Accounting Rules for Executive Compensation
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2020.06.04 "Cheap Stock" and Section 409A Tax Implications

    • "Impact of “Cheap Stock” Charges under Section 409A. ...  If the SEC requires the company to restate its financials to increase the compensation charges taken with respect to its stock option grants, the Internal Revenue Service may be more likely to question whether the options were also granted at a discount for tax purposes – even though cheap stock charges may be based on perfect “20-20” hindsight. This creates a risk of additional taxes to the optionees under Section 409A."
  • PWC 2017:  “Roadmap for an IPO A guide to going public" [page 24] 
    • “Cheap stock” refers to the issuance of equity instruments (e.g., options, warrants, common stock or restricted stock) typically during the 12 to 24 months preceding an IPO, for a price (or with a strike price) that is below the expected IPO price. This issue usually arises in connection with the granting of employee stock options and often results in the recognition of additional stock-based compensation expense. 
    • ... Companies may receive comments requiring explanations for valuations that appear unusual (e.g., unusually steep increases in the fair value of the underlying shares leading up to the IPO). Companies preparing for an IPO need to carefully review their option pricing history. Where option exercise prices are significantly less than the price of other equity instruments sold near the dates of option grants, there will be close scrutiny by the SEC, and the closer the grant dates are to the IPO, the more intense the review.
    • Useful tip A contemporaneous common stock valuation report from a third-party valuation specialist can not only ease SEC scrutiny, it can also be used for computation of stock based compensation and for safe harbor purposes under Section 409A.
  • LATHAM 2010 ALERT:
    • "If the SEC Staff requires an issuer to increase the compensation charge associated with a grant of stock options, this charge indicates that, at least for accounting purposes, the issuer has determined (or is taking the position) that it has granted discount options. If, by implication, these stock options are also treated as discount options for tax purposes, the options may be subject to additional income taxes under Section 409A and may be ineligible for preferential ISO tax treatment. The question then becomes whether the issuer can continue to rely for tax purposes on the fair value used in setting the exercise price, notwithstanding its accounting position. The IRS has issued no formal guidance on the interplay of cheap stock accounting charges and fair value for Section 409A and ISO purposes."
  • DLAPiper 2012: Establishing fair market value for purposes of Section 409A and stock option grants | The Venture Alley
    • While not within the scope of this post, it is important to note that the requirements of Section 409A are independent of accounting considerations associated with granting options below fair market value, such as the SEC’s concern with the proper accounting for “cheap stock.”  Such “cheap stock” accounting assessments are performed by the SEC (typically in connection with a company’s IPO registration process) and may result in one-time, non-cash earnings charges on the company’s financial statements.
  • WilmerHale "2019 IPO Report" [see PDF]. 
  • From page 22, "Managing Cheap Stock Issues":
    • Although the accounting consequences of a cheap stock finding often are not as severe as in the days prior to the mandatory adoption of ASC Topic 718 (the accounting standard requiring companies to record compensation expense for employee equity grants), the resultant changes to the company’s audited financial statements can trigger a restatement. Perhaps more importantly, the time required to achieve closure with the staff on cheap stock issues can delay an IPO, particularly since the topic typically cannot be resolved until the estimated price range for the offering becomes available shortly before commencing the road show.  
      • Note the text shown in red italics above involves a consideration that is never applicable to a 409A valuation, because the tax determination is based on the grant date, without regard to subsequent event. 

2017.03.15  Modification of Equity Awards. FASB's board has approved an update that will make the following clarifications, quoted here from this release

  • ​An entity should apply modification accounting in Topic 718 if a change to an award affects the fair value (or calculated value or intrinsic value, if such an alternative measurement method is used), vesting conditions, or classification of the award.
  • The guidance should not explicitly state that an entity is permitted to apply judgment to evaluate whether a change to the fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of an award is insignificant.

2016.08.18  Tax Withholding under Equity Plans.  A new FAQ C-1 from the New York Stock Exchange clears the way for employers to amend their equity award plans in order to allow for tax withholding up to maximum rather than minimum statutory levels.  This alternative emerged from a FASB change announced in April 2016 to raise the tax withholding level that is allowable under equity-based awards without disqualifying them from equity classification for expense purposes.

2016.04.16  Summary by Frederic W. Cook -- of Equity vs Liability Accounting. 

2015.07  PWC's Comprehensive Guide (downloadable)

2013.Oct.29  Delay of All Expense? Possible through CIC or IPO Contingency. Twitter's Form S-1 Amendment No. 1 (filed on Oct. 15, 2013) discloses the absence of any past financial expense for certain restricted stock units, aka RSUs, because their vesting was considered uncertain for GAAP purposes - due to being contingent on both future service and the completion of an IPO or change in corporate control.  Twitter's S-1 explains on pages 81-82 that the closing of the IPO will result in future RSU financial expense, due to satisfaction of the IPO condition.  This handling of the expense for stock-based awards is common, and may also apply to cash-based awards.  In each case, the lynchpin for deferred expense is the uncertainty of future vesting.  Thoughtful drafting and communication with financial experts are needed to assure this design brings the desired financial consequences without triggering adverse effects (with one key consideration being Code §409A).