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.