Navigating ASC 718: Essential Insights for Financial Reporting

Even if you are familiar with the fundamentals of stock options and can navigate a cap table, the regulations around equity-based compensation can be a big challenge. One such regulation is accounting standard ASC 718, which is used across the US to regulate equity-based compensation. 

ASC 718 emerged as a solution to a complicated problem concerning how companies present their financial performance. There was no standardized method to determine stock-based compensation's fair value as an expense. As a result, many companies found it difficult to provide accurate and comparable financial statements to investors and other stakeholders. ASC 718 now offers a standard approach that you can use to expense equity awards in your financial statements.

This blog explores key facets of ASC 718, including its importance, classification, disclosure requirements, suitability, challenges and more. Read on!

What is ASC 718?

ASC 718, or Accounting Standards Codification 718, is a standard established by the Financial Accounting Standards Board (FASB) to govern share-based compensation. It prescribes the methodology for recognizing the cost of equity-based rewards granted to employees, directors, and other parties as an expense on the company's income statement. The standard governs how to determine the fair value of an option and allocate it as compensation expense over the requisite service period. This is crucial for maintaining transparency and providing updated financial data to investors as well as other stakeholders.

This ASC topic directs that companies include details about their stock-based compensation plans in the footnotes of their financial statements. This requirement ensures transparency, allowing stakeholders to understand the effects of these plans on the company's financial status and operational results.

Understanding US Accounting Standards: GAAP, FASB, and ASC

In the United States, the framework for accounting standards is primarily governed by the Generally Accepted Accounting Principles (GAAP). GAAP is a collection of officially recognized accounting rules and standards for financial reporting. 

The Financial Accounting Standards Board (FASB) is regarded as the primary organization that creates and maintains accounting standards in the United States. These standards are compiled and presented in the Accounting Standards Codification (ASC), the sole source with authority on non-governmental US GAAP.

One critical area covered by ASC is stock-based compensation, specifically under ASC 718. This standard requires all stock-based compensation to be accounted for at fair value in the income statements. It aims to deliver pertinent information to investors and other readers of financial statements to facilitate informed decision-making.

What Must Be Disclosed Under ASC 718?

Under ASC 718, companies are required to disclose specific information about their stock-based compensation plans. This disclosure is crucial for maintaining transparency and ensuring compliance with the accounting standards. Let's understand the details of what your startup must disclose under ASC 718.

• Nature and Terms of Share-Based Payment Arrangements: You need to provide general information about the nature and general terms of your startup's stock-based compensation arrangements that were outstanding during the period. This includes details about: some text
  • The requisite service periods.
  • Substantial conditions such as vesting conditions and the maximum term.
  • Total number of authorized shares for awarding options or other equity grants.
• Method for Estimating the Fair Value of the Awards: ASC 718 requires you to disclose the method your company uses to measure compensation cost. This could be the fair value, calculated value, or intrinsic value. You should also disclose your startup's policy for assessing anticipated forfeitures or acknowledging forfeitures as they occur.
• Effect of Compensation Costs on Financial Statements: You must also disclose the impact of stock-based compensation on your startup's financial statements. This disclosure covers the effects on both the income statement and cash flows. When stock-based compensation is recognized as an expense, it increases operational costs, which in turn reduces net income. Equity transactions linked with stock-based compensation have a direct impact on the equity section of your balance sheet.

What is the Importance of ASC 718?

Let's have a look at some important aspects of ASC 718 that make it an important part of the financial and operational aspects of companies:

• Compliance Requirements: Adhering to ASC 718 is non-negotiable, as it ensures that your startup is following the regulatory standards set by the FASB. By understanding and following ASC 718, you are safeguarding your business from potential risks, as non-compliance may lead to fines, legal issues, and damage to the company's reputation. 
• Financial Transparency: ASC 718 mandates clear and transparent reporting of equity-based compensation costs, which is vital for investors and other stakeholders. When they see a clear picture of your compensation expenses, they have a better understanding of your company's financial standing for making informed decisions.
• Internal Decision-Making: ASC 718 offers more than just external reporting benefits. It provides valuable data on equity compensation costs, which can be used for internal decision-making. By understanding the true cost of stock-based compensation, you can make informed decisions about employee incentives, capital allocation, fundraising, and overall financial strategy.
• Financial Forecasting and Planning: ASC 718 provides a robust foundation for accurate forecasting and planning. By correctly accounting for equity compensation expenses, you can develop reliable financial models. This helps you make informed decisions about critical aspects like growth strategies, resource allocation, and fundraising.
• Valuation and Exit Strategy: ASC 718 is instrumental in shaping your startup's exit strategy, as accurate valuation is essential for successful mergers, acquisitions, or IPOs. By diligently following ASC 718, you ensure that equity-based compensation is accounted for correctly, providing a clear and accurate picture of your company's value. This transparency can significantly influence the valuation multiples you achieve and the overall attractiveness of your startup to potential buyers and investors.

How Does ASC 718 Work?

ASC 718 provides a comprehensive framework for accounting for stock-based compensation. Let's break down the basic steps of implementing ASC 718.

Determining the Option's FMV

A crucial step in applying ASC 718 is establishing the Fair Market Value (FMV) of stock options granted to employees. The FMV is the estimated value of the option on the grant date and is used to calculate the compensation expense. Several factors influence this valuation:

• Option's Term: The duration for which the option can be exercised significantly impacts its value. Longer-term options generally have higher FMVs due to the increased potential for stock price appreciation.
• Option's Strike Price: The exercise price of the option is another key factor. A lower strike price relative to the current stock price increases the option's value.
• Annualized Interest Rate: This represents the risk-free rate of return and is used in the valuation model. It reflects the time value of money and is compounded annually to reach the equivalent annual return.
• Price of Underlying Security: The current market price of your company's stock is a fundamental input in determining the option's value.
• Price Volatility of Underlying Security: The expected fluctuation in your stock price affects the option's risk and, consequently, its value. Higher volatility generally leads to a higher FMV.

Allocating Expense Over the Useful Economic Life of the Option

One of the critical aspects of ASC 718 is the process of expensing stock options over their vesting period. This process aligns with the fundamental accounting principle of matching expenses with the period in which the related service is received.

Once the fair value of the option, it's recorded in the financial statements. Unlike a one-time expense, the cost of stock options is spread out over their useful economic life, similar to depreciation or amortization.

The useful economic life is the expected period in which an option benefits its owner. For startups, this often aligns with the vesting schedule. A four-year cliff vesting schedule, for instance, indicates a four-year useful economic life.

To distribute the option cost over this period, companies generally use either of the following options:

• Straight-line method: This method evenly spreads the total compensation cost of stock options over the entire vesting period.
• FIN28 method: This method allocates a higher portion of the compensation cost to earlier vesting periods, reflecting the increased risk of forfeiture in later periods.

Disclose the Calculation Method and Data Used

Transparency is crucial when it comes to disclosing the methods and data used for stock option valuations. ASC 718 requires a detailed explanation of the valuation method and key assumptions used to determine the fair or calculated value of stock-based compensation awards during the year.

• Valuation Model: When preparing your financial statements, you need to include a detailed explanation of the valuation model you used, whether it is the Black-Scholes model, a binomial model, or another method. 
• Underlying Assumptions: You also need to disclose the assumptions underlying these models, such as the expected volatility, dividend yield, risk-free interest rate, and expected option life. ASC 718 also requires you to provide information on the data sources for these assumptions. For example, if you used historical data to estimate volatility, this should be disclosed. 
• Impact of Stock Options: ASC 718 also mandates the disclosure of the impact that stock-based compensation has on your financial statements. This includes detailing the total expense recognized, the impact on net income, and the effect on earnings per share (EPS). 

By providing these disclosures, you help stakeholders see the full picture of how stock options affect your company's financial health.

Types of Stock Options Under ASC 718

ASC 718 encompasses various types of equity instruments. Let's explore them in detail.

Stock Options

A stock option is a financial contract granting the holder the discretionary right, but not the obligation, to buy or sell a given number of shares at a predetermined price within a designated timeframe. Under ASC 718, the expense associated with stock options, determined at the grant date using valuation models like Black-Scholes or binomial models, is recognized over the vesting period. 

This period is when employees earn the right to exercise their options. If a stock option vests over four years, the expense is spread across these years, ensuring your financial statements accurately reflect the compensation expense as the employee renders their services.

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are promises to deliver shares to an employee once certain conditions, typically a vesting period, are met. Unlike stock options, RSUs don't require an employee to purchase the shares; instead, the shares are delivered outright at no cost once they vest. Under ASC 718, RSUs are treated as compensation expenses, recognized over the vesting period. 

The value of RSUs, determined by the Fair Market Value (FMV) of the company's stock on the grant date, is then expensed evenly over the vesting period, reflecting the employee's earned compensation over time. RSUs offer more predictable outcomes for both the company and the employee, as they guarantee the delivery of shares as long as vesting conditions are met.

Restricted Stock Awards (RSAs)

RSAs are shares granted to employees, often with certain restrictions, such as a vesting period or performance conditions that must be met before the employee gains full ownership of the shares. RSAs are typically valued at the FMV of the stock on the grant date. Under ASC 718, RSAs are expensed over the vesting period, similar to RSUs. The total compensation expense is determined at the grant date based on the stock's fair value. 

This expense is then allocated over the vesting period, ensuring your financial statements reflect the cost as the employee earns their rights to the shares. One key difference between RSAs and RSUs is that RSAs usually provide the employee with voting rights and dividends during the vesting period, even if the shares are not fully vested. This feature can make RSAs more attractive to employees who value immediate participation in the company's governance and profit-sharing.   

When Should You Consider ASC 718?

Understanding when to implement ASC 718 can save your company from potential compliance issues and ensure the accuracy of your financial statements. Here are the key scenarios when ASC 718 should be top of mind:

• Issuing Stock Options: The moment you decide to include stock options as part of your compensation plan, ASC 718 comes into play. Whether you are offering stock options to attract top talent or to incentivize existing employees, ASC 718 requires that these options be accounted for as an expense on your financial statements. 
• Preparing for Audits: Auditors will scrutinize how your company accounts for stock-based compensation, and any discrepancies or failures to adhere to ASC 718 can lead to significant issues. Proper implementation of ASC 718 ensures that your stock-based compensation is recorded accurately, reducing the risk of audit findings that could negatively impact your company's financial reputation.
• Raising Capital: Investors and regulators carefully examine your financial statements during the due diligence process. Any inconsistencies or lack of transparency in how stock-based compensation is reported can raise red flags. ASC 718 provides a standardized method for accounting for stock options and other equity-based compensation. This helps ensure that your financial statements accurately reflect the true cost of these benefits.

What are the Challenges with ASC 718 Reporting?

Compliance with ASC 718 is essential but presents several challenges for companies, particularly startups. Here are some of the most common issues you may face:

• Accurate Valuation: Determining the fair value of stock options can be particularly challenging, especially for private companies. Without a public market to provide a clear stock price, you must rely on complex valuation methods like the Black-Scholes model. Inaccurate valuations can lead to significant compliance issues and misrepresentation of financial health.
• Complex Calculations: The calculations required under ASC 718 are inherently complex, involving estimates of volatility, risk-free interest rates, and expected option life. These assumptions can be difficult to accurately estimate, particularly for startups with limited historical data.
• Maintaining Compliance: As your equity compensation plans evolve and new awards are granted, maintaining compliance with ASC 718 can become increasingly challenging. Each modification requires careful recalculations and adjustments to ensure ongoing adherence to the standard, making it a continuous and demanding task.
• Internal Controls and Processes: Robust internal controls and processes are essential to ensure the accurate and consistent application of ASC 718. Without these controls, there is a higher risk of errors and inconsistencies in your financial statements, which could lead to audit findings or regulatory issues.
• Resource Intensity: ASC 718 compliance is resource-intensive, often requiring specialized knowledge that may not be readily available in-house. Many startups may find themselves relying on external advisors or consultants, which can increase costs and add to the complexity of managing equity compensation plans.

What is the Difference Between ASC 740 and ASC 718?

ASC 740 and ASC 718 are both accounting standards established by the FASB, but they serve varied purposes and are applicable to different aspects of financial reporting

• Purpose
  • ASC 718: Provides guidance on recognizing and measuring employee compensation costs related to share-based payments.
  • ASC 740: Controls how businesses recognize the impact of income taxes on financial statements as per US GAAP.
• Scope
  • ASC 718: Applies to various types of stock options that companies use to compensate their employees.
  • ASC 740: Deals with deferred tax assets and liabilities, tax expense, and the tax effects of transactions.
• Compliance
  • ASC 718: Ensures that companies accurately report expenses related to equity compensation in their financial statements.
  • ASC 740: Ensures that companies accurately report the tax effects of differences between financial statement values and tax bases of assets and liabilities.
• Financial Reporting
  • ASC 718: Requires companies to record the fair value of employee stock compensation as an expense on the grant date.
  • ASC 740: Outlines the accounting treatment for tax effects due to differences between financial statement values and tax bases of assets and liabilities.

Conclusion

As a founder, understanding and implementing ASC 718 can significantly contribute to your startup's success. It helps ensure accurate financial records and plays a vital role in attracting investors by presenting a true picture of your company's financial health.

At Qapita, we understand the complexities of ASC 718 and the challenges it presents for startups like yours. Our platform provides equity and transaction management services, helping you manage your stock-based compensation plans efficiently. We offer a one-stop solution for all equity matters, from capitalization table management to employee stock ownership plan (ESOP) management and digital ESOP issuance.

We are proud to be rated as the #1 Equity Management Software by G2. This recognition highlights our promise to deliver exceptional value and user satisfaction. We offer a one-stop solution for all equity matters, from capitalization table management to employee share purchase plans (ESPPs) management and digital ESOP issuance. 

Let us help you navigate the complexities of ASC 718 and make informed decisions about equity compensation in your startup. Get in touch with our experts to learn more.

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