Back when I was a controller, my company issued stock options to all new employees, and occasionally granted additional stock options to existing employees as bonuses, promotions, etc. Back then, Stock-Based Compensation (SBC) fell under FASB123r which applied to both private and public companies. Now that FASB has codified it into ASC 718, we will go over the meat of the SBC transactions. This memo is the first lesson in ASC 718 and will be high-level explanation how to properly record any expense, liabilities or equity transactions from stock-based compensation to employees. You don’t need fancy software to do the calculations, you just need a good understanding and some strong Excel skills to develop your own software to record the transactions. When I was a controller, my calculations were thoroughly tested by the auditors with zero audit adjustments.
First, what is the objective:
The objective is to calculate the value of the stock option using the fair value method and record the expense over the option’s useful life.
The objective of accounting for transactions under share-based payment arrangements with
employees is to recognize in the financial statements the employee services received in exchange for equity instruments issued or liabilities incurred and the related cost to the entity as those services are consumed. This Topic uses the terms compensation and payment in their broadest senses to refer to the consideration paid for employee services.
Second, who does this apply to:
All companies who want to be GAAP compliant and want audited financial statements.
Now that we know our objectives and we want to be GAAP compliant, how do we go about calculating the fair value. Lets say you are a privately held company and you just hired Joe. Joe was offered 3,600 shares as part of his employment agreement. We now have to calculate a) the fair value and b) determine the useful life of the 3,600 stock options.
Since you are privately held, you don’t have a value for your options. It could be worth $1.00 or 10 cents per share. There is no market where you shares are traded so we have to find a way to value your shares.
When I was controller, I used the Black-Scholes Model to valuate the stock options. There were several factors that went into this calculation. They were:
- Stock Price
- Strike Price
- Expected term
- Interest rate
- Dividend yield
We will discuss using the Black-Scholes model in another section, but for now, let assume Joe’s shares were valued at $0.86 per share using Black-Scholes calculation. We now have to come up with useful life. In my case, I used vesting period as useful life. So, if Joe’s 3,600 shares vested over 3 years, I amortize 1/36th per month, calculated as follows:
3,600 shares x $0.86 = $3,096.00 FMV of shares / 36 months = $86.00 expense per month.
There is a second vesting period called FIN28 method which treats each vesting event as a separate award allocated over its period. I will discuss FIN28 method later.
This is just a simple overview of ASC 718. I plan on covering the more complex transactions in later lessons.
Next Lesson: Black-Scholes and Other Methods of Valuating your stock options.