Preferred Stock

Preferred shareholders are owners who have certain rights superior to those of common shareholders. Preferences as to earnings exist when the preferred shareholders have a stipulated dividend rate (expressed either as a dollar amount or as a percentage of the preferred stock's par or stated value). Preferences as to assets exist when the preferred shares have a stipulated liquidation value. If a corporation were to liquidate, these preferred holders would be paid a specific amount before the common shareholders would have a right to participate in any of the proceeds.

In practice, preferred shares are more likely to have preferences as to earnings than as to assets. Although unusual, preferred shares may have both preferential rights. Preferred shares may also have the following optional features:

• participation in earnings beyond the stipulated dividend rate;
• the cumulative feature, ensuring that dividends in arrears, if any, will be fully satisfied before the common shareholders participate in any earnings distribution; and
• convertibility or callability by the corporation.

Preferences must be disclosed adequately in the financial statements, either on the face of the statement of financial position or in the notes thereto.

In exchange for the preferences, the preferred shareholders' other rights or privileges are often limited. For instance, the right to vote may be restricted to common shareholders. The most important right denied to the preferred shareholders, however, is the right to participate without limitation in the earnings of the corporation. Thus, if the corporation has exceedingly large earnings for a particular period, most of these earnings would accrue to the benefit of the common shareholders. This statement is true even if the preferred stock is participating (a fairly uncommon feature) because participating preferred stock usually has some upper limitation placed upon the extent of participation.

Occasionally, several classes of stock will be categorized as common (e.g., Class A common, Class B common, etc.). Since there can be only one class of shares that represents the true residual risk-taking ownership in a corporation, it is clear that the other classes, even though described as common shareholders, must in fact have some preferential status. Typically, these preferences relate to voting rights. An example of this situation arises when a formerly closely held corporation sells shares to the public but gives the publicly held shares a disproportionately small capacity to exercise influence over the entity, thereby keeping control in the hands of the former majority owners even as they are reduced to the status of minority owners. The rights and responsibilities of each class of shareholder, even if described as common, must be fully disclosed in the financial statements.

Issuance of Shares

The accounting for the sale of shares by a corporation depends upon whether the stock has a par or stated value. If there is a par or stated value, the amount of the proceeds representing the aggregate par or stated value is credited to the common or preferred stock account. The aggregate par or stated value is generally defined as legal capital not subject to distribution to shareholders. Proceeds in excess of par or stated value are credited to an additional paid-in capital account. The additional paid-in capital represents the amount in excess of the legal capital that may, under certain defined conditions, be distributed to shareholders.

A corporation selling stock below par value credits the capital stock account for the par value and debits an offsetting discount account for the difference between par value and the amount actually received. If the discount is on original issue capital stock, it serves to notify the actual and potential creditors of the contingent liability of those investors. As a practical matter, corporations avoid this problem by reducing par values to an arbitrarily low amount. This reduction in par eliminates the chance that shares would be sold for amounts below par.

Where the Model Business Corporation Act has been adopted or where corporation laws have been conformed to the guidelines of that Act, there is often no distinction made between par value and amounts in excess of par. In those jurisdictions, the entire proceeds from the sale of stock may be credited to the common stock account without distinction between the stock and the additional paid-in capital accounts. The following example illustrates these concepts:

Preferred stock will often be assigned a par value because in many cases the preferential dividend rate is defined as a percentage of par value (e.g., 10%, $25 par value preferred stock will have a required annual dividend of $2.50).

Stock Issued in Exchange for Property or Services

If the shares in a corporation are issued in exchange for services or property rather than for cash, the transaction should be reflected at the fair value of the property or services received. If this information is not readily available, then the transaction should be recorded at the fair value of the shares that were issued. Where necessary, appraisals should be obtained in order to properly reflect the transaction. As a final resort, a valuation of the stock issued can be made by the board of directors.

Stock Issued to Employees for Services

Stock issued to employees as compensation for services rendered should be accounted for at the fair value of the services performed, if determinable, or the value of the shares issued. If shares are given by a major shareholder directly to an employee for services performed for the entity, this exchange should be accounted for as a capital contribution to the company by the major shareholder and as compensation expense incurred by the company. Only when accounted for in this manner will there be conformity with the general principle that all costs incurred by an entity, including compensation, should be reflected in its financial statements.

Lump-Sum Sales

In certain instances, two or more classes of securities may be issued to investors as a unit (e.g., one share of preferred and two shares of common sold as a package). There are two methods of allocating the proceeds among the classes of stock:

• The proportional method, and
• The incremental method.

Where each of the classes of stock are publicly traded, the entity should use the proportional method. The proceeds from a unit offering should be allocated in proportion to the relative market values of the securities. If the entity cannot determine the fair value of all the classes of securities, then the incremental method should be used. The proceeds should be allocated to the securities that are publicly traded based on known fair value. Any excess is allocated to the other. Where the market value of neither security is known, appraisal information may be used. The imputed fair value of one class of security, particularly the preferred shares, can be based upon the stipulated dividend rate. In this case, the amount of proceeds remaining after the imputing of a value of the preferred shares would be allocated to the common stock.

Issuance Costs

Equity offerings generally involve the incurrence of various costs, such as legal and accounting fees and underwriting commissions. These are offset against the proceeds of the offering, generally reducing paid-in capital, which is thus reported net of costs. If a unit offering involves debt and equity, the offering costs should be allocated proportionally against equity and debt, possibly creating a discount on the debt issuance that will be amortized as additional interest expense in the usual manner. (See the chapter on ASC 470 for a full discussion of accounting for premium or discount on debt.)

Promise to Register

In certain situations, equity (or debt) is issued with a promise by the reporting entity to effect registration of the instruments by a defined date after issuance, or upon the occurrence of a contingent event. Per ASC 825-20, such obligations are recognized and measured consistent with the requirements of ASC 450, which does not alter the accounting for the associated financial instrument itself.

Dividends

Dividends are the pro rata distribution of earnings to the owners of the corporation. The amount and the allocation between the preferred and common shareholders is a function of:

• the stipulated preferential dividend rate;
• the presence or absence of:
  • a participation feature,
  • a cumulative feature, and
  • arrearages on the preferred stock; and
• the wishes of the board of directors. Dividends, even preferred stock dividends, where a cumulative feature exists, do not accrue.

Dividends only become a liability of the corporation when declared by the board of directors.

Traditionally, corporations were not allowed to declare dividends in excess of the amount of retained earnings. Alternatively, a corporation could pay dividends out of retained earnings and additional paid-in capital but could not exceed the total of these categories (i.e., they could not impair legal capital by the payment of dividends). States that have adopted the Model Business Corporation Act grant more latitude to the directors. Corporations can now, in certain jurisdictions, declare and pay dividends in excess of the book amount of retained earnings if the directors conclude that, after the payment of such dividends, the fair value of the corporation's net assets will still be a positive amount. Thus, directors can declare dividends out of unrealized appreciation that, in certain industries, can be a significant source of dividends beyond the realized and recognized accumulated earnings of the corporation. This action, however, represents a major departure from traditional practice and demands both careful consideration and adequate disclosure.

Three important dividend dates are:

1. The declaration date, when a legal liability is incurred by the corporation
2. The record date, the point in time when a determination is made as to which specific registered stockholders will receive dividends and in what amounts
3. The payment date, to the date when the distribution of the dividend takes place.

These concepts are illustrated in the following example:

If a dividends account is used, it is closed to retained earnings at year-end.

Occasionally, what appear to be disproportionate dividend distributions are paid to some, but not all, of the owners of closely held corporations. Such transactions need to be carefully analyzed. In some cases these may actually represent compensation paid to the recipients. In other instances, these may be a true dividend paid to all shareholders on a pro rata basis, to which certain shareholders have waived their rights. If the former, the distribution should not be accounted for as a dividend. It should be accounted for as compensation or some other expense category and included on the income statement. If the latter, the dividend should be “grossed up” to reflect payment on a proportional basis to all the shareholders, with an offsetting capital contribution to the company recognized as having been effectively made by those to whom payments were not made.

Dividends may be made in the form of cash, property, or scrip:

• Cash dividends are either a given dollar amount per share or a percentage of par or stated value.
• Property dividends consist of the distribution of any assets other than cash (e.g., inventory or equipment).
• Scrip dividends are promissory notes due at some time in the future, sometimes bearing interest until final payment is made.

Property Dividends

If property dividends are declared, the paying corporation may incur a gain or loss. Since the dividend should be reflected at the fair value of the assets distributed, the difference between fair value and book value is recorded at the time the dividend is declared and charged or credited to a loss or gain account.

Scrip Dividends

If a corporation declares a dividend payable in scrip that is interest bearing, the interest is accrued over time as a periodic expense. The interest is not a part of the dividend itself.

Liquidating Dividends

Liquidating dividends are not distributions of earnings, but rather a return of capital to the investing shareholders. A liquidating dividend is normally recorded by the declarer through charging additional paid-in capital rather than retained earnings. The exact accounting for a liquidating dividend is affected by the laws of the states where the business is incorporated.

Stock Dividends

Stock dividends represent neither an actual distribution of the assets of the corporation nor a promise to distribute those assets. For this reason, a stock dividend is not considered a legal liability or a taxable transaction.

Despite the recognition that a stock dividend is not a distribution of earnings, the accounting treatment of relatively insignificant stock dividends (defined as being less than 20% to 25% of the outstanding shares prior to declaration) is consistent with it being a real dividend. (ASC 505-20-25-3) Accordingly, retained earnings are debited for the fair market value of the shares to be paid as a dividend, and the capital stock and additional paid-in capital accounts are credited for the appropriate amounts based upon the par or stated value of the shares, if any. A stock dividend declared but not yet paid is classified as such in the stockholders' equity section of the statement of financial position. Because a stock dividend never reduces assets, it cannot be a liability.

The selection of 20% to 25% as the threshold for recognizing a stock dividend as an earnings distribution is arbitrary, but it is based somewhat on the empirical evidence that small stock dividends tend not to result in a reduced market price per share for outstanding shares. The aggregate value of the outstanding shares should not change, but the greater number of shares outstanding after the stock dividend should necessitate a lower per share price. As noted, however, the declaration of small stock dividends tends not to have this impact, and this phenomenon supports the accounting treatment.

Stock Splits

On the other hand, when stock dividends are larger in magnitude, it is observed that per-share market value declines after the declaration of the dividend. (ASC 505-20-25-2) In such situations, it would not be valid to treat the stock dividend as an earnings distribution. Rather, logic suggests that it should be accounted for as a split. The precise treatment depends upon the legal requirements of the state of incorporation and upon whether the existing par value or stated value is reduced concurrent with the stock split.

If the par value is not reduced for a large stock dividend and if state law requires that earnings be capitalized in an amount equal to the aggregate of the par value of the stock dividend declared, the event should be described as a stock split effected in the form of a dividend, with a charge to retained earnings and a credit to the common stock account for the aggregate par or stated value. (ASC 505-20-25-3) When the par or stated value is reduced in recognition of the split and state laws do not require treatment as a dividend, there is no formal entry to record the split but merely a notation that the number of shares outstanding has increased and the per share par or stated value has decreased accordingly. (ASC 505-20-25-6) It should be noted that many companies account for stock splits as if they were a large stock dividend. By doing this, par value per share remains unchanged. The concepts of small versus large stock dividends are illustrated in the following examples.

Distributions to Shareholders having Cash and Stock Components

If a corporation makes a distribution to shareholders that allows them to elect to receive their distribution in either cash or shares of an equivalent value, and there is a limitation on the total amount of cash that shareholders can receive, then the stock portion of the distribution is considered a share issuance, not a stock dividend.

Cost Method

Under the cost method, the gross cost of the shares reacquired is charged to a contra equity account (treasury stock). The equity accounts that were credited for the original share issuance (common stock, paid-in capital in excess of par, etc.) remain intact. When the treasury shares are reissued, proceeds in excess of cost are credited to a paid-in capital account. Any deficiency is charged to retained earnings (unless paid-in capital from previous treasury share transactions exists, in which case the deficiency is charged to that account, with any excess charged to retained earnings). If many treasury stock purchases are made, a cost flow assumption (e.g., first-in, first-out [FIFO] or specific identification) should be adopted to compute excesses and deficiencies upon subsequent share reissuances. The advantage of the cost method is that it avoids identifying and accounting for amounts related to the original issuance of the shares and is, therefore, the simpler, more frequently used method.

The cost method is most consistent with the one-transaction concept. This concept takes the view that the classification of stockholders' equity should not be affected simply because the corporation was the middle “person” in an exchange of shares from one stockholder to another. In substance, there is only a transfer of shares between two stockholders. Since the original balances in the equity accounts are left undisturbed, the cost method is most acceptable when the firm acquires its stock for reasons other than its retirement, or when its ultimate disposition has not yet been decided.

Par Value Method

Under the par value method, the treasury stock account is charged only for the aggregate par (or stated) value of the shares reacquired. Other paid-in capital accounts (excess over par value, etc.) are relieved in proportion to the amounts recognized upon the original issuance of the shares. The treasury share acquisition is treated almost as a retirement. However, the common (or preferred) stock account continues at the original amount, thereby preserving the distinction between an actual retirement and a treasury share transaction.

When the treasury shares accounted for by the par value method are subsequently resold, the excess of the sale price over par value is credited to paid-in capital. A reissuance for a price below par value does not create a contingent liability for the purchaser. It is only the original purchaser who risks this obligation to the entity's creditors.

Constructive Retirement Method

The constructive retirement method is similar to the par value method, except that the aggregate par (or stated) value of the reacquired shares is charged to the stock account rather than to the treasury stock account. This method is superior when:

1. it is management's intention not to reissue the shares within a reasonable time period or
2. the state of incorporation defines reacquired shares as having been retired.

In the latter case, the constructive retirement method is probably the only method of accounting for treasury shares that is not inconsistent with the state Business Corporation Act, even if the state law does not necessarily dictate such accounting. Certain states require that treasury stock be accounted for by this method.

The two-transaction concept is most consistent with the par value and constructive retirement methods. First, the reacquisition of the firm's shares is viewed as constituting a contraction of its capital structure. Second, the reissuance of the shares is the same as issuing new shares. There is little difference between the purchase and subsequent reissuance of treasury shares and the acquisition and retirement of previously issued shares and the issuance of new shares.

Treasury shares originally accounted for by the cost method can subsequently be restated to conform to the constructive retirement method. If shares were acquired with the intention that they would be reissued and it is later determined that such reissuance is unlikely (due, for example, to the expiration of stock options without their exercise), then it is proper to restate the transaction.

Alternatively, under the par or constructive retirement methods, any portion of or the entire deficiency on the treasury stock acquisition may be debited to retained earnings without allocation to paid-in capital. Any excesses will always be credited to an “Additional paid-in capital—retired stock” account.

The laws of some states govern the circumstances under which a corporation may acquire treasury stock and may prescribe the accounting for the stock. For example, a charge to retained earnings may be required in an amount equal to the treasury stock's total cost. In such cases, the accounting per the state law prevails. Also, some states (including those that have adopted the Model Business Corporation Act) define excess purchase cost of reacquired (i.e., treasury) shares as being “distributions” to shareholders that are no different in nature than dividends. In such cases, the financial statement presentation should adequately disclose the substance of these transactions (e.g., by presenting both dividends and excess reacquisition costs together in the retained earnings statement).

When a firm decides to formally retire the treasury stock, the journal entry is dependent on the method used to account for the stock.

If the constructive retirement method was used to record the treasury stock purchase, no additional entry would be necessary upon the formal retirement of the shares.

After the entry is made, the pro rata portion of all paid-in capital existing for that issue (i.e., capital stock and additional paid-in capital) will have been eliminated. If stock is purchased for immediate retirement (i.e., not put into the treasury) the entry to record the retirement is the same as that made under the constructive retirement method.

In some circumstances, shares held by current stockholders may be donated back to the reporting entity, possibly to facilitate a resale to new owners who will infuse needed capital into the business. In accounting for donated treasury stock, the intentions of management regarding these reacquired shares is key; if these are to simply be retired, the common stock account should be debited for the par or stated value (if par or stated value stock) or the original proceeds received (if no-par, no-stated-value stock). The current fair value of the shares should be credited to the “donated capital” account, and the difference should be debited or credited to a suitably titled paid-in capital account, such as “additional paid-in capital from share donations.”

If the donated shares are to be sold (the normal scenario), variations on the par and cost methods of treasury stock accounting can be employed, with “donated capital” being debited and credited, respectively, when shares are received and later reissued, instead of the “treasury stock” account employed in the above illustrations. Note, however, that if the cost method is used, the debit to the donated capital account should be for the fair value of the shares, not the cost (a seeming contradiction). If the constructive retirement method is utilized instead, only a memorandum entry will be recorded when the shares are received; when reissued, the entire proceeds should be credited to “donated capital.”

Takeover Defense as Cost of Treasury Stock

In certain instances an entity may incur costs to defend against an unwelcome or hostile attempted takeover. In some cases, in fact, putative acquirers will threaten a takeover struggle in order to extract so-called greenmail from the target entity, often effected through a buyback of shares held by the acquirer at a premium over market value. ASC 505-30-30-3 states that the excess purchase price of treasury shares should not be attributed to the shares, but rather should be attributed to the other elements of the transaction and accounted for according to their substance, which could include the receipt of stated or unstated rights, privileges, or agreements. The SEC's position is that such excess is anything over the quoted market price of the treasury shares.

Accelerated Share Repurchase Programs

Accelerated share repurchase programs are combinations of transactions that permit an entity to purchase a targeted number of shares immediately, with the final purchase price determined by an average market price over fixed periods of time. Such programs are intended to combine the immediate share retirement benefits (boosting earnings per share, etc.) of tender offers with the market impacts and pricing benefits of disciplined open market stock repurchase programs. (ASC 505-30-25-5)

The ASC states that an entity should account for an accelerated share repurchase program as two separate transactions:

• first, as shares of common stock acquired in a treasury stock transaction recorded on the acquisition date, and
• second, as a forward contract indexed to its own common stock.

  (ASC 505-30-25-6)

An entity would classify the forward contract in the above example as an equity instrument because the entity will receive cash when the contract is in a gain position but pay cash or stock when the contract is in a loss position. Changes in the fair value of the forward contract would not be recorded, and the settlement of the forward contract would be recorded in equity.

The treasury stock transaction would result in an immediate reduction of the outstanding shares used to calculate the weighted-average common shares outstanding for both basic and diluted (EPS). The effect of the forward contract on diluted EPS would be calculated in accordance with ASC 260.

Own-Share Lending Arrangements Related to Convertible Debt Financing

An entity may enter into a share-lending arrangement with an investment bank that is related to a convertible debt offering. (ASC 470-20-05) See the Chapter on ASC 470 for more information.

Measurement Date

For purposes of ascertaining the amounts to be assigned for these transactions, the key concern is the determination of the measurement date. Essentially, the amount of expense or the value of the asset acquired through the issuance of equity instruments is fixed as of the measurement date, although, under certain circumstances as explained below, some subsequent adjustments may need to be made.

Per ASC 505-50, the measurement date will be the earlier of the date at which a commitment for performance is made or when the performance is actually completed. Whether or not there has been a “performance commitment” by the party providing the goods or services is a question of fact and must be determined from the surrounding circumstances, but in general will be deemed to exist if there is a “sufficiently large disincentive for nonperformance” to make performance probable. This disincentive must derive from the relationship between the equity instrument issuer/recipient of the goods or services and its counterparty. Mere risk of forfeiture is not enough to qualify as a disincentive, nor is the risk of being sued for nonperformance. (ASC 505-50-30-12) When a sufficiently large disincentive exists, however, the measurement date will precede the completion of performance and, accordingly, when accrual of the related expense or recognition of the asset would otherwise be required under GAAP, it will be necessary to include the value of the equity instruments in such cost.

For example, if the agreed-upon price for the construction of a new power plant includes options on the utility company's stock, subject to a completion date of no longer than three years hence, and the contract also contains substantial financial disincentives to late completion, such as a provision for liquidated damages, then it would be concluded that there was a performance commitment within the meaning of ASC 505-50. On the other hand, if the price agreed to were to be fully payable even in the event of late delivery, there would be no “performance commitment” as that term is used.

In many situations in which the compensation includes significant equity instrument components, there will still be no finding of a performance commitment because the payment arrangement provides for phases of work, with payment in full for work as it is completed. For example, if a contractor agrees to build a multiplicity of sales kiosks in various air terminals for a retailing chain, with payment to be made in cash and the retailer's stock upon the completion of each kiosk, the contractor could terminate the arrangement after any intermediate completion date without significant penalty. In such cases, the measurement date would be, for each subproject, the date on which the work is completed.

When to Recognize the Fair Value of the Equity Instruments

In general, the normal rules of GAAP would apply in circumstances in which stock or other equity instruments were being granted as part, or all, of the consideration for the transaction. Thus, if the services provided represented an expense of the enterprise, the expense should be recognized when incurred, which could well precede the date on which the payment was ultimately to be made.

An expense or asset measurement is made with the best information available at that time, and there is no “look back” based on subsequent events; the value assigned to the option would be credited to an appropriate paid-in capital account (e.g., “capital from expired options”) if this becomes necessary.

Accounting Prior to Measurement Date

If, under GAAP, it is necessary for the entity to recognize an expense or an asset related to the transaction involving the issuance of equity for goods or services prior to the measurement date, the then-current fair values of the equity instruments must be utilized to determine these amounts. If fair values change later, these variations are attributed to those later periods. Thus, for a transaction which calls primarily for cash payment but also, to a lesser extent, for the issuance of stock, a decline in the value of the equity portion in a later interim period would reduce the cost (or asset value) to be recognized in that period; if the stock portion is a significant component, a decline could largely eliminate the cost otherwise to be accrued or even, conceivably, cause it to become negative in a later reporting period. Of course, overall, the aggregate cost would be positive upon ultimate completion (at worst it could be zero, if the transaction were predicated only on the issuance of equity instruments, and these became worthless—an obviously unlikely scenario).

Measurement of Fair Value of the Equity Instrument Portion of the Transaction When Certain Terms are not Known at Inception

In some circumstances where there is a performance commitment there will also be a material uncertainty regarding the valuation of the equity instruments, either because of some question regarding the number of instruments to be delivered, the value of such instruments, or some factor dependent upon the performance of the party providing the service. For example, the arrangement may include a guarantee of the value of the instrument extending for some period subsequent to completion of performance that unless the underlying shares maintain a market price of $15 or greater for one year following delivery, or else a defined number of additional shares will be granted. This type of arrangement is referred to as a “market condition.” In other circumstances, there may be a condition based on the counterparty's performance—for example, when options are granted to a tax accountant structuring a tax shelter, in which the number of options ultimately deliverable depends upon successfully surviving an IRS audit. Situations such as this are denoted “counterparty performance conditions.”

Where the arrangement contains a market condition, measurement of the equity instrument portion of the contracted price should be based on two elements:

• the first is the fair value of the basic equity instrument;
• the second is the fair value of the contingent commitment, such as the aforementioned promise to grant a specified number of extra shares if the market price falls below $15 during the one-year period.

In practice, the valuation of these contingencies might prove to be challenging, but clearly any such promise has some positive value, and the standard requires that this be assessed. Changes in the value of the second (contingent) element subsequent to the performance commitment date would not be recognized since, per ASC 815, a derivative financial instrument to be settled in a company's own shares (as contrasted to a settlement in cash) is not to be remeasured.

Compared to a market condition, measurement when there are counterparty performance conditions is more complicated. At the measurement date, the equity instruments are valued at the lowest of the defined alternative amounts. For example, if the value of the option award to the tax accountant noted above is $20,000 (at the performance commitment date) assuming survival against IRS challenge, but only $5,000 if the IRS ultimately prevails, then the measurement of the value of the service would be based on the $5,000 amount. However, later, when the outcome of the performance condition is known, an additional cost would have to be recognized if a more favorable outcome occurred (in this example, successful defense of the tax shelter). The added cost would be based not on the values as of the performance commitment date, but rather as of the date of resolution of the condition. If the value of the options under the “success” outcome is $28,000 at that date, and the value of the “failure” outcome is $19,000, then an added cost of ($28,000 – 19,000 =) $9,000 would be recognized.

Where a given transaction involves both market and counterparty performance conditions, the accounting specified for situations involving only counterparty performance conditions is to be applied.

Reporting Prior to the Measurement Date When Certain Terms are not Known

When market conditions (e.g., the value of the stock underlying the options two years hence) are not known, and expenses must be accrued or assets recorded prior to the measurement date, the then-current fair values of the equity instruments at such dates should be used, with subsequent adjustments as necessary. When there are counterparty performance conditions, either alone or in conjunction with market conditions, then interim measurements should be based on the lowest of the alternative values as of each date, with subsequent changes in this same measure assigned to later periods.

Reporting After the Measurement Date When Certain Terms are not Known

When market conditions (e.g., the value of the stock underlying the options two years hence) are not known, after the measurement date the principles of ASC 815 are to be applied, which generally would mean that changes in value would not be recognized. On the other hand, when there are counterparty performance conditions, with or without market conditions also being present, modification accounting procedures are to be utilized. This results in reporting an adjustment in subsequent periods determined with reference to the difference between the then-current fair value of the revised equity instruments and that of the old instruments immediately prior to the recognition event. In all cases, the “then-current” values are to be determined with reference to the lowest aggregate fair values under the alternative outcomes specified by the contractual arrangement. (ASC 505-50-35-22)

Further Guidance

Where fully vested, exercisable, nonforfeitable equity instruments are issued at the date the grantor and grantee enter into an agreement, by eliminating any obligation on the part of the counterparty to earn the equity instruments, a measurement date has been reached. The grantor should recognize the equity instruments when they are issued (in most cases, when the agreement is entered into). Whether the corresponding cost is an immediate expense or a prepaid asset (or whether the debit should be characterized as contra equity) depends on the specific facts and circumstances.

If an entity grants fully vested, nonforfeitable equity instruments that are exercisable by the grantee only after a specified period of time, and the terms of the agreement provide for earlier exercisability by the grantee only after a specified period of time, and the terms of the agreement provide for earlier exercisability if the grantee achieves specified performance conditions, the grantor should measure the fair value of the equity instruments at the date of grant and should recognize that measured cost under the same guidance as the foregoing. If, subsequent to the arrangement date, the grantee performs as specified and exercisability is accelerated, the grantor should measure and account for the increase in the fair value of the equity instruments resulting from the acceleration of exercisability using modification accounting. Since, generally, option-pricing models are not sensitive to exercisability restrictions, it may be necessary to provide additional guidance on how to measure the discount attributable to the exercisability restriction.

For transactions that include a grantee performance commitment, the grantee should account for the arrangement as an executory contract (that is, generally no accounting before performance) in the same manner as it would if the grantor had agreed to pay cash (upon vesting) for the goods or services. Further consideration will be directed to the accounting in cases in which the fair value at the date the equity instruments are earned is greater than or less than the fair value measured at the performance commitment date (measurement date).

Consideration for Future Services

ASC 505-50 discusses the appropriate statement of financial position presentation of arrangements where unvested, forfeitable equity instruments are issued to an unrelated nonemployee (the counterparty) as consideration for future services. SEC staff has since addressed situations where the grantor is entitled to recover the specific consideration paid, plus a substantial mandatory penalty, as a minimum measure of damages for counterparty nonperformance. Fair value measurement under ASC 718 is required. In practice, however, some reporting entities have made no entries until performance occurs, while others have recorded the fair value of the equity instruments as equity at the measurement date and record the offset either as an asset (future services receivable) or as a reduction of stockholders' equity (contra equity).

The SEC staff believes that if the issuer receives a right to receive future services in exchange for unvested, forfeitable equity instruments, those equity instruments should be treated as unissued for accounting purposes until the future services are received (that is, the instruments are not considered issued until they vest). Consequently, there would be no recognition at the measurement date and no entry should be recorded. This does not apply to similar arrangements in which the issuer exchanges fully vested nonforfeitable equity instruments, as those types of arrangements are addressed in ASC 505-50.

Spin-Offs

One method that is used as a means of reorganizing an entity's operations is through the use of a spin-off. This can involve the transfer of assets that constitute a business, by their holder referred to as the spinnor, into a new legal entity (spinnee), the shares of which are distributed to the spinnor's shareholders. The distribution is nonreciprocal in that the shareholders of the spinnor are not required to surrender any of their stock in the spinnor in exchange for the shares of the spinnee. (ASC 505-60-05-2)

Besides facilitating a reorganization of the reporting entity, a spin-off may also qualify as a nontaxable reorganization with the distribution not being treated as a taxable gain by the spinnor or its shareholders. In addition, if the spinnee stock is subsequently sold by the shareholders, they avoid the effect of the double taxation that would occur if the company sold the company directly and distributed the net proceeds to the stockholders in a taxable cash dividend. (ASC 505-60-05-3)

The accounting rules governing spin-offs and reverse spin-offs are found in ASC 505-60 and ASC 845-10-30.

In accordance with ASC 505-60-25-2, the distribution of shares of a wholly owned or consolidated subsidiary that constitutes a business to an entity's shareholders is to be recorded based on the carrying value of the subsidiary. Irrespective of whether the spun-off operations are to be sold immediately following the spin-off, management is not to account for the transaction as a sale of the spinnee followed by a distribution of the proceeds.

Further, in accordance with ASC 845-10-30-10, a pro rata distribution to owners of an entity of shares of a subsidiary or other investee entity that has been or is being consolidated or accounted for under the equity method is to be considered the equivalent of a spin-off.

Reverse Spin-Offs

Under certain circumstances, a spun-off subsidiary/spinnee will function as the continuing entity post-spin-off. When the spin-off of a subsidiary is structured in such a way that the legal form of the transaction does not represent its economic substance, this will be accounted for as a reverse spin-off whereby the legal spinnee is treated as if it were the spinnor for financial reporting purposes. (ASC 505-60-05-4)

The determination of whether reverse spin-off accounting is appropriate is a matter of professional judgment that depends on a careful analysis of all relevant facts and circumstances. ASC 505-60-25-8 provides indicators to be considered in determining whether a spin-off should be accounted for as a reverse spin-off. No one indicator is to be considered presumptive or determinative:

1. The relative sizes of the legal spinnor and the legal spinnee. If all other factors are equal, in a reverse spin-off, the legal spinnee/accounting spinnor is larger than the legal spinnor/accounting spinnee. This comparison is to be based on assets, revenues, and earnings of the two entities with no established bright lines that should be applied.
2. The relative fair value of the legal spinnor and the legal spinnee. All other factors being equal, in a reverse spin-off, the fair value of the legal spinnee/accounting spinnor is greater than the fair value of the legal spinnor/accounting spinnee.
3. Retention of the majority of senior management. All other factors being equal, in a reverse spin-off, the legal spinnee retains the senior management of the formerly consolidated entity. Senior management is generally understood to include the chairman of the board of directors, chief executive officer, chief operating officer, chief financial officer, the divisional heads that report directly to them, or the executive committee, if applicable.
4. Length of holding period. All other factors being equal, in a reverse spin-off, the legal spinnee is held for a longer period than the legal spinnor. A proposed or approved plan of sale for one of the separate entities concurrent with the spin-off transaction may assist in the identification of the entity to be sold as the spinnee for accounting purposes.

The determination of the accounting spinnor and spinnee, respectively, has significant implications. In a spin-off, the net book value of the spinnee is treated, in effect, as a dividend distribution to the shareholders of the spinnor. Since the net book value of these entities will differ from each other, the amount of the reduction to retained earnings of the surviving reporting entity (the accounting spinnor) will be affected by this determination. ASC 505-60 offers several examples of fact patterns which support spin-off or reverse spin-off determinations.

Finally, the accounting for a reverse spin-off is further complicated by the fact that the determination of the accounting spinnor and spinnee significantly affects the reporting of discontinued operations in accordance with ASC 360. The accounting spinnee is reported as a discontinued operation by the accounting spinnor if the spinnee is a component of an entity and meets the conditions for such reporting contained in ASC 360.