ASC 718: Accounting for Share-Based Payments

Accounting Standards Codification (ASC) Topic 718, “Compensation—Stock Compensation,” dictates how companies account for share-based payments. The standard requires companies to recognize the issuance of equity, like stock options or restricted stock, as compensation for goods or services received. The principle of ASC 718 is that these transactions must be measured at their fair value and recorded as an expense in the financial statements.

This guidance applies to a wide array of arrangements for both employees and nonemployees. The cost associated with these awards is recognized over the period in which the recipient provides the related goods or services, which enhances the transparency and comparability of financial statements.

Scope and Covered Award Types

ASC 718 applies to all transactions where an entity issues its equity instruments for goods or services, covering awards to both employees and nonemployee vendors or consultants. The standard covers several award types.

• Stock options give an employee the right to purchase company stock at a predetermined exercise price for a specified period. The accounting for the issuing company focuses on the option’s fair value at the grant date, regardless of whether they are Incentive Stock Options (ISOs) or Non-qualified Stock Options (NSOs).
• Restricted Stock Awards (RSAs) are grants of company shares that are subject to a vesting schedule, meaning ownership is contingent on continued service or meeting performance goals. Restricted Stock Units (RSUs) are a promise to issue shares at a future vesting date without an exercise price.
• Employee Stock Purchase Plans (ESPPs) allow employees to buy company stock, often at a discount, through payroll deductions. If the discount is significant, it is considered compensatory and the company must recognize an expense for the benefit.
• Performance awards are contingent on achieving specific, predetermined goals. These goals can be tied to the company’s stock price (a market condition) or to operational metrics like revenue or profitability (a performance condition).

The nature of these conditions impacts how the expense is recognized. For instance, compensation cost is recorded only if it is probable that a performance condition will be met.

The Fair Value Measurement Principle

The measurement principle of ASC 718 is that all share-based payments must be measured at fair value. This value represents the total cost of the award that will be recognized as compensation expense. For awards like RSAs and RSUs, determining fair value is the market price of the company’s stock on the grant date. The process is more complex for stock options, which require a valuation model to estimate their worth.

The most widely used valuation method for stock options is the Black-Scholes model. This model requires several inputs to calculate the fair value of an option at the grant date, and companies must disclose these assumptions in their financial statements.

• Exercise price: The fixed price at which the option holder can purchase the stock.
• Stock price: The market price of the underlying share on the grant date.
• Expected term: The period the option is expected to be outstanding before it is exercised or expires. Companies estimate this based on historical data or a simplified method provided by ASC 718 for those with limited history.
• Expected volatility: The anticipated fluctuation in the stock’s price over the expected term. This is a driver of an option’s value and is calculated using historical stock price volatility.
• Risk-free interest rate: The U.S. Treasury yield for a term that corresponds to the option’s expected term.
• Expected dividend yield: The company’s anticipated dividend payments over the option’s term. A higher expected dividend yield lowers the fair value of a stock option, as option holders do not receive dividends.

Recognizing Compensation Expense

Once the total fair value of an award is determined, the company recognizes that amount as compensation expense in the income statement. This expense is allocated over the requisite service period, which is the time an employee must work to earn the award and is commonly the award’s vesting period.

The pattern of expense recognition is dictated by the vesting schedule. For awards with a cliff vesting schedule, where 100% of the shares vest on a single future date, the total compensation cost is recognized on a straight-line basis over the entire service period.

For awards with a graded vesting schedule, where portions of the award vest in installments, companies have two permitted methods. The first is the straight-line method, which recognizes the total expense evenly over the full service period. The alternative is the accelerated method, where each vesting portion is treated as a separate award, resulting in higher expense recognition in the earlier years of the award’s life.

Companies must also account for forfeitures by estimating the number of awards they expect will be forfeited before vesting. ASC 718 allows entities to either estimate a forfeiture rate at the grant date and adjust it over time, or to account for forfeitures as they actually occur. This ensures compensation cost is recognized only for awards that are expected to vest.

Accounting for Award Modifications

Companies sometimes change the terms of a share-based award after its grant date. ASC 718 treats a modification as an exchange of the original award for a new one, requiring the company to measure and account for any incremental compensation cost from the change.

The accounting for a modification involves calculating the fair value of the award immediately before and after the change. If the fair value of the modified award is greater than the original, the difference represents incremental compensation cost.

This incremental cost is then recognized as an expense. If the modification affects a vested award, the cost is recognized immediately. If the award is not yet vested, the incremental cost is added to any remaining unrecognized compensation from the original award and is recognized over the remaining service period.

Common examples of modifications include the repricing of stock options. Lowering the exercise price increases the option’s fair value, creating incremental cost. Another modification is the acceleration of vesting, which requires the company to immediately recognize any compensation cost that had not yet been recorded for the award.

Financial Statement Presentation and Disclosures

The accounting for share-based payments affects how costs and equity changes are presented in financial statements. On the income statement, compensation expense is recorded in the same functional lines as the cash compensation of the employees, such as Research and Development or Selling, General, and Administrative expenses.

On the balance sheet, the offset to compensation expense for equity-classified awards is recorded in Additional Paid-In Capital (APIC), a component of stockholders’ equity. On the statement of cash flows, share-based compensation is a non-cash expense that is added back to net income in the operating activities section. Cash received from the exercise of stock options is classified as a financing activity.

ASC 718 mandates extensive disclosures to provide users with a clear understanding of a company’s share-based payment arrangements. Required disclosures include:

• A description of the stock compensation plans and the general terms of the awards.
• The method used to calculate fair value, such as the Black-Scholes model, and all key assumptions used in the calculation.
• The total compensation cost recognized for the period and the associated tax benefit realized.
• A detailed roll-forward of stock option activity, showing the number of options granted, exercised, forfeited, and expired.
• The total unrecognized compensation cost related to non-vested awards and the weighted-average period over which this cost is expected to be recognized.