ASC Codification
Example Memo:
Guest lecturer – Morgan Watson, Assurance Partner, Ernst & Young
Congratulations, you have just won the audit for the year ended December 31, 2012, for a new client,
ResearchPlus (the Company), which provides market research to companies through online surveys that
leverage the Company’s significant panel of members that take surveys and provide feedback on
potential products, services or advertising campaigns.
The Company has experienced significant growth over the past 10 years. Much of this growth was
funded by various rounds of equity funding from its private equity investors via preferred stock
issuances.
As is typical of a high-growth company, a significant portion of the compensation package that the
Company has provided to its key employees is options to purchase common stock. On June 30, 2012,
the Company issued 2 million options to its employees. The options have the following criteria:
• Vesting - 25% per year for four year
• Exercise price - $2.00/share (fair value of the common stock at the date of the grant)
• Estimated fair value of the options - $1.00
• Estimated forfeiture rate - 10%
Based on your review of the prior year financial statements, you note that the Company has applied
equity accounting for these options.
The Company is planning to file an Initial Public Offering document with the SEC in the next 6-12
months, and based on your experience you expect several questions from the SEC staff related to stock
compensation as it is common topic of comments from the staff.
During 2012, the Company raised $100 million of equity funding in exchange for issuing Series D
preferred stock to new investors. The Company utilized approximately $50 million to repurchase its
Series A preferred stock from its initial investors.
Prior to year-end, management approaches the audit team to discuss its plans to re-constitute its
repurchase of common stock from its employees as a reward for the successful equity raise utilizing $20
million of the proceeds as Management has agreed to allow employees to exercise their options and
then repurchase those shares of common stock.
Questions:
1. What is the proper accounting treatment for each of the following?
a. The stock options
b. The preferred stock
c. The treasury stock
2. What additional investigation should the audit team do into how the repurchase program has
operated in the past?
Example Answer (okay…:
Memorandum
To: Morgan Watson, CPA
CC: Dr. Calk, CPA
From: XXX, YYY, ZZZ, AAA, BBB
Date: 2/6/2019
Re: Case Study
Fact Pattern
The Company, a high growth corporation that is preparing to go public, had the following transactions and plans for
the year ended 2012:
On June 30, 2012 the company issued two million stock options to employees. The options will vest at a rate of 25%
a year, for four years. The exercise price was $2.00/share and the company estimated the value of the options at
$1.00 per option using the Black-Scholes pricing model. The options have an estimated forfeiture rate of 10%.
During 2012 the company issued $100 million in Series D preferred stock to new investors. The series D preferred
stock is redeemable at the election of the shareholders. The company took $50 million of the proceeds, from the
issue, and used them to repurchase the Series A preferred stock.
Management has agreed to allow employees to exercise their options and then repurchase those shares of common
stock. The shares are not puttable to the company.
Issues
1) Our group must determine the proper accounting treatment for the following: a. The stock options b. The preferred stock c. The treasury stock
2) Are there any additional investigations the audit team should perform into how the repurchase program has operated in the past?
Conclusion
Issue #1
a) The stock options must be recorded as equity pursuant to ASC 718.10.25.2 through 12.
b) Preferred stock must be reported by the company as equity pursuant to ASC 480.10.65.1.
c) Treasury stock will ultimately not be shown on the balance sheet for acquired shares due to retirement
Issue #2
Additional investigation includes obtaining the following information:
The audit team needs to obtain documentation verifying that the stock options are in fact not puttable
to the company, in order to support the audit team’s current stance that the stock options be reported
as equity, for SEC registration purposes.
Discussion
Stock Options
The conditions requiring an award to be classified as a liability are not met. The first conditions cited in
ASC 718.10.25.9 pertain to “puttable shares” awarded to an employee. The company has confirmed that
the options are not puttable to the employer, thus this condition has not been met.
Neither condition cited in ASC 718.10.25.11 have been met either: the underlying shares are classified as
equity, not liabilities and the entity cannot be required under any circumstances to settle the option by
transferring cash or other assets because the options may not be “put” to the company. Additional
conditions cited in ASC 718.10.25.12 are not applicable as the Company is not yet a SEC Registrant. As
none of these conditions have been satisfied, the shares shall be classified as equity, pursuant to ASC
718.10.25.10.
As the stock options shall be recorded as equity, ASC 718.10.35.2 mandates that the compensation shall
be recognized over the requisite service period with a corresponding credit to equity (generally, paid-in
capital).
According to ASC 718.10.25.2, “an entity shall recognize share-base payment transaction with an
employee as services are received” and continues, “As services are consumed, the entity shall recognize
the related cost”. Unless otherwise stated, the service period is the vesting period. Thus, the company
will continue to expense the compensation at 25% a year for four years per the vesting period.
Preferred Stock
The preferred securities are not mandatorily redeemable according to ASC 480-10-65-1 because the
shares within the Company do not obligate the repurchase at a stated redemption date. Therefore, the
preferred securities are recorded as equity. Preferred stock is reported at par value on the balance sheet
as the first line item and any excess over par is listed as a part of additional paid-in capital with the
number of shares issued and outstanding parenthetically included according to ASC.210.10.S99.1. To
comply with the disclosure requirements stated in ASC 505.10.50.4, The Company must state the
applicable rights of each series within the notes of the financial statements in summary form. This will
include the liquidation preferences, redemption requirements, and conversion or exercise prices or
rates. Terms of potential conversion are also stated. Also, to help users better understand the impact of
contingently convertible securities, all terms and conditions relevant to the potential conversion are
stated in the notes of the financial statements according to ASC 505.10.50.6.
Treasury Stock
According to ASC 505.30.45.1, the cost of acquired stock is shown as a deduction of capital stock. When the
common shares are repurchased from employees, upon exercise of the employee’s options, the shares will be treated
as treasury stock and recorded at par, per ASC 505.30.45.1 before the subsequent retirement of the shares. Upon
retirement of the treasury shares stockholder’s equity will be reduced. Treasury stock will ultimately not be shown
on the balance sheet for the shares repurchased.