Under ASC 718-50, accounting for an employee share purchase plan starts with a single classification question: is the plan compensatory or noncompensatory? A plan that meets all three criteria in ASC 718-50-25-1 is noncompensatory, and the company simply records the stock issuance with no expense on the income statement. A plan that fails any one of the criteria is compensatory, and the company must measure the fair value of the purchase right at the grant date and recognize it as compensation expense over the offering period.
ESPPs sit specifically within Subtopic 718-50 of the broader share-based payment standard.1Financial Accounting Standards Board. Accounting Standards Update 2018-07 – Compensation-Stock Compensation (Topic 718) Employee Stock Ownership Plans, which have a fundamentally different structure, fall under a separate subtopic (718-40) and are not covered by the guidance below.
The Three Criteria That Make an ESPP Noncompensatory
A plan qualifies as noncompensatory only if it satisfies all three tests. Miss one, and the plan is compensatory in full.
A Reasonable Discount
The purchase discount from market price cannot exceed the per-share amount of share issuance costs the company would have incurred to raise a significant amount of capital through a public offering. A discount of 5% or less from market price satisfies this condition without further analysis. A discount above 5% can still qualify, but the company must demonstrate it aligns with the share-issuance-cost standard and reassess that justification at least annually. If the higher discount cannot be justified, the entire discount amount becomes compensation cost.
There is an alternative path: if the plan’s terms are no more favorable than those available to all holders of the same class of shares, the discount test does not apply.
Broad, Equitable Participation
Substantially all employees who meet limited employment qualifications must be eligible on an equitable basis. The plan cannot single out senior executives or top performers. Permissible exclusions track the categories allowed under IRC Section 423: employees with fewer than two years of service, those who customarily work 20 hours or less per week, seasonal employees working five months or less per year, and highly compensated employees.2Office of the Law Revision Counsel. 26 USC 423 – Employee Stock Purchase Plans
No Option Features
The plan cannot include option-like features, with only two narrow exceptions. Employees may be given a short enrollment window of up to 31 days after the purchase price is fixed. And the purchase price may be based solely on the market price at the purchase date, with employees permitted to cancel before the purchase and receive a refund of withheld amounts. Anything beyond these two makes the plan compensatory.
Why Look-Back Plans Are Always Compensatory
A look-back provision sets the purchase price based on the lower of the stock’s market price at the beginning of the offering period or at the purchase date. This is the feature that trips up classification most often. A look-back is an option feature: it gives employees the upside of price appreciation during the offering period while shielding them from declines. Under ASC 718-50, a plan with a look-back is compensatory regardless of the discount percentage, and the 5% safe harbor does not help.
Most Section 423–qualified ESPPs pair a 15% discount with a look-back. Section 423 allows a maximum discount of 15% of fair market value at the grant date or the purchase date, whichever is lower.2Office of the Law Revision Counsel. 26 USC 423 – Employee Stock Purchase Plans A plan can be fully compliant with the tax code and still be compensatory for accounting purposes. Once a look-back enters the design, the company must value and expense the purchase right.
Noncompensatory Accounting
If the plan clears all three criteria, the accounting is short. As employees contribute through payroll withholdings during the offering period, the company debits cash and credits a liability account for employee contributions. On the purchase date, the liability is debited, Common Stock is credited at par, and Additional Paid-in Capital is credited for the remainder. Any discount does not run through the income statement. There is no impact on diluted earnings per share.
Compensatory Accounting: Grant Date, Fair Value, Expense
When the plan is compensatory, the company measures the fair value of the purchase right at the grant date and recognizes it as compensation expense over the requisite service period.
Identifying the Grant Date
The grant date is the point at which the employer and employee have a mutual understanding of the key terms, the employer becomes contingently obligated to issue shares, and the employee begins to be affected by subsequent changes in the stock price. For most ESPPs, this is the enrollment date or the first day of the offering period, which typically precedes the actual purchase date by months.
Valuing the Purchase Right
The purchase right is economically similar to a stock option, and its fair value must be estimated with an option-pricing model such as Black-Scholes-Merton or a lattice (binomial) model. The key inputs are:
- Stock price at the grant date.
- Exercise price, determined by the plan’s discount and look-back terms.
- Expected volatility, based on historical or implied volatility.3U.S. Securities and Exchange Commission. Codification of Staff Accounting Bulletins – Topic 14: Share-Based Payment
- Expected term, tied to the length of the offering period.
- Risk-free interest rate on U.S. Treasury instruments matching the expected term.
- Expected dividend yield during the offering period.
For a look-back plan, the purchase right is typically decomposed into two components: a purchase discount component (the known percentage discount from the grant-date price) and a look-back component valued as a call option that captures the additional value from being able to purchase at the lower of two prices.
Recognizing the Expense
Total fair value at the grant date is recognized on a straight-line basis over the offering period. The journal entry debits Compensation Expense and credits Additional Paid-in Capital. The share count reflects employee withholding elections at enrollment, adjusted for estimated forfeitures if the company has elected that policy.
Modifications, Withdrawals, and Forfeitures
Changes to a compensatory plan’s terms mid-offering are treated as an exchange of the original award for a new one. The company compares the fair value of the modified award to the fair value of the original immediately before the modification, and any excess is incremental compensation cost recognized over the remaining service period. If the modification does not change fair value, vesting conditions, or equity/liability classification, no additional accounting is required.
An employee who irrevocably withdraws from the plan before the purchase date and receives a full refund is treated as a cancellation without replacement. Any previously unrecognized compensation cost for that employee’s award is recognized immediately rather than reversed, because under ASC 718 a cancellation without a replacement award is treated as a repurchase for no consideration.
A partial withdrawal, where the employee reduces future payroll withholdings but stays in the plan, is handled differently. ASC 718-50-35-2 says the decrease in withholdings is disregarded for expense recognition. The company continues recognizing compensation cost based on the original grant-date fair value, and the employee simply purchases fewer shares on the purchase date.
For forfeitures from employee terminations before the purchase date, ASU 2016-09 gives companies a choice: estimate forfeitures at the grant date and true up as actual forfeitures occur, or account for forfeitures only when they happen. This is a one-time, entity-wide election that applies to all share-based payment awards, not just ESPPs. Both approaches arrive at the same total expense; only the timing differs.
Impact on Diluted Earnings Per Share
Compensatory ESPP awards are treated as the equivalent of stock options for diluted EPS under ASC 260. They are considered outstanding as of the grant date and included in the diluted EPS denominator using the treasury stock method, even though the shares have not yet been purchased.
Under the treasury stock method, assumed proceeds include the amount employees will pay to exercise the purchase right plus the amount of compensation cost not yet recognized. Those proceeds are treated as used to repurchase shares at the average market price for the period. The dilutive impact is the difference between shares assumed issued and shares assumed repurchased. When assumed proceeds exceed the average market price, the shares are excluded because they would be antidilutive.
Noncompensatory shares do not affect diluted EPS. There is no unrecognized compensation cost, and the modest discount does not create a meaningful option-like dilution effect.
Income Tax Effects
Compensation expense recognized over the offering period creates a deductible temporary difference. The cumulative book expense multiplied by the applicable tax rate produces a deferred tax asset.
The actual tax deduction the company claims often differs from the cumulative book expense. For a nonqualified plan, the deduction is generally based on the spread between market price and purchase price on the exercise date, while the book expense was locked in at the grant-date fair value. When the deduction exceeds the book expense, the excess tax benefit reduces income tax expense in the period the deduction is determined. When the deduction falls short, the tax deficiency increases income tax expense. Either way, the difference flows through the income statement and affects the effective tax rate.
Section 423–qualified plans add another layer. Section 423 requires shareholder approval, uniform rights and privileges for eligible employees, and a purchase price no less than 85% of fair market value at the grant date or the purchase date.2Office of the Law Revision Counsel. 26 USC 423 – Employee Stock Purchase Plans It also caps each employee’s purchases at $25,000 of stock per calendar year, measured by fair market value at the time the option is granted. That cap can limit the shares included in the compensation cost calculation and the EPS computation.
The tax outcome then depends on the employee’s disposition. A qualifying disposition requires holding the shares at least two years from the grant date and one year from the purchase date.2Office of the Law Revision Counsel. 26 USC 423 – Employee Stock Purchase Plans With a qualifying disposition the company generally receives no tax deduction, and the deferred tax asset built up during the offering period may need to be written off. A disqualifying disposition typically generates ordinary income for the employee and a corresponding tax deduction for the company. That uncertainty about whether the deferred tax asset will ultimately be realized has to be evaluated as the plan runs.
Required Disclosures
ASC 718 requires note disclosures for both compensatory and noncompensatory plans. For every plan, the company describes the general terms: shares authorized, service and offering period length and any vesting requirements, the discount percentage, and whether the plan has a look-back feature.
For compensatory plans, disclosures also include the option-pricing model used, the weighted-average assumptions fed into it (expected volatility, expected term, risk-free rate, and dividend yield), and the weighted-average grant-date fair value of purchase rights granted during the period.3U.S. Securities and Exchange Commission. Codification of Staff Accounting Bulletins – Topic 14: Share-Based Payment The notes must also disclose total compensation cost recognized in the period, any amounts capitalized as part of an asset such as inventory, and cash received from employees under the plan.
SEC Registration for Public Companies
Public companies issuing shares under an ESPP must register those shares with the SEC. The standard vehicle is Form S-8, available to issuers current on their Exchange Act reporting obligations (all required reports filed during the preceding 12 months).4Securities and Exchange Commission. Form S-8 Registration Statement Shell companies cannot use Form S-8 until at least 60 calendar days after they cease to be a shell company and file current Form 10 information reflecting that change. The S-8 covers the securities to be issued under the plan and, when applicable, interests in the plan itself. File it before shares are first offered under the plan to avoid issuing unregistered securities.