July 29, 2016
What Business Leaders need to know about ASC 718
ASC 718 is a part of the Generally Accepted Accounting Principles (GAAP) determined by the Financial Accounting Standards Board (FASB), which defines the methodology for determining the expense for issuing equity compensation to employees. A separate policy, ASC 505-50 governs the methodology for non-employees. Whenever equity is granted to employees, it produces a cost for the company which must be reported. Unlike salaries and wages, these costs are more difficult to estimate, but are also important to include on financial statements.
Why do I need a valuation?
A valuation is necessary when issuing equity grants of any kind. Some common forms of equity grants include options, units, profits interests, capital interests, restricted stock, and stock appreciation rights. In a valuation, the fair value of a single option//interest is calculated, typically using the Black Scholes model, which calculates option value based on certain inputs such as term, risk free rates, and equity volatility. This value is then multiplied by the number of options/interests granted to find the firm’s total expense of issuing the equity. This expense is then required to be recognized over the life of the equity that has been granted.
How is equity compensation expensed over time?
According to ASC 718, this expense must be amortized over the vesting period of the equity as the grant is vested or earned. This practice is similar to the concept of spreading the expense of a tangible asset over its useful lifetime through a depreciation schedule rather than accounting for the entire expense in the year it is purchased. Although the value of the equity granted at issuance is not adjusted over this period, there may be adjustments to the annual expense to account for forfeitures. Some grants may never vest due to employment termination and are then allocated to remainder holders, or to pay equity plan fees. In each period, previous forfeiture estimates are compared to actual forfeitures, and the difference is added or subtracted from the period’s expense as a “true up” methodology.
What’s the relationship between stock compensation expense and the strike price of my 409A valuation?
The expensed cost of issuing equity compensation associated with ASC 718 should not be confused with Section 409A of the tax code which declares that options must be issued at or above fair market value. Section 409A requires a valuation to determine the current Fair Market Value of one share of common stock so that the company does not issue the options above this value and create a tax liability for the employees. (409A valuations are discussed in more detail here. This strike price is then utilized in ASC 718 as an input into a black scholes calculation that estimates the value of stock based compensation. As explained above, this cost must be spread out over the vesting period of the equity grant and must be adjusted for forfeitures in order to comply with the accounting standards set forth in ASC 718.