On the Radar
On the Radar
To incentivize employee performance and align the interests of
employees and shareholders, entities often grant share-based payment awards —
including stock options, restricted stock, restricted stock units (RSUs), stock
appreciation rights (SARs), and other equity-based instruments — in exchange for
services. Entities may also incur liabilities that are based, at least in part, on
the price of their shares or other equity instruments or that require or may require
settlement by issuing their equity shares or other instruments. To a lesser extent,
entities also grant such awards to compensate vendors for goods and services or as
share-based consideration payable to customers.
ASC 718 provides the accounting guidance on
share-based payment awards, which requires entities to use a
fair-value-based measure when recognizing the cost
associated with these awards in the financial statements.
Some of the more challenging aspects of applying this
guidance are highlighted below.
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Scope
An entity must first determine whether an award is within the
scope of ASC 718 or is, in substance, a bonus or profit-sharing arrangement. ASC
718 applies to awards that require or may require settlement in the equity of
the entity or whose settlement is based, at least in part, on the price of the
entity’s equity. An entity’s conclusion related to whether an award is within
the scope of ASC 718 can significantly affect the amount of compensation cost
recognized and when such cost is recognized in the financial statements.
Nonpublic limited partnerships, limited liability companies, and
other pass-through entities often establish special classes of equity, referred
to as profits interests. These special equity classes often have distribution
thresholds or hurdles related to amounts that must be paid to other classes of
equity before the grantee of the profits interest can receive distributions. On
the grant date, an award may have zero liquidation value for tax purposes but a
fair value for financial reporting purposes.
While the features of a profits interest award can vary, such an award should be
accounted for on the basis of its substance. If the award has the
characteristics of an equity interest, it represents a “substantive class of
equity” and should be accounted for under ASC 718. However, an award that is, in
substance, a performance bonus or a profit-sharing arrangement would be
accounted for as such in accordance with other U.S. GAAP (e.g., typically ASC
710 for employee arrangements).
There are several characteristics to consider when determining whether an
instrument is within the scope of ASC 718. To be a substantive class of equity,
the profits interest must be legal form equity. An entity would also consider
whether the instrument’s holder can retain a vested interest in an award if the
holder stops providing goods or services to the company. In determining whether
a repurchase feature allows the grantee to retain a vested interest, an entity
would assess whether the repurchase price of that repurchase feature is
consistent with the fair value of the award. Other characteristics of the award
(e.g., claim to residual assets of the entity upon liquidation, substantive net
assets underlying the interest, and distribution rights after vesting) could
also be relevant to the entity’s conclusion.
On March 21, 2024,
the FASB issued ASU
2024-01, which clarifies U.S. GAAP
by adding an illustrative example to help entities
determine whether a profits interest or similar
award should be accounted for under ASC 718. The
illustrative example includes four different cases,
A through D, and the ASU’s guidance applies to all
entities that issue profits interest awards as
compensation to employees or nonemployees in
exchange for goods or services. For public business
entities, the ASU’s amendments are effective for
fiscal years beginning after December 15, 2024,
including interim periods within those years. For
all entities other than public business entities,
the ASU’s amendments are effective for fiscal years
beginning after December 15, 2025, including interim
periods within those years. See Section
2.6 for additional details about the
ASU.
Classification
If an entity concludes that an award is within the scope of ASC
718, it must then determine whether that award will be recognized within equity
or as a liability. Equity-classified awards are generally measured as of the
grant date and, in the absence of any modifications, the total amount of
compensation cost to be recognized is fixed at the grant-date measurement
amount. By contrast, liability-classified awards must be remeasured to fair
value as of every reporting period until settled. Accordingly, if the value of
an entity’s shares increases before the liability is settled, the total
recognized compensation cost of a liability-classified award will also
increase.
Determining the classification
of a share-based payment award can be challenging. While classifying a
cash-settled award as a liability may seem straightforward, other awards may
contain features and conditions that entities must analyze further. Examples of
questions to consider in the determination of the classification of an award
include the following:
Some of these questions typically only pertain to nonpublic entities. For
example, nonpublic entities often include repurchase features to remain closely
held or may choose to settle the award in cash to provide liquidity to the
grantee for shares that are not actively traded.
Secondary Transactions
When an entity repurchases common shares from its employees at
an amount greater than the estimated fair value of the shares at the time of the
transaction, the excess of the purchase price over the fair value of the common
shares generally represents employee compensation. In addition, investors (e.g.,
private equity or venture capital investors) may purchase shares held by current
or former employees of an entity because such investors want to acquire or
increase their stake in that entity or provide liquidity to the entity’s
employees. Any consideration paid in excess of the fair value of the shares is
presumed to be compensation cost and an in-substance equity contribution that
must be recognized by the reporting entity.
A nonpublic company should carefully evaluate secondary
transactions when determining the fair value of its common shares. Often, an
entity may conclude that a secondary transaction includes a compensatory element
that must be recognized even when there are also indicators that the secondary
transaction was conducted at fair value. In such situations, an entity should
consider whether to give some weight to that transaction when determining the
fair value of the common shares.
On June 23, 2024, the AICPA’s Financial Reporting
Executive Committee announced the release of a
working draft of two revised
chapters that are expected to be included in the
next edition of the AICPA Accounting and Valuation
Guide Valuation of Privately-Held-Company Equity
Securities Issued as
Compensation. The revisions
are primarily intended to expand the interpretive
guidance on the comprehensive framework for
evaluating and assessing the impact of secondary
transactions and to better align the guide with the
accounting literature issued after the publication
of the guide’s current edition in 2013. See
Deloitte’s March 28, 2025, Technology
Spotlight for additional
information about secondary transactions.
Cheap Stock
Since private companies often heavily rely on equity grants to
compensate their employees, it is critical for such entities to proactively
address potential issues that may emerge during the IPO process related to their
equity plan. As an entity prepares for an IPO, the SEC staff often focuses on
“cheap stock”1 issues. The staff is interested in the rationale for any difference
between the fair value measurements of the underlying common stock of
share-based payment awards issued within the past year and the anticipated IPO
price. In addition, the staff will challenge valuations that are significantly
lower than prices paid by investors in recent acquisitions of similar stock. If
the differences cannot be reconciled, a nonpublic entity may be required to
record a cheap-stock charge. Such a charge could be material and, in some cases,
lead to a restatement of the financial statements.
Waiting to consider cheap stock issues until after the
SEC raises related questions may delay a declaration
that an IPO registration statement is
effective.
When the estimated fair value of an entity’s stock is
significantly below the anticipated IPO price, the entity should be able to
reconcile the change in the estimated fair value of the underlying equity
between the award grant date and the IPO. To perform this reconciliation, the
entity would take into account, among other things, intervening events and
changes in assumptions that justify the change in fair value. The SEC staff has
frequently inquired about a registrant’s pre-IPO valuations. Specifically,
during the registration statement process, the SEC staff may ask an entity to
(1) reconcile its recent fair value measurements with the anticipated IPO price
(including significant intervening events); (2) describe its valuation methods;
(3) justify its significant valuation assumptions, including (a) the weight
given to operating the business both under and in the absence of an IPO and (b)
the appropriateness of the entity’s comparable companies under the market
approach; and (4) discuss the weight it gives to secondary transactions (see
discussion above).
Consideration Payable to a Customer
The scope of ASC 718 does not include the recognition of share-based
payments issued to a customer that (1) are not in exchange for a distinct good or
service or (2) are in exchange for a distinct good or service but can result in a
reduction of the transaction price in accordance with ASC 606-10-32-26 (i.e.,
share-based consideration payable to a customer because the consideration exchanged
exceeds fair value). Such recognition must be accounted for under ASC 606 (i.e., as
a reduction of revenue). However, the measurement (and measurement date) of
share-based consideration payable to a customer and its classification are subject
to the guidance in ASC 718.
In May 2025, the FASB issued ASU 2025-04 to clarify the accounting for
share-based consideration payable to a customer. The ASU’s purpose is to reduce
diversity in practice and improve existing guidance, primarily by revising the
definition of a “performance condition” and eliminating a forfeiture policy election
specifically for service conditions associated with share-based consideration
payable to a customer. In addition, the ASU clarifies that the variable
consideration constraint guidance in ASC 606 does not apply to share-based
consideration payable to a customer regardless of whether an award’s grant date has
occurred. See Deloitte’s May 16, 2025, Heads Up for more information about ASU
2025-04, including its effective dates and transition guidance.
Footnotes
1
Cheap stock refers to issuances of equity securities
before an IPO in which the value of the shares is below the IPO
price.