ASC 718-40: Accounting for Employee Stock Purchase Plans

Accounting Standards Codification (ASC) 718 provides the U.S. Generally Accepted Accounting Principles (GAAP) for employee stock purchase plans (ESPPs). An ESPP is a program that allows employees to purchase company stock, frequently at a discounted price. The guidance focuses on whether the plan should be treated as employee compensation, which requires recording an expense, or as a transaction to raise capital. This distinction dictates the entire accounting process a company must follow.

Determining if an ESPP is Compensatory

Under the guidance of ASC 718, all ESPPs are presumed to be compensatory unless they meet a strict set of criteria. If a plan satisfies all of these conditions, it qualifies for a “safe harbor” and is considered noncompensatory, which simplifies the accounting. Failure to meet even one requirement means the plan’s discount represents a form of compensation that must be measured and recorded as an expense. The determination hinges on three specific tests that assess the plan’s structure and accessibility. Companies must evaluate their ESPP against each of these rules to determine the correct accounting path.

Substantially All Employees

The first condition for a plan to be considered noncompensatory is that it must be available to substantially all full-time employees. This requirement ensures the opportunity to purchase stock is not limited to a select group, such as executives. The plan cannot use criteria like seniority or job level to exclude large segments of the workforce. While the guidance does not define “substantially all” with a precise percentage, it does allow for certain reasonable exclusions. A company can exclude employees who have not completed a minimum service period, such as one year, or those who work less than a certain number of hours per week, as long as the exclusions are applied consistently.

Equitable Participation

The second criterion is that the plan must be structured to allow for equitable participation among all eligible employees. This means the terms of the plan cannot favor certain employees over others. For instance, the amount of stock an employee is permitted to purchase is often limited by a uniform percentage of their compensation. This ensures that all participants have a proportionally similar opportunity to invest. A plan would fail this test if it allowed executives to purchase a significantly higher multiple of their salary in stock compared to other employees.

Limited Discount

The final condition relates to the purchase price discount. To qualify as noncompensatory, the discount offered to employees from the stock’s market price must be minor. A discount of 5% or less is considered reasonable and not compensatory. This small discount is viewed as a way to cover the administrative costs of the stock purchase rather than as a direct benefit to the employee.

A “look-back” feature allows employees to purchase stock at a price determined by the lower of the stock’s market value at the beginning of the offering period or the end of the purchase period. Any plan that includes a look-back feature is automatically deemed compensatory, regardless of the stated discount percentage. This is because the look-back itself is a valuable option, protecting the employee from price declines and enhancing their potential gain from price increases.

Accounting for Compensatory Plans

Once an ESPP is identified as compensatory, the company must measure and recognize the associated cost. This process treats the benefit provided to employees as a form of compensation expense, similar to salaries or bonuses. The accounting is designed to reflect the value of the economic benefit that employees receive for their service.

Measurement of Compensation Cost

The compensation cost is measured at the grant date, which is the beginning of the offering period. The cost is based on the fair value of the stock purchase rights that employees are expected to exercise. This fair value is not simply the discount; it must also incorporate other valuable features of the plan, such as a look-back provision. To estimate this fair value, companies use financial valuation models, with the Black-Scholes model being a common choice. This model considers several inputs to calculate the value of the purchase right, including the current stock price, the expected volatility of the stock, the risk-free interest rate, and the expected life of the option.

Recognition of Compensation Expense

After measuring the total estimated compensation cost, it must be recognized as an expense. This expense is allocated over the period in which the employee provides the service required to earn the award, which for most ESPPs is the purchase period. The expense recognition is done on a straight-line basis. For example, if the total compensation cost for a six-month purchase period is estimated at $600,000, the company would record $100,000 of compensation expense each month. The corresponding journal entry is a debit to Compensation Expense and a credit to Additional Paid-In Capital.

Accounting for Noncompensatory Plans

When an ESPP successfully meets all the safe harbor criteria, the accounting is straightforward. Because the plan is not considered a form of compensation, no compensation expense is recorded on the income statement. The transaction is treated as a simple issuance of stock. When employees purchase shares, the company records the cash received and the issuance of new shares. The journal entry involves a debit to the Cash account, with credits to Common Stock for the par value and Additional Paid-In Capital for the excess proceeds.

Required Financial Statement Disclosures

Companies must provide detailed disclosures in the footnotes to their financial statements for all ESPPs to ensure investors understand the plan’s terms and financial impact. Companies must provide a general description of the ESPP, outlining its features, purchase periods, the method for determining the purchase price, and any discounts offered. The disclosures must also state the total number of shares authorized for issuance under the plan.

For all plans, companies must report on activity during the year, including the number of shares purchased by employees and the weighted-average purchase price. If a plan is compensatory, more extensive disclosures are required, including:

• The valuation method used to estimate the fair value of the purchase rights.
• The significant assumptions used in the valuation model, such as the risk-free interest rate, expected stock volatility, and the expected life of the purchase rights.
• The total compensation cost recognized for the period.