Nonemployee Awards Subject to ASC 718 after ASU 2018-07
Part of the FASB’s Simplification Initiative in 2014 was a review of the accounting for share-based payments to nonemployees. While no changes ended up in the main update to ASC 718 per Accounting Standards Update No. 2016-09 (ASU 2016-09), many expected nonemployee awards to ultimately come under the umbrella of ASC 718. This expected simplification came to fruition when the FASB issued ASU 2018-07.
ASU 2018-07 is a welcome change that also further aligns GAAP and IFRS. Share-based payments issued in exchange for goods or services always have been subject to IFRS 2—the IFRS equivalent of ASC 718—regardless of employee classification. (Note that ASU 2018-07 doesn’t change the accounting to awards granted to provide financing to the issuer, or awards granted in conjunction with selling goods or services to customers as part of a contract.)
In the sections that follow, we’ll discuss the highlights of the changes as well as the intricate transition considerations.
Grant Date is the Fair Value Measurement Date for Nonemployee Awards
Before ASU 2018-07, nonemployee awards fell under the scope of ASC 505. The guidance in ASC 505 required that the fair value of instruments be remeasured each reporting period until the service is rendered (or goods are delivered)—in practice, that typically meant remeasuring fair value each period until vest. Under the new guidance, nonemployee awards will be under the purview of ASC 718. As such, the grant date is the measurement date of an award’s fair value, assuming the award will be settled in shares. A liability-classified award will still require mark-to-market treatment until final settlement.
The original rationale for remeasurement was that nonemployees are less financially dependent on the companies they work for than are normal employees. The thinking went like this: if the company’s value (i.e., stock price) went down significantly after the grant date, there is a higher likelihood that the individual would not complete the service, and therefore the fair value should remain variable until service is completed. The basis of this assumption was shaky since nonemployees do not have notably more opportunities than employees to shop around for work, hence the FASB now aligning the treatment.
Probabilities of the Performance Outcome Should be Considered when Expensing Performance Awards
Under ASC 505, the “lowest aggregate fair value” was used when accounting for performance-based stock compensation. This means there was often no compensation cost recognized for nonemployee awards until the performance condition is actually satisfied. This is inconsistent with the expense recognition for nonemployee transactions that are paid in cash, because an expense would be recorded when the cash outflow is probable. By aligning with ASC 718, ASU 2018-07 requires companies to assess the probability of the performance outcome and base the expense attribution off of that estimate.
Other Updates Under ASU 2018-07
In addition to those major updates, ASU 2018-07 has several other simplifications for nonemployee awards that are worth noting:
- Companies have the choice to use the full contractual term or a shorter expected term to value nonemployee options on an award-by-award basis. Analogizing to other instruments, employee stock options typically rely on an expected term derived from historical company exercise data from similar awards, and warrants issued to corporations typically rely on a full contractual term assumption. We expect practice with nonemployee options to break down on similar lines, depending on the type of recipient.
- The classification re-assessment for certain nonemployee awards is gone. Therefore, the re-assessment of whether a nonemployee award is subject to equity treatment or liability treatment upon completion of services or delivery of goods is no longer required, unless the award is subsequently modified. This eliminates another difference between the employee awards and nonemployee awards.
- Non-public companies can make a one-time election to use intrinsic value instead of fair value for liability-classified instruments, consistent with the treatment of such awards granted to employees of non-public companies in the wake of ASU 2016-09. The value of liability-classified awards should continue to be marked-to-market until settlement.
- Non-public companies may use the historical volatility of an appropriate industry-sector index to calculate their own expected volatility when estimating the expected volatility of the share price is not practicable. However, we expect that use of public peer companies will continue to result in a more robust volatility estimate than an index for non-public companies, just as it does for newly public companies.
Transition Method and Early Adoption Considerations
These updates are effective for public companies with fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. Non-public companies will have more time for transition—for them, updates are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years in the subsequent fiscal year.
Early adoption is permitted as long as the company has adopted the new revenue recognition standard (ASC 606). The transition method is modified retrospective. Any outstanding cash-settled awards and vesting equity awards should be remeasured on the adoption date. The cumulative adjustments to expense amortization as well as deferred tax assets should flow through retained earnings as of the beginning of the fiscal year of adoption.
When we first read the ASU, the language regarding adoption method struck us as ambiguous. It’s not entirely clear what the adoption date should be. For instance, if a December 31 year-end company early adopts ASU 2018-07 in Q2, should the adoption date be January 1 or April 1? The adoption date is critical, as the fair value of any affected awards will be fixed on that date.
We contacted the FASB for further clarification. The staff explained that the intent is for the adoption date to be April 1 in this particular example. Any one-time impact would flow through as an adjustment to the retained earnings as of January 1. Compensation expense would then be based on the April 1 fair value for future periods. The financials for prior quarters should not be restated for nonemployee awards due to the accounting updates. Based on our discussion with FASB, the alternative interpretation to have an adoption date of January 1 is also acceptable. Under this approach, companies would present the current year year-to-date financials based on the new guidance to reflect the effect of adoption from the beginning of that fiscal year, as if the new guidance was adopted as of the beginning of the fiscal year.
We’re excited to see ASU 2018-07 issued in line with the preliminary guidance introduced last year. Awards issued to nonemployees are economically indistinguishable from those issued to employees, and the accounting now reflects that fact. This simplification will reduce the cost of compliance and enhance the comparability of the financial statements between companies which have many nonemployees and those which have a more traditional common law employee base. It also furthers many accountants’ dream of converging US GAAP and IFRS.
For more background on the historical guidance around nonemployee awards, please see our earlier piece. As we noted then and will remind companies now, ASC 718 limits its own scope to a period of 60 to 90 days beyond the point when an employee is no longer providing service to the company, so postemployment modifications should still be made with extraordinary care.
Please see the FASB website for the comprehensive release of ASU 2018-07. And, as always, we welcome your questions and comments.