Equity Stock Based Compensation Audit Guide: A Comprehensive Resource

Equity stock based compensation can be a complex and nuanced topic, but with the right guidance, you can ensure your company's practices are accurate and compliant.

According to the IRS, equity stock based compensation is subject to income tax withholding, and employers are required to withhold at least 25% of the compensation amount.

To avoid costly errors, it's essential to understand the key components of equity stock based compensation, including strike price, vesting periods, and option expiration dates.

Companies that fail to properly account for equity stock based compensation may face penalties and fines, as seen in the case of a Fortune 500 company that paid over $10 million in back taxes and penalties due to improper accounting.

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Stock options give employees the right to buy company stock at a predetermined price, while restricted stock units (RSUs) and restricted stock awards (RSAs) are company shares given to an employee which vest over time.

Stock options are a common type of grant, and they come in two forms: statutory and non-statutory options. Statutory options, such as Incentive Stock Options (ISOs), generally have stricter requirements than non-statutory options.

Statutory options, like ISOs, allow recipients to defer paying tax until the option has been exercised and the underlying equity has been sold, thus deferring any tax on the recipient until they receive sale proceeds.

Non-statutory options, on the other hand, result in ordinary income on the date of exercise, and may be subject to IRC §409A if they have an exercise price less than the fair market value on the date of grant.

Here are some common types of equity incentives for employees of startups:

Stock appreciation rights (SARs) are another type of grant, where the employee is entitled only to the appreciation of the underlying stock between the issue and exercise dates.

Restricted stock units (RSUs) are agreements to pay either cash or stock at a specified date, and one restricted stock unit typically represents one share of actual stock.

Stock warrants are similar to stock options and allow the holder to purchase a specified number of shares at a specified price and at a specified time, and they may be taxable under IRC §83(b) subject to certain conditions.

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Valuing options for accounting purposes can be a complex task, but it's essential for companies to get it right. The fair value of stock options is estimated using models such as the Black-Scholes Model, the Binomial Model, and Monte Carlo Simulation.

Pulley's SBC Tool utilizes the Black Scholes Option Pricing model to calculate the fair value of options. This model is widely used due to its simplicity and effectiveness in situations where market data is limited. For private startup companies, the Black-Scholes Model provides a reasonable and accepted method for estimating the fair value of service-based incentive grants.

The fair value of RSUs and RSAs is estimated using the 409A value as the current price of the underlying share. This is a practical expedient under ASU 2021-07, and it's used for nonpublic entities.

Here are the common methods used to determine the fair value of equity-based compensation:

These methods can be used to estimate the fair value of stock options, which is a key component for both tax and accounting purposes.

ISOs have favorable tax treatment for the recipient in most cases. To ensure ISO treatment of option grants by the IRS, a company should follow certain rules, including having a valuation of its common stock performed on at least an annual basis or more often if material changes to the business have occurred.

Improper option issuances may lead to unintended tax liabilities for both the company and the employee. This highlights the importance of careful planning and compliance.

To qualify as an ISO, the stock option plan must be in writing and approved by the shareholders of the company within 12 months of the plan's adoption by the Board of Directors. The plan may also be approved up to 12 months prior to the adoption by the Board.

Options must be granted within 10 years of the formal approval of the option plan. This is a key consideration for companies looking to offer ISOs to their employees.

Here are the key rules for ISOs:

Valuing options is a crucial step in accounting, and it's essential to understand the different methods and models used to determine their fair value. The Black-Scholes Model is widely used because of its simplicity and effectiveness in situations where market data is limited.

There are several models for valuing stock options, including the Black-Scholes Model, the Binomial Model, and Monte Carlo Simulation. The Black-Scholes Model is particularly effective in estimating the value of options for private startup companies, which often don't have a trading history or market price for their shares.

To determine the fair value of equity-based compensation, companies can use the market approach, income approach, or option pricing models. The option pricing models, such as the Black-Scholes model, use inputs like expected term, volatility, risk-free rate, and dividend yield.

For private companies, determining the fair value of equity-based compensation can be a difficult exercise, and many engage a third party to prepare a valuation to satisfy the IRS and independent auditors. A more robust independent appraisal, commonly referred to as a 409A valuation, is used to establish fair market value and provide comfort against a stock valuation challenge.

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The fair value of stock options will determine how much expense should be reflected in the financial statements. Since stock options are not liquid, their worth needs to be calculated using a valuation model, such as the Black-Scholes model. ASC 718 does not recommend any specific valuation model, but it enumerates the factors necessary for a proper valuation model, including expected term, expected volatility, risk-free interest rate, strike price, and dividend yield.

Here are the key factors to consider when using an option pricing model:

These factors are essential in determining the fair value of stock options and should be carefully considered when using an option pricing model.

Valuing RSUs and RSAs for Accounting Purposes is a crucial step in ensuring accuracy and compliance with accounting regulations.

For nonpublic entities, Pulley’s SBC tool uses the practical expedient under ASU 2021-07 and uses the 409A value as the current price of the underlying share for purposes of determining the fair value of an award that is classified as equity.

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The fair value of an RSU or RSA is estimated as being the value of one common share in the company as determined by the 409A valuation in effect at the measurement date.

To accurately report compensation information to the IRS, companies must consider the vesting date when determining the fair market value of the underlying stock.

The company is responsible for reporting accurate compensation information to the IRS for awards and exercises on employees’ W-2 each year.

Here are the key valuation methods for RSUs and RSAs:

For RSAs, recipients recognize taxable income in the year of vesting, equal to the fair market value of the underlying stock on the vesting date.

Pulley's SBC tool does not yet support the impacts of modifications made to awards, so if modifications have been made, you'll need to consult with your accountant and/or auditor for adjustments.

Modifying equity awards after they're granted can trigger a new round of valuation and reporting exercises, as the company is responsible for determining the award value under its original terms and then its modified terms.

For tax purposes, the modification of an equity award is treated as a new option grant unless certain specific rules are met, which can result in unexpected tax consequences.

The modification of an equity award is treated as an exchange of assets at the modification date for financial reporting regulations, requiring another round of valuation and reporting exercises.

Pulley's SBC tool does not yet support award repricings. If repricings have occurred, please consult with your accountant and/or auditor for adjustments that may need to be made.

The tool provides comprehensive disclosure calculations required for financial statement footnotes. It generates applicable disclosures for stock options, RSAs, and RSUs for the specified expense period.

Disclosures shown in the report include the Weighted Average Exercise Price, Weighted Average Remaining Contractual Term, Aggregate Intrinsic Value, Weighted Average Grant Date Fair Value, and Fair value assumptions.

A roll forward schedule detailing grants, exercises, expirations, and forfeitures is also provided.

Pulley's SBC tool does not yet support the impacts of modifications made to awards, so if modifications have been made, you'll need to consult with your accountant and/or auditor for adjustments.

Modifying equity awards after they're granted can trigger a new round of valuation and reporting exercises, as the company is responsible for determining the award value under its modified terms.

For tax purposes, the modification of an equity award is treated as a new option grant unless specific rules are met, which can result in unexpected tax consequences for both the company and employees.

In general, financial reporting regulations treat modifications of equity awards as an exchange of assets at the modification date.