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:
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:
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.
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:
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:
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.
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.