Stock-based compensation has become a prevalent method for private equity firms to attract and retain top talent. This form of compensation aligns the interests of employees with those of the firm by providing them with equity interests. However, the complexity of stock-based compensation necessitates rigorous auditing to ensure accuracy and compliance.
Stock-Based Compensation in Private Equity
Private equity firms often use stock-based compensation to incentivize employees, particularly executives and key management personnel. This compensation can take various forms, including stock options, restricted stock units (RSUs) and performance shares. The primary goal is to align employees’ interests with those of the firm, encouraging them to work towards increasing the firm’s value.
- Stock Options: These give employees the right to purchase shares at a predetermined price, known as the exercise price. If the firm's value increases, employees can buy shares at the lower exercise price and sell them at the higher market price, realizing a profit.
- Restricted Stock Units (RSUs): RSUs are shares granted to employees, subject to vesting conditions. Once vested, employees own the shares outright. This form of compensation is often used to retain employees over a longer period.
- Performance Shares: These are shares granted based on the achievement of specific performance targets. They align compensation with the firm's performance, rewarding employees for meeting or exceeding goals.
Fair Value Considerations
ASC 718, titled Compensation—Stock Compensation, is the U.S. GAAP standard that governs the accounting for share-based payment transactions, including stock-based compensation to employees and nonemployees. Key topics include:
- Measurement: Awards are measured at fair value on the grant date. Fair value is typically determined using models like Black-Scholes for options or Monte Carlo simulations for options and performance-based awards.
- Expense Recognition: Compensation cost is recognized over the requisite service period (usually the vesting period). If performance conditions are involved such as a change of control event, expense is recognized only if and when it’s probable the condition will be met.
- Amendments to Awards: Modifications (e.g., repricing, extending terms) may result in incremental fair value, which must be accounted for based on the type of amendment:
- Type I: Probable-to-Probable - The award was expected to vest before the modification and continues to be expected to vest afterward.
- Accounting impact: Recognize the original grant-date fair value plus any incremental fair value resulting from the modification (e.g., repricing or extending the term).
- Type II: Probable-to-Improbable -The award was expected to vest before the modification, but after the change, it is no longer expected to vest.
- Accounting impact: Recognize compensation cost equal to the original grant-date fair value, even if the modified condition is not met, as long as the original condition was expected to be met.
- Type III: Improbable-to-Probable - The award was not expected to vest before the modification but is now expected to vest.
- Accounting impact: Recognize full compensation cost, including both the original grant-date fair value and any incremental fair value. The cumulative compensation cost recognized for the original award should be zero prior to the modification as the award was not expected to vest. As such, the incremental fair value is equal to the fair value of the modified award.
- Type IV: Improbable-to-Improbable - The award was not expected to vest before or after the modification.
- Accounting impact: Recognize incremental fair value only if the award ultimately vests under the modified conditions.
- Type I: Probable-to-Probable - The award was expected to vest before the modification and continues to be expected to vest afterward.
Preparing for Your Annual Financial Statement Audit
Auditing stock-based compensation is a complex process that requires management to have a thorough understanding of the types of awards granted to employees and retain underlying contracts in an organized fashion. As part of the financial statement audit process, your auditor will aim to ensure that stock-based compensation calculations and disclosures are accurate and comply with applicable accounting standards by doing the following:
- Reviewing Agreements: Document retention is key. An audit firm will start by reviewing underlying contracts for key terms such as vesting conditions and the number of units granted. It’s recommended that management maintain all documents associated with stock-based compensation in a centrally located finance folder. A lack of easily accessible agreements, including amendments, can lead to audit delays.
- Valuation and Measurement: CPAs are responsible for verifying the valuation models used to estimate the fair value of stock options and other equity instruments. They must ensure that these models are applied correctly and consistently. It is common for management to retain a valuation specialist to perform a 409a valuation, which determines the fair value of the share included in the award.
- Reviewing Vesting Conditions: CPAs must review the vesting conditions for options, RSUs and performance shares to ensure that the appropriate expense is accurately recorded in the financial statements. Management should be cognizant of awards that contain both probable and improbable vesting conditions and evaluate accordingly.
- Financial Statement Disclosures: CPAs must ensure that the firm provides adequate disclosures related to stock-based compensation. This includes but is not limited to the number of options outstanding at the beginning and end of periods presented, the number of options granted and forfeited in the periods presented, expected volatility, expected term, risk-free rate and intrinsic value.
Stock-based compensation is a powerful tool for private equity firms to attract and retain top talent. However, its complexity requires an in-depth understanding of valuation techniques and US GAAP accounting treatment. CPAs play a crucial role in this process, ensuring that financial statements accurately reflect stock-based compensation and adhere to relevant accounting standards. Management’s knowledge of valuation techniques, measurement and disclosure requirements is essential for maintaining complete and accurate financial reporting.
Author: Michael Tiplady, CPA | [email protected]
Contact Us
For more information on this topic, reach out to Withum’s Private Equity Portfolio Services Team.
