ASU 2021-07: Understanding the New Stock Compensation Standard
By: Joe E. Paulus, CPA – Audit and Accounting Senior Manager at Wipfli LLP
In October 2021, the Financial Accounting Standards Board (FASB) released an accounting standard update that provides nonpublic companies with a practical option for issuing share-based payment awards. Accounting Standards Update (ASU) 2021-07 offers a practical expedient for nonpublic companies on determining the current price of an underlying share for equity-classified share-based awards subject to Accounting Standards Codification (ASC) 718.
As a way to compensate their employees or nonemployees, companies will issue share-based payment awards, which are typically accounted for under ASC 718. The scope of ASC 718 applies to all share-based payment transactions in which a grantor acquires goods or services to be used or consumed in the grantor’s own operations or provides consideration payable to a customer by issuing (or offering to issue) its shares, share options or other equity instruments, or by incurring liabilities to an employee or nonemployee that meet either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments.
- The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.
The term “shares” includes various forms of ownership interest that may not take the legal form of securities (for example, partnership interests). Common awards within the scope of ASC 718 include unvested common stock, restricted stock and restricted stock units, stock options, stock appreciation rights, profits interests and incentive units.
The award may be liability or equity classified depending on its features. Equity-classified awards must be measured at fair value on its grant date. Depending on the type of award, the fair value technique will differ, but companies will need to know the current price of the entity’s underlying equity on its grant date in order to value all of the awards. The Private Company Council received feedback that the current price of the underlying equity is typically one of the most difficult inputs for private companies to observe, as nonpublic company shares are not actively traded. This concern lead to the new practical expedient described in ASU 2021-07.
The new practical expedient allows a nonpublic entity to determine the current price input of equity-classified share-based awards issued using the reasonable application of a reasonable valuation method. The practical expedient describes the characteristics of the reasonable application of a reasonable valuation method including:
- The date on which the valuation’s reasonableness is evaluated is the measurement date.
- The following factors should be considered in a reasonable valuation:
- The value of the tangible and intangible assets of the entity.
- The present value of the anticipated future cash flows of the entity.
- The market value of stock or equity interests in similar entities engaged in trades or businesses substantially similar to those engaged in by the entity for which stock is to be valued.
- Recent arm’s-length transactions involving the sale or transfer of the stock or equity interests of the entity.
- Other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation is used for other purposes that have a material economic effect on the entity, its stockholders, or its creditors.
- The entity’s consistent use of a valuation method to determine the value of its stock or assets for other purposes.
- The scope of information to be considered in a reasonable valuation is all information material to the value of the entity.
- The following criteria must be met for the use of a previously calculated value to be considered reasonable:
- The value is updated for any information available after the date of calculation that may materially affect the value of the entity.
- The value is calculated no more than 12 months earlier than the date for which the value is being used.
The same characteristics are used in the regulations of the U.S. Department of the Treasury related to Section 409A of the U.S. Internal Revenue Code (the Treasury Regulations) to describe the reasonable application of a reasonable valuation method for income tax purposes. A reasonable valuation performed in accordance with the Treasury Regulations is an example of a way to achieve the practical expedient. Some nonpublic entities may obtain separate valuations to satisfy the requirements of both ASC 718 and Treasury Regulations. The practical expedient cements that a single valuation is acceptable for both.
The practical expedient is not allowed for liability-classified awards.
ASU 2021-07 is effective prospectively for all qualifying awards granted or modified during fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Early application, including application in an interim period, is permitted for financial statements that have not yet been issued or made available for issuance as of October 25, 2021.
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