Financial Reporting Valuations: ASC 718

Overview of ASC 718

When a company issues stock-based compensation, the accounting is governed by ASC 718 – Compensation – Stock Compensation (formerly SFAS 123R).  ASC 718 generally requires that the fair value stock-based compensation be determined on the date of grant and recorded as an expense over the vesting period of the award. 

There are many types of share-based compensation, but some of the arrangements that are seen most commonly in practice are summarized below:

  • Stock options
  • Stock grants
  • Profits interests
  • Stock appreciation rights

In order to properly account for share-based compensation, one must have a supportable fair value for the company’s equity.  Determining the value of a company’s stock is not difficult when it is publicly traded, but privately-held companies do not have readily available market prices, which often necessitates the services of a valuation expert.

If stock grants are being issued, only the fair value of the company’s equity needs to be known in order to properly record the related compensation expense.  If stock options are being issued, however, there are actually two steps that need to be undertaken:

  1. Determining the value of the company’s equity (which is a key input to valuing a stock option); and
  2. Determining the value of the stock option.

A stock option’s value is derived from a variety of factors.  Unless the option is properly valued, a company cannot correctly record the associated compensation expense, which may lead to difficulties during its year-end financial statement audit.

Given the complexity of ASC 718, it is a best practice for companies to get out in front of the accounting for stock-based compensation before their year-end audit begins.  Companies should discuss stock-based compensation issues with their auditors as awards are granted and determine the level of analysis that will be required to document/support the fair value of the award and whether the use of a third-party valuation expert will be necessary.  Proactively addressing these issues can lead to a much smoother audit process and avoid potential delays that may be encountered otherwise.

Scope of ASC 718

ASC 718 provides guidance on a number of topics encountered in accounting for stock-based compensation.  Some of the more common issues encountered in accounting for stock options, stock grants and other share-based compensation arrangements are summarized below:

  • Awards to employees vs. non-employees
  • Equity vs. liability treatment of awards
  • Determination of the fair value of stock-based compensation
  • Measurement and recognition of compensation expense associated with awards
  • Modifications to awards
  • Income tax provision considerations when issuing awards
  • Disclosure requirements

Overview of Stock Option Valuation

Stock options represent a right, but not an obligation, to purchase an ownership interest in a company at a specific price over a defined period of time (e.g. the right to buy one share at a price of $10 over a five-year period).  Although a stock option may not be “in the money” (when the value per share is greater than the exercise price of the option) on the grant date, options still have value based on the potential that they may end up “in the money” before their expiration date.  There are two methods typically used to determine the fair value of stock options – the Black-Scholes method and the binomial/lattice model method.  In practice, it is much more common to see the Black-Scholes method utilized to value options given the complexity associated the application of the binomial/lattice model method and the fact that the inputs to the Black Scholes model are easily auditable. 

There are six inputs in the Black-Scholes model that drive the resultant stock option value:

  1. Stock Price – The stock price is the per share fair value (including any applicable discounts for lack of control and lack of marketability) of the stock class into which the option is convertible.  For privately-held companies, this is often the most difficult input to reliably support in the Black-Scholes model and the assistance of a valuation expert is often required to determine the value per share.  The AICPA has issued extensive guidance on the factors that should be considered when valuing shares in privately-held companies for stock-based compensation purposes.
     
  2. Exercise Price of Option – The exercise price is the amount that the option holder must pay in order to receive a share of stock when exercising an option.  The exercise price will be identified in the stock option agreements.
     
  3. Option Term – The option term is the length of time that the option holder has to exercise the option.  The longer the term, the greater the possibility for the option to end up “in the money,” which increases its value (and vice versa).  The maximum term of the option will be disclosed in the option agreements, but that is often not used as the term in the Black-Scholes model.  Instead, companies must look to the length of time that previously-issued options were outstanding before being exercised.  Since detailed option exercise histories are not available for many companies, an alternative approach often used to arrive at a term for the Black-Scholes model is based on the following formula from SAB 107: (Weighted-average of vesting period + maximum term) / 2.  The expected holding period until a liquidity event for the company may also be considered in setting the estimated term.
     
  4. Volatility – Volatility is the likelihood of a company’s stock increasing or decreasing in value.  The higher the volatility, the higher the likelihood that an option will end up “in the money,” which increases its value (and vice versa).  Volatilities for privately-held companies are typically based on the historical volatilities of similar guideline public companies over a period of time consistent with the option term used in the Black-Scholes model. 
     
  5. Risk-Free Rate of Return – This is the rate of return associated with risk-free investments – typically U.S. Treasuries – which can be found on the U.S. Treasury website.  The U.S. Treasury maturity that is used should be consistent with the option term used in the Black-Scholes model.
     
  6. Dividend Rate – The dividend rate is the rate of expected future dividends expressed as a percentage of total equity value.  The higher the level of dividends, the lower the option value since the option holder does not receive any dividends (and vice versa).  The dividend rate is oftentimes estimated to be zero for privately-held companies without histories of paying dividends, particularly those with significant levels of debt or those that will require the reinvestment of profits to support future projected growth.

While the six Black-Scholes inputs are easily auditable, the key consideration for companies issuing options is to develop supportable assumptions that are consistent with the content of the option agreements and the financial position of the company issuing the options. 

Tax Considerations in Issuing Stock-Options

There can be significant tax ramifications if share-based compensation is not properly valued, particularly with stock options.  If a company sets the stock option exercise price lower than the fair market value of the underlying stock on the grant date, the stock option could be deemed to be deferred compensation according to Internal Revenue Code 409A.  Under 409A, such deferred compensation (the amount that each option is “in the money” on the grant date) would be immediately taxable to the employee receiving the grant at ordinary income tax rates.  Perhaps even more distressing, a 20% penalty calculated on the deferred compensation would also be triggered.  In addition, employers would be responsible for withholding income taxes for employees on these types of option grants, which if not done, could result in additional tax penalties.  The immediate taxability, penalty and withholding requirements of 409A do not apply when a stock option’s exercise price is equal to or greater than the fair market value of the company’s stock on the grant date.  Comparing the exercise price of a stock option to the fair market value of a privately-held company’s stock is a difficult task unless a valuation of the company’s stock has been performed.  In addition, in cases where a valuation has been performed to establish the fair market value of a company’s stock, the burden of proof shifts to the IRS to disprove the appraised value.  Therefore, unless there is documentation to support the fair market value of a company’s stock near the option grant date, there could be significant tax issues that the company and its employees must content with.

Sean Saari HS 2019
Sean Saari
CPA/ABV, CVA, MBA
Partner

VIEW BIO

Skoda Minotti’s Valuation and Litigation Advisory Services Group offers the expertise to assist executive management and boards of directors of both private and public companies in satisfying their external audit requirements related to fair value financial reporting.

Related Resources