Navigating the accounting for share-based compensation by private companies
Companies may use share-based payments to compensate employees and non-employees. Accounting for share-based compensation such as stock options, restricted stock, and other types of share-based payments can be challenging. With increasing transaction volumes, especially acquisitions of private companies by special purpose acquisition companies (SPACs), we believe there comes a heightened level of scrutiny over the application of generally accepted accounting principles (GAAP) in private company financial statements, including accounting for share-based compensation. Obtaining an understanding of accounting for share-based compensation in accordance with Accounting Standards Codification (ASC) 718, Stock Compensation – as well as Accounting Standards Update No. 2018-07, which predominately aligns the accounting requirements for nonemployee awards with those for employee awards – is essential for proper financial reporting under GAAP.
There are many reasons why companies grant share-based payment awards, such as:
- Saving cash by paying a portion of company expenses in equity awards
- Aligning employees’ financial interests with shareholders’
- Providing compensation to employees that is competitive
- Attracting and retaining employees
What are the challenges in accounting for share-based compensation?
Granting of share-based payment awards has many accounting implications. Ultimately, share-based compensation is recognized as a non-cash expense on the income statement. There are many pitfalls to the accounting treatment of these awards under ASC 718.
The following are the key factors that a company needs to consider in recording share-based compensation expense:
- Identifying the grant date
- Determining the fair value of the share and award
- Determining vesting conditions and expense attribution
- Determining if an award should be classified as a liability or within equity
- Accounting for the modification of an award
Key factors to consider
Identifying the grant date
The grant date is when accounting commences. According to the definition in Accounting Standards Update No. 2018-07, the grant date is determined when there is “a mutual understanding of the key terms and conditions of a share-based payment award.” The company is “contingently obligated on the grant date to issue equity instruments or transfer assets to a grantee who delivers the goods or renders the service.” Essentially, “the grant date for an award of equity instruments is the date that a grantee begins to benefit from, or be adversely affected by, subsequent changes in the price of the grantor’s equity shares.”
Determining the fair value of the share and award
On the grant date, the fair value of the share-based compensation award is determined with a valuation method based on the terms of the awards, like an option-pricing model. A key component in determining the value of an award is the fair value of the underlying stock (which may also be used to determine the strike price of the award). Unlike companies whose stock is publicly traded, private companies may need to engage a valuation specialist to determine the fair value of their stock. In addition, the company may need assistance identifying an appropriate method of valuing and subsequently determining the value of an award, and discussing such valuation method (including the results thereof) with external auditors. A company will generally remeasure awards classified as liabilities at each balance sheet date.
Determining vesting conditions and expense attribution
Share-based payment awards may include terms that the recipient must meet in order to earn the right to benefit from the award, which is the vesting period. The terms of the award may include a service, performance, or market condition, or a combination thereof. For example, under an award with a service condition, the employee must render service for a requisite service period, and compensation cost is recognized over that period. However, that may not be the case, for example, for an award with a requisite service period that also contains a market or performance condition. It is critical to understand the terms and conditions of each award, to determine the timing of the related accounting recognition.
Determining if an award should be classified as a liability or within equity
In general, share-based compensation settled in cash is usually classified as a liability, while an award settled in shares is usually classified as equity. Based on the terms of the award, there is added complexity when determining liability or equity classification, such as in the case when share-based compensation is redeemable at the employee’s option.
Accounting for the modification of an award
A modification to the terms of the award may be made after the grant date, such as a repricing or a change in vesting period. For example, the fair value of an equity-classified share-based compensation award with a service condition is determined on the grant date and then is typically recognized as expense over the remaining service or vesting period. Generally, if such an award is modified, the company must calculate and compare the fair value of the modified award and the fair value of the original award immediately before the modification. If the fair value of the modified award is higher, the excess will generally be recognized over the remaining period as incremental compensation cost. The accounting for the modification of a share-based award will depend on the nature of the modification and could impact the award’s balance sheet classification.
We recommend obtaining a complete listing of all share-based awards issued by your company and taking stock of the terms and conditions of those awards and related accounting treatment. An understanding of all terms and conditions of awards is necessary to determine the appropriate accounting treatment under ASC 718. With the rise of acquisition-related activity, especially the increase in SPACs, focus in this area will be beneficial to achieving proper financial reporting under GAAP. Staying on top of awards granted will help companies navigate the requirements of ASC 718, which may include engagement with valuation specialists or external accountants on a timely basis.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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