3.11 Nonrecourse and Recourse Notes

ASC 718-10

25-3 The accounting for all share-based payment transactions shall reflect the rights conveyed to the holder of the instruments and the obligations imposed on the issuer of the instruments, regardless of how those transactions are structured. For example, the rights and obligations embodied in a transfer of equity shares for a note that provides no recourse to other assets of the grantee (that is, other than the shares) are substantially the same as those embodied in a grant of equity share options. Thus, that transaction shall be accounted for as a substantive grant of equity share options.

An entity may offer financing in the form of a recourse note or a nonrecourse note in connection with a grantee’s purchase of its shares or the exercise of stock options. A nonrecourse note is a loan that limits the liability of the holder of the stock being purchased if for any reason the holder defaults on the note. If, however, the loan was collateralized by more than the stock purchased (e.g., the entity would seek recovery of the money by claiming personal assets of the grantee), the loan would be considered a recourse note. The measurement and recognition of an award is based on whether the financing is a recourse note or a nonrecourse note.

3.11.1 Recourse Notes

If the consideration received from the grantee consists of a recourse note, the transfer of shares is a substantive purchase of stock or an exercise of an option. If the stated interest rate is less than a market rate of interest, the exercise or purchase price is equal to the fair value of the note (i.e., the present value of the principal and interest payments when a discount rate equivalent to a market rate of interest is used). The impact of a below-market rate of interest would be reflected as a reduction of the exercise or purchase price and an increase in compensation cost recognized (see the example below). If the stated interest rate is equal to a market rate of interest, the exercise or purchase price is equal to the principal of the note. That is, the impact of an at-market rate of interest would have no effect on the exercise or purchase price and therefore would not result in an increase in compensation cost recognized.

Example 3-37

An entity indirectly reduces the price of an award when it provides an employee with a non-interest-bearing, full-recourse note to cover the purchase price of shares. If an employee purchased shares with a fair value of $20,000 but the entity provided a five-year, non-interest-bearing note (when the market rate of interest was 10 percent), the fair value of the consideration (i.e., the purchase price) is now only $12,418 (the present value of $20,000 in five years, discounted at 10 percent). A reduction in the purchase price results in an increase in the grant-date fair-value-based measure of the award and an increase in the amount of compensation cost recognized. The entity would therefore record compensation cost of $7,582, equal to the $20,000 fair value of the shares less the $12,418 fair value of the consideration received.

3.11.2 Nonrecourse Notes

If the consideration received from the grantee consists of a nonrecourse note, the award is, or continues to be, accounted for as an option until the note is repaid. That is, if an entity provides a loan to its employees to purchase shares or exercise options and that loan is collateralized only by the stock issued, the issued stock and the loan collateralizing it are accounted for as an option. This is because even after the original options are exercised or the shares are purchased, a grantee could decide not to repay the loan if the value of the shares declines below the outstanding loan amount and could instead choose to return the shares in satisfaction of the loan. The result would be similar to a grantee’s electing not to exercise an option whose exercise price exceeds the current share price.

The same result would occur if the nonrecourse note was not for the entire award. For example, a grantee could exercise 1,000 stock options in exchange for (1) cash equating to the exercise price for 720 of the options and (2) a nonrecourse note for 280 of the options solely to cover the required tax withholdings. However, only the 280 options exercised in exchange for the nonrecourse note would continue to be accounted for as options until the note is repaid.

When shares are exchanged for a nonrecourse note, the principal and interest are viewed as part of the exercise price of the “option” (therefore, no interest income is recognized). If the note bears interest, the exercise price increases over time by the amount of interest accrued and, accordingly, the option valuation model must incorporate an increasing exercise price. Further, because the shares sold on a nonrecourse basis are accounted for as options, the note and the shares are not recorded. Rather, compensation cost is recognized over the requisite service period or nonemployee’s vesting period, with an offsetting credit to APIC. Periodic principal and interest payments, if any, are treated as deposits. Refundable deposits are recorded as a liability until the note is paid off, at which time the deposit balance is transferred to APIC. Nonrefundable deposits are immediately recorded as a credit to APIC as payments are received. In addition, the shares would be excluded from basic EPS and included in diluted EPS in accordance with the treasury stock method until the note is repaid.

3.11.3 Cash Loans Through Nonrecourse Notes

An entity may pay cash to an employee for personal use in exchange for a nonrecourse loan that is collateralized by the entity’s stock that is already owned by the employee. Although the loan is not issued in connection with the purchase of shares or the exercise of options, the employee obtains a right similar to that of a stock option (i.e., the employee will make a decision to either repay the loan and retain the shares or not repay the loan and forfeit the shares). In this scenario, the entity has effectively repurchased the employee’s shares in exchange for cash proceeds from the nonrecourse loan and the grant of an option. Accordingly, the entity would recognize as compensation cost any excess of the repurchase amount (i.e., the cash proceeds and the fair-value-based measure of the option) over the fair value of the shares pledged.

Example 3-38

Entity K provides a three-year, 5 percent interest-bearing note of $200,000 to its CTO. The note is a nonrecourse loan that is collateralized by 15,000 of K’s common shares that the CTO had previously acquired. The fair value of the common shares on the loan inception date is $300,000.

Although the obligation to repay the loan and the associated collateral are not in the legal form of an option, the CTO has obtained a right similar to a stock option. Entity K has effectively repurchased the CTO’s 15,000 common shares in exchange for $200,000 cash and an option. It has also determined that the fair-value-based measure of the instrument (the “option”) granted to the CTO is $120,000. The entity would recognize compensation cost equal to the difference between the repurchase amount (cash proceeds of $200,000 and the fair-value-based measure of the option of approximately $120,000) and the fair value of the shares pledged at $300,000. Therefore, K would recognize $20,000 of compensation costs over the requisite service period of the “option,” if any.

3.11.4 Changes Made to the Notes

If (1) a grantee is allowed to exercise an option with a note that was not provided for in the terms of the options when the options were granted, (2) the terms of a note (e.g., interest rate) are changed, or (3) the note is forgiven, these changes constitute modifications that should be accounted for in accordance with ASC 718-20-35-2A through 35-3A. See Chapter 6 for a discussion and examples of the accounting for the modification of a share-based payment award. In addition, a change in the terms, or forgiveness of, an outstanding recourse note would constitute a modification even if the issued shares are no longer subject to ASC 718, unless the modification made to the outstanding recourse note applies equally to all shares of the same class.

Further, an entity should reevaluate whether it intends to forgive other outstanding recourse notes and determine whether such notes should instead be considered in-substance nonrecourse notes. If, as a result of a change in its terms, a note becomes a nonrecourse note, an entity should account for the modification as a repurchase of shares by using the treasury stock method. If the repurchase amount exceeds the fair value of the repurchased shares, the difference would be recognized as compensation cost. This would be calculated as the sum of the outstanding principal and interest on the note and the fair value of the nonrecourse note, less the fair value of the repurchased shares. See Section 6.10 for more information about repurchases and settlements of shares.

3.11.5 In-Substance Nonrecourse Notes

A recourse note issued to a grantee may be an in-substance nonrecourse note. In determining whether a recourse note is, in substance, a nonrecourse note, entities should consider Issue 34 of EITF Issue 00-23. Although it was nullified, EITF Issue 00-23 contains guidance that remains relevant on determining whether a recourse note is substantively a nonrecourse note. It indicates that a recourse note should be considered nonrecourse if any of the following factors are present:

The entity has legal recourse to the grantee’s other assets but does not intend to seek repayment beyond the shares issued.
The entity has a history of not demanding repayment of loan amounts in excess of the fair value of the shares.
The grantee does not have sufficient assets or other means (beyond the shares) of justifying the recourse nature of the loan.
The entity has accepted a recourse note upon exercise and subsequently converts the recourse note to a nonrecourse note.

At an EITF meeting to discuss Issue 00-23, an SEC observer stated that all other relevant facts and circumstances should be evaluated and that if the note is ultimately forgiven, the SEC will most likely challenge the appropriateness of a conclusion that the note was a recourse note.

3.11.6 Combination Recourse and Nonrecourse Loans

For tax purposes, a grantee may exercise options by using a nonrecourse note for a portion of the total exercise price and a recourse note for the remainder. If the respective notes are not distinctly aligned with a corresponding percentage of the underlying shares (i.e., in a non-pro-rata structure), both notes should be accounted for together as nonrecourse. A non-pro-rata structure is one in which the share purchase price or exercise price for each share of stock is represented by both the nonrecourse note and the recourse note on the basis of their respective percentages of the total exercise price (e.g., 40 percent of the exercise price is nonrecourse and 60 percent of the exercise price is recourse). However, if the nonrecourse and recourse notes are related to a pro rata portion of the shares (e.g., 40 percent of the shares correspond to a nonrecourse note, and 60 percent of the shares correspond to a recourse note), an entity would account for (1) the shares associated with the recourse note as a substantive exercise of the option and (2) the shares associated with the nonrecourse note as an outstanding option.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.