What is ASC 718?

ASC 718, or Accounting Standards Codification 718, is a set of rules established by the Financial Accounting Standards Board (FASB) to guide how companies handle stock-based compensation in their financial reports. This includes things like employee stock options, restricted stock units (RSUs), and other forms of equity compensation.

The main purpose of ASC 718 is to ensure that companies properly account for the cost of giving out stock-based awards. It helps provide a clear picture of how these compensation practices affect a company’s financial performance. 

By doing so, ASC 718 gives stakeholders better insight into the true cost of these equity rewards and their impact on the company’s bottom line.

What does ASC 718 apply to?

ASC 718 applies to all forms of equity-based compensation granted to both employees and non-employees.

This includes:

Stock options: Rights given to employees or non-employees to purchase company stock at a set price in the future.

Restricted Stock Units (RSUs): Stock grants that are subject to vesting conditions, typically based on performance or time.

Employee Stock Purchase Plans (ESPPs): Programs that allow employees to buy company stock at a discounted price, usually through payroll deductions.

Performance-based awards: Equity grants contingent on achieving certain company or individual performance targets.

Other equity-based compensation arrangements: Any other form of compensation linked to company equity, such as stock appreciation rights or phantom stock.

The standard is applicable to all types of companies, including private companies, public companies, and limited liability companies (LLCs). 

Why do companies need to report under ASC 718?

ASC 718 ensures that stock-based compensation is properly accounted for as an expense in their financial statements. 

This is important for several reasons:

• ASC 718 ensures that the cost of equity-based compensation is recognized in a way that reflects its true economic impact on the company. Without compliance, a company may misstate its financial performance, potentially overreporting profitability or understating expenses.

• Transparent reporting builds trust with investors, auditors, and regulatory bodies. 

• Non-compliance with ASC 718 can result in legal or audit complications. Companies may face penalties or restatements of their financials, which can damage their reputation and create unnecessary financial or legal burdens.

• By adhering to ASC 718, companies not only meet current accounting standards but also prepare for future events, such as public offerings or acquisitions. Properly reported stock-based compensation can simplify audits and ensure smoother transactions with potential investors or acquirers.

When should my company start implementing ASC 718?

The Financial Accounting Standards Board (FASB) sets the GAAP guidelines, offering a consistent framework for financial reporting, which includes ASC 718.

Although early-stage companies may initially choose not to record employee equity as an expense, as they raise larger funding rounds, they typically need to comply with Generally Accepted Accounting Principles (GAAP).

In the U.S., audits are conducted based on GAAP, and startups generally undergo their first audit when raising Series A or Series B funding, depending on the size of the round. 

Investors often require an independent audit to verify the accuracy of a company’s financial records.

How to expense employee options under ASC 718

Implementing ASC 718 involves a structured process to accurately value, allocate, and record stock-based compensation.

It includes:

1. Valuing the options based on their fair market value

For private companies, a 409A valuation is typically the first step, as it establishes the fair market value (FMV) of the underlying stock. This FMV is then used as a critical input in models like black-scholes to calculate the grant-date fair value of stock options considering variables like expected term, volatility, strike price, risk-free interest rate, and dividend yield. 

2. Expense allocation over the option’s useful economic life

Once the value is determined, the next step is to allocate the expense over the vesting period. The vesting period is the time during which employees earn the right to exercise their options or receive their equity. 

Typically, stock options vest over a multi-year period, often spanning four years. The expense should not be recorded all at once but rather spread out over the vesting period. 

There are two methods to do this:

• Straight-line method: The expense is recognized evenly over the vesting period. For example, if a grant vests over four years, 25% of the total expense is allocated each year.

• FIN28 method: Under the FIN28 method, each portion of the equity grant is treated as a separate award and expensed accordingly. For example, if the grant vests over four years with an equal number of shares each year, the shares that vest in the first year are expensed over one year, those in the second year are spread over two years, and so on.

3. Recording compensation expenses on your income statement

Once the expense is calculated and allocated, it is recorded in the income statement under "Compensation Expense." 

Simultaneously, corresponding adjustments are made to equity accounts, such as "Additional Paid-In Capital" (APIC). This adjustment ensures that both the recognized expense and the equity interest granted through stock-based compensation are properly reflected in the company’s financial statements

Expensing LLC employee compensation under ASC 718

For LLCs, ASC 718 compliance can be more complex due to the use of profit interest units (PIU) or phantom equity instead of traditional stock options.

A profits interest unit gives the employee a share in the future growth of the LLC. This means that the recipient of a PIU is entitled to a portion of the profits or proceeds if the LLC is sold for more than its value at the time the PIU was granted. In other words, the employee only benefits from the LLC’s growth after the point at which the PIU was issued.

What is the difference between ASC 718 and 409A

ASC 718 and 409A both deal with the accounting and valuation of equity-based compensation, but they serve different purposes. 

ASC 718 governs how companies recognize and expense stock-based compensation, such as stock options or profits interest units, on their financial statements. It ensures that these expenses are properly allocated over the vesting period and reported in compliance with Generally Accepted Accounting Principles (GAAP). 

On the other hand, 409A is specifically concerned with determining the fair market value (FMV) of a private company's stock, to ensure compliance with tax regulations. The FMV from a 409A valuation is used as a critical input in models like black-scholes for calculating the grant-date fair value of stock options, which is then expensed under ASC 718.

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