# A Simple Explanation of ASC 718 (123R)

July 7, 2014

What is stock expensing and how is it done?

Here’s a quick explanation on what you need to know about ASC 718 (FAS 123R) and how it affects your company.

## What is ASC 718?

According to ASC 718, a company that issues equity as compensation needs to list a compensation expense on its income statement that corresponds to the estimated cost of those equity grants. If you work at a tech startup, often your compensation has two parts: salary and equity. It’s easy to show salaries as an expense, but under GAAP, the government also wants to see an expense for the equity portion of employee’s compensation.

## Do I Need to Complete an ASC 718 Expense?

There are two questions to ask when a company is trying to decide whether or not they need to complete the expense report:

1. Do you have employee equity grants? These could include:
• Options
• Restricted stock awards
• Restricted stock units
• Stock appreciation rights
• Etc.
2. Do you have audited financials?

Usually when the answer to both is yes, then the expense is required.

## Stock Option Expense Calculation

There are two steps to calculating the ASC 718 Expense:

### Step 1: Valuing the Options

First, a company needs to determine what each option is worth.

While the 409A valuation is often used as an input, it’s important to note that the value of the options is not the same as the common value from the 409A valuation.

A 409A valuation results in a value per common share.

While it’s used to set the strike price for the options, your options have a distinct value different from the 409A price.

Several people ask, “If my common is worth \$1.00, and the strike price for my options is \$1.00, aren’t the options worthless since it’s just a wash?”

Technically, if the company were selling on the day the options were granted, that would be right.

But if options were truly worthless, employees would never take options as compensation.

Options have value based on the future potential upside of the company.  For ASC 718, we use the Black-Scholes calculation to quantify that future value.

Black-Scholes is a formula that values derivative securities based on 5 inputs:

1. Strike Price
2. Underlying Value (the value of common)
3. Term (or time until expiration)
4. Volatility
5. Risk Free Rate

Running the Black-Scholes calculation will give you a value per option on each of your grants which can then be used in step two.

### Step 2: Amortizing the Expense

It would be great if we could value the option, list that entire amount as an expense in the year it is granted and be done. Unfortunately, GAAP accounting for stock options requires that the expense be spread across its useful life, which is typically defined as the option’s vesting life. In step two of the process, the expense is spread out so that it matches the vesting of the option.

### Option Expense Example

Let's use an example to show how this would be done:

Let’s say John is granted 100,000 options, and using the Black-Scholes calculation, we determine that his options are worth \$0.10 apiece. We’ll also say that 25% of his options vest on December 31st each year for 4 years (I’m intentionally making things nice and easy). Based on that info, we would book an expense of \$2,500 in each year (25,000 options * \$0.10 each.) Simple enough.

### When it Gets Complicated

With that overview, here a few examples of common complexities, and how you may go about addressing them:

1. If an option is canceled midway through its vesting, no additional expense should be listed in the future, but an expense should be listed for any vesting that does occur regardless of whether the vested options are ultimately exercised. So, if Sue vests halfway, then leaves the company and doesn’t exercise her options, we would still book an expense for the half that actually vested.
2. Note that employee grants and non-employee grants are handled very differently. Employee grants fall under ASC 718, but non-employee grants fall under ASC 505-50.  Also, differentiating between ISO’s and NSO’s isn’t enough; I can give an employee an NSO, and that would still fall under ASC 718.
3. If an option is early exercised, the expense will continue to occur as if no transaction occurred, as long as the restricted stock continues to vest. Canceling the restricted stock would stop the expense on the option.
4. If the end of a fiscal year comes midway through the cliff period on a grant, an expense should be booked for a ratable portion of the share within their cliff even though the vesting hasn’t yet occurred. A forfeiture rate would need to be taken into consideration on those unvested shares.

## Next Steps

We’ve built an ASC 718 tool to help deal with all of the corner cases and exceptions to make this task easier for the user. Ultimately, the expense calculation is just math, but there are a lot of variables. The process quickly becomes difficult as you encounter more corner cases. With a cap table recorded and up to date in Shareworks Startup Edition, you can perform the calculation quickly. That includes all of the calculations, amortization of the expense, and disclosure for auditors.

## Stock Option Expense Example Report

If you’re thinking about using Shareworks Startup Edition to keep you compliant with ASC 718, perform your option expense calculations, or generate reports, you may want to check out a demo of those features.

You can click here to get a personalized demo of our stock option expensing software.

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