Offering an appealing compensation package can be key to attracting the right talent for your business. This can be difficult for startups on a tight budget with little cash to spare. The best solution for many companies is to offer employees equity in the business in the form of stock-based compensation, or employee stock options (ESOs). Stock-based compensation is a non-cash incentive used to motivate and retain employees by offering them a “slice of the cake” in return for their services.
Stock-based compensation comes with a list of pros and cons, but one area frequently overlooked by founders is the reporting requirements that come with ESOs. The Financial Accounting Standards Board (FASB) has strict standards for when and how compensation expenses are reported on financial statements, formalized with the release of ASC Topic 718.
In this article, we will tell you what you need to know about ASC 718 and how to implement it in your accounting and financial reporting based on our experience providing accounting services to startups with equity-based compensation.
What is ASC 718 and why is it important?
FASB introduced ASC 718 in 2009 to standardize the reporting of stock-based compensation expenses on income statements. Before ASC 718, there was no standard method for calculating the fair value of an ESO as an expense. Many companies neglect to report compensation expenses in their financial reporting, which could be misleading to investors and shareholders.
ASC 718 was established to promote consistency in how entities report compensation expenses. It requires disclosure on income statements, preventing understated compensation expenses on financial records, thereby providing greater transparency to investors.
The most common types of equity-based compensation addressed by ASC 718 include:
- Restricted Stock Awards (RSA): The recipient owns the shares, typically with voting or dividend rights, but the shares are subject to vesting and cannot be transferred or traded.
- Restricted Stock Units (RSU): The recipient does not own shares and does not have voting or dividend rights. Instead, an RSU is a promise of stock that will be awarded once certain conditions are met.
- Incentive Stock Options (ISO): Typically reserved for upper management, ISOs offer employees the chance to buy stock at a fixed rate within a specific time frame. Notably, ISOs offer a tax advantage since the employee only pays tax when the stock is sold.
- Non-Qualified Options (NSO): Like ISOs, recipients can buy stock at a fixed rate, but NSOs do not offer the same tax advantages. Unlike ISOs, NSOs can be issued to non-employees.
All publicly traded companies must comply with ASC 718 standards. Private companies have more flexibility, especially in the early stages before institutional investors are involved. However, following ASC 718 is required for any company striving to be GAAP-compliant.
How does ASC 718 work?
Implementation starts by calculating the fair market value (FMV) of the stock. ASC 718 does not prescribe a specific valuation model but requires certain factors to be considered for the model to be acceptable:
- Expected term of the award
- Volatility of the stock price
- Strike price, also called the exercise price
- Interest rate
- Dividend yield
- FMV of the stock calculated using a 409A valuation (which is required for all private companies issuing certain kinds of equity compensation in compliance with the safe harbor provisions of 409A)
Once the FMV has been determined, the next step is to allocate the expense over the ESO’s useful economic life – also referred to as its vesting period – using either the straight-line or FIN-28 method, depending on the entity’s preferences. The straight-line method is simpler; it allocates the expense pro rata over the vesting period. The FIN-28 method is a more complicated calculation but is frequently used when an entity expects its FMV to rise. With FIN-28, expense accrues for each tranche of shares as the tranche is granted, resulting in more expense in the first year, and a progressively smaller allocation per year as the vesting period progresses.
ASC 718 also stipulates an entity must determine a reasonable forfeiture rate to account for the possibility an award is forfeited before it fully vests. Forfeiture can occur due to employee termination or if a performance obligation tied to the award is not satisfied. Under ASC 718, an entity must apply a fair forfeiture rate based on professional judgment, but how this rate is determined is left to the discretion of the entity.
The last step is to record compensation expenses on the income statement.
Need help with your ASC 718 reporting?
Reporting stock-based compensation expenses may seem straightforward, but it can get complex and challenging quickly as your business grows and more options are issued. Founder’s CPA is here to help with ASC 718 and all your other accounting needs. Contact our experts today to get started.
