Equity or capital transactions are often complex and should involve close scrutiny by auditors. As highlighted at the conclusion of this Alert, substantial additional guidance is available addressing differing forms of equity or capital transactions. In this Alert, the PITF will provide some of the more common examples which require careful consideration to determine the appropriate accounting treatment.

Stock Issued for Goods and Services

Start-up companies commonly issue stock in exchange for property, services, or any other form of asset other than cash. The general rule to be applied when equity instruments are issued to non-employees for property or services other than cash is that the transaction should be recorded at the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.

An example of the above is as follows:

ABC Manufacturing Inc. purchased inventory from their vendor XYZ & Co. In lieu of cash, ABC issued 1,000 shares of common stock to XYZ. ABC is a closely held company and the value of its stock has no readily determinable market value.

In the above example, ABC should determine the fair value of the inventory they are purchasing and assign that value to the inventory. Assuming the fair value of the inventory was estimated at $2,500, the accounting entry would be to record inventory at the fair value ($2,500) with the corresponding credits being recorded to common stock and additional paid-in capital.

Similarly, if ABC issued stock to compensate XYZ for services performed, the services would generally be valued at the estimated fair value of the services, because the services are generally more reliably measurable than the fair value of the securities issued. The manner in which the services are recorded (e.g., capitalize versus expense) will depend on the nature of the services and their treatment under generally accepted accounting principles.

An example of this scenario follows:

Mr. Baylor, a consultant who is not considered a founder or an insider of ABC, performs 1,000 hours of services for 10,000 shares of ABC's common stock. The stock has no readily determinable market value. Mr. Baylor typically charges his clients $100 an hour.

In this instance the most reliable measurable value would appear to be Mr. Baylor's services valued at 1,000 hours multiplied by $100 an hour, or $100,000. Thus, the ABC would record an expense for $100,000 and credits to common stock and paid-in capital for $100,000.

In circumstances where the stock issued has no readily determinable market value and the goods and or services received cannot be measured objectively and reliably, a company generally should record the asset or service at a nominal value.

Another example of the above concepts follows:

Mr. Smith, who is not an insider or founder of the company, contributes raw land to a start-up company that will be used to build its manufacturing facility. The land was willed to Mr. Smith 20 years ago and has never been appraised. In exchange for the land, the company issues Mr. Smith 500,000 shares of the company's convertible preferred stock. The company's convertible preferred stock has no active trading, but a valuation was performed by a consultant six months before the land was donated. Mr. Smith is the consultant's uncle. The question is how do you value this transaction.

The above example demonstrates the complexities of equity transactions. First, the valuation of the company's stock by Mr. Smith's nephew would probably not be considered to be a reliable measure due to the fact that they are related parties. If practical, an appraisal of the land by an independent, qualified person may be a reliable measure. However, if an independent, qualified person performed the appraisal of the company's stock, this value may also be a reliable measure. If neither can be reliably measurable, the asset should be recorded at a nominal value.

The use of the book, par, or stated value of the stock as a basis for valuation is not appropriate. Similarly the contractual value assigned to goods, services or other assets received does not represent an appropriate surrogate measure of their value. The company should be able to furnish evidence to outside parties as to how the fair value of the goods, services or other assets was determined, as in the example cited above involving the transaction with Mr. Baylor. In that example, Mr. Baylor kept time records for his consulting services.

Emerging Issues Task Force (EITF) 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, provides numerous examples of situations where (1) the fair value of the equity instrument is more reliably measurable than the fair value of the goods or services received and (2) the counterparty receives shares of stock, stock options or other equity instruments in settlement of all or a part of a transaction.

EITF 96-18 also addresses the measurement date for accounting for equity instruments that are issued to other than employees in exchange for goods and services. The EITF reached a consensus that the issuer should measure the fair value of the equity instruments using the stock price and other measurement assumptions at the earlier of either of the following:

1. The date at which a commitment for performance by the counterparty to earn the equity instrument is reached (referred to as a "performance commitment"), or

2. The date at which the counterparty's performance is complete.

Examples 1-3 of Exhibit 96-18A of EITF 96-18, describe transactions in which a performance commitment exists prior to the time that the counterparty's performance is complete. Examples 4-7 describe transactions in which a performance commitment does not exist prior to the time the counterparty's performance is complete.

EITF 96-18 is extremely complex. This very brief summary should not be relied upon without a complete reading and understanding of the pronouncement itself. It is mentioned only as a reminder of an important source of authoritative literature on accounting for equity transactions.

Stock Issued to an Owner for Expertise or Intellectual Capital Contributed to Business

Companies sometimes issue stock to an owner for expertise contributed to a business, such as a patent or other intellectual capital. Such circumstances are most common immediately prior to an initial public offering (IPO). The question is what value should the company place on the asset acquired.

The Securities and Exchange Commission (SEC) states in Staff Accounting Bulletin (SAB) Topic 5-G, Acquisition of Assets from Promoters and Shareholders in Exchange for Common Stock, that "transfers of nonmonetary assets to a company by its promoters or shareholders in exchange for stock prior to or at the time of the company's initial public offering normally should be recorded at the transferor's historical cost basis determined under generally accepted accounting principles."

The following is an example applying the above principle:

Mr. Norton, a founder of ABC Industries, Inc., contributes a patent to ABC in exchange for stock immediately prior to ABC's IPO. The patent was obtained by Mr. Norton at a cost of $1,000 (filing fees). The remainder of the costs associated with the patent relate to Mr. Norton's own time developing the intellectual property. If Mr. Norton maintained books in accordance with generally accepted accounting principles, the patent would be recorded on those books at $1,000. Therefore, when the patent is contributed, ABC should record the patent at $1,000 with corresponding credits to common stock and additional paid-in capital.

Employee Stock Options

The financial accounting and reporting standards for stock-based employee compensation plans are contained in the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards (SFAS) 123, Accounting for Stock-Based Compensation (SFAS 123), and the Accounting Principles Board's (APB) Opinion 25, Accounting for Stock Issued to Employees (APB 25). These pronouncements cover all arrangements by which employees receive shares of stock or other equity instruments of the employer or the employer incurs liabilities to employees in amounts based on the price of the employer's stock. Examples are stock purchase plans, stock options, restricted stock, and stock appreciation rights.

SFAS 123 prescribes a fair value method of accounting for an employee stock option or similar equity instrument and encourages all entities to adopt that method of accounting for all of their employee stock compensation plans. However, SFAS 123 also permits an entity to continue to measure compensation cost for those plans using the intrinsic value method of accounting prescribed by APB 25. Where entities elect to continue using the accounting in APB 25, they are required to make pro forma disclosures of net income and, if presented, earnings per share, as if the fair value method of SFAS 123 had been applied.

Under the fair value method, compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. Under the intrinsic value-based method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date or other measurement date over the amount an employee must pay to acquire the stock.

The determination of fair value, either for accounting under SFAS 123 or the pro forma disclosures under APB 25, can be achieved through use of an option-pricing model (for example, the Black-Scholes or a binomial model) that takes into account, as of the grant date, the exercise price and expected life of the option, the current price of the underlying stock and its expected volatility, expected dividends on the stock, and the risk-free interest rate for the expected term of the option. The discussion of stock option valuation techniques is beyond the scope of this Alert but further guidance is available in SFAS 123. Also, for some non-public entities with minimal trading information upon which to assess price volatility as required for traditional option valuation techniques, the entity may use a minimum value method. Under the minimum value method, the stock option value is generally considered to equal the current price of the stock reduced by the present value of the expected dividends on the stock, if any, during the option's term minus the present value of the exercise price. For this purpose the present value discount is based on the risk-free rate of return. However, the minimum value could also be computed using the standard option-pricing model and volatility of zero.

It also is important to note that SFAS 123 requires a fair value method for all equity awards to non-employees, and use of the minimum value method, as described in the preceding paragraph, is not appropriate. This is demonstrated in the above sections of this Alert.

Where options are granted near an IPO, the value at which stock is issued in the IPO should be carefully considered in assessing the market value of options. For such grants, the SEC staff expects the registrant to have objective evidence to support its determination of "fair value." Such objective evidence would include contemporaneous third-party transactions and independent appraisals. "Rule of thumb" discounts, management estimates, related-party transactions (even for cash), and general market data do not represent objective evidence for this purpose. The most objective evidence that can be used to support the value assigned to stock, options, or warrants is information from a contemporaneous transaction where the value of the consideration received for the company's securities is objectively measurable, i.e., an equity transaction with a third party for cash that is entered into in the same time frame. Absent a contemporaneous transaction, an independent appraisal can form the basis for the valuation. The independent appraisal should have been performed at the time the stock, options, or warrants were issued. Appraisals performed "after the fact" are not acceptable. If the appraised value of the stock is substantially below the IPO price, the company must be able to reconcile the difference between the appraised value and the IPO price, i.e., explain the events or factors that support the difference in values.

In 1999, the FASB issued an exposure draft addressing several issues regarding the accounting for employee stock options and awards under APB 25. Comments have been submitted and the FASB is re-deliberating many of the conclusions expressed in the exposure draft. A final interpretation of these issues is expected early in 2000. At this time it is expected that practice with respect to many aspects of APB 25 will be changed as a result of the interpretation.

Retroactive Earnings Per Share Adjustment for Cheap Stock

Cheap stock refers to stock issued for nominal consideration (i.e., a price below the price at which stock is subsequently sold in a public issuance of shares) to employees or others closely related to the Company. SAB 98 Topic 4-D, Earnings per Share Computations in an Initial Public Offering, describes the SEC's position on this issue.

In applying the requirements of SFAS 128, Earnings per Share, the SEC staff believes that nominal issuances are recapitalizations in substance. Accordingly, in computing basic earnings per share (EPS) for the periods covered by income statements included in the registration statement and in subsequent filings with the SEC, nominal issuances of common stock should be reflected in a manner similar to a stock split or stock dividend for which retroactive treatment is required by paragraph 54 of SFAS 128. Consequently, in computing basic EPS, nominal issuances of common stock would be included for all periods; whereas in computing diluted EPS for such periods, nominal issuances of common stock and potential common stock (e.g., options) would be included for all periods. In addition, use of the treasury stock method is not allowed and retroactive treatment is required even if anti-dilutive.

This retroactive presentation of such nominal issuances as outstanding for all historical periods in the computation of EPS does not alter the requirement that entities determine whether the recognition of compensation expense for any issuance of equity instruments to employees is necessary.

Guidance has not been provided on what constitutes "nominal consideration." SAB Topic 4-D states that it should be determined based upon facts and circumstances by a comparison of the "consideration an entity receives" to the security's fair value (at the date of the issuance).

Extinguishment of Related Party Debt

The AICPA frequently receives questions about whether an entity should record an expense or a charge to equity when a company forgives a receivable from an individual that is a related party of the company. Typically in such situations, the company should record a charge to equity. As a reminder, it should be noted that in certain circumstances, such receivables from related parties often are recorded as a reduction in equity rather than as an asset. This is sometimes required, depending on the nature of the receivable, by the SEC (see SAB Topic 4-E, Receivables from Sale of Stock, and Topic 4-G, Notes and Other Receivables from Affiliates) and by EITF 85-1, Classifying Notes Received for Capital Stock.

Similar to a company forgiving a loan from a related party, sometimes a company's outstanding loan is forgiven by a related party. Such a forgiveness usually should be recorded as a credit to equity. (APB 26, Early Extinguishment of Debt, paragraph 20 states "that extinguishment transactions between related parties may be in essence capital transactions.")

Other Accounting Literature Addressing Equity Transactions

When auditing and accounting for equity transactions, members should review the FASB current text and the EITF index for a more complete list of accounting literature on such transactions. There are more than 50 accounting pronouncements addressing various equity transactions, including numerous EITFs on the subject. This is indicative of and exemplifies the careful research that is necessary when dealing with equity transactions.

Furthermore, members should review the SEC's SAB Topics when auditing public companies. Several SAB Topics covering equity transactions have been referred to in this Alert.

Summary

Accounting for equity transactions is complex and requires comprehensive research of accounting literature to ensure the appropriate accounting treatment. The above examples provide a summary of the appropriate accounting for certain equity transactions.

Comments or questions on this alert should be directed to the AICPA SEC Practice Section at 201/938–3022.