Stock options are accounted for using a compensation expense based on the fair value of the options on the grant date and the number of options expected to vest. The fair value is based on the market value of a similar security or can be priced using a model like the Black Scholes model.
The compensation expense is allocated to the I/S over the service period (grant date – vesting date). Recognition of the expense decreases net income and retained earnings but paid in capital increases by the same amount, leading to no overall change in total equity.