Stock-Based Compensation: Equity vs. Liability Classification
Author: Andrea Mendlik
In today’s business environment, companies frequently use many different stock-based compensation awards and plan designs to incentivize and retain key executives and employees. Each type of award has advantages and disadvantages, including specific taxation treatment and sometimes difficult-to-understand accounting guidance, e.g., balance sheet classification of a stock-based compensation award.
Why should management care whether an award is classified as equity or liability?
The fair value (FV), or in certain situations, a calculated value or intrinsic value, of the award is measured at the award grant date, regardless of its classification. However, liability awards also must be remeasured at each reporting date using an appropriate valuation method until the award is settled. The changes to the value of the share-based awards are recorded in the income statement. Therefore, certain plan structures can result in significant charges to earnings and additional management estimates if not structured to achieve equity treatment.
How do companies avoid unwanted liability classification of their stock-based compensation?
By designing the award to exclude all of the liability classification criteria, companies can avoid unwanted classification. Awards that contain any of these five criteria should be classified as liabilities (certain exceptions not covered by this article exist):
1. Repurchase Feature
A share award should be classified as a liability if it allows an employee to avoid the risks and rewards of stock ownership, or if it’s probable the employer will prevent the employee from bearing the risks and rewards of stock ownership for at least six months after stock issuance. This includes providing the employee with a put right at FV within six months of the grant date or the right to put the award back to the company at a fixed redemption amount not based on the company’s stock price after six months. An employer’s right to call the award may require liability classification if the exercise of that call is assessed as probable. This determination would depend on the employer’s past practices, intentions or existence of any legal, regulatory or contractual limitations.
2. Cash Settlement
An option or similar instrument that could require the employer to pay an employee in cash or other assets may be classified as a liability. For example, cash-settled stock appreciation rights and phantom stock are classified as liabilities because the awards will be settled in cash. In general, if the employee can choose the form of settlement, the award should be classified as a liability; if the company has the choice of settlement and the ability to deliver shares, the award would be classified as equity. However, if a company technically has the choice of settling awards by issuing stock but past practice indicates predominant settlement in cash, the entity is settling a substantive liability, and liability classification would be required.
3. Certain Criteria of ASC 480
Although Accounting Standards Codification (ASC) 480 – Distinguishing Liabilities from Equity, excludes stock-based compensation from its scope, certain classification criteria can apply and can require liability classification. Unless ASC 718 – Compensation – Stock Compensation specifically provides for equity classification, the following awards generally should be accounted for as a liability:
- Mandatorily redeemable financial instruments (for companies and arrangements not under the indefinite deferral of ASC 480)
- Obligations to repurchase a company’s equity shares by transferring assets
- Certain obligations to issue a variable number of the company’s shares
4. Indexed to Nonmarket, Nonperformance or Nonservice Conditions
In addition to the entity’s share price, an award may be indexed to another factor (a dual-indexed award). If that factor isn’t a market, performance or service condition, the award should be accounted for as a liability. Examples include:
- An award of options whose exercise price is indexed to the market price of a commodity
- A share award that will vest based on the appreciation in the price of a commodity
- A stock option with an exercise price indexed to the Consumer Price Index
5. Underlying Stock Is a Liability
Options or similar instruments also are classified as liabilities if the underlying shares would be classified as liabilities. For example, if the underlying shares have repurchase features or are mandatorily redeemable, then the options on those shares also could be classified as a liability.
These criteria are a high-level summary of the complex accounting guidance underlying stock-based compensation awards. Contact your BKD advisor for more in-depth information before finalizing any award agreements or programs.