During the dot-com boom, the practice of issuing equity shares as a portion of employee compensation gained tremendous popularity. Unfortunately, at the time that so many tech startups were springing up in the early 2000s, accounting practices related to the expensing of equity-based compensation were not well standardized. Many emerging companies, in their zeal to appear as profitable as possible, chose not to recognize such expenses at the time they were incurred. This led to significant inconsistencies in evaluating company performance and regulators made the eventual decision to standardize accounting related to employee equity and stock-based compensation.
Standardization began in the mid-2000s with FAS123R. In 2006, FAS123R contained new standards, which were reclassified in 2009 as ASC718. Generally accepted accounting principles in the United States now incorporate ASC 718 as a standard methodology for handling stock issued to employees as part of their compensation.
For a typical venture-backed startup, ASC 718 reporting serves as an important element of financial disclosure to investors. Many companies will begin incorporating ASC 718 reporting for the first time after a Series A or B round of funding. Thereafter, ASC 718 reporting becomes a standard part of the overall financial reporting package and serves as backup to subsequent financial audits.
What Goes Into ASC 718 Reporting?
ASC 718 reporting can get complicated very quickly, so it helps to step back and take a high-level look at what goes into the process. The reporting exists to support the recognition of compensation expenses. That process consists of three basic steps:
- Calculate the fair value of stock options. This can be difficult in the case of startup companies because shares are generally not liquid. In other words, there is no open market upon which the company’s stock is sold, so the determination of a fair value is somewhat debatable. A number of different pricing models exist to determine the worth of such shares. ASC 718 guidelines do not dictate that you use any one model. Rather, companies may choose whichever they prefer, provided that they remain consistent over time.
Calculation of a fair value requires a number of inputs, typically including the option strike price, the fair market value, the expected dividend yield (usually zero for startup companies), the expected term of the grant, the volatility of the company’s stock, and the risk-free interest rate for the period in which the grant is in effect.
- Allocate the associated expense over the useful economic life of the associated benefit. Just as you depreciate (or amortize) any tangible or intangible asset over its useful economic life, you handle the value associated with employee stock options similarly. Just as with depreciation, there are multiple ways in which you can make such an allocation. The simpler “straight-line” method allocates the value of a grant evenly over the service period to which the grant applies. If a grant vests over three years, for example, then you would allocate one-third of the total cost in each year. Another option is the FIN28 method, often referred to as the “ratable” method. This involves the allocation of each tranche in an equity grant separately, resulting in the accelerated expensing of equity compensation costs. To return to our previous example, if the first third of options vest in year one, then you would recognize the associated expenses in year one. If the second third vests in year two, then you would expense it in years one and two, and so on. This method is also sometimes referred to as “tranche-by-tranche” accrual.
- Recognize those expenses as employee compensation on your income statement. Finally, you must record the expenses associated with the award of equity compensation as expenses in the general ledger, and reflect them in the company’s income statement.
Although the last of these three steps sounds easy, the first two can get complicated very quickly. If your organization is struggling with accounting for equity compensation, or if you’ll be needing to perform your first ASC 718 reporting at some point in the near future, here are some best practices to keep in mind as you get started.
ASC 718 Reporting Best Practices
- Avoid Messy Manual Processes
Even if you choose to work with one of the simpler valuation models, ASC 718 calculations can get complicated very quickly. In small startups that are long on innovation and short on formal processes, you may be tempted to embark on the process of equity compensation reporting using Excel spreadsheets, hand-keyed data, and complex inline formulas.
As the number of employees in your organization grows, as members of your workforce come and go, and as the inputs to stock valuation fluctuate, the challenges of managing your ASC 718 reporting can quickly overwhelm you. At best, this is a distraction that consumes inordinate amounts of time from your most talented finance personnel. At worst, it results in poorly managed data, spreadsheet formula errors, and inaccurate financial statements.
- Plan for Scale
The problem of manual processes becomes far more significant as the organization grows, the number of employees increases, and the frequency and value of equity grants rise. At this point, the stakes are growing ever higher, while you stretch the availability of skilled resources in-house thinner and thinner. You can’t simply hand off ASC 718 reporting to a poorly prepared financial analyst. It requires substantial ramp-up time, and it demands a highly trusted person that you can rely on to work with confidential information relating to employee compensation.
For companies planning to scale up quickly, which includes most startup companies, it is best to plan well in advance for this rapid growth phase. That means having effective, reliable systems in place that can prevent bottlenecks from happening in the first place. As your company grows, the compliance requirements grow more complex, and so does the cost of getting it wrong.
- Get Professional Advice
Ultimately, ASC 718 reporting is one of those specialty functions that outside professionals with deep expertise in the subject may handle best. For some, that might mean seeking advice and training from an external consulting organization. For others, it might mean a complete turnkey service that offloads record-keeping, administration, and reporting. For startup companies that view ASC 718 reporting as an unwelcome distraction, calling in professional help is often the most direct path to getting the job done accurately and on time.
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If your organization is grappling with the challenges of ASC 718 reporting, insightsoftware can help. We offer a full range of equity management software, administration services, and equity compensation services for public and private companies. Our experts have extensive industry knowledge and can help you maximize the effectiveness of your stock plan administration. Contact us today to request a demo and speak with one of our equity administration experts.