ASC 718: Calculating Fair Value When Accounting for Options

Are stock options accounted for as expenses in a company after a certain period? Companies often grant stock options to employees as part of their compensation packages. These options give employees the right to purchase company stock at a predetermined price, known as the exercise or strike price, over a specified period.

Employee stock options are a bonus that lets workers own a slice of the company’s success by buying its stock at a special price. If the company does well, employees can make extra money.

What is ASC 718?

ASC 718 focuses on how companies should account for and report stock-based compensation when employees or others receive company stock as part of their compensation (like stock options or restricted stock). It applies to all entities that issue equity instruments as compensation for goods or services. This includes both public and private companies. The standards help,

• Companies measure the value of these stock-based awards,
• Recognize the associated expenses in their financial statements over time,
• Disclose relevant information to ensure transparency in their financial reporting.

It ensures that companies accurately show the cost of giving out stock as part of employee compensation in their financial statements. ASC 718 is the “expense accounting,” earlier known as FAS 123(r).

When is ASC 718 needed?

In the early stages, startups may distribute little employee equity, which might not be considered an expense. GAAP compliance becomes crucial as the business grows and seeks funding in Series A & B rounds.

Investors, such as Angel and Venture Capital funds, scrutinize a startup’s financials to understand equity allocation for employee compensation, making it particularly important. This impacts the startup’s valuation, making it essential to account for cash and equity expenses in financial statements.

Here are some examples of transactions that fall under ASC 718:

Stock Options Grant

• A company grants stock options to its employees as part of their compensation package.
• ASC 718 requires the company to recognize the fair value of the options as an expense over the vesting period.

Restricted Stock Units (RSUs) Issuance

• An employer grants RSUs to employees, promising them a certain number of shares upon meeting specified vesting conditions.
• ASC 718 requires the company to recognize the fair value of the RSUs as an expense over the vesting period.

Modification of Stock Options

• If a company modifies the terms of existing stock options, such as changing the exercise price or the number of options granted, ASC 718 provides guidance on how to account for these modifications.

Forfeiture of Stock Awards

• If an employee leaves the company before the vesting period is complete and forfeits stock options or other equity awards, ASC 718 guides how to account for the forfeiture.

Employee Stock Purchase Plans (ESPP)

• If a company offers an ESPP to employees allowing them to purchase company stock at a discount, ASC 718 provides guidance on the accounting treatment for this type of equity compensation.

Employee Stock Ownership Plans (ESOP)

• In cases where a company establishes an ESOP to provide employees with an ownership interest in the company, ASC 718 helps in determining the fair value of the equity instruments issued.

Share-Based Payment to Non-Employees

• ASC 718 also covers transactions in which the company issues equity instruments to non-employees (such as consultants or vendors) in exchange for goods or services.

Performance-Based Stock Awards

• If a company grants stock awards contingent on achieving specific performance targets, ASC 718 provides guidance on how to account for the awards based on the probability of achieving those targets.

What are the Types of ASC 718?

ASC 718 has different sections explaining how companies should deal with accounting for stock options. These guidelines help companies show, measure, and discuss these transactions in their financial reports. There are seven subtopics under ASC 718:

1. ASC 718–10 Overall: This section provides an overview and background information on stock-based compensation.
2. ASC 718–20 Scope and Scope Exceptions: Defines the scope of ASC 718 and provides exceptions.
3. ASC 718–30 Awards Classified as Equity: Covers the classification of stock-based compensation awards as equity instruments.
4. ASC 718–40 Awards Classified as Liabilities: Addresses the classification of certain stock-based awards as liabilities.
5. ASC 718–50 Award Modifications: Discusses the accounting treatment for modifications of stock-based awards.
6. ASC 718–10–15 Transition and Effective Date Information: Provides information about the transition and effective dates of ASC 718.
7. ASC 718–10-S99 Overall 99: Addresses specialized industry accounting topics related to stock-based compensation.

How does ASC 718 Work?

The ASC 718 guidelines have three basic steps for expensing Employee Stock-based compensation:

1. Calculate Fair Market Value (FMV).
2. Spread the expense over the option’s complete vesting period.
3. Report Compensation Expenses on the Income Statement.

Calculate the Fair Market Value of the Shares

Knowing Fair Market Value (FMV) in ASC 718 is important for accurate financial reporting and fair compensation. It ensures compliance with rules, helps in tax calculations, and builds confidence among investors and stakeholders.

Below are the steps through which FMV is calculated:

Understand ASC 718 Requirements:

Get to know the rules laid out in ASC 718. This set of guidelines is like a guidebook for dealing with stock-based compensation in accounting. It tells you what to consider when determining how much stock options are worth.

Select an Option Pricing Model:

Choose an appropriate option pricing model. The two commonly used models are the Black-Scholes-Merton model and the binomial model. ASC 718 allows the use of different models, but the chosen model should be appropriate for the company’s specific circumstances.

Gather Relevant Information:

Collect the necessary information to input into the option pricing model. This includes the current stock price, exercise price, expected volatility, expected term, risk-free rate, and dividend yield.

Expected Volatility:

Determine the expected volatility of the company’s stock. This measures the stock’s price fluctuations over a certain period. Estimating volatility involves using historical stock price data and considering other relevant factors.

To calculate Volatility, the below formula is used:

σ√T

σ = Standard Deviation

T = Time Period

Click here To know more about the Volatility concept.

Expected Term:

Estimate the expected term of the stock options. This represents the period during which we expect the options to be outstanding. ASC 718 guides estimating the expected term, considering the vesting period, contractual term, and other relevant factors.

Risk-Free Rate:

Determine the risk-free rate, the rate of return on a risk-free investment. The U.S. Treasury yield, matching the expected term of the options, is frequently utilized as the risk-free rate.

Calculate Fair Value:

Use the chosen option pricing model and input the gathered information to calculate the fair value of the stock options. The fair value represents the compensation cost that the company will recognize.

For the Fair Market Value calculation using Black Scholes Formula is:

C = SN(d1) — Ke -rt N (d2)

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Spread the Expense over the option’s complete vesting period.

Let’s imagine a company giving employee stock options as part of their compensation. The company decides the employee must work for four years to benefit from those options. This four-year period is the vesting period.

Instead of saying, “Let’s recognize all the costs of these stock options right now,” the company chooses to spread or allocate that cost evenly over the entire four-year period. So, if the total cost of the stock options is $40,000, the company would recognize $10,000 (which is $40,000 divided by 4 years) as an expense on their financial statements each year for four years.

By doing this, the company is matching the recognition of the cost with the time the employee is putting into the company. It’s like saying, “As the employee works for us and fulfills the conditions, we’ll gradually account for the cost of these stock options over the entire time they earn them.” This approach accurately reflects how the company earns the benefit over the vesting period.

Report Compensation Expense on the Income Statement

Once the Fair Value is ascertained, it becomes a pivotal component of the Compensation Expense, which is then reported on the Income Statement. This financial statement provides stakeholders, including investors, analysts, and regulatory bodies, a clear view of the impact of stock-based compensation on the company’s overall financial performance.

In essence, reporting Compensation Expenses on the Income Statement under ASC 718 fulfills regulatory requirements and offers transparency, aligning with best practices in financial reporting.

Choose Eqvista for your ASC 718 Guidance

Issuing, Managing, and Tracking Equity in a startup is complex. As the company initially tracks information in Excel sheets, it becomes complicated and prone to errors if not monitored properly. Trust Eqvista in this process to handle your company’s end-to-end equity needs. ASC 718 Implementation is one of our well-known strengths. Contact us to know more.