Chapter 1 — Overview

To incentivize employee and nonemployee performance and align the interests of grantees and shareholders, entities often grant share-based payment awards such as stock options, restricted stock,1 RSUs, SARs, and other equity-based instruments in exchange for goods or services or consideration paid to a customer. Such awards are a form of compensation. One of ASC 718’s objectives is for entities to recognize the cost of that compensation in their financial statements as the goods or services associated with the awards are provided. The amount of cost to recognize is generally based on the fair value of the share-based payment arrangement, and ASC 718 requires entities to apply a “fair-value-based measurement method” when accounting for such arrangements.2

It is important for an entity to consider all of an award’s terms when evaluating a share-based payment arrangement. While the written plan and agreement are generally the best evidence of the award’s terms, an entity’s past practice or other factors may indicate that the substantive terms differ from the written ones. For example, if an entity’s award agreement indicates that the award will be settled in shares of the entity’s stock, but the entity has made an oral promise to settle the award in cash or has a past practice of settling awards in cash, the substantive terms of the award would indicate that there is a cash settlement feature. The substantive terms that are mutually understood by the entity and the grantee provide the basis for determining the accounting irrespective of how the award and related agreements may be drafted or structured. This concept is illustrated in ASC 718-10-25-3, which indicates that a nonrecourse note received by an entity as consideration for the issuance of stock is, in substance, the same as the grant of stock options and therefore should be accounted for as a substantive grant of stock options. Another example of this concept is a feature that allows an entity to repurchase “vested” shares awarded in a share-based payment arrangement for no consideration if the grantee ceases providing goods or services before four years after the grant date of the awards. In this scenario, the repurchase feature functions, in substance, as a vesting condition.

In addition, an entity should evaluate transactions between (1) grantees that provide goods and services or grantees that are customers and (2) related parties or other economic interest holders of the entity. If a transaction is deemed to be compensation for goods or services or if the transaction provides consideration to a customer that is not in exchange for a good or service, it is accounted for as a capital contribution to the entity and as a share-based payment arrangement between the entity and the grantee. See Section 2.5 for additional guidance.

An employee’s requisite service period4 can be explicit, implicit, or derived, depending on the award’s terms and conditions:

• An explicit service period is stated in the terms of an award. For example, if the award vests after four years of continuous service, the explicit service period is four years.
• An implicit service period is not explicitly stated in the terms of the award but may be inferred from an analysis of those terms and other facts and circumstances that are typically associated with a performance condition. For example, if an award vests only upon the completion of a new product design and the design is expected to be completed two years from the grant date, the implicit service period is two years.
• A derived service period is inferred from the application of certain techniques used to value an award with a market condition. For example, if an award becomes exercisable when the market price of the entity’s stock reaches a specified level, and that specified level is expected to be achieved in three years (as inferred from the valuation technique), the derived service period is three years.

An award may contain more than one explicit, implicit, or derived service period (i.e., multiple conditions). However, it can have only one requisite service period, with the exception of a graded vesting award that is accounted for, in substance, as multiple awards; see Section 3.6.5. If an award contains multiple conditions, an entity may need to take into account the interrelationship of those conditions. Further, the entity must make an initial best estimate of the requisite service period as of the grant date, and it should revise that estimate as facts and circumstances change. Section 3.8 discusses how to account for a change in the estimated requisite service period.

Compensation cost is based on the number of awards that vest, which generally depends on satisfaction of the awards’ service conditions, performance conditions,5 or both. For service conditions, an entity can, separately for employee awards and nonemployee awards, make an entity-wide accounting policy election to either (1) estimate the total number of awards for which the good will not be delivered or the service will not be rendered (i.e., estimate the forfeitures expected to occur) or (2) account for forfeitures when they occur. If the entity elects the first option, it will estimate the likelihood that employees will terminate employment or nonemployees will cease providing goods or services before satisfying the service condition and factor this forfeiture estimate into the amount of compensation cost accrued (i.e., decrease the quantity of awards). It will then adjust the estimated quantity if facts and circumstances change so that the total amount of compensation cost recognized at the end of the employee’s requisite service period or the nonemployee’s vesting period is based on the number of awards for which the employee’s requisite service is rendered or the nonemployee’s goods or services are provided. If the entity elects the second option, it will reverse previously recognized compensation cost when a grantee forfeits the award by terminating employment (for employee awards) or ceasing to provide goods or services (for nonemployee awards) before the grantee has satisfied the service condition.

For awards that vest upon the achievement of a performance condition, an entity will need to assess the probability of such achievement and will only recognize compensation cost if it is probable that the performance condition will be met. The total compensation cost recognized will ultimately be based on the outcome of the performance condition.

If a grantee forfeits an award that contains a market condition because of failure to meet the market condition but delivers the promised good or renders the requisite service, compensation cost previously recognized is not reversed. Compensation cost is only reversed if the grantee does not deliver the promised good or render the requisite service, because a market condition is not considered a vesting condition. In determining the fair-value-based measurement of the award, an entity takes into account the likelihood that it will meet the market condition.

See Sections 3.4 and 3.5 for additional information about service, performance, and market conditions, and see Chapter 3 for detailed guidance on the recognition of compensation cost.

For equity-classified awards, compensation cost is recognized over the employee’s requisite service period or the nonemployee’s vesting period on the basis of the fair-value-based measure of the awards on the grant date. The measurement of such awards is generally fixed on the grant date. By contrast, liability-classified awards are remeasured at their fair-value-based measurement as of each reporting date until settlement. That is, changes in the fair-value-based measure of the liability at the end of each reporting period are recognized as compensation cost, either (1) immediately or (2) over the employee’s requisite service period or the nonemployee’s vesting period. The total compensation cost ultimately recognized for liability-classified awards on the settlement date will generally equal the settlement amount (e.g., the amount of cash paid to settle the award).

Nonpublic entities can use certain practical expedients as a substitute for a fair-value-based measurement. See further discussion in Section 1.7. See Chapter 4 for additional guidance on the measurement of share-based payment awards.

Several practical expedients are available only to entities that meet the definition of a nonpublic entity in ASC 718. In determining whether it qualifies as a nonpublic entity and can therefore apply the practical expedients, an entity should note that the definition of a public entity is not the same as that of a public business entity, which is separately defined in ASC 718. While an entity uses the definitions of a public entity and a nonpublic entity to apply most of the guidance in ASC 718, it may also need to determine whether it meets the definition of a public business entity when adopting a new standard’s requirements.