Whether you own a startup or an established firm, equity compensation is complex and requires detailed maintenance of records with caution.
Various laws control equity-based pay. One such control that regulates complexity is the accounting principle ASC 718, which details how businesses should record the fair value of stock awards as a compensation expense on their income statements.
Under ASC 718, the definition of ‘employee’ extends beyond traditional employees and includes board members, leased employees, part-time employees, and employees in pass-through entities, depending on their services. Businesses should understand who is considered an employee in ASC 718 to appropriately account for them and have consistent financial reporting.
This article explains the scope of ASC 718 and the definition of ‘employee’ for practical applications in a company’s accounting principles.
What is the scope of ASC 718?
ASC 718 covers various equity forms such as employee stock options, restricted share plans, performance-based rewards, share appreciation rights, and more. In general, we can say that ASC 718 relates to any stock-based remuneration paid to employees and non-employees in which the company either:
Purchases goods or services in return for company equity (Subtopic 718-10)
Incurs liabilities depending on their company stock’s FMV (Subtopic 718-20).
Other areas of ASC 718 scope include:
Plans of employee stock ownership under Subtopic 718-40
Plans for employee share purchase under Subtopic 718-50
Each of these share-based plans has reporting rules, and learning about the nuances of each is probably too much for a founder to handle. So, it is advisable to get professional help to implement this accounting principle.
Who Qualifies as “Employees” under ASC 718?
Though the accounting for non-employees and employees is almost the same under ASC 718, there are specific significant differences. Specifically, the cost and measurement of stock instruments given to employees could differ from those given to non-employees.
So, it is important that you understand the definition of ‘employees’ for proper recognition and accounting. Let’s understand the categories under which we need to know who falls under the employee category under the accounting principle ASC 718.
Recognitions for Board of Directors Members
Under ASC 718, a nonemployee who sits on the board of directors and gets a salary from the firm just for their position as a director will be classified as an employee if
The company's shareholders have elected the individual or
At the end of the current term, the shareholders will choose another person to replace the employee appointed to the board seat.
Thus, a company should treat an award given to a non-employee director as an award given to an employee, so long as the award is in return for services rendered just in the person's role as a director. However, it is important to record an award given to such a director for non-board activities as a non-employee transaction.
Usually not elected by a company's shareholders, the exception for non-employee directors does not extend to independent contractors or advisory board members (e.g., board members that function in a consulting capacity, provide legal services, or give scientific advice). Any instruments received in return for non-director services should be recorded as a nonemployee transaction and shown on the company's financial statements, in MD&A, and on the proxy statement under related-party classification.
Separate boards of directors may exist among a consolidated group of subsidiary firms. Generally speaking, only those outside directors on the parent company's board count as employees. Under ASC 718, if non-employee directors serve on the board of a consolidated subsidiary, they would be regarded as employees either directly or indirectly.
The parent business or another member of the consolidated group categorizes the subsidiary's shareholdings based on control. The subsidiary will report the directors as employees in its own financial accounts if they are chosen by the subsidiary's shareholders, whether they are independent or parent shareholders.
For example, let us consider a nonemployee of a company appointed to the board who has no obligations outside the board. In such instances, ASC 718 states that the company must regard any compensation—stock or salary—just as it would an employee, even though the person is a nonemployee as they become a board member chosen by shareholders.
Also, if the individual provides additional work to the company outside their board duties, any payment or stock compensation for that consulting will be considered a nonemployee transaction.
Recognition for part-time and leased employees
When determining whether an individual qualifies as an employee under ASC 718, the primary factor to consider is their status under common law. A leased individual must also meet the common law definition of an employee. However, according to ASC 718-10-20, additional requirements must be met for a leased person to be considered an employee.
Those are - being eligible to participate in the lessee’s employee benefit plans, having the exclusive right to determine the economic value of the services performed by the lessee (including wages, number of units, and value of stock compensation granted), and having the right to hire, fire, and control the individual’s activities. If they don’t meet those requirements, they are non-employees.
Part-time employees normally meet the definition of an employee under ASC 718 and are treated as employees.
For example, two employees (A&B) joined the same company. Employee A works part-time, while the staffing agency leases Employee B to the company. Per ASC 718, the part-time worker’s stock options are treatable like ordinary employee compensation. However, employee B is eligible for regular consideration only when they meet the above mentioned requirements.
Recognition to pass-through entity employees
If the grantee qualifies as a typical law employee, businesses should usually treat share-based payment awards of a pass-through entity as employee awards.
Generally speaking, given the combined service and ownership relationship of owners in a pass-through corporation—e.g., a limited liability company—the fact that the pass-through entity does not designate the grantee as an employee for payroll tax reasons is irrelevant.
For example, an individual is a part-owner in a law firm structured as an LLC, a pass-through entity. They receive stock awards as compensation for their work in the firm.
Even though the individual is not an employee for payroll tax purposes (as they are the owner), ASC 718 treats them like a typical employee for stock compensation. Though the individual’s ownership stake in an LLC has different taxation, their stock options will be under the category of employee awards.
Employ a Comprehensive Approach in ASC 718
Understanding the criteria for considering ‘employees’ in ASC 718 is important for your company’s accurate financial reporting and compliance with accounting principles. To understand the employee category clearly, you must be familiar with the different types of employees, the underlying accounting principles, the stocks awarded, and other relevant factors.
It is good to get support from specialized platforms to consider all the nuances and better streamline the process. These professionals can support you in managing your equity compensation, ensuring accurate classifications, and reporting financial statements precisely.
By utilizing these platforms, you can easily navigate the complexities of employee definitions and make well-informed business decisions, improving your overall company’s performance.