Under ASC 718, compensation expense for employee stock purchase plans (“ESPPs”) must be recognized in a company’s financial statements. The only exception is a plan that is considered “non-compensatory” – which means it does not contain a look-back feature nor have a discount over ~5%. Thus, a company must estimate the expense for any ESPP with a look-back feature or a purchase discount greater than 5%. It doesn’t matter if a plan is tax qualified under Section §423, or alternatively a non-qualified plan; the fair value of an ESPP will be based on its features.
Equity or Liability Accounting
The biggest difference in how ESPP expense is accounted for is whether the offering is equity or liability classified. For plans where the purchase price is based off of a look-back or the beginning price, expense is equity classified. For plans where the purchase price is based off of the ending price, expense is liability classified based on the guidance in ASC 480, Distinguishing Liabilities from Equity. This is because the award provides for a fixed monetary value which is converted to shares on the purchase date, which is considered “stock-settled debt”.
Regardless of the classification, expense is recognized from the service inception date (which is generally the offering date) over the requisite service period of the award (i.e., the purchase date). For awards with with multiple purchases within a single offering, the expense is recognized over the full offering period using the straight-line or graded vesting approach. See our article on graded ESPPs for more details.
Total expense can be estimated at the measurement date in one of two ways:
- For ESPPs with a discount, expense is based on the relevant employee contributions, the estimated number of shares to be purchase, and the estimated fair value. ESPPs with a discount can be equity or liability classified.
- For ESPPs with a match, expense is based on the relevant employee contributions multiplied by the matching percentage (i.e, 20%). ESPP shares with a match are generally purchased based on the purchase date stock price, and thus will be liability classified.
Differences will emerge in how the expense is reconciled depending on if the ESPP is equity or liability classified as discussed below.
Accounting for Equity Classified ESPPs
Equity classified ESPPs most commonly feature a discount and a look-back where the purchase price is based on the lesser of the beginning and ending price. The general steps for expense recognition are as follows:
- The expense is estimated on the accounting grant date based on the expected contributions, the stock price on the grant date, and the fair value per share purchased.
- Expense is recognized over the requisite service period based on the grant date estimate.
- At the end of the purchase period, expense is not trued up based on the actual value delivered, but continues to be based on the grant date fair value. Changes in contributions are accounted for in different ways as outlined below:
- Salary changes are reconciled to actual contributions
- Shares not purchased due to a termination (forfeitures) are reversed out
- Decreases in contribution elections and full withdrawals are ignored (grant date expense estimate remains)
- Increases in contribution elections are a modification under ASC718
See the following example for a common ESPP design with a 15% discount, look-back, and no increases in contributions allowed. The expense recognized is based on the grant date fair value and accounting contributions required to be expensed (only terminations are reversed).
Accounting for Liability Classified ESPPs
Liability classified ESPPs most commonly feature a discount or a match when the purchase price is based on the ending price. While liability classified accounting is generally not preferred for most equity compensation, it can actually be simpler for ESPP accounting. The general steps for expense recognition are as follows:
- The expense is estimated at the end of each reporting period based on the expected contributions, the stock price on the measurement date, and the fair value, all as of the end of the reporting period.
- Expense is recognized marked-to-market over the requisite service period.
- Final expense is based on the actual compensation delivered.
- Note that this eliminates the need to separately track salary changes, terminations, and changes in contributions, since all are reconciled to actual contributions.
See the following example for a common ESPP design with a 15% discount as of the purchase date.
Note that regardless of how the stock price changes, the expense is relatively fixed over the period. This is because as the stock price increases or decreases, the shares purchased moves inversely (i.e., decreases when stock price increases and increases when stock price decreases). Thus the total expense is the same except for reconciling for any changes in contributions that occur during the period, regardless of why they change.
Companies should be aware of the expense implications of their ESPP based on their own specific design nuances. It is often a surprise that a common ESPP design can result in liability accounting treatment. However, liability classification for ESPPs should not be viewed negatively as it is for other types of equity compensation, as the calculations are often simpler. As financial reporting for ESPPs becomes an area of increased auditor scrutiny, it is important to have sound documentation and processes in place to account for an ESPP appropriately.