FASB

Accounting for Certain Equity Transactions

Paul Munter

As we discussed in the lastFASB column, the FinancialAccounting Standards Board(FASB) is increasingly bringingfair value information into thefinancial statements. Use of fairvalue now applies to invest-ments in certain marketablesecurities and debt securities aswell as to derivatives. As a con-sequence, the profession hasfound it necessary to issue addi-tional guidance on the applica-tion of these principles in certainsituations.

PRACTICE ALERT 2000-1

In January 2000, theAmerican Institute of CertifiedPublic Accountants (AICPA)issued Practice Alert 2000-1,entitled Accounting for CertainEquity Transactions. PracticeAlert 2000-1 is intended to pro-vide auditors with informationthat may help them improve theefficiency and effectiveness oftheir audits, and is based onexisting professional literature,the professional experience ofthe members of the ProfessionalIssues Task Force (PITF) andinformation proved by SECPractice Section member firmsto their own professional staff.

Equity or capital transac-tions often are complex andshould involve close scrutiny byauditors as well as those respon-sible for financial reportingwithin the company. In reality,the accounting/auditing profes-sional literature provides sub-stantial guidance that is useful inaddressing differing forms ofequity or capital transactions.However, because of some ofthe complexities involved,Practice Alert 2000-1 was issuedto provide a discussion and illus-tration of some of the morecommon situations that requirecareful consideration to deter-mine the appropriate accountingtreatment.

Start-up companies com-monly issue stock in exchangefor property, services, or othernonmonetary assets. The gener-al rule to be applied when equi-ty instruments are issued tononemployees for property orservices is that the transactionshould be recorded at the fairvalue of the considerationreceived or the fair value of theconsideration surrendered,whichever is more clearlydeterminable.

To illustrate, consider thefollowing example.

ABC Manufacturing, Inc.purchased inventory from one ofits vendors, XYZ, Inc. ABCissued 1,000 shares of commonstock to XYZ. To complicate thesituation, assume that ABC is aclosely held company and thevalue of its stock has no readilydeterminable market value.

Because the fair value of itsstock is not readily deter-minable, ABC should determinethe fair value of the inventorythat is being purchased andassign that value to the transac-tion. That amount would be usedin determining the amount ofpaid-in capital from theexchange. Similarly, if ABCissued stock to compensate XYZfor services performed, the serv-ices generally would be valuedat the estimated fair value of theservices because the servicesgenerally are more reliablymeasurable than the fair value ofthe securities issued.

A more difficult situation iscreated when neither the stocknor the goods or services have areadily determinable marketvalue. The Practice Alert con-cludes that in circumstanceswhere the stock issued has noreadily determinable marketvalue, and the goods and/or

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services received cannot bemeasured objectively and reli-ably, a company generallyshould record the asset or serv-ice at a nominal value.

For example, assume thatMr. Smith, who is not an insideror founder of the company, con-tributes land to a start-up compa-ny that will be used to build itsmanufacturing facility. The landwas willed to Mr. Smith 20 yearsago and has never beenappraised. In exchange for theland, the company issues500,000 shares of the companyÕsconvertible preferred stock toMr. Smith. The companyÕs con-vertible preferred stock has noactive trading, but a valuationwas performed by a consultantsix months before the land wasdonated. However, Mr. Smith isthe consultantÕs uncle. Howshould the transaction be valued?

The example demonstratesthe complexities of equity trans-actions. First, the valuation ofthe companyÕs stock by Mr.SmithÕs nephew probably wouldnot be considered to be a reliablemeasure because they are relatedparties. If practical, an appraisalof the land by an independent,qualified person may be a reli-able measure. However, if anindependent, qualified personperformed the appraisal of thecompanyÕs stock, this value alsomay be a reliable measure. Ifneither can be reliably measured,the asset should be recorded at anominal value.

Importantly, in this situation,the use of the book, par, or stat-ed value of the stock as a basisfor valuation is not appropriate.Similarly the contractual valueassigned to goods, services, orother assets received does notrepresent an appropriate surro-gate measure for fair value. Thecompany should be able to fur-nish objective evidence as to

how the fair value of the goods,services, or other assets aredetermined.

EITF 96-18

Emerging Issues Task Force(EITF) 96-18, entitledAccounting for EquityInstruments That Are Issued toOther Than Employees forAcquiring, or in Conjunctionwith Selling, Goods or Services,provides numerous examples ofsituations where (1) the fairvalue of the equity instrument ismore reliably measurable thanthe fair value of the goods orservices received, and (2) thecounterparty receives shares ofstock, stock options, or otherequity instruments in settlementof all or a part of a transaction.

EITF 96-18 also addressesthe measurement date foraccounting for equity instru-ments that are issued to otherthan employees in exchange forgoods and services. The EITFreached a consensus that theissuer should measure the fairvalue of the equity instrumentsusing the stock price and othermeasurement assumptions at theearlier of:

¥ The date at which a commit-ment for performance by thecounterparty to earn theequity instrument is reached(the Òperformance commit-mentÓ); or

¥ The date at which the coun-terpartyÕs performance iscomplete.

Companies sometimes issuestock to an owner for expertisecontributed to a business (e.g., apatent or other intellectual capi-tal). Such circumstances aremost common immediately priorto an initial public offering(IPO). The question, of course,

is at what value the companyshould assign to the assetsacquired.

The SEC stipulates in StaffAccounting Bulletin (SAB)Topic 5-G, entitled Acquisitionof Assets from Promoters andShareholders in Exchange forCommon Stock, that transfers ofnonmonetary assets to a compa-ny by its promoters or share-holders in exchange for stockprior to or at the time of thecompanyÕs initial public offeringnormally should be recorded atthe transferorÕs historical costbasis determined in accordancewith generally accepted account-ing principles (GAAP).

FAS NO. 123

The financial accounting andreporting standards for stock-based employee compensationplans are contained in FinancialAccounting Standard (FAS) No.123, entitled Accounting forStock-Based Compensation, andin Accounting Principles Board(APB) Opinion No. 25, entitledAccounting for Stock Issued toEmployees. These pronounce-ments cover all arrangementsthrough which employeesreceive shares of stock or otherequity instruments of theemployer, or the employer incursliabilities to employees inamounts based on the price ofthe employerÕs stock. Examplesof transactions/events are stockpurchase plans, stock options,restricted stock, and stock appre-ciation rights.

FAS No. 123 prescribes afair value method of accountingfor an employee stock option orsimilar equity instrument andencourages all entities to adoptthat method of accounting for allof their employee stock compen-sation plans. However, FAS No.123 also permits an entity to

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continue to measure compensa-tion cost for those plans usingthe intrinsic value method ofaccounting of AccountingPrinciples Board (APB) OpinionNo. 25. Where entities elect tocontinue using the accounting inAPB Opinion No. 25 (the over-whelming majority of compa-nies), they are required to makepro forma disclosures of netincome and earnings per share,as if the fair value method ofFAS No. 123 had been applied.

Under the fair value method,compensation cost is measuredat the grant date based on thevalue of the award and is recog-nized over the service period,which usually is the vesting peri-od. Under the intrinsic value-based method, compensationcost is the excess of the quotedmarket price of the stock at grantdate or other measurement dateover the amount an employeemust pay to acquire the stock.

The determination of fairvalue, either for accounting orthe pro forma disclosures, usual-ly is the result of applying anoption-pricing model (e.g., theBlack-Scholes or a binomialmodel) that takes into accountthe exercise price and expectedlife of the option, the currentprice of the underlying stock andits expected volatility, expecteddividends on the stock, and therisk-free interest rate for theexpected term of the option. It isimportant to note that FAS No.123 requires a fair value methodfor all equity awards to nonem-ployees, and use of the mini-mum value method is not appro-priate for that computation.

Where options are grantednear an IPO date, the value atwhich stock is issued in the IPOshould be considered in assess-ing the market value of options.For such grants, the SEC staffexpects the registrant to have

objective evidence to support itsdetermination of fair value. Suchobjective evidence wouldinclude contemporaneous third-party transactions and independ-ent appraisals. ÒRule of thumbÓdiscounts, management esti-mates, related-party transactions(even for cash), and generalmarket data do not representobjective evidence for this pur-pose. The most objective evi-dence that can be used to sup-port the value assigned to stock,options, or warrants is informa-tion from a contemporaneoustransaction where the value ofthe consideration received forthe companyÕs securities isobjectively measurable (i.e., anequity transaction with a thirdparty for cash that is entered intoin the same time frame). Absenta contemporaneous transaction,an independent appraisal canform the basis for the valuation.The independent appraisalshould have been performed atthe time the stock, options, orwarrants were issued. Appraisalsperformed Òafter the factÓ arenot acceptable. If the appraisedvalue of the stock is substantial-ly below the IPO price, the com-pany must be able to reconcilethe difference between theappraised value and the IPOprice (i.e., explain the events orfactors that support the differ-ence in values).

In 1999, the FASB issued anexposure draft addressing sever-al issues regarding the account-ing for employee stock optionsand awards under APB OpinionNo. 25. [See Munter, P. (1999,Autumn). New proposals onstock compensation, asset secu-ritization, consolidations, andmore. The Journal of CorporateAccounting & Finance, 10(1),133Ð149] Comments have beensubmitted, and the FASB is rede-liberating many of the conclu-

sions expressed in the exposuredraft. A final interpretation ofthese issues is expected early in2000. It is expected that practicewith respect to many aspects ofAPB Opinion No. 25 will bechanged as a result of the inter-pretation if/when the interpreta-tion is finalized.

CHEAP STOCK ISSUES

ÒCheap stockÓ refers tostock issued for nominal consid-eration (i.e., a price below theprice at which stock is subse-quently sold in a public issuanceof shares) to employees or othersclosely related to the company.SAB No. 98 (Topic 4-D), enti-tled Earnings per ShareComputations in an InitialPublic Offering, describes theSECÕs position on this issue.

In applying the requirementsof FAS No. 128, entitledEarnings per Share, SEC staffbelieves that nominal issuancesare, in effect, recapitalizations.Accordingly, in computing basicearnings per share for the peri-ods covered by income state-ments included in the registra-tion statement and in subsequentfilings with SEC, nominalissuances of common stockshould be reflected in a mannersimilar to a stock split or stockdividend for which retroactivetreatment is required by para-graph 54 of FAS No. 128.

Given these facts, in com-puting basic earnings per share(EPS), nominal issuances ofcommon stock would be includ-ed for all periods. In computingdiluted EPS for these periods,nominal issuances of commonstock and potential commonstock (e.g., options) would beincluded for all periods. Inaddition, use of the treasurystock method is not allowed andretroactive treatment is required

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even if antidilutive. It is impor-tant to note, however, that thisretroactive presentation of nom-inal issuances as outstanding forall historical periods in thecomputation of EPS does notalter the requirement that enti-ties determine whether therecognition of compensationexpense for any issuance ofequity instruments to employeesis necessary.

One problem practitionersface, however, is that guidancehas not been provided on what

constitutes Ònominal considera-tion.Ó SAB No. 98 stipulates thatthis determination should bebased upon facts and circum-stances by a comparison of theÒconsideration an entityreceivesÓ to the securityÕs fairvalue at the date of the issuance.

The AICPA frequentlyreceives questions about whetheran entity should record anexpense or a charge to equitywhen a company forgives areceivable from an individualthat is a related party of the

company. Typically in these situ-ations, the company shouldrecord a charge to equity. Thistreatment would be consistentwith the conclusions of the EITFin Issue No. 85-1, entitledClassifying Notes Received forCapital Stock.

Similar to a company forgiv-ing a loan from a related party,sometimes a companyÕs out-standing loan is forgiven by arelated party. Such a forgivenessusually should be recorded as acredit to equity.

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Paul Munter, Ph.D., CPA, is a KPMG Peat Marwick Professor of Accounting at the University of Miami. Heis editor-in-chief of The Journal of Corporate Accounting & Finance.