Welcome to Luca!globe
CPA Journal - March 1998 Current Issue!    Navigation Tips!
Main Menu
CPA Journal
Professional Libary
Professional Forums
Member Services



By Joel Steinberg, CPA, Goldstein Golub Kessler & Company, P.C.

SFAS No. 123, Accounting for Stock-Based Compensation, provides a choice between two acceptable accounting methods for measuring compensation cost in transactions with employees. Companies can measure compensation cost using the intrinsic value model prescribed by APB No. 25, Accounting for Stock Issued to Employees, or can measure compensation cost using the fair value model described in SFAS No. 123. There are a number of practical issues that should be considered before a company enters into compensation transactions using equity securities.

Accounting for Transactions with Other than Employees

Regardless of the method used by a company to account for stock-based transactions with its employees, transactions with nonemployees must be accounted for at fair value. SFAS No. 123 states that except for transactions with employees that are within the scope of APB No. 25, all transactions in which goods or services are the consideration received for the issuance of equity instruments should be accounted for based on the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.

This provision can present a problem for newly-formed companies and for companies in the process of raising capital by going public or otherwise. Such companies may be short on cash and might issue options or warrants to employees, attorneys, consultants, and others in lieu of making cash payments. While no compensation cost may be recognized for issuances to employees, these options or warrants may have a determinable fair value using an option pricing formula such as the Black-Scholes model. The transactions with nonemployees will have to be accounted for at fair value, which will result in expense recognition. If the company's stock is not publicly traded, an independent appraisal of the company may be required to value the options. This process can be costly and might not be practicable in the circumstances.

Expense recognition in stock-based transactions results in an increase to paid-in-capital. Total stockholders' equity is unchanged. Accordingly, if a company is being evaluated based on total equity or tangible book value per share rather than earnings or earnings per share, such transactions might not be of concern.

Definition of Employee. A question often arises as to the definition of an employee for this provision. For example, are members of a company's board of directors who are not otherwise full-time employees considered to be employees for the purposes of this provision? SFAS No. 123 does not provide guidance on this issue.

At the December 1996 AICPA National Conference on Current SEC Developments, an SEC Professional Accounting Fellow discussed this question. The SEC staff had addressed an inquiry as to whether options issued to members of a company's advisory board would be considered employee options. Members of the advisory board had specific knowledge and expertise within the company's industry and were given equity instruments as compensation for advising the company on such matters as policy development, future technology, and product improvement. The advisory board members were appointed for annual terms, met two or three times a year for three or four hours each meeting, and received a set number of options per meeting.

In evaluating whether the advisory board members were employees, some of the factors the SEC staff considered were whether the members a) received Forms 1099 or W-2, b) were eligible to participate in the company's employee benefit programs, c) had stated service periods, d) performed services for others while performing services for the company, e) received payment for services on a project or per meeting basis, and f) were subject to the company's personnel policies and procedures. In the particular situation discussed, the SEC staff determined the board members were not considered to be employees.

Issuances in Conjunction with the Issuance of Debt

Another situation where the issuance of equity options or warrants should be recorded at fair value is where such instruments are issued in conjunction with the issuance of debt. For example, prior to an initial public offering (IPO), a company might complete a private placement of debt to serve as bridge financing. As an incentive, noteholders might also receive options or warrants on the debtor's stock. The accounting for such issuances is covered by APB No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants. A portion of the proceeds from the issuance of the notes should be allocated to the equity-based instruments based on the relative fair values of the two securities at the time of issuance and credited to additional paid-in capital. This typically results in a discount on the debt, which should be amortized to interest expense over the term of the debt or charged to operations if the debt is repaid prior to maturity. Although the options or warrants may have no intrinsic value, their fair value will have to be determined using an option pricing formula such as the Black-Scholes model. As noted above, for nonpublic companies this may require obtaining a costly independent appraisal of the company.

Escrow Share Arrangements

In a typical escrow share arrangement, specific shareholders place all or a portion of their shares in escrow with the return of the shares conditioned on the achievement of certain performance goals. For example, the shares might be released to a stockholder if the company or a division attains a specified level of income for a specified period. If the goals are not met, the shareholder forfeits the shares and they are canceled. The release of the shares as a result of the performance goals being met results in the recognition of compensation expense. This is the case even though the release of shares from escrow does not require the company to issue new shares and may not cost the company anything. The measurement date for compensation cost will generally be the date the performance goals are met.

Other events or transactions might prompt the company and shareholders to agree to cancel or modify an escrow share agreement before it expires. The release of shares as a result of cancellation or modification can result in a compensation charge even if the predetermined goals have not been met. Accordingly, caution should be exercised before entering into escrow share arrangements.

The accounting treatment could differ if the agreement provides that, even if the goals are not attained, the shares are automatically released after the passage of a reasonable amount of time, generally not more than five years from the date the shares were originally place in escrow. It should be noted that the compensatory charge resulting from the release of escrow shares is not deductible for income tax purposes.

Equity Instruments Granted by Principal Stockholder

Another potential trap is the provision of SFAS No. 123 paragraph 15. That paragraph states that equity instruments granted or transferred directly to an employee by a principal stockholder are stock-based employee compensation to be accounted for by the company under either APB No. 25 or SFAS No. 123, unless the transfer clearly is for a purpose other than compensation. Even though the transaction is between two stockholders outside of the company, a compensatory charge may be required on the books of the company. This is because the economic substance of a stock-based transaction between a principal stockholder and an employee may be the same as a transaction between the company and the employee. The substance of the transaction is that the principal stockholder makes a capital contribution to the company and the company awards equity instruments to the employee. An example of a situation in which the transaction is not compensatory is a transfer of equity instruments to settle an obligation of the principal stockholder unrelated to the employment of the transferee by the company.

A principal stockholder is defined as one who either owns 10 percent or more of an entity's common stock or has the ability, directly or indirectly, to control or significantly influence the entity.

This accounting treatment has been required since 1973 by AICPA Accounting Interpretation No. 1 of APB No. 25, Stock Plans Established by a Principal Stockholder. The interpretation stated that stock plans established by a principal stockholder should be accounted for on the company's books unless a) the relationship between the principal stockholder and the employee is one that would normally result in generosity, such as an immediate family relationship, b) the principal stockholder has an obligation to the employee completely unrelated to employment, or c) the company clearly does not benefit from the transaction.

Stock-based transactions among stockholders can raise significant practical questions. As an example, assume a principle stockholder sells stock to another stockholder/employee at a price below the market price. The circumstances surrounding the transaction need to be evaluated to determine whether the transaction is compensatory. What was the purpose of the transaction? The transaction may have been entered into to satisfy a personal obligation of the principal stockholder, or it may have been to increase or maintain the value of the principal stockholder's investment. The company may implicitly be benefiting from the transaction by the retention, or the improved performance, of the employee.

Measuring Fair Value

Once it has been determined a transaction is compensatory, the next question is how should fair value be measured. Fair value is defined as the amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used, if available.

However, what if the transaction involves stock that is thinly-traded or restricted under applicable SEC rules? Should the shares be valued based on the quoted market price of a freely-traded share or should they be discounted? If a discount should be applied, how much is a reasonable discount in the circumstances? Similarly, what if the shares represent a large proportion of the total shares being traded such that selling all of the stockholder's holdings might affect the price, or if the market's normal volume for one day might not be sufficient to absorb the quantity held? Should an adjustment be made to the value of the shares for the "blockage" factor?

More than Just Accounting Literature

Whether a stock-based transaction will result in expense recognition and how the expense should be measured can be difficult to determine by reading the related accounting literature alone. The appropriate treatment can vary depending on the facts and circumstances surrounding each transaction. Public companies are advised to consult with the SEC before entering into stock-based transactions
and for determining how to account for transactions that have already been

Douglas R. Carmichael, PhD, CPA
Baruch College

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

©2009 The New York State Society of CPAs. Legal Notices

Visit the new cpajournal.com.