Deep Dive into ASU 2021-07: Private Company Practical Expedient Alternative for Equity Classified Awards
Accounting Standards Update 2021-07 Determining the Current Price of an Underlying Share for Equity-Classified Share-Based Awards was issued to address concerns raised by stakeholders about the cost and complexity of determining the fair value of equity classified share awards for private companies. The guidance provides nonpublic entities with a practical expedient alternative to use a reasonable application of a reasonable valuation method as the current share price input when determining the fair value of equity classified share awards on grant or modification of the awards. ASU 2021-07 was issued with an effective date of year-end beginning after December 15, 2021, and interim periods for year-end beginning after December 15, 2022, with early adoption for interim periods allowed.
Before ASU 2021-07, the guidance in ASC 718 required an entity to account for the compensation cost from share-based payment transactions in accordance with a fair-value-based method. Private Company stakeholders, through the Private Company Council, raised concerns about the complexity and costs involved in determining the fair value of private company share-option awards at the grant date or upon a modification to an award. Most private companies use the Black-Scholes valuation model for the valuation of share awards whose inputs include the exercise price, expected term, expected volatility, expected dividends, risk-free rate, and current share price. Private companies indicated that the current share price can be costly and complex to estimate because there is no active market for most private company shares. Under 2021-07 practical expediency, private companies may use a recent Treasury Regulations section 409A valuation from within the last 12 months or other reasonable valuation methods to value equity classified share awards on grant date or modification date.
Criteria for Determining Reasonable Application of a Reasonable Valuation Method
The determination of whether a valuation method is reasonable or whether an application of a valuation method is reasonable shall be made based on the facts and circumstances as of the measurement date. As outlined in ASU 2021-07, factors to be considered under a reasonable valuation method include, as applicable:
- The value of tangible and intangible assets of the nonpublic entity;
- The present value of anticipated future cash flows of the nonpublic entity;
- The market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the nonpublic entity for which the stock is to be valued, the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm’s-length private transaction);
- Recent arm’s-length transactions involving the sale or transfer of stock or equity interests of the nonpublic entity;
- Other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the nonpublic entity, its stockholders, or its creditors; and
- The nonpublic entity’s consistent use of a valuation method to determine the value of its stock or assets for other purposes, including for purposes unrelated to compensation of service providers.
ASC 718-10-30-20E states that for the valuation method to be reasonable, it must consider all available information material to the value of the nonpublic entity.
ASC 718-10-30-20F states that the use of a value previously calculated under a valuation method is not reasonable as of a later date if the calculation is not updated to reflect material information available after the date of the calculation and the valuation was performed more than 12 months earlier.
Examples of Reasonable Application of Reasonable Valuation Methods
Valuations performed in accordance with the Treasury Regulations section 409A are examples of reasonable valuation methods mentioned in ASU 2021-07.
Under the Treasury Regulations, the two primary ways in which an entity may that the fair value of a share underlying a share-option award was determined using a reasonable application of a reasonable valuation method are by (a) considering certain facts and circumstances as of the valuation date (the “facts and circumstances method”) or (b) meeting a rebuttable presumption of reasonableness.
The facts and circumstances method identifies the characteristics of the reasonable application of a reasonable valuation as being related to:
- The date on which a valuation’s reasonableness is evaluated;
- The factors that a reasonable valuation should consider;
- The scope of information that a reasonable valuation should consider; and
- The criteria that should be met for the use of a previously calculated value to be considered reasonable.
Three methods are acceptable under the rebuttable presumption of reasonableness requirements of the Treasury Regulations to determine the fair market value of a share and, as a result, are examples of ways to achieve the practical expedient:
- A valuation determined by an independent appraisal within the 12 months preceding the grant date.
- A valuation based on a formula that, if used as part of a non-lapse restriction with respect to the share, would be considered the fair market value of the share.
- A valuation made reasonably and in good faith and evidenced by a written report that considers the relevant factors of the illiquid stock of a start-up corporation (as defined in the Treasury Regulations).
Application to Share-Based Awards
When elected, the nonpublic entity shall apply the practical expedient alternative on a measurement date by measurement date basis to all share-based awards within the scope of the practical expedient having the same underlying share and the same measurement date.
Audit Considerations
The requirements relating to auditing of accounting estimates in AU-C Section 540 have not changed and are applicable to the audit of the valuation methods used by private companies under the practical expediency in ASU 2021-07. There is no reduction in the audit effort, audit costs and level of audit evidence required when evaluating the valuation methods used based on the practical expediency. The evaluation, as of the valuation date, of whether the derived amount represents a reasonable application of a reasonable valuation method remains a core auditor responsibility.
Impact on Nonpublic Companies Going Public
The practical expediency does not provide transition guidance on nonpublic companies that elected the practical expediency but are going public. These companies would have to reserve the impact of the practical expediency on the financial statements and record the impact based on the approach required for public companies. Therefore, nonpublic companies planning to go public in the foreseeable future might have to weigh the cost and benefits of the practical expediency to the cost of reversing and recording the impact on the financial statements.
Author: Godswill Mhlanga | [email protected]