—and implementing best practices, you can harness the full potential of RSUs as a strategic tool for attracting and retaining top talent.

Remember, seeking professional advice tailored to your specific circumstances is paramount. Leverage the power of RSUs effectively to position your organization for success in today's competitive landscape. Embrace the opportunities that RSUs offer, and witness your company grow with your employees.

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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