An employer may provide an employee with a nonrecourse cash loan collateralized by the employee’s shares in the employer. In this case, there is both an accounting and economic event that need to be reflected in the financial statements. As described in
SC 2.3.2, the cash received by the employee in exchange for the nonrecourse loan is treated as an option for accounting purposes. The employee no longer has downside risk on the shares below the loan balance and must pay off the loan–akin to exercising the option–to “reobtain” full rights to the shares. Thus, the employee has effectively received cash and an option in exchange for giving up the full rights to the shares that the employee previously owned “free and clear.”
While this transaction is not explicitly addressed in
ASC 718, we believe it is economically similar to the guidance for converting a full recourse note to a nonrecourse note. As described in
SC 2.3.1.4, such conversions should be accounted for as the repurchase of the shares previously held by the employee and the grant of a new award in exchange for a nonrecourse note. The repurchase should be accounted for as a treasury stock transaction, and the company should recognize compensation cost for any excess of the repurchase amount over the fair value of the shares.
In the case of issuing cash in return for a nonrecourse loan secured by shares, the consideration issued to the employee is the amount of the cash loan plus the fair value of the option represented by the nonrecourse loan.
Example SC 2-2 illustrates the accounting for cash loaned to an employee in return for a nonrecourse note.
EXAMPLE SC 2-2
Cash loaned to an employee in exchange for a nonrecourse note secured by shares
SC Corporation, a nonpublic company, loans its CEO $1,000,000 for personal use. The loan has a fixed annual interest rate, and principal and accrued interest are due in full in five years. The loan is secured only by 100,000 common shares of SC Corporation that the CEO acquired through a stock option exercise a year earlier. The loan provides no recourse to any other assets held by the CEO. The current fair value of the pledged shares is $1,500,000. During the term of the loan, the CEO is not permitted to sell or otherwise transfer the pledged shares.
How should SC Corporation account for the loan?
Analysis
Although the loan proceeds are not being used to exercise stock options or purchase stock, the nonrecourse nature of the loan secured by the shares pledged as collateral essentially provides the CEO with rights similar to that of a stock option (as described in
ASC 718-10-25-3). Similar to an option, the CEO could choose not to repay the loan and surrender the pledged shares or pay the loan in full and retain the rights to the shares. In other words, the CEO is protected from downside risk but retains unlimited upside potential (whereas prior to the transaction, the CEO was subject to both the upside and downside risk of share ownership). SC Corporation has effectively repurchased the pledged shares and issued the CEO an option to buy back the shares with a strike price equal to the loan principal plus accrued interest.
The repurchase should be accounted for as a treasury stock transaction, and SC Corporation should recognize compensation cost for any excess of the repurchase amount over the fair value of the shares pledged. The repurchase amount is the consideration exchanged for the pledged shares, which in this case is equal to the sum of the cash loaned and the fair value of the in-substance option to buy back the pledged shares. For purposes of this example, assume the company estimated the fair value of the option to be $800,000. The option is the right to buy back the pledged shares at an exercise price equal to the loan principal plus accrued interest. The expected term of the option would equal the term of the loan (considering prepayment terms, if applicable). SC Corporation would calculate total compensation cost as follows:
Fair value of pledged stock
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Total compensation cost to be recognized
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SC Corporation would recognize the compensation expense over the requisite service period, if any, which may differ from the term of the loan. Depending on the circumstances, there may not be a service period associated with the option, in which case compensation cost would be recognized immediately.
SC Corporation would record the following journal entries:
Cr. Additional paid-in capital
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To recorded issuance of the loan
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Cr. Additional paid-in capital
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To record compensation expense over the requisite service period associated with the arrangement, if any
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