ASC 718, also known as share-based compensation accounting, represents the intersection of two important startup phrases: “Due diligence” and “stock options.”
As startups prepare for financial due diligence from potential investors, they must expense share-based payments to employees on their income statements. ASC 718 specifies the generally accepted accounting principles (GAAP) treatment for stock options, stock appreciation, restricted stock units, and restricted stock grants.
Founders and CFOs are busy, and ASC 718 accounting is complex. It’s essential for these startup leaders to understand the foundational elements of ASC 718.
Looking to arm yourself with ASC 718 knowledge? Scott Goodwin, Principal at Wolf & Company – a national CPA and business consulting firm – joined us to deliver insights on share-based compensation accounting and some tips and tricks for companies at every stage.
Each ASC718 report builds on the previous version. If you’re an early-stage company fundraising for the first time, it’s crucial to build a strong foundation. Alternatively, growing startups preparing for their Series A or Series B should continue practicing good habits as their equity management strategy becomes more complex.
No matter your stage, it’s important to avoid the trap of ignoring GAAP accounting for stock options until the eve of due diligence.
“If you have three years of granting history and someone has now said you need to produce GAAP financial statements in the next six months, getting that three years of history into any cap table management software is not going to be that simple,” Goodwin said. “It’s going to create additional stress and time.”
Dos and Don’ts for Share-Based Compensation Accounting
Goodwin outlined a few helpful strategies for GAAP accounting for stock options – and also highlighted the challenges that some clients face:
Do: Keep good records
No one wants to delay a fundraising deal with an investor because they’re scrambling to recover old documents.
Both early and later-stage startups should focus on day-to-day due diligence. Create a system for organizing stock option grants and paperwork. Clearly document your stock promises, and make sure all parties understand the terms of the agreement. This way, when it’s time to generate an ASC 718 report, you’ll be able to point to clearly-labeled documents with well-defined terms.
“Keep the raw materials in good shape,” said Goodwin, who’s worked with many startup clients in his time at Wolf & Co. “Don't make vague or poorly-documented promises about any share-based compensation arrangements.”
Don’t: Generate reports without understanding the process
Startup leaders using the best equity management software can generate an ASC 718 report with just a few clicks. CFOs and founders have so many tasks to handle on a daily basis. It can be tempting to let your software do the work, then simply shuffle your paperwork over to your accounting firm.
Goodwin cautions against this behavior. Startup leaders don’t have to become ASC 718 experts – that’s their CPA’s job – but it’s important for them to understand the basics of their stock option agreements. That way, when investors or auditors come with questions, you’re able to provide meaningful feedback.
Do: Stay in constant contact with your CPA firm/accountant
Your accounting firm is an excellent source of knowledge about GAAP accounting for stock options. CFOs and founders should tap into their CPA’s expertise early and often.
Not knowing every answer is okay. It’s better to ask questions than to incorrectly report your share-based compensation accounting.
“What I see frequently [amongst startup leaders] is a lack of depth of understanding of ASC718,” Goodwin said. “Half knowledge is dangerous. Make sure you check in with your financial consultant or CPA to make sure you’re on the right track.”
Goodwin also advises startups to find a firm that aligns with their company’s industry and stage. Think of hiring your CPA like adding an executive to your team; the more closely their experience aligns, the better fit they’ll likely be.
Don’t: Cut corners on your 409A valuation
The 409A valuation is a close relative of ASC 718 reporting. Both 409A and ASC 718 deal with share-based compensation. 409A is the tax standard for the Internal Revenue Service (IRS), while ASC 718 is the GAAP accounting standard. In simple terms, the 409A calculation factors into the value of stock options, which is then related to ASC 718 reporting.
It’s essential to generate an accurate 409A valuation – and to update this calculation whenever your startup experiences changing conditions (company growth, an acquisition, etc). Failing to keep an accurate 409A will result in skepticism and issues when your investors (or other auditors) conduct due diligence.
“The only thing worse than having to pay for a 409A valuation is having to pay for one that doesn't muster when your auditor starts ripping it apart, “ Goodwin said.
Do: Look out for modifications
Modifications to stock options will occur constantly, and they often impact your GAAP reporting. The exercise price of your stock might change. A high-performing employee might receive accelerated vesting if they leave your company. Perhaps the exercise period was increased to offer relief during the pandemic.
No matter the modification, it’s important to stay on top of these changes. It’s always better to flag modifications, rather than waiting to deal with them at the last minute.
“It’s better for you – the company or your internal accounting department – to bring those changes proactively to your auditors than to have your auditors find them,” Goodwin said.
Don’t: Forget to keep up good habits
After you tackle share-based compensation accounting for the first time, it’s largely an operation procedure.
Goodwin strongly advises companies to use cap table software like Shoobx to keep ASC 718 documents organized. As your company grows, it’s important to ensure that option grants are entered into your software, policy elections are accurate and you have a process to flag performance or service conditions for equity grants and share grants.
“I can say definitively there are fewer issues that come up when someone is using a cap table management software,” Goodwin said. “When you’re in a spreadsheet, a lot of things can go wrong.”
The keys to ASC 718 success lie in day-to-day due diligence and constant communication with the right CPA partner. Stock options are an exciting tool for recruiting and retaining talent and behind-the-scenes accounting makes it all possible.
Are you a startup founder or CFO looking for more insights on ASC 718 and share-based compensation accounting? Watch Shoobx’s free webinar, “ASC 718: How to Stay Audit-Ready and Boost Investor Confidence” with Scott Goodwin, Principal at Wolf & Company.