For folks who are new to equity compensation, accounting for the expense associated with equity compensation awards can be daunting, especially to those of us without a background in finance. This article will help privately-held companies determine if they should be expensing their equity compensation awards.
ASC stands for Accounting Standards Codification developed by the Financial Accounting Standard Board (FASB) in 2009 as a centralized and authoritative source of the generally accepted accounting principles (GAAP) used for financial reporting in the United States. ASC 718 is the section that governs the proper expensing of stock-based compensation issued to employees on a company’s income statement. And beginning later this year, ASC 718 will be the standard for expensing equity compensation issued to non-employees also. Note: The precursor to ASC 718 is FAS 123(r), and some veterans of equity compensation still refer to the accounting codification in this way.
Why does ASC 718 matter?
Equity compensation is an increasingly important part of competitive compensation package design. Originally used as a way for early-stage technology startups to leverage equity instead of cash wages, equity compensation quickly spread across most high-growth industries as a tool to attract, retain and incentivize increasingly sophisticated employee populations. Incentivizing employees with equity has many advantages:
- Conserving cash – Equity compensation allows companies to redirect cash to other areas of the business. This is particularly relevant for start-ups and early-stage private companies that may be cash-strapped.
- Deeper incentivization – Employees who are invested in the success of the company by holding company stock and equity awards may be more motivated to help that company succeed. This type of motivation can be very powerful, especially in early-stage private companies.
- Reduced employee turnover – Strategic vesting periods provide additional incentive for employees to stick around. Oftentimes, vesting periods include a one-year cliff which means that if the employee chooses to leave before one year, they forfeit unvested equity compensation awards. An additional motivation to longevity with the company is watching the value of the company’s stock, and an employee’s awards, increase over time.
Despite these benefits, using equity compensation is not a walk in the park. It is one of the most highly regulated activities in the US and internationally, and a smart company will require expertise and advisors knowledgeable in securities laws, tax regulations, accounting standards, and administration procedures. From an accounting perspective equity compensation can be complicated to expense and even more complicated to track, especially for companies with mobile or international employees. ASC 718 spells out the US accounting treatment clearly, but doing the actual calculations can be a challenge. Throw in awards to non-employees or international employees and you might be ready to pull your hair out.
When do you need to consider ASC 718?
If a company issues any sort of stock-based compensation, and if the company has its financials audited, then the company will need to expense this compensation in accordance with ASC 718. There are multiple steps involved to properly ascertain and report equity compensation expense under ASC 718:.
- You will need to do a proper valuation using an option pricing model, most commonly the Black-Scholes method. Note: Privately-held companies may need assistance in calculating the fair value of their awards. Check out our Black-Scholes Calculator and let us know if you need any assistance.
- Once valued, you’ll need to determine the total expense to the company over the vesting period.
- Then you’ll decide what method to use for recognizing that expense.
- Finally, you’ll need to make disclosures on your financial statements.
How can you be sure you are complying with ASC 718 properly?
Shareworks by Morgan Stanley has created a Equity Compensation Reporting: A Beginner’s Guide for Private Companies to help get you started! This guide takes you through the basic principles and terminology for equity compensation expensing and reporting that should be understood in order to comply with ASC 718.
Need help with ASC 718?
Feeling overwhelmed or need some help ensuring you are ASC 718 compliant? Shareworks by Morgan Stanley has an experienced team of equity compensation experts standing by to help. Get in touch with us today.