The guidelines of ASC 718 are critical for companies that want to offer employee compensation plans, remain compliant, and stay transaction-ready. Let’s dive into some of the key components and considerations.
What is ASC 718?
FASB is the authority that establishes financial accounting and reporting standards for public and private companies that follow Generally Accepted Accounting Principles (GAAP).
ASC is the single source of those principles. Topic 718 is the reference number for “Compensation—Stock Compensation.”
Great! Now, what is it?
ASC 718 outlines the accounting standards for stock-based compensation, including stock options, restricted stock, performance-based awards, and other equity-based compensation arrangements.
“The objective of accounting for transactions under share-based payment arrangements is to recognize in the financial statements the goods or services received in exchange for equity instruments granted or liabilities incurred and the related cost to the entity as those goods or services are received” (https://asc.fasb.org/718/10/showallinonepage)
More specifically, ASC 718 includes guidelines for the measurement, recognition, and presentation of stock-based compensation expenses in financial statements. The standard requires companies to recognize the fair value of equity awards as an expense over the vesting period, usually, the period during which employees are required to provide service in exchange for the award.
ASC 718 requires companies to disclose information about their stock-based compensation plans in the notes to those financial statements, providing transparency about the impact of these arrangements on the company's financial position and results of operations.
The goal of ASC 718 is to improve the consistency and comparability of financial reporting related to stock-based compensation and to provide relevant information for investors and other financial statement readers.
What companies need to implement ASC 718?
While focused more prominently on public companies, ASC 718 is relevant for private companies that issue stock-based compensation plans. Many companies adhere to the guidelines of ASC 718 right from the start so they’re IPO-ready.
ASC 718 becomes particularly relevant when they engage in share-based transactions, whether through stock options, RSUs, or other equity instruments. The decision to implement ASC 718 is not solely driven by regulatory compliance; it's a strategic move to accurately represent the true cost of compensating employees.
Additionally, some private investors may require adherence to ASC 718 as part of their investment agreement.
How to expense an employee stock option to comply with ASC 718
To expense an employee stock option in compliance with ASC 718, companies typically follow three specific steps to accurately account for the cost of stock-based compensation:
1. Determine the fair value of equity compensation
In order to comply with the guidelines, a company needs to determine the fair value of its shares.
“The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” (https://asc.fasb.org/718/10/showallinonepage)
Generally, employee stock options are non-transferable, so the concept of a fair market value doesn’t exist. While ASC 718 doesn’t specify a single method of valuation, there are many models to consider: the Black-Scholes model, for example, is commonly used, but it’s important to consider all the factors first, like the type of option, current stock price of the underlying security, exercise (strike) price, expected volatility, time to expiration, risk-free interest rate and expected dividends.
2. Determine the expense associated with the option across its useful economic life
ASC 718 requires companies to recognize the expense associated with stock options over the option's vesting period. The expense is recognized on the income statement over the periods during which employees provide service and earn the right to exercise the options.
There are again multiple GAAP-approved options for recording the expense:
Straight-line method
In this method, the option is recorded as a single expense on a straight-line basis over its full-service period. For example, this could be done over 4 years (25% for each year).
FIN28 method
For this method, each vesting increment is treated as a separate award or expense.
3. Disclose a summary of all information that was considered
Here’s where you sum up all of your considerations and findings from the previous steps. ASC 718 emphasizes transparency in financial reporting, so companies are required to disclose key information about their stock-based compensation plans, including the method of valuation, significant assumptions, and the impact on financial statements.
Other considerations for disclosure include details on any pre-existing arrangements, compensation costs, and cash flow effects.
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While the core guidelines are perhaps more easily understood, there are plenty of nuances to ACS 718 reporting. It's important for companies to consult with accounting professionals or financial advisors to ensure proper implementation of ASC 718 and compliance with the relevant accounting standards.
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