ASC 718 – All You Need to Know
ASC 718 is the subset of a law that regulates spending of equity-based compensation in US companies.
Stock-based compensation is one of the most sought-after employee benefit schemes today. Initially it was used to incentivize top management in established companies or as a go-to tool for startups to hire and retain top talent. But these days it is an increasing trend among fast-growing established businesses to adapt it for all their employees. Equity compensation creates a sense of ownership among employees and is proven to be a reliable tool in an accelerating business environment. But how is it regulated?
Equity distribution and tracking is a daunting task as it is. In a flourishing business, equity holdings are not just limited to employees but external investors as well. Managing all their timely equity needs is a task in itself. In addition to this, equity benefits issued to employees demand special attention in terms of their accounting needs. Let’s take a closer look.
US Accounting Standards
Equity compensation deals with the company shares. Irrespective of the size of the business, shareholding schemes not only involve money but also voting rights in company matters. Thus globally, equity compensation is a highly regulated activity. As a continuum, spending of employee stock options, which is a byproduct of equity rewards, is a highly specialized task. It is a complex process to track and expense.
In the US, Generally Accepted Accounting Principles (GAAP) are used as a reference for all forms of financial reporting. In 2009, The Financial Accounting Standard Board (FASB) developed the Accounting Standards Codification (ASC) as the only centralized and authoritative source for equity-related GAAP. The ASC system simplifies individual rules so that they can be easily referenced. ASC 718 is one such rule. Let’s explore this more.
What is ASC 718?
ASC 718 is the subset of a law that regulates spending of equity-based compensation in US companies. Accounting Standards Codification or ASC is the only source of GAAP in the US. It is 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. ASC 718 rules 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?
As we have observed so far, spending employee stock options is a convoluted process as it is. Then what is the use of such a standard? Does it simplify the process or force conformity to a highly complex discipline? To understand the significance of ASC 718, let’s explore some basic questions that would remain unaddressed in absence of a standard such as ASC 718:
- How is the fair market value determined before issuing equity rewards?
- How does stock-based compensation differ for employees and non-employees?
- How is it different in the case of equity and liability treatment?
- What are the income tax considerations?
- On what grounds are modifications to equity rewards allowed?
- What are the disclosure requirements?
These are only some of the questions that arise during the accounting of equity rewards. As one can imagine, depending on the business structure, the complexity would only increase. This is why ASC 718 implementation is so important. It is a comprehensive guideline that helps address all these questions and many more across various business structures.
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 round, 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?
The biggest advantage of having a spending standard in place is that not much is left to the accountant’s imagination. As complex as the process may be, it is the only one available, and learning to adhere to it is enough to keep up with it. Here is a basic outline as to how ASC 718 implementation works:
This is the primary step towards ASC 718 filings. In private companies, it is only a professional business valuation that determines the fair market value of its shares. For private companies, this is conducted through a 409a valuation. Without the FMV, one cannot determine the worth of stock-based compensation granted to an employee. Thus post a business valuation, with an ascertained FMV, a company can finally determine the value of equity rewards to be reflected in their expense statements.
The most commonly used options pricing model to determine FMV is the Black-Scholes method. This method uses the current price of stocks, expected dividends, the strike price of the options, expected interest rates, expiration date, and expected volatility to arrive at a theoretical value of the options. It is a fairly complex process and a company is best advised to engage professionals to handle it.
The expense to the company
Expensing of employee stock options always happens over a certain period. This is determined by the vesting schedule which is usually 4 years. Thus an expense from equity rewards is not a one-time event. It should be approached as a recurring expense throughout the vesting period. In this context, the vesting period is otherwise known as the “option’s useful economic life”. Expensing thus can be approached in two ways:
- As a one-time expense on a straight-line basis spread over the option’s useful economic life
- By treating each vesting increment as an individual award and expense
Once the first two most determining aspects are covered, the company must ensure complete disclosure of their required financial statements. This is a must in ASC 718 implementation. A company must have the necessary mechanism in place to ensure financial disclosures.
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:
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:
- 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
This models 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
Issuing, tracking, and managing equity in an expanding business is a daunting task. A process that is initially handled on simple excel sheets quickly gets complicated and prone to errors if not monitored properly. Eqvista is an expert in this process. We are adept to handle end-to-end equity needs of companies across diverse industries. ASC 718 implementation is one of our celebrated strengths. Here is a snapshot of all our services. For further information reach us today!