In our previous blogs, we have seen the benefits of employee equity and why you should consider it as a form of compensation. This article deals with the accounting aspect of employee equity.
The Financial Accounting Standards Board or FASB has laid out the accounting treatment for stock compensation, another term for employee equity, in the Accounting Standards Codification Topic 718, which is simply referred to as ASC 718. Let us explore this in detail.
Background of ASC 718
ASC 718 is a mandatory financial disclosure and is an important line item that impacts the Income Statement of an organization. It deals with recording, valuing and expensing compensation by way of employee equity. In its 2018 amendment, its scope has been widened to cover accounting for share-based payments to non-employees or freelance/temporary/contract-based employees.
Guidelines as per ASC 718
The ASC 718 guidelines suggest a three-step process to account for employee equity or stock compensation, which are discussed below
Step 1: Ascertaining the Fair Value
ASC 820 (FAS 157) defines fair value as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’
In other words, the amount that would be paid in exchange for an asset (in this case, the employee stock options) if it were bought and sold by potential buyers and sellers in a market is the fair value. The fair value is an estimate of the current value at a given point in time.
While ASC 718 has not prescribed a set way of fair valuation, it has suggested a few factors that must be considered while evaluating an option, such as duration, variance, the strike price (exercise price) and dividend yield.
There are three methods of valuation listed in the 409A, which talks about equity valuation. There are also popular statistical models like the Black Scholes Option Pricing Model.
Step 2: Allocating the Expense, Period-Wise
Once the fair value has been calculated, it needs to be allocated across multiple years. This is because the benefit of the expense from stock compensation is enjoyed for a long period of time, and it is only rational to distribute the expense over a period of time.
For this, you have to determine the life of the option or the number of years over which the fair value has to be distributed. This concept is quite similar to ascertaining the useful life of a tangible, depreciating asset like machinery.
Step 3: Recognizing the Expense Periodically
Once the amount to be written off each period or each year is determined, it needs to be recognized in the respective period’s financial statements. In other words, the transaction needs to take place in the Income Statement and Balance Sheet of the company.
If your company is a very young startup whose revenues are yet to stabilize, you may not want to begin expensing off the annual portion of the fair value of the option. However, it may not be wise to put off expensing for a long time, particularly if your company has started raising funds through Series A or B, to ensure that your auditors or investors feel that you are being prudent.
Three ASC 718 Best Practices
ASC 718 is highly technical, and compliance to it requires know-how that does not come cheap or easy. Here are some of the best practices that your company can follow to ensure smooth operations relating to ASC 718 compliance.
1. Professional Valuation
Arriving at the fair market value can be a tricky affair that is best left to experts. If you do not have an in-house expert, we highly recommend you consult professionals who are adept at it so that your company’s numbers, reports and processes are accurate and timely.
Poring over technical documents and acting on informal recommendations might turn out to be incorrect and also consume precious time that can be dedicated to activities that can expand the business.
If you are a new entrepreneur or hold the forte of a small company, your company will possibly grow in the future. As it grows, the size, complexity and number of transactions will increase, which will require departmentalization. Automating processes right from this stage will greatly contribute to reducing the overall quantum and cost of the manual work involved.
Startups, particularly young ones, should invest in the automation of ASC 718 since this is going to be a recurring and ongoing activity for the foreseeable future. Once this is taken care of, the management can focus on business operations and revenue generation.
3. Strategic Planning
If your organization is planning to commence or continue with employee equity, it is best to plan ahead. Once you decide on the tentative stock compensation, its impact on your company’s future financials must be captured so that you can know what exactly you can expect and re-evaluate your plan if necessary.
Tools like scenario modeling can greatly simplify this process, and save time while making your strategy solid. Click here to know more about trica equity’s scenario modeling tool.
To Sum Up
The purpose of ASC 718 is to have a structured and standardized way of expensing stock compensation. Following the three-step approach combined with the best practices can simplify your compliance process and give you a deep insight into the impact of stock compensation on your company’s financials.