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How Does ASC 718 Work for Stock-based Compensation?

The Accounting Standards Codification, or ASC, is a system of accounting principles established by the Financial Accounting Standards Board (FASB). ASC 718 requires companies to measure and recognize compensation costs for stock-based incentive plans using a fair-value approach.

In today’s competitive market, companies use stock-based compensation as a major incentive for employees. Stock-based compensation consists mainly of employee stock options, restricted stock, employee stock ownership plans, and other stock-based programs.

In this regard, the ASC 718 principle has become an important element of accounting for stock-based compensation. Under ASC 718, it is essential to include the stock compensation expenses in the financial statements. In this article, we will investigate the principles and concepts of ASC 718. 

ASC 718 and Stock-based Compensation

The primary objective of ASC 718 is to measure and account for stock-based compensation using a fair-value measurement. In this regard, the stock-based compensation will be recognized as a non-cash expense on the company’s income statement. The amount of the expense will be determined based on various factors.

While stock-based compensation is a form of employee benefit rather than equity, it is classified as an expense in the income statement. The equity or the shares are granted as a part of the stock-based compensation to encourage employees to perform better and feel motivated simultaneously. The extent of the compensation is based on a series of factors, including the number of shares, the date that a stock option is granted, and vesting terms.

As a result, ASC 718 requires companies to fully reflect any stock-based compensation costs in their financial statements. But, what does ASC 718 apply for? 

What is ASC 718?

ASC 718 is a standard that establishes guidelines for accounting for stock-based compensation in the books of accounts. Under this standard, companies will disclose the stock-based compensation cost in their financial statements. As per the Generally Accepted Accounting Principles (GAAP) reporting rules, the government is willing to identify the stock compensation expenses involved in the process of granting employees equity as an incentive.

This will enhance the transparency of the finances and allow the government to determine whether the stock-based compensation plans are being carried out ethically. Additionally, ASC 718 will give companies and investors an insight into the costs of stock-based compensation. Companies that fall under the jurisdiction of the GAAP must abide by the ASC 718 standard. Therefore, it is crucial to comply with the standard to avoid any penalties.

When Do Companies Start Expensing Stock-based Compensation?

Under ASC 718, the stock-based compensationshould be expensed in the financial statements when the employees gain legal ownership of the shares. This is the point when the employees receive equity as part of their compensation package. Based on the vesting terms, the employees may receive the stock option they have been granted over time. Once the employees receive these shares, it will be expensed as non-cash in accordance with ASC 718.

As such, companies initiate various programs to encourage their employees to participate in the company’s growth and success. According to statistics, annual stock-based compensation in the United States for 2022 is $0.228 billion, a 14% increase from 2021. The market is in constant flux, and employees expect greater benefits. Having said that, ASC 718 is important for limiting these costs and reporting them in the financial statements.

The principle of ASC 718 will ensure that the transactions are historically recorded and that the reporting is objective and accurate. Therefore, the right time to file a company report is when the company grants equity to its employees. Be sure that the fair-value expense is determined based on specific facts and circumstances.

Why Do Companies Need ASC 718?

The main objective of ASC 718 is to ensure that companies have a clear picture of the stock compensation cost in their financial statements. As a non-cash expense, stock compensation is more difficult to measure and recognize. In this regard, ASC 718 allows companies to report the fair-value cost of stock-based compensation on a non-cash basis. Following are a few other benefits of ASC 718:

To Maintain Legal Terms

With the rise of stock-based compensation, it is important to protect the legal rights of both companies and employees. ASC 718 helps companies maintain the terms in force during the stock-based compensation process. To abide by the laws and regulations, ASC 718 will clearly define the terms and conditions of the stock-based compensation.

Hence, the company can clearly document the date when it will recognize the expense and the value of the equity grants. As a result, the company will be able to achieve compliance with legal and other regulatory requirements.

For Valuation

The stock compensation expenses being recorded in the financial statements will directly impact the companies’ valuation. It is useful to keep track of the stock compensation costs as it is one of the most important expense items in the companies financial statements. As such, business valuations can be improved with the use of ASC 718 in regard to stock-based compensation.

The overall value that is derived from the stock-based compensation will be an important factor for the company’s valuation. Thus, ASC 718 will standardize the valuations to ensure transparency and stability in the market.

To Store Financial Information

ASC 718 will play a crucial role in recording and storing financial information. The financial data disclosure will enable the government to determine whether the companies are following the rules and regulations of stock-based compensation. This will ensure the creditability of the companies and will enhance their market value. In addition, potential investors, such as banks and other financial institutions, will be able to measure the performance of the company based on the fair-value cost of stock-based compensation.

As a result, it will become easier for companies to gain access to larger sums of equity funding from investors. Therefore, it is vital for ASC 718 to be applied across industries and jurisdictions.

What are the Important ASC 718 Reporting Standards?

The essence of ASC 718 lies in the accounting rules governing the disclosure of the expenses linked to the granting of stock-based compensation. Here are a few ASC 718 reporting guidelines in order to understand the accounting principles:

  • ASC 718 requires companies to calculate the fair market value of the stock-based compensation. In other words, it is important to determine the measure of the value of this equity. Well, 409A valuation is the framework that is applicable for companies to determine the fair market value of the private company’s share.
  • ASC 718 requires companies to allocate the fair-value expense of stock-based compensation among different categories. The stock-based compensation expenses are expected to be allocated reasonably and consistently based on the vesting terms. To prepare the financial statements, it is important to calculate how much of this expense will be allocated.
  • ASC 718 requires companies to include the stock compensation expenses in the income statement to distinguish them from other operating expenses. The income statement represents a summary of the revenue and expenses incurred by a company during a specific period. Therefore, the company should ensure that the stock-based compensation expense is properly reflected in the income statement.

Why Does ASC 718 Reporting Get Complicated?

The reason ASC 718 reporting gets complicated is that there are many variables in the process of determining the fair value of the stock-based compensation. It is important to understand the critical factors that impact the stock-based compensation cost. For instance, if a company decides to reprice options, the modifications of the existing options will result in changes to the fair value of the stock-based compensation, and it may significantly impact the company’s financial statements.

There are a number of restatements that happen in the stock-based compensation process. This may include the initial recognition of the stock-based compensation expense and subsequent changes in the fair value of stock-based compensation. It is clear that the complications in reporting are related to the determination of the fair value of the stock-based compensation. Therefore, it is important for companies to have a detailed understanding of the ASC 718 accounting principles that govern the stock-based compensation process in order to avoid unnecessary expenses.

How Can You Make It Less Complicated?

In order to make the ASC 718 process less complicated, it is important to understand the various rules that apply to stock-based compensation. At the same time, companies should make sure that the data is accurate by using the provisions of ASC 718. In addition, the financial statements should be scalable and easy to comprehend in order to have a smooth transition from the old accounting framework to ASC 718.

While digitizing the data is one of the best ways to simplify the reporting process of stock-based compensation, by automating the accounting information, the companies can make sure that the financial data is available and accessible. Lastly, it is important to focus on cost-effective options when companies choose to pivot from the old accounting framework to ASC 718. Overall, companies can reduce the whole ASC 718 reporting process into a streamlined and efficient process by following these guidelines.

Summing Up

ASC 718is comprehensive accounting guidance that governs the reporting process for stock-based compensation. It seeks to standardize how companies report stock compensation expenses and provide transparent financial reporting for investors.

The purpose is to help companies develop and grow by ensuring that the stock-based compensation expense is properly accounted for. Additionally, be sure to comply with the rules and regulations of the accounting framework to avoid unnecessary financial reporting costs.

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