Accounting for ESPPs: Part II: Contributions & Recognition

Part II of our Accounting for ESPP White Paper:


Estimated Contributions

Once the fair value has been established, the total expense must be calculated and then the expense recognized over the vesting period (time until purchase).

To calculate total expense, you must estimate the contributions for the period. This should be calculated at the employee level so that (in some cases) after the purchase the expense can be adjusted based on the actual shares purchased.

Generally, you should calculate the estimated contributions with the assistance of payroll. When the participant enrolls in most plans they will specify what percentage of included pay types they would like deducted from their pay[1] and used to purchase shares. Once that % is known, the % is multiplied by the estimated pay for the purchase period. 

Example of Estimated Contributions

Some companies attempt to calculate a different estimate for each employee for each purchase period based on planned pay increases. We discourage this practice since it complicates the process and can more easily be performed with the true-up at the purchase date.

Limits

Nearly all plans apply a limit on the number of shares that can be purchased by an employee on any given purchase date. For 423-qualified ESPPs, each participant is limited to purchasing $25,000 of value within a calendar year.[3] These limits should be applied to the contribution estimate to reduce variability in expense and make the estimates more accurate.

Once estimated contributions are calculated, the contributions at the participant level are divided by the estimated purchase price to arrive at an estimated number of shares purchased. Total expense is derived by multiplying estimated shares by the fair value per share calculated on the enrollment date.  

Recognition

Once the total expense for the ESPP is calculated (see prior blog post), the expense is recognized over the service period: the time from enrollment to vest/purchase. 

Originally under FTB 97-1, accelerated recognition was required, meaning that each purchase period was expensed from the enrollment date to the respective purchase date, resulting in front-loaded expense.

Accelerated Recognition

When FAS 123(R) was released in 2005, the requirement for accelerated recognition was eliminated. So, the majority of companies now use straight-line attribution.

Straight-line Recognition

Please note that whichever method you are using for your employee stock options and/or restricted stock/units (accelerated or straight-line), you should use the same method for your ESPP expense recognition. 

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[1] Remember that purchase plans vary widely in which pay types they include in ESPP deductions. Some plans include commissions, overtime, and bonuses, which can make estimating pay extremely challenging. Some companies exclude these pay types from the estimate and simply perform a true up process after the purchase occurs. This simplifies the process and may reduce variability in expense but may not be acceptable to some auditors. Including only regular wages in included pay types simplifies the process without requiring the true up. 

[2] Rounded down to the nearest whole share.

[3] For offering periods that span a calendar year any unused limit from the prior year may be “carried forward” to subsequent calendar years. Calculating these limits is complex and generally estimating the maximum shares under the limit is best practice followed by a true up after the purchase occurs. 

Accounting for ESPPs: Basics: Fair Value Components & Inputs

EPS recently wrote an article on accounting for ESPPs. We will post it here over the next few blog entries:

Employee Stock Purchase Plans (ESPPs) are a wonderful employee benefit and can even provide a significant inflow of cash for the issuing company. However, many of these plans are complex and can present substantial challenges when calculating and recognizing expense for them.

Background

Accounting for most ESPPs is similar to accounting for stock options, with a grant-date fair value and recognition of expense over the vesting period. However, some features of ESPP cause divergences from the typical option expensing methodologies.

FASB Technical Bulletin (FTB) 97-1, released in 1997 and codified into ASC 718-50-30, -35 and -55 in 2009, clarified the treatment of many of the special features of these plans, but further developments have evolved in practice since that time.

Basics

Fair Value

Fair value for ESPPs is calculated as of the enrollment date of plan.[1] In some literature (and on some tax forms) this is also referred to as the grant date. And, just as with options, an option-pricing model is needed to calculate this value for most plans. However, since these plans offer features not available in typical employee stock options, the fair values can contain up to three components, depending on the features of the plan.[2]

Feature	Fair Value  Component	Notes
Discount	Discount (Enrollment Date Market Value x Discount %)
Lookback	Call output of Black-Scholes Model	Ability to benefit from an increase in stock price. Inverse of discount x Call output
Ability to purchase more shares if price declines during purchase period	Put output of Black-Scholes Model	Ability to benefit from a decrease in stock price.

If your plan does not contain all these features, then not all the components would be included in your fair value.

Note that FTB 97-1 also mentions that an “option” where the purchase price is paid before the exercise date is less valuable than an option where the price is paid on the exercise. Therefore, the standard does allow the inclusion of “interest foregone” as a discount to the fair value. However, the examples do not include this component, nor do most systems and spreadsheets include it.

For plans with multiple purchase periods within an offering period, generally, a different fair value is calculated for each purchase period. Some audit firms require that the different fair values be calculated and then averaged together to arrive at a single fair value for the entire offering. Other companies use the different fair values specific to each purchase period for both expense recognition and true up at the time of purchase.[3]

Think of these plans as an option grant with multiple vest dates and with a known and fixed exercise date (the purchase date) and a potentially variable number of shares (since in many plans the number of shares finally purchased will depend on the stock price on each purchase date).

Option-pricing Model Inputs

As with employee stock options, an option-pricing model must be used to create a fair value. A Black-Scholes is not required but, as for options under ASC 718, at least the following six factors are required to be used by the option-pricing model selected.

Example of Fair Value for a Two-year ESPP Offering Period with Four Purchases

Enrollment Date	Purchase Date	Market Value	Price	Expected Term	Volatility	Interest Rate	Dividend Rate	Fair Value per Share
Jan-1-2019	May-30-2019	$10	$10	.5	50%	2.15%	0%	$2.9336
Jan-1-2019	Dec-31-2019	$10	$10	1	45%	2.35%	0%	$3.3428
Jan-1-2019	May-30-2020	$10	$10	1.5	40%	2.45%	0%	$3.5310
Jan-1-2019	Dec-31-2020	$10	$10	2	35%	2.55%	0%	$3.5891
Average Fair Value								$3.3491

As stated above, please note that some auditors will require the averaging of the fair values for each tranche and the expense recognized to be based solely on the average fair value. In other cases, companies will recognize expense using the fair value specific to that tranche.

In our next blog entry: Using ESPP Estimated Contributions to calculate ESPP expense. (And after that, true ups and modification accounting, what fun!)

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[1] To be perfectly clear, this is not the date that the employee signs up to participate in the plan, but the first date of the offering period. All employees enrolled in a particular offering should have the same enrollment date.

[2] Other features can also trigger modification accounting and fair values computed after the initial enrollment date, these features will be explained later in this article.

[3] True ups at purchase are discussed in more detail later in this article.