CFA Level I Exam · Topics in Long-Term Liabilities and Equity

Share-Based Compensation: Options and Restricted Stock

Updated 7 October 2026 · Fact-checked

Share-based compensation pays employees with company shares, restricted stock or stock options instead of cash. Under IFRS, you measure fair value at the grant date, then expense it over the vesting period. Total expense is fair value × number expected to vest. Equity rises by the same amount, so net equity is unchanged.

Understand Share-Based Compensation

Share-based compensation pays staff with the company's own equity instruments. Firms use it to keep employees, align their interests with shareholders and save cash. It is still a real cost. The employee gives services and the company gives up a claim on its equity.

The main types are stock grants, restricted stock and stock options. A stock grant gives shares outright. Restricted stock gives shares that cannot be sold until a condition is met, such as staying for three years. A stock option gives the right to buy shares at a set exercise price (strike price) for a set period.

The key date is the grant date, when employer and employee agree the terms. You measure fair value then. For restricted stock, fair value is the market price of the share at grant date. For options, fair value comes from an option pricing model such as Black-Scholes-Merton or a binomial model. The inputs include the share price, exercise price, expected term, volatility, dividends and the risk-free rate. A higher volatility or longer expected term raises option value.

You do not expense it all at once. Spread the total cost over the vesting period, which is the time the employee must serve to earn the award. Each year you record compensation expense and a matching credit to equity (paid-in capital). Under IFRS, grant-date fair value is not remeasured for equity-settled awards. The number expected to vest is updated each period, but the per-award fair value stays fixed.

On the financial statements, the expense reduces net income and retained earnings. The credit to paid-in capital increases equity. So total equity is unchanged by the expense itself. The expense is non-cash, so it is added back in operating cash flow under the indirect method. When options are exercised, cash received from the exercise price increases equity and shares outstanding rise, which dilutes EPS. Analysts also watch diluted EPS, because in-the-money options can add shares under the treasury stock method.

Key formulas to remember

Total compensation cost (equity-settled): Total cost = Grant-date fair value per award × Number of awards expected to vest; Fair value is fixed at grant date. Only the expected number of awards is updated.
Annual expense, straight-line: Annual expense = Total cost ÷ Vesting period in years; Used for cliff vesting when no other pattern is given.
Restricted stock fair value: Fair value per share = Market price of the share at grant date; No pricing model is needed.
Cumulative catch-up: Expense this year = Cumulative cost to date (revised estimate) − Expense already recognised; Use when the expected number vesting changes.
Journal entry each period: Dr Compensation expense; Cr Paid-in capital (equity); Net income falls, paid-in capital rises, total equity unchanged. Cash flow: add back as a non-cash item.
Option exercise (cash received): Dr Cash (exercise price × options); Dr Paid-in capital (previously recorded); Cr Share capital and share premium; Equity increases by the cash received. The previously recorded paid-in capital is transferred within equity to share capital and share premium.

How to solve Share-Based Compensation questions

Use this order for any question on stock grants, restricted stock or options.

1Identify the instrument: stock grant, restricted stock or stock option, and whether it is equity-settled.
2Find the grant-date fair value per award. For stock and restricted stock, it is the share price at grant. For options, use the pricing model value given.
3Do not use later prices or revalue equity-settled awards after the grant date.
4Find the number of awards expected to vest, after allowing for forfeitures.
5Multiply to get total cost, then divide by the vesting period for annual expense.
6Record the effect: expense reduces net income, paid-in capital increases, total equity is unchanged.
7For cash flow questions, add the expense back as a non-cash item in operating cash flow (indirect method).
8Check the question wording on timing: grant, vesting or exercise date, then eliminate options that use the wrong date.

Quickest way: Grant-date value × expected vesting ÷ years

When to use it: Use for most numerical questions asking for annual expense or the effect on equity.

Pick the fair value at grant date. Ignore the current share price.
Multiply by awards expected to vest.
Divide by vesting years.
Remember equity net effect is zero, and cash is unaffected.
Eliminate any option that uses exercise-date value or the full cost in year one.

Common mistakes in Share-Based Compensation

Using the share price at vesting or exercise date to measure the expense.
Students think the cost should reflect what the employee finally gets.
Fix: For equity-settled awards, fair value is fixed at the grant date and is not remeasured.
Recognising the whole cost in the year of grant.
The value is known at grant, so it feels like a one-time cost.
Fix: Spread the cost over the vesting period, since the employee earns the award by service.
Ignoring expected forfeitures.
Students multiply by all awards granted.
Fix: Use the number expected to vest and revise it as estimates change.
Saying the expense reduces total equity.
Confusing the income statement hit with the balance sheet.
Fix: Retained earnings fall but paid-in capital rises by the same amount, so total equity is unchanged.
Treating the expense as a cash outflow.
Compensation expense usually means cash wages.
Fix: It is non-cash. Add it back in operating cash flow under the indirect method.
Treating restricted stock like an option and using a model.
Both are equity awards with vesting.
Fix: Restricted stock is valued at the market price at grant. Only options need a pricing model.

Worked examples

Example 1

On 1 January, a company grants 10,000 restricted shares to executives when the share price is $30. The shares vest after a 4-year service period. The company expects 5% to be forfeited. The price is $36 at the end of Year 1. What is the compensation expense in Year 1? A. $71,250 B. $75,000 C. $90,000

Show the solution

Grant-date fair value per share = $30. The $36 price is ignored.
Expected to vest = 10,000 × 95% = 9,500 shares.
Total cost = 9,500 × $30 = $285,000.
Annual expense = $285,000 ÷ 4 = $71,250.

Answer: A. $71,250. B ($75,000) is 10,000 × $30 ÷ 4, which uses all 10,000 shares and ignores the expected forfeitures. C ($90,000) is 10,000 × $36 ÷ 4, which uses all shares and the $36 year-end price instead of the $30 grant-date fair value.

Example 2

A firm grants 1,000 employee stock options, with grant-date fair value of $8 per option, a 3-year cliff vesting period, and all options expected to vest. Which statement about Year 1 is correct? A. Net income falls by $2,667 and total equity falls by $2,667. B. Net income falls by $2,667 and total equity is unchanged. C. Net income falls by $8,000 and total equity is unchanged.

Show the solution

Total cost = 1,000 × $8 = $8,000.
Annual expense = $8,000 ÷ 3 = $2,667 (rounded).
Entry: Dr compensation expense $2,667, Cr paid-in capital $2,667.
Retained earnings fall by $2,667 through net income, paid-in capital rises by $2,667.
Total equity is unchanged.
Statement A is wrong because the credit to paid-in capital offsets the fall in retained earnings, so total equity does not fall. Statement C is wrong because it expenses the full $8,000 in Year 1 instead of spreading it over the 3-year vesting period.

Answer: B. Net income falls by $2,667 and total equity is unchanged.

Exam tips

Look for the words grant date. They almost always signal that the fair value is fixed and later price moves are irrelevant.
Expect conceptual questions on which financial statements are affected: net income down, equity total unchanged, operating cash flow add-back.
Remember that higher volatility and longer expected term increase option value, a frequent direction-of-change question.
With three choices, eliminate any that expense everything at grant or use exercise-date value, then check the vesting division.
For restricted stock, no model is needed. If a question gives you a model value for restricted stock, check what it is measuring.

Practice questions from Topics in Long-Term Liabilities and Equity

Share-Based Compensation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CFA Level IIShare-Based Compensation and Stock Options

Share-Based Compensation: frequently asked questions

What is the difference between restricted stock and stock options for accounting?

Restricted stock is valued at the market price of the share at grant date. Options are valued with a pricing model, as they give only a right to buy at the exercise price. Both are expensed over the vesting period.

Why is grant-date fair value used for the expense?

The award is priced when the terms are agreed, and the employee earns it through service afterwards. For equity-settled awards, the value is not updated for later share price changes. Only the expected number vesting is revised.

Does share-based compensation affect cash flow?

The expense is non-cash, so under the indirect method it is added back to net income in operating cash flow. Cash only changes when options are exercised and the exercise price is paid.

How do stock options affect EPS?

Options can dilute EPS. In-the-money options add shares to diluted EPS under the treasury stock method. The compensation expense also lowers net income.