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Debt vs Equity

There are two basic ways of financing for a business: Debt financing and equity financing. Debt financing is defined as 'borrowing money that is to be repaid over a period of time, usually with interest" (Financing Basics, 1). The lender does not gain any ownership in the business that is borrowing. Equity financing is described as "an exchange of money for a share of business ownership" (Financing Basics, 1). This form of financing allows the business to obtain funds without having to repay a specific amount of money at any particular time. There are also a few different instruments that could be defined as either debt or equity. One such instrument is stock options that an employee can exercise after so many years with the company. Either using the debt or equity method, or a combination of the two methods can be used to account for stock options or other instruments with the similar characteristics.

There are pros and cons to deciding to use either of these methods. First I will discuss the pros of using the debt or equity methods. One pro of using the debt method is that it "does not entail 'selling' their equity, but instead works by 'borrowing' against it" (Financing Using, 1). So the company could account for future stock options by assuming that employees will cash the option in, and, in the books, it will look as if they simply have a liability. Another pro with the equity method is that the company is receiving money, and it does not have to pay the money back. In the end the investing company will normally make money on the investment, but it will come in the form of dividends and/or selling the stock back.

There are also a few cons in accounting for these instruments are either debt of equity. "Excessive debt financing may impair your (the company's) credit rating and your ability to raise more money in the future (Financing Basics, 1). If a company has too much debt, it could be considered too risky and unsafe for a creditor to lend money. Also with excessive debt, a business could have problems with business downturns, credit shortages, or interest rate increases. "Conversely, too much equity financing can indicate that you are not making the most productive use of your capital; the capital is not being used advantageously as leverage for obtaining cash" (Financing Basics, 1). A low amount of equity shows that the owners are not committed to their own business. They do not want to make the important decisions that could have a big and lasting effect on their own.

Now I will discuss the pros and cons of the alternative decision, which is a combination of the debt and equity methods. A positive of this method is that the instrument is split between debt and equity. The company could just split it up 50/50 between the two methods. Also if they had too much debt, they could account for the instrument with 20% as debt and 80% as equity. This would make it look as if they do not have too much debt or too much equity. This method would be an advantage, if the company were looking to get more financing in the future.

A negative aspect of this method is how the instrument is split between debt and equity. An example would be if the company split an instrument 50/50 between the two methods. This may seem fair when first accounting for it, but what if the split did not represent the actual split of the instrument. Let's say that it turns out that 90% of the instrument ends up being equity, and 10% ends up debt. The books would be off by quite a bit, and creditors my not be happy with the company when they learn of this.

Now that I have discussed pros and cons of each method, I will now explain the instrument that I will be using as an example. I will be using stock options as the instrument. Stock options are offered by many businesses to employees that stay with the company for a specified length of time. It is offered by the company as an attempt to keep the important employees, and to give the employees a reason to help the company get a bigger market share. With a stock option, an employee may get 100 shares of stock after they are with the company for five years. Once the five years is up the employee has the option to keep the shares and watch them grow, or they can take the cash equivalent of the shares. If the employee decided to take the cash, it would be like a debt to the company. However if the employee wants to watch the stocks grow, it would be as if the option was always equity. How should an accountant look at a stock option? Should they consider it a debt or equity? Or should they account for it as both?

First I will explain the debt or equity method. This is quite simple. The hard part comes when deciding which method of the two to use. A good way to decide this is to figure out if most stock options become debt or equity. Once the method is decided the business can account for it. They must decide if, like in the 100 shares example above, they want to account for 20 shares or all of it at once. Say the company decides to account for 20 shares a year, the shares are at $25 after an employee's first year, and they are using the debt method. The journal entry for this is shown below:

Intangible Asset 500
Accounts Payable 500

I am not positive what the asset would be called in this particular example, but it would be an intangible asset. If this were the equity method, the credit account would be common stock. This would be the entry every year until the five years are up, assuming that the price per share stays the same. Then it is decision time for the employee. Below are the journal entries for either decision:

Employee takes the cash
Accounts Payable 2500
Cash 2500

Employee takes the stocks
Accounts Payable 2500
Common Shares 2500

As shown, either entry wipes the liability away, and either creates equity or decreases cash. This is a very simple way to account for the stock option.

Another method to account for this is with a combination of both the debt and equity methods. The one major decision here is how the company wants to split up the stock option. An easy way would be 50/50, but the way I will split it up is with a 20/80 percentage. I would split it up this way assuming that 20% of the employees take the cash and 80% take the stocks. Below are the journal entries for each year:

Intangible Asset 500
Accounts Payable 100
Common Shares 400
This would be a very efficient way of accounting for the stock options. There will not be many changes in amounts when the employee has the option. This would be the entry for five years, and then the employee will have their option. Below is the journal entries for both decisions:

Employee takes the cash
Common Shares 2000
Accounts Payable 500
Cash 2500

Employee takes the stock
Accounts Payable 500
Common Shares 500

Again, both methods clear out the accounts payable. Also the employee is receiving the cash or common shares in the right amount.

Debt and equity methods are important decisions when deciding what to do with an instrument like stock options. All three methods, debt, equity, or a combination, are helpful in keeping the books correct and fair until the employee exercises their option. The best method in my mind is the combination of methods. It best shows were the money will go on average before the option is decided on. However the other two methods are also important considering the pros and cons of each decision. No clear answer, however, will ever be known as long as accounting exists.

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