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5.3 Recognition and measurement of compensation cost for ESPPs
Publication date: 31 Mar 2024
us Stock-based compensation guide
Consistent with other forms of share-based payments, compensation cost for equity awards is measured as the fair value of the award at grant date.
However, for ESPPs that incorporate some form of a look-back feature, determining the fair value of the award can be complex. While this guide does not provide comprehensive fair value measurement guidance, ASC 718 provides some examples of typical ESPP features and implementation guidance for measuring compensation cost in those cases.
Notwithstanding the recognition and measurement of compensation cost, any cash withheld from employees over the course of the purchase period is recorded as a liability on the company’s books, until such time that the cash is either returned to the employee (either at their election or upon their termination of employment prior to the end of the purchase period, if allowed or required by the terms of the ESPP) or used to purchase shares at the end of the purchase period. The cash withheld from employees’ salaries is viewed as an advance payment of the exercise price of the ESPP award, which is not viewed as a substantive purchase of stock.
5.3.1 Grant date for ESPPs
The definition of grant date used in ASC 718-50 for ESPPs is consistent with the definition used for other forms of share-based payments. As such, the grant date for ESPP awards is when (i) the employer and employee reach a mutual understanding of the key terms and conditions of the award, (ii) the employer becomes contingently obligated to issue equity instruments or transfer assets to an employee who renders the requisite service, (iii) the award has been approved by all necessary parties, and (iv) the employee begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer’s equity shares.
Most of these criteria are evaluated in the same fashion as described in SC 2.6.1. However, given the nature of ESPPs, certain of the criteria can be more complex. For example, in an ESPP with a look-back feature (as described in SC 5.3.4), the final exercise price may be based on the stock price at the end of the purchase period, which might call into question whether criterion (iv) is met at the start of the purchase period. However, ASC 718-10-55-83 notes that while the ultimate exercise price in an award with a look-back feature is not known up-front, it cannot be greater than the share price at the start of the purchase period. Therefore, the relationship between the exercise price and the current share price provides a sufficient basis to understand both the compensatory and equity relationship established by the award. The recipient begins to benefit from subsequent changes in the price of the grantor’s equity shares as of the beginning of the purchase period; therefore, this criterion is met at the beginning of the purchase period. Similarly, in a typical ESPP award, all of the terms are made available to employees in order for them to choose whether to enroll in the plan and elect a withholding amount as a percentage of salary, often subject to a maximum amount. Employees then have a short period of time in order to make such elections prior to the start of purchase period. As referred to in ASC 718-50-35-1, only when the employees have initially agreed to the offer and have chosen a withholding rate is there a mutual understanding of the key terms and conditions of the award.
Accordingly, in most circumstances, the grant date will be the start of the purchase period, as all of the above criteria will typically be met at this date.
There are scenarios when the grant date criteria will not be met until a later date or, conversely, where a new grant date will subsequently occur. For example:
- ASC 718-50-55-32 through ASC 718-50-55-33 describe a type of ESPP (a “Type I plan”) where employees can change their withholding rate and make a catch-up contribution based on the amount that would have been withheld had the new rate been in effect during the entire purchase period. While most changes in withholding rates are applied prospectively and accounted for as modifications (see SC 5.3.6), a Type I plan is economically different because it allows an employee to elect not to participate (or to participate at a minimal level) in the plan until just before the exercise date, making it difficult to determine when there truly is a mutual understanding of the terms of the award. In this case, there may not be a mutual understanding of the terms (and, therefore, a grant date) until shortly before the end of the purchase period when the employee has to make a substantive decision about how much to participate in the plan.
- A company that undertakes an IPO may establish a new ESPP after completion of the offering, and allow employees to enroll in the plan during a short period of time after completion of the IPO, using the IPO date as the start of the purchase period (i.e., a look back feature) and the IPO price as the look-back price. Employees may also change their election any time within that enrollment period. While the IPO date may be defined as the beginning of the purchase period of the ESPP, it is not until the employees are committed to their withholding elections that there is a mutual understanding of the key terms and conditions of the award. Therefore, the grant date will be established on that date, and the fair value of the award must be determined incorporating the company’s stock price on that date and the formulaic terms of the ESPP. If the stock price on that date is higher than the IPO price, the fair value of the ESPP award will be higher as the award will be in the money on the grant date.
- A company may determine during the purchase period that it will not have a sufficient number of remaining shares authorized to satisfy all the shares that may be issued under the ESPP through the end of the purchase period. This could occur, for example, if the stock price declined significantly during the purchase period and the ESPP has a look-back feature. The lower stock price at the end of the purchase period would be used to determine the purchase price, leading to a larger number of shares necessary to satisfy the withholding liability at the end of the purchase period than initially anticipated. This could be accentuated in the case of ESPPs with multiple purchase periods and/or reset features, as described in SC 5.3.5 and SC 5.3.6. If the company authorizes additional shares (including obtaining shareholder approval, if required) as a result, that would lead to a new grant date for the awards which are dependent upon the newly authorized shares to be fulfilled.
In this fact pattern, the company may also need to evaluate the terms of the plan to determine what legal obligation the company has to employees if there are insufficient authorized shares available to satisfy all of the amounts withheld from employees during the purchase period. If the company is only required to deliver authorized shares on a pro rata basis in relation to employee purchase requests, and any excess amounts withheld are simply returned to employees, no further accounting may be required as this withholding liability is already reflected on the company’s books (as described in SC 5.3). However, if the company must make the employees “whole” for any purchase discounts “foregone” as a result of not being able to deliver all of the shares under the terms of the ESPP, there may be a share-based payment liability for this additional value that would need to be recognized on a mark-to-market basis until such time as the company can authorize additional shares in order to be able to settle the obligation in equity.
5.3.2 Requisite service periods for ESPPs
Most ESPPs require participants to be employed on the purchase date and therefore, employees are required to provide service during the offering period. As a result, the requisite service period for an ESPP will generally be the time between the start of the offering period and the date the employee purchases the shares.
Typical ESPPs have shorter requisite service periods than typical employee stock options because of the constraint on the maximum purchase period required for tax-qualified status under IRC Section 423. The most common purchase period for ESPPs is 6 or 12 months.
5.3.3 Forfeitures for ESPPs
The ultimate expense for ESPP awards should reflect only those awards for which the requisite service period is completed. Companies can make an entity-wide accounting policy election for all share-based payment awards to employees, including ESPPs, to account for forfeitures only when they occur, as described in ASC 718-10-35-3. If a company makes the policy election to estimate forfeitures, an estimated forfeiture rate (i.e., the percent of withholdings expected to go unused and revert to the employee due to termination of employment prior to the purchase date) should be applied in determining compensation expense when it can be reasonably estimated. In practice, a minimal forfeiture rate may be appropriate when the ESPP purchase periods are short and anticipated employee turnover is minimal. The forfeiture rate should be updated for any changes in estimate throughout the requisite service period and updated for actual forfeitures upon completion of the requisite service period.
5.3.4 Measurement of ESPPs with look-back features
ASC 718-50-55-2 identifies nine different types of look back features found in ESPPs and provides guidance for measuring compensation cost for ESPPs with those characteristics. A typical ESPP award is granted under a Type B plan. This is a plan in which the number of shares an employee can purchase depends solely on the employee’s withholding election. The fair value of these types of awards generally consists of the following:
- A purchase discount (e.g., 15% of the enrollment/grant-date stock price)
- The fair value of the look-back feature on the enrollment/grant date (which consists of a call option on 85% of a share of stock and a put option on 15% of a share of stock)
Compensation cost for awards under Type B plans should be calculated based on the number of employees that enroll in the ESPP and the amount of payroll withholdings initially elected by those employees, along with the application of the specific terms of the ESPP plan to determine the number of shares of stock that can be purchased with those withholding amounts as of the grant date. Subsequent changes in withholding rates are discussed in SC 5.3.6 and forfeitures are discussed in SC 5.3.3.
See ASC 718-50-55-2 for details on the other types of look-back features in ESPPs.
5.3.5 ESPPs with multiple purchase periods
Some ESPPs provide for multiple purchase periods during the plan’s offering period. In that case, each purchase period essentially constitutes a separate tranche of awards for which a separate fair value and separate expense attribution schedule may be determined, as described in SC 5.3.5.1 and SC 5.3.5.2.
5.3.5.1 ESPPs with a look back to enrollment date
The fair value of an award under an ESPP with multiple purchase periods that all have a look-back feature based upon the stock price at the beginning of the offering period enrollment date should be determined at the enrollment date in the same manner as a stock option award with graded-vesting (i.e., with a different estimated "option life" for each purchase period). The attribution of expense (accelerated or straight-line) should be consistent with a company's accounting policy for other awards with graded vesting and service conditions only (see SC 2.8).
Under the accelerated attribution approach, awards under a plan with a two-year offering period with purchase dates at the end of each six-month period would be accounted for as having four separate tranches starting on the same initial enrollment date. The requisite service periods for the four tranches would be 6, 12, 18, and 24 months. Under the straight-line attribution approach, a company recognizes compensation cost on a straight-line basis over the 24-month requisite service period, while ensuring that the amount of compensation recorded at each reporting date is at least equal to the grant-date fair value of the vested portion of the award.
5.3.5.2 ESPPs with a look back to each start period
The measurement and attribution approach for an ESPP with a two-year offering period that includes four separate six-month purchase periods, each of which has a look-back feature to the stock price at the beginning of the respective purchase period, differs from the approach when the look back is to the initial enrollment date that is described in SC 5.3.5.1. When the look back is to the beginning of the purchase period, compensation cost would be measured and recognized separately and sequentially (i.e., measured at the beginning of each six-month purchase window and recognized starting at that date, as that would be the grant date for such tranche) for each of the six-month offering periods. The fair value of each award would be recognized over its 6-month requisite service period; accelerated attribution would not be applicable.
5.3.6 Changes in withholding elections and reset features of ESPPs
ASC 718-50-55 provides implementation guidance and examples for a variety of features that may be found in an ESPP, including resets, rollovers, and changes in withholdings:
- Reset mechanism: If the market price of the stock at the end of any purchase window is lower than the stock price at the original grant date (initial enrollment date), the plan resets so that during the next purchase period an employee may purchase stock at the stipulated discount in relation to the lower of (a) the stock price at the beginning of the purchase period (rather than the original grant date price) or (b) the exercise date.
- Rollover mechanism: If the market price of the stock at the end of any purchase window is lower than the stock price at the original grant date (initial enrollment date), the plan is immediately cancelled and a new plan is established using the then-current stock price as the base purchase price.
- Variable or semifixed withholdings: Variable withholding features permit an employee to change the amount of payroll withholdings throughout the purchase period to any amount. Semifixed withholding features permit an employee to change his or her withholding election at the beginning of each purchase window.
When or if these plan features occur or are elected by an employee, the changes in the award's terms are considered to be modifications, and modification accounting described in ASC 718-20-35-2A through ASC 718-20-35-9 should be applied. See SC 4 for further guidance on modification accounting.
In an ESPP with a reset feature, the look-back purchase price will "reset" if the stock price at a future purchase date is lower than the stock price on the first day of the offering period. On the date that a reset feature is triggered, the terms of the award have been modified. As a result of the reset feature, the employee now has the ability to purchase more shares with the same amount of salary withholdings as a result of the decrease in exercise price. When determining the amount of incremental compensation cost, companies should consider the impact of changing both the number of shares and the exercise price.
If the ESPP permits employees to change their payroll withholdings during the offering period and an employee elects to do so, the change is accounted for as a modification. If an employee elects to increase his/her payroll withholdings, compensation cost should be recognized for the additional shares that the employee will be permitted to purchase.
However, if an employee elects to decrease his/her payroll withholdings or withdraw completely from the plan (but does not terminate employment), the decrease is accounted for as a cancellation of an award without a concurrent grant and any unrecognized compensation cost is recognized immediately in accordance with ASC 718-20-35-9. If an employee does not complete the requisite service period (i.e., terminates employment prior to the purchase date), the award is forfeited and any compensation cost related to that employee’s awards would be reversed, as described in SC 5.3.3.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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