ASC 718 Explained: Key Considerations for Expensing Stock Compensation

Equity compensations have evolved from an executive perk to a widespread practice, spanning all levels of organizations. They build a sense of belonging, ownership, and responsibility among employees, motivating them to contribute to the company’s success. Given how widespread equity compensations have become, understanding their accounting implications is critical for maintaining transparency in financial reporting and tax compliance.

At the heart of the accounting treatment for equity-based compensations lies ASC 718. Through this article, we will explore its significance in financial reporting. First, we will uncover its meaning and importance. Then, we will go over some types of ASC 718. Finally, we will understand the ASC 718 process with calculation examples. Read on to know more!

What is ASC 718?

Let us break this question into two parts- what is ASC and what is ASC 718? Accounting Standards Codification (ASC) is a set of accounting standards and principles developed by the Financial Accounting Standards Board (FASB), a non-governmental body. Private as well as public companies in the US follow the ASC since it simplifies how various transactions and accounting adjustments must be reported.

ASC 718 is the part of ASC that deals with the accounting treatment of various types of equity compensations such as restricted stock units (RSUs), phantom stocks, profit interest units (PIUs), and performance-based equity compensation. Very basically, ASC 718 guides companies on how to calculate the fair value of equity compensation, allocate the expense over the vesting period and record the effect in financial statements.

Accounting Standards Codification or ASC is the only source of GAAP in the US. It is a well-organized research enabling system where all accounting standards are categorized based on topics, subtopics, and thematic areas. A company must engage with experts and advisors experienced in accounting standards, security laws, tax regulations, and admin procedures to handle all filings. This is best considered right from the time company management decides to issue equity compensation to employees. Provisions for ASC 718 accounting must be made simultaneously.

Equity awards though part of an employee’s regular compensation follow a different set of accounting rules. What is categorized today under ASC 718 was earlier known as FAS 123 (r). These determine the rules by which a company should expense equity rewards in their income statements. This rule can extend the shares issued to non-employees as well. However, it is a highly technical process and as much as a founder can learn about it, it is best left to experts (hired employees or consultants) to manage this.

Why is ASC 718 important?

Among several reasons, the primary role of ASC 718 is related to ensuring accurate financial reporting and compliance for stock-based compensation. Below we added few points highlighting the importance:

• Fair Value measurement – This requires companies to measure the FV of equity awards at grant date and recognize its value over vesting period, which helps to provide a picture of a company’s financial health.
• Transparency and disclosure – Crucial for Investors and analysts to know the impact of equity compensation on a company’s financial position and performance.
• Regulatory compliance – Compliance with ASC 718 is crucial for public and private companies seeking to adhere to GAAP and to prepare for IPO or funding rounds.
• Complex transaction guidance – Helps companies to overcome difficult situations of stock based compensation and ensure compliance and minimize financial reporting errors.
• Standardization of accounting practices – This helps to ensure the consistency in financial reporting across different companies ,making it easier for investors and stakeholders to compare financial statements.

This is why ASC 718 implementation is so important. It is a comprehensive guideline that helps address all the questions and many more across various business structures.

Types of ASC 718

There are six subtopics that comprises ASC 718:

• 718-10 Overall – This subtopic gives general guidance on share-based payment arrangements with employees.
• 718-20 Awards Classified as Equity – Under this subtopic, it focuses and gives guidance on share-based payment awards that are classified as equity.
• 718-30 Awards Classified as Liabilities – As compared to 718-20, this subtopic gives guidance share-based payment awards that are classified as liability.
• 718-40 Employee Stock Ownership Plans – For employee stock ownership plans, ASC 718-40 offers guidance and notes the purposes for entities using these plans.
• 718-50 Employee Share Purchase Plans – Under this subtopic, entities have to first determine whether the plan is either compensatory or non-compensatory. Guidance is provided to entities that have employee share purchase plans.
• 718-740 Income Taxes – This subtopic specifically addresses the accounting for current and deferred income taxes that resulted from share-based payment arrangements, including employee stock ownership plans.

When should I consider ASC 718?

In the initial stages of a startup, the extent of employee equity distribution is not much. It might be negligible to a point that a company might choose not to record it as an expense. But as the business expands and the company enters into Series A & B rounds, it becomes necessary for the company finances to be GAAP compliant. This is where ASC 718 implementation comes into play.

Before ASC 718 implementation, businesses were required only to disclose stock-based compensation but not expense it. But now with ASC 718 in place, once a startup reaches a stage in the business cycle where it has to maintain financial audited statements, then any stock-based compensation that the company is issuing must be expensed. A typical situation is while approaching Angel and VC funds. Before these investors come on board, a thorough check of the startup’s financials, especially their ‘bottom line is mandatory. Besides, as these funds are granted in exchange for equity, these investors must have clarity over how much of the startup equity is already being expensed for employee compensation. A startup’s balance sheet looks very different when only cash flow expenses are accounted for instead of both cash and equity. It has a direct impact on the startup’s overall valuation.

How does ASC 718 Work?

When you follow ASC 718, you must take the following three steps:

Business valuation

In the US, when you issue equity compensation, the Internal Revenue Service (IRS) requires you to get a business valuation compliant with Section 409A of the Internal Revenue Code (IRC), i.e. a 409A valuation. Through a 409A valuation, you will know your company’s Fair Market Value (FMV), i.e. the price that would be fair in a market where your company’s key details are known and understood. The exercise price must be set as per the FMV.

To have the best shot at tax compliance, you must qualify for safe harbor status, for which there are three routes:

• Illiquid startup presumption
• Independent appraisal presumption
• Binding formula presumption

Calculating the expenses to the company

Since stock options vest over a schedule, they cannot be recorded all at once. In this regard, the accounting treatment of stock options is similar to that of depreciation. If a stock option has a vesting schedule of 5 years, it will be recorded over 5 years. Under ASC 718, two ways to calculate the amount of stock options to be recorded are:

Straight-line method

In the straight-line method, we divide the stock options by years in the vesting schedule. This is the number of stock options to be recorded each year in the vesting schedule.

Suppose SEMyx Laboratories issues 100,000 stock options to Gary McAllister that will vest over the next 5 years.

Then, the number of stock options to be recorded each year for 5 years = 100,000/5 = 20,000

FIN28 method

Under the FIN28 method, every vesting increment is treated as a separate award and expense. This is not as complicated as it seems. Let us understand this through an example. Suppose SEMyx is still issuing 100,000 stock options to Gary McAllister with a vesting schedule of 5 years. But this time, they want to use the FIN28 method. So, the calculations for this will look like this:

Calculating stock options vested each year:

Calculating the percentage of stock options from each award to be recorded each year:

For every nth award, 1/n of stock options must be recorded until 100% of the stock options in the award are recorded.

Calculating stock options expense to be recorded each year:

Disclosing the expenses in financial statements

Now that you have calculated the stock options to be recorded each year, all you need to do is disclose these details in your financial statements. With this, you will have satisfied the requirements of ASC 718.

Calculating ASC 718 Expense

ASC 718 calculations are pretty complex and require experienced professionals to regularly track and manage the entire process. Though the expensing rules are standard, now and then some amendments are introduced to improve the process. Based on all these variations, FMV being the cornerstone of this process, the following two methods of pricing are most commonly used:

Black-Scholes method

Otherwise known as BSM, this formula helps in the accurate calculation of FMV at any given time. It also estimates the market price a buyer would be willing to pay in the present time. The accuracy of this method is based on the following assumptions:

• The market is fluid. This means that stock trading remains continuous and regular predictions of market direction or fluctuations in stock price are not required.
• If dividends are regularly paid, BSM subtracts the discount value of a possible dividend from the present stock price.
• Stocks are normally sold in sets of 100. This means BSM allows securities to be divisible.
• No commissions are charged. Usually, share transactions are required to pay a commission to trade in the market.
• Interest rates are constant and ‘risk-free’ as stated in the US Government Treasury Bills.

The mathematical formula used in the Black Scholes model is complicated. Thankfully automated programs and online options calculators are available that enable experts to simply key in the values and get the results. However, here is the actual formula:

Where:

• C – Call option price – Actual price of the option in future after all variations are accounted for
• S – Current stock price – This is the fair market value of the stock determined by a 409A valuation of the company
• K – Strike price – This is the price at which the call option can be exercised.
• r – Risk-free interest rate – This is the interest rate at which one can lend money. Usually, the rate prescribed on the US Treasury Website is used as a reference
• t – Time to maturity – This is the period over which options would vest incrementally until all the stocks are vested
• σ – Volatility – This is the estimated variance the stock price would undergo during the entire grant period. It is difficult to estimate this variance for private companies. Hence public company trends are used as a reference
• N – Normal distribution – A statistical measure (normal distribution) corresponding to the probability that the call option will be exercised at the expiration

Lattice-based model

This model can also be used for ASC 718 implementation. It is similar to the Black-Scholes method and uses almost similar categories of input. But in addition, this method also allows volatility in dividends and the contractual terms of the equity rewards. Lattice-based models are used to value derivatives that help determine the underlying stock price. This model uses a binomial tree that plots the possible changes in the stock price over the entire period of the derivative’s life.

Since Lattice-based models are better at accounting for the volatility factor, they are considered a better options pricing model in comparison to Black-Scholes Method in markets prone to fluctuations. This is especially helpful for small businesses in the growth phase. They are the ones with the highest chances of fluctuating stock prices. While the Black-Scholes method with its constant volatility factor is better suited for mature companies, the Lattice-based models favor the startups.

Tax considerations in issuing stock options

When tax considerations come into play, employee stock options are categorized into two – Statutory Stock Options or Incentive Stock Option (ISO) and Non-Statutory Stock Options or Non-Qualified Stock Options. Here is how tax implications are different for these two:

• Incentive Stock Options – The grant of an ISO does not incur taxes. Neither does the act of exercising these options to gain access to them if the employee holds on to the stocks for a period of one year from the exercise date. In the case of ISO, it is a tax event only when the exercised stocks are sold.
• Non-Qualified Stock Options – The grant of NSO however is taxed at three levels. First during the grant (provided the fair market value of the stock can be determined, else no tax at this stage), second at the time of exercise, and third during the sale.

Looking for expert guidance on ASC 718

ASC 718 requires companies to recognize the fair value of stock-based compensation as an expense on their income statements during the awards’ vesting period. Issuing, tracking, and managing equity in an expanding business is a daunting task, so many companies engage Eqvista’s experts to assist with valuation, accounting, and reporting requirements.

Eqvista is an expert in this process. We know proper implementation is crucial for financial reporting accuracy and regulatory compliance. ASC 718 implementation is one of our celebrated strengths. Here is a snapshot of all our services. For further information reach us today!