What Is The ASC 718 Report?
It’s no surprise that one of the perks about working for a startup is the ability to receive equity in the company. Many startups, for this reason, enhance their job offering by complementing a salary with an ownership stake. Since equity is considered payment for an employee’s services, it is taxable to the recipient and deductible to the company. The preparation of an ASC 718 report is useful in helping a company calculate and document these expenditures for equity grants; it is simply a way for your company to disclose the cost of its equity grants. Although the mechanics can be somewhat complex, this blog post provides high-level information to help demystify the ASC 718 reporting process.
ASC 718 Origins
The practice of considering employee grants as company costs was initially popularized through a raging debate in Silicon Valley and has since risen to national prominence because employees are often issued equity as part of their compensation package. As a result of this debate, the general consensus was that a company’s failure to expense equity grants essentially inflates its profits, and it became clear that there was a need for standardized reporting of equity grants.
Prior to 2009, the FAS 123(r) was the guideline used to report equity compensation. However, after 2009, the Accounting Standards Codification (ASC) was developed by the Financial Accounting Standard Board (FASB) as a source of generally accepted accounting principles (GAAP) in the United States. In particular, the ASC 718 topic addresses how to detail stock awards to employees on a company’s income statement.
When Do I Need To Prepare An ASC 718 Report?
Most companies report financial statements, but that is not usually the case for early-stage, privately held startups who are not yet generating revenue. However, once a startup involves third party stakeholders, such as institutional investors, it will be required to provide standard financial reporting on a regular basis (usually annually or quarterly). These financial reports are a way for investors to mitigate risk by monitoring and overseeing the transactions of the company they have invested in. The ASC 718 report is a small, yet important, piece of those financials which are a necessary component of the investor’s information rights. As is the case, most companies will prepare financials (including an ASC 718 report) for the first time after raising a Series A or B. It is also generally around this period in a company’s life that it begins to generate income. Once generating revenue, it is common for a company to undergo an external audit by an accountant and this process will require an ASC 718 report as well.
Who Should Be Involved In This Process?
The ASC 718 report involves several moving pieces and a fair bit of math, so you will most likely want your accountant, controller, or CFO to prepare it. This report is an important component of your company’s profile for investors so you do not want to make any mistakes when preparing the final version.
How Can Shoobx Facilitate This Process?
Few people like complex math, and the ASC 718 involves a lot of it. The good news is that Shoobx can ease the burden by performing many of these calculations for you! Shoobx provides the ability to generate an ASC 718 report with a few clicks. That being said, having a CFO or knowledgeable person spearhead the process within Shoobx is highly advisable.
What Goes Into An ASC 718 Report?
Now that we’ve covered the basics, it is important to know what actually goes into an ASC 718 report. We have broken it down into three main topics that you will want to familiarize yourself with, since they are essential to preparing the ASC 718 report.
- Valuation of Options - To begin, you will want to understand how to accurately report the value of the options granted by the company. Because an option’s true value at a private company cannot be determined by market forces, companies rely on models to determine their worth (restricted stock awards are valued at their fair market value, which is why the valuation calculation only applies to options). This is known as determining the “fair value” of an option grant. There are several different models that are used today, and the ASC 718 guidelines do not prescribe a specific model that must be followed. The approach endorsed by Shoobx is that of the Black-Scholes model because it is the most commonly used (and therefore most widely understood), relatively simple formula that does not require additional information for each grant, other than six predefined inputs. To properly value your company’s option grants, you will need to plug into the formula these six pieces of information: the option strike price, the fair market value, the expected dividend yield (which is normally zero for startups), the expected term of the grant, the volatility of the option price, and the risk free interest rate over the time period of the grant. As you may have gleaned from what is required, the calculation of an option’s value tries to determine how risky the shares of the company are, which then informs how valuable their worth would be in an open market. Without a clear price point for your option grants, reporting on this information is impossible—it is like stating that you pay your employees for their work without knowing their salary!
- Expense Report - After calculating a reasonable fair value for an option grant, it is time to, quite literally, take them into account. In other words, to report this information, you will want to use the information about the option’s worth only for the period in which you are preparing your ASC 718 report. This becomes a bit complex since not all options are granted at once in bulk. In most cases, employees are granted options that are tied to a vesting schedule, to ensure that the employee is incentivized to remain at the job for a certain period of time. In addition to a vesting schedule, like the ice cream bucket at the grocery store, all option grants are subject to an expiration date. The time between the day the option is first granted all the way until the expiration date is known as the contractual term; it is the time during which an employee can “claim their equity payment” before it is too late. If calculating expense was simple, we would multiply the fair value of the option by the number of options vested during the time period in which you are preparing the ASC 718 report. Yet not all employees remain at the company for the entirety of their option grant’s lifecycle, so to predict future expenses you must account for the probability of the employee’s termination and any cash flow which may occur due to option exercises or forfeitures.
- Disclosure Summary - To wrap things up nicely, you will want to create a detailed list with all of the information you have collected in the prior steps concerning active grants (including options granted, exercised, forfeited, and expired). This section of your report displays in depth the methodology behind how you have obtained your option valuation information in the beginning of your ASC 718 report preparation process, as well as information that will help evaluate your company’s projected expenses in the future. Put simply, a disclosure summary is an option and restricted stock award balance sheet for your company.
And there you have it, folks—the three essential pieces of an ASC 718 report that your company must prepare on a regular basis. If you would like to read about the ASC 718 in more detail, check out our white paper or read our blog posts about the different elements included in the report. Happy accounting!