ASC 718 vs 409A – Everything you need to know

Businesses must comply with ASC 718 and 409a valuation requirements when granting stock options to their employees. Internal Revenue Code Section 409A requires that stock options maintain an exercise price at or above the common stock’s fair market value (FMV) as of the grant date. Your employees could suffer from paying immediate taxes, a 20% penalty tax, prospective interest payments, and prompt taxation if the business breaches 409A. Additionally, according to Accounting Standards Codification (ASC) Topic 718 of the Financial Accounting Standards Board (FASB), all equity awards given to workers must be recorded at fair value. If the award’s fair value increases as a consequence of subsequent adjustments, the compensation cost will rise for your business.

To comply with IRC 409a regulations and FASB ASC 718, businesses employ individual valuation experts for 409a valuation and ASC 718 reporting. This article discusses why do companies need 409a valuation and why do companies need as 718. Additionally, it explains the difference between 409a and ASC 718, how to do 409a valuation, and how to report ASC 718.

ASC 718 and 409a valuation

According to FASB ASC 718, the valuation of stock-based compensation is necessary for both tax reporting under IRC 409a and financial reporting.

What is a 409a valuation?

An independent appraisal to determine a fair market value (FMV) of the common stock held primarily by founders and key employees of a private firm is known as a 409A valuation. The price to buy a share is established by this appraisal guided by Internal Revenue Code (IRC) Section 409A.

Private corporations must adhere to a structure set out in Section 409A while valuing private shares. With a few exceptions, the IRS will assume that the value was performed by an unrelated or independent entity, creating a safe harbor.

The IRS may impose fines if a corporation violates 409A guidelines and inaccurate equity pricing. Employees and stockholders are often the ones who pay.

Why do companies need to do a 409a valuation?

Before issuing your first common stock options, you must first get a 409A valuation if you already provide equity or intend to do so. Early-stage businesses and founders need 409A valuations to protect stockholders from IRS penalty fees that may otherwise be imposed. A reliable 409A valuation service provider can assist you in using “safe harbors”.

How to do a 409a valuation?

There are several ways of business valuations. Experts can use a single method or a mix of two or more to get an accurate valuation. However, typically experts use valuation methods that are typically divided in the following three common approaches during a 409A valuation:

• Market approach – The option pricing model (OPM) backsolve approach is commonly used by valuation companies when your firm secures a funding round. Although the preferred stock is given to investors, it may be presumed that current investors bought it at FMV for equity. Thus, modifications must be performed to calculate the FMV for common stock. Other market-based methods evaluate the company’s equity worth using financial data from similar publicly listed firms, such as sales, EBITDA (earnings before interest, taxes, depreciation, and amortization), and net income.
• Cost Approach – Early-stage businesses that haven’t collected funds and don’t make any money often adopt the asset model. This process evaluates a company’s net asset value to arrive at an accurate assessment.
• Income approach – Valuation service providers often use the simple income approach for companies with adequate sales and healthy cash flow. This approach establishes a company’s worth based on its anticipated future cash flows, risk-adjusted.

What is ASC 718?

All organizations are required to adhere to the ASC 718 accounting guidelines for stock awards. The comprehensive standard known as ASC 718 mandates the bookkeeping of stock-based compensation. This standard aims to have stock-based compensation values included in financial statements. The government intends to identify the costs incurred for the equity component of employee remuneration per GAAP reporting guidelines.

What is ASC 718 reporting?

The appropriate reporting of stock-based remuneration in corporate accounting is covered by ASC 718. ASC 718 is the acronym for Accounting Standards codification, Topic No. 718. For expensing equity pay to both its workers and non-employees, businesses see it as the norm. These guidelines must be followed by businesses when creating GAAP-compliant financial reports.

Why do companies need to report ASC 718?

ASC 718 stock-based compensation reporting is necessary due to the intricate procedures for applying for equity awards. To apply the regulations and determine the proper amount of compensation expenditure, it is crucial to have clear and accurate instructions on employee stock ownership plans. Additionally, it establishes the FMV of stock options before their issuance.

How to report ASC 718?

When preparing ASC 718 reports, valuation experts are required to adhere to certain rules. While there are extensive requirements, the rules surrounding ASC 718 specify three key procedures for expensing an option:

Determine the value of options

Establishing FMV at the beginning lets you understand the value of the option and how to reflect it on financial statements. Startup options are illiquid; therefore, valuing them may be difficult. A formal valuation methodology is needed since the market cannot decide its worth.

Businesses may pick from several such models, but consistency is key. So, if you choose a value model, stay with it. Expected period, volatility, strike price, interest rate, dividend yield, and underlying value must be included in each model. When all dependent parameters are entered into the model, the worth of the options figure will materialize, allowing you to proceed.

Allocate the expense over the option’s useful economic life

In a perfect world, we could use the technique above to determine a value per option, report the whole amount as the appropriate expenditure for the options is granted, and go on with our lives. But it’s not that simple due to GAAP rules.

For accounting reasons, the corporation must spread the expenditure across the vesting period of an option. Thus, an option with a five-year vesting schedule, its economic life is five years, and its expenditure must be recorded in each of those years.

Let’s understand with an example: Say employee A has 100,000 options. We calculated $0.20 per option using any model. Employee A earns 20% of his options after each year with a five-year vesting arrangement. Twenty thousand options multiplied by $0.20 is $4,000 each year, so we will allocate that as an expense yearly.

The “straight-line” technique equitably distributes the option’s cost, as seen above. Instead of considering each vesting event connected with an options grant as a distinct award, the FIN28 technique adopts a different approach. This second technique allocates shares vesting in year one over one year, year two over two years, and so on, up to year five over five years.

Recognize those expenses as employee compensation on your income statement

Finally, you must include the expenses of stock-based compensation as expenditures in the cap table and disclose them on the company’s income statement.

The third and final stage may appear simple, but the first two can get quite complex in a short amount of time. Here are some best practices to keep in mind if your company is having trouble accounting for stock compensation or if you will soon be performing your first ASC 718 reporting.

Major differences between ASC 718 and 409a

IRC 409A is a tax rule the IRS has issued and is enforcing. In contrast, ASC 718 are accounting standard issued by the FASB and regulated by public accounting organizations (and the SEC for publicly traded enterprises).

IRC 409A specifies a requirement for granting stock options to staff and other parties; this condition must be fulfilled to avoid harsh tax penalties for option beneficiaries. This fundamental condition stipulates that the cost of stock options must be above or equal to the FMV of the underlying asset or the security into which the options are exercisable, often common stock. Then, IRC 409A outlines how a private corporation may demonstrate that it correctly established FMV.

The procedure for calculating the remuneration expenditure for stock options under GAAP for reporting in financial statements is outlined in ASC 718. The fair value of the common stock rather than the fair market value is the criterion used by ASC 718, which is somewhat different from IRC 409A. However, this variation is usually insignificant.

The emphasis on the stock option pricing switches from tax compliance to GAAP compliance since there hasn’t been much IRS enforcement action with IRC 409A, but because most corporations have had their ASC 718 work examined by an audit firm.

Audit companies examine valuation statements used to value stock options using a practice tool issued by the AICPA. Most high-quality valuation studies follow this recommendation to assure GAAP conformity, and in most situations, tax compliance follows almost seamlessly.

Why choose Eqvista for 409a valuation and ASC 718 reporting?

Eqvista, one of the prominent valuation providers in the US, provides top-notch expertise providing 409A/ASC 718 valuations for businesses of all sizes. We have a staff of highly skilled professionals that handle each case with dedication, and we are NACVA certified. To get the finest and most accurate value assessment, our staff has the necessary credentials, expertise, and understanding. Contact us today to learn more about 409a valuation and ASC 718 reporting services by Eqvista.