New Accounting Treatment for Non-Employee Equity Awards

Over the past few years, the Financial Accounting Standards Board (“FASB”) has been releasing various Accounting Standards Updates (“ASU”) simplifying the accounting treatment for the measurement, and testing, of fair value measurements.

On June 20, 2018, the FASB continued this trend and issued Accounting Standards Update 2018-07, Compensation – Stock Compensation (Topic 718) – Improvements to Nonemployee Share-Based Payment Accounting. The purpose of this update is to align the accounting for share based payment awards issued to employees and non-employees. The valuation of share based payment awards to employees have fallen under FASB Accounting Standards Codification (“ASC”) Topic 718, Compensation – Stock Compensation, which superseded FASB 123r. ASC 718 (financial reporting) and Section 409A of the Internal Revenue Code (tax reporting) regulate nonqualified deferred compensation and 409a was enacted, in part, in response to the Enron meltdown and the corresponding financial crisis. In 2004, the AICPA released an accounting practice aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation. This practice aid became the de facto Bible on how to perform valuations for nonqualified deferred compensation and introduced the valuation community to the following equity allocation methods: Current Method (or simply a Waterfall calculation which was popular pre-Practice Aid release), the OPM (based on a Black Scholes Option Pricing Model) and the PWERM (Probability Weighted Expected Return Method).

While this practice aid, and the subsequent literature, white papers, etc. gave companies and valuation practitioners an understandable and logical method for valuing nonqualified deferred compensation to employees, it did not address non-employee payments. For these payments to non-employees, the accounting literature had previously followed FASB ASC Topic 505 – Equity, not ASC 718, Compensation – Stock Compensation. The resulting impact and changes as a result of this new ASU are as follows:

• The measurement date will now be on the grant date rather than the vesting date. As a result, these awards will not need to be premeasured and marked to market through the completion date. This will simplify the accounting treatment and valuation of these instruments.
• The contractual term will be able to be used instead of the expected term in the option-pricing model for nonemployee awards.
• For performance conditions, compensation cost associated with the award will be recognized when achievement of the performance condition is probable, rather than upon achievement of the performance condition.
• Private companies will now be able to use an industry sector volatility index if the calculation of expected volatility is not reasonable.
• Private companies can use the simplified approach to estimate the expected term of an award so long as it meets certain conditions.
• The guidance under this ASU becomes effective for public companies for fiscal years beginning after December 15, 2018. The amendments become effective for private companies for fiscal years beginning after December 15, 2019. Like many previous ASUs, early adoption is permitted.

By simplifying the accounting treatment and valuations of these equity awards to nonemployees, and by putting them on the same basis as equity award to employees, companies may be more willing to grant these awards to others. Additionally, if these nonemployees eventually switch status and become employees, issuing companies will not need be concerned about a change in the accounting treatment. All in all, this ASU will result in less headaches for companies, as well as reducing costs. All while potential keeping nonemployees more incentivized in the future of the business itself.

References:

Accounting Standards Update 2018-07, Compensation – Stock Compensation (Topic 718) – Improvements to Nonemployee Share-Based Payment Accounting. Financial Accounting Standards Board. June 2018.

FASB Accounting Standards Codification Topic 718, Compensation – Stock Compensation. Financial Accounting Standards Board.

Valuation of Privately-Held Company Equity Securities Issued as Compensation. American Institute of Certified Public Accountants, Inc. 2003.

FASB Accounting Standards Codification Topic 505 – Equity. Financial Accounting Standards Board.