Stock options are a form of compensation given to employees. When granted, the employee obtains the right to purchase a set number of shares from the company at a predetermined price. This arrangement is beneficial for both parties: when employee stock options are exercised, it gives the employee an ownership stake in the company, and it allows the company to attract and retain talented employees without giving up too much of its equity.
When this type of transaction takes place, there are several journal entries that must be made. These entries include an increase to the company’s stock option liability account and a corresponding debit to its retained earnings. Additionally, an offsetting credit must be recorded in order to recognize the difference between the fair value of the shares and the cost of the stock option grants. Finally, when the options are exercised, a new entry must be made to write off any remaining balance in the stock option liability account.