What Is ASC 718?
Whether you’re a fresh-faced founder or a grizzled veteran of the startup scene, you’ve likely already learned a fun thing about equity compensation: it can get pretty complex. Even if you understand the basics of how stock options work and can find your way around a cap table, the laws that regulate equity-based compensation can be difficult to parse. One such regulation is addressed in a document called ASC 718, which outlines how companies should account for the fair value of equity awards as a compensation expense in their income statements.
ASC 718 was created to address a very real and very messy issue in terms of how companies report their financial performance. Without a standardized way to account for the fair value of stock-based compensation as an expense, many companies struggled to provide accurate, comparable financial statements to investors and other interested parties. ASC 718 now provides a standard methodology that companies are required to use to expense equity awards in their income statements.
In this guide, we’ll review the basics of ASC 718. We’ll start with how it came about and what it’s used for. We’ll also cover some important aspects of the methodology itself, and when your company should start planning to implement ASC 718.
- What is ASC 718?
- What does ASC 718 apply to?
- When should my company start implementing ASC 718?
- How does implementing ASC 718 work?
- Track and manage your full equity picture with Pulley
What is ASC 718?
ASC 718 is an abbreviation of Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 718, Compensation—Stock Compensation. That is a mouthful, but the basic purpose of ASC 718 is to outline how companies should expense equity awards in their income statements. It provides guidance that generally requires all stock-based compensation—including employee equity awards and nonemployee equity awards—to be accounted for in income statements at fair value.
Recognizing the fair value of compensation costs in this way has some real benefits. For example, it prevents some companies from inaccurately overstating their income and thereby inflating their valuation. This gives investors more transparency regarding companies’ financial statements, and it crucially allows them to make apples-to-apples comparisons between the financial statements of different companies. Proper ASC 718 implementation can also save a company from any penalties or expensive legal proceedings in case it’s audited and discrepancies are found.
To really understand ASC 718 and how its guidance came about, it helps to take a step back and look at how U.S. accounting standards are developed, accepted, and implemented. And to do that, we need to define a few things: Generally Accepted Accounting Principles (GAAP), the Financial Accounting Standards Board (FASB), and the Accounting Standards Codification (ASC).
What is GAAP, FASB, and the ASC?
Generally Accepted Accounting Principles (GAAP) are exactly what they sound like—a set of accounting principles that are generally accepted to help maintain consistency and comparability in financial reporting across U.S. companies. When a common set of principles dictates how every company reports its financials, it’s much easier for investors and other interested parties to figure out what’s actually going on in a company’s books.
While early-stage private companies aren’t technically required to be GAAP compliant, most of them try their best to become GAAP compliant (or at least semi-compliant) before seeking out financing from investors. It may be tough, if not impossible, to attract investors in post-seed financing rounds if your company’s financials aren’t basically in accordance with GAAP. (Publicly traded companies are required to be GAAP compliant.)
The Financial Accounting Standards Board (FASB) is the organization behind GAAP standards. In 2009, the FASB published a set of guidelines called the Accounting Standards Codification (ASC), which serves as an exhaustive source of GAAP standards and breaks down each principle into a topic for reference. ASC Topic 718—ASC 718, for short—is one such topic. Prior to ASC 718, guidance suggested, but did not require, a fair-value-based method of accounting for share-based employee compensation. ASC 718 also replaced earlier guidance that provided different requirements for non-employee awards versus employee awards.
So, to summarize: all U.S. public companies and many U.S. private companies should strive to be GAAP compliant (in the latter case, it may not be necessary until a Series B or C funding round). And if your company issues equity awards as part of its compensation, part of being GAAP compliant is following the methodology outlined in ASC 718.
What does ASC 718 apply to?
ASC 718 covers a lot of different equity types, including employee stock options, restricted share plans, performance-based awards, share appreciation rights, and more. To keep things somewhat simple, we can say that ASC 718 generally applies to all stock-based compensation issued to employees and non-employees in which the company either:
- Acquires goods or services in exchange for company stock (Subtopic 718-10)
- Incurs liabilities based on the fair value of company stock (Subtopic 718-20)
Other subtopics of ASC 718 provide guidance for include:
- Employee stock ownership plans (Subtopic 718-40)
- Employee share purchase plans (Subtopic 718-50)
Each of these share-based arrangements comes with its own set of guidelines for reporting, and it’s probably asking a founder too much to learn about the intricacies of each. We recommend enlisting expert help to implement ASC 718.
Pulley offers a custom solution that includes ASC 718 and provides a summary report of your company’s stock-based compensation based on ASC 718.
When should my company start implementing ASC 718?
If your company is still in its earliest stages and equity awards haven’t been distributed to a large number of employees, you may not yet need to worry too much about GAAP compliance. In any case, the extent and expense of the stock-based compensation you’ve issued to date might not have a huge impact on your income statements.
But! You will likely need to get your financial statements in GAAP shape as your business expands and begins reaching out to angel investors and venture capitalist investors as part of a Series A round. Generally speaking, the larger and more established the investor, the greater the chance that they’ll only sniff at companies with accurate and GAAP compliant financials. Investors—who receive their own equity stake in exchange for funding—simply must know how much of the company’s existing equity is already expensed and accounted for, as this plays a significant role in determining the company’s valuation.
How does implementing ASC 718 work?
Let’s say your startup is at a stage where you need to comply with ASC 718 and start recording employee stock options as an expense on your balance sheet. How do you actually go about doing that?
The answer can be broken down into a few steps. Note that there are multiple ways to go about some of these steps, so don’t assume that a particular methodology is invalid just because we don’t get into the specifics here. The SEC, which regulates the proper recording of share-based payment arrangements for public companies, recognizes this and notes that “it will be rare…when there is only one acceptable choice in estimating the fair value of share-based payment arrangements.” With that disclaimer out of the way, here are the general steps for expensing employee options.
1. Determine the fair market value of an option
In order to comply with ASC 718, a company needs to understand the fair market value of its shares. The fair market value of a private company’s stock is how much one share of that stock would be worth on the open market. A private company’s stock is by definition not traded on the open market, but the fair market value of that stock can be determined via a 409A valuation.
There are a number of different valuation models that can be used in a 409A valuation. One common model for calculating the fair value of an option is the Black-Scholes option pricing model, which factors in variables such as the type of option, the option’s strike price (a.k.a. Its exercise price), its expected term, its expected volatility, and the risk-free interest rate. Lattice models, which use similar variables along with the awards’ contractual terms to better pinpoint potential volatility in a stock price over time, can also be used. ASC 718 doesn’t specify a single methodology that must be used in all cases, but the variables mentioned above are common among many accepted models.
If your head is starting to spin, the good news is that you don’t have to complete this step all on your own. Pulley can help you get an audit-ready 409A valuation if your company doesn’t yet have one, and our experts will work with you to ensure that you provide the right inputs and get an accurate valuation of your business and its shares.
2. Determine the expense over the option’s useful economic life
When you expense employee stock options, you generally don’t expense their entire value all at once. It’s far more common to expense options over a multi-year period of time determined by the options’ vesting schedule.
A vesting schedule dictates what needs to happen before an employee earns the right to exercise their options, and it’s typically based on a specific period of time from the grant date. (It may also include certain performance conditions.) Though vesting schedules vary between companies, a time-based vesting schedule of four years is the most common.
The key takeaway here is that options, in most cases, are a recurring expense that should be allocated across the full vesting period—otherwise known as the option’s useful economic life. You can either expense an option as a one-time expense on a straight-line basis (e.g. for a four-year grant, a quarter of the full expense will be allocated each year) or by treating each vesting increment as its own award (and thus, as its own expense item).
Track and manage your full equity picture with Pulley
By now, you should have a solid grasp of what ASC 718 is and why it’s so important for a growing startup to comply with equity-related GAAP. What you might not know is where to go from here. Don’t worry—Pulley has your back.
Our plans offer pricing and features that scale with your team, and we even offer a tailored solution that includes ASC 718 implementation with help from our experts. Whether you’re looking to prepare for investors with a 409A valuation and accurate cap table or you just want to talk about the possibilities, schedule a call with one of our experts today and learn how Pulley can help.