Cash-strapped start-ups and high growth firms often award stock options and other forms of equity-based compensation to attract and retain skilled employees. These awards can also provide incentives for employees to boost performance and add value. But there’s a downside: Accounting for these payments can be costly and complicated, especially for privately held businesses.
Here’s an overview of the existing guidance under U.S. Generally Accepted Accounting Principles (GAAP), along with a possible practical expedient that’s on the upcoming agenda of the Private Company Council (PCC).
How to report equity-based awards
Under existing GAAP, employee stock options are generally expensed as they vest at their fair value on the grant date, not the exercise date. Usually a deferred compensation liability also is recorded on the balance sheet. To complicate matters further, these awards also may be subject to Internal Revenue Code (IRC) Section 409A, which may give rise to deferred tax items.
Measuring the fair value of equity-based awards
Companies generally consider six inputs:
- Exercise price,
- Expected term (time until expiration),
- The risk-free rate (usually based on Treasury bonds),
- Expected dividends,
- Expected stock price volatility, and
- The fair value of the company’s stock on the grant date.
The first four inputs are fairly straightforward. Private companies may estimate expected stock price volatility using a comparable market-pricing index. But the fair value of a private company typically requires an outside appraisal, whereas public stock prices are usually readily available.
The PCC, the body that advises the FASB on private company matters, will meet in mid-December to discuss a practical expedient for private companies that issue equity-based compensation. A practical expedient is a more cost-effective way of achieving the same or a similar accounting or reporting objective. In this case, the PCC is considering a proposal that would provide private companies with a simpler, more cost-effective way to measure the grant-date fair value of equity-based awards.
Specifically, an accounting exception would align the measurement philosophy for determining the underlying share price with the measurement philosophy articulated in IRC Sec. 409A. Tying the language of the exposure document directly to Sec. 409A would eliminate the need for private companies to perform two separate valuations.
Equity-based compensation awards often depend on the stage of a company and the level of the employee. There’s a continued trend among companies toward issuance of restricted stock units and management incentive units, rather than traditional stock options. A Sec. 409A compliant valuation isn’t overly costly to obtain, and companies generally rely on the Sec. 409A valuation to determine current price.
FASB Chairman Russell Golden said a Sec. 409A alignment would make more sense than prior suggestions that have been discussed. “To me it would be a lot simpler, a lot more understandable if you tied the measurement philosophy of the underlying stock with what’s in 409A and not this use that says ‘this is what management says it is unless you find evidence that it is not.’”
Not every company obtains a Sec. 409A compliant valuation, however. This could limit the population of private companies likely to adopt the practical expedient.
We are here to help
Financial reporting complexity and the cost of outside appraisals have caused some companies to shy away from issuing equity-based compensation awards. But relief in the form of book-to-tax conformity may soon be on its way. Contact your CPA for the latest developments on this issue or to help you comply with the current guidance on reporting equity-based payments.