How to Expense Stock Options Under ASC 718?

In startups, stock options are a popular way to attract and keep talented employees. About 70% of startups offer stock options to their employees. But when it comes to accounting for these options, things can get tricky.It’s a set of rules that helps companies figure out how to record the cost of stock options on their financial statements.

ASC 718 stands for Accounting Standards Codification Topic 718. It tells companies how to measure, recognize, and disclose the expenses related to stock options. ASC 718 provides the accounting principles for expensing stock options, which include the following key aspects:

Measuring Stock Options

The first step is to determine the stock options’ fair value. This means deciding how much the options are worth when given to employees. Companies can use different models to do this, but they must consider things like how long the options will last, how volatile the company’s stock is, and the option’s strike price.

Let’s say a startup gives an employee 1,000 stock options with a strike price of $10 each. If the stock’s fair market value is $15 on the grant date, the total expense is $5,000 (1,000 options x ($15 — $10)).

Recognizing Stock Option Expenses

Once the value is known, the company spreads the expense over the “useful economic life” of the options. This usually matches the vesting period, which is the time the employee must wait before they can use their options.

If the options from our earlier example vest over four years, the company would record an expense of $1,250 annually for four years. Companies must also tell investors about their stock option expenses.

Disclosure

ASC 718 mandates companies to disclose the nature and terms of such arrangements, the determination of the fair value of goods or services received or the equity instruments granted, and the impact of compensation cost on income.

These principles guarantee that the costs linked to stock-based compensation are acknowledged in a way that mirrors the substance of economic transactions and furnishes users of financial statements with valuable information.

Example For Application of ASC718

Here’s a practical example to illustrate the application of ASC 718:

Example: Service-Based Vesting of Stock Options

Imagine a company, Tech Innovations Inc., grants 500 stock options to its new employee, Jane, as part of her compensation package. The options have a four-year vesting schedule, with 25% of the options vesting at the end of each year, provided Jane continues to work for the company.

Grant Date: January 1, 2023 Number of Options: 500 Vesting Schedule: 25% per year over four years Fair Value of Options at Grant Date: $20 per option

Under ASC 718, Tech Innovations Inc. would account for these stock options as follows:

Determine Total Compensation Cost: The total compensation cost is the fair value of the options multiplied by the number of options granted, which is $20 * 500 = $10,000.

Recognize Expense Over Vesting Period: The Company recognizes the expense over the vesting period. Since the vesting period is four years, each year, the company will recognize 1/4th of the total compensation cost, which is $10,000 / 4 = $2,500 per year.

Accounting Entries Each Year:

At the end of year one, if Jane is still employed, the company will make the following journal entry:

Debit: Compensation Expense $2,500

Credit: Additional Paid-In Capital (Equity) $2,500

This process continues each year until all the options are vested or until there is a change in Jane’s employment status. If Jane leaves the company before the end of the vesting period, the unvested options are forfeited, and no further compensation expense is recognized for those options.

This example demonstrates how a company would apply ASC 718 to account for stock options with a service-based vesting condition. It’s important for candidates to understand these principles for accurate financial reporting and compliance with the standard.

Common pitfalls while expensing stock options

A common pitfall in expensing stock options is underestimating the impact of the fair value measurement. Companies might not fully grasp the option-pricing model’s complexity, leading to inaccurate valuations.

To avoid these issues, companies should:

• Work closely with financial experts to accurately determine the fair value.
• Carefully consider the vesting terms and performance conditions to spread the cost correctly.
• Stay updated on ASC 718 guidelines to ensure compliance and transparency.

By addressing these points, companies can ensure a more accurate and consistent approach to expensing stock options, reflecting the true economic cost in their financial statements.

Eqvista: ASC 718 Simplified for Smarter Stock Option Accounting!

Streamline Your ASC 718 Expense Reporting with Eqvista! Simplify stock option expensing effortlessly as our experts guide you through the process using the latest technology and compliance know-how. Feel confident about meeting deadlines and FASB regulations — contact us today for worry-free reporting