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2.3 Recourse and nonrecourse notes to purchase stock
Publication date: 14 Sep 2023
us Stock-based compensation guide 2.3
Entities may allow employees to purchase stock or exercise stock options in exchange for a note payable to the company. The accounting for these arrangements depends on whether the note is a recourse or nonrecourse loan.
2.3.1 Recourse notes to purchase stock
A recourse loan is an enforceable obligation under which a default by the borrower (employee in this context) entitles the lender (employer in this context) to pursue recovery from any and all of the assets of the employee. A recourse loan may or may not be collateralized. A collateralized loan simply means that specified assets of the borrower have been identified to provide specific security to the lender (e.g., the shares of stock that the employee purchased with the loan) or other investment assets of the employee have been placed in an escrow account. A collateralized loan may or may not be a full recourse obligation. An uncollateralized loan may still legally provide for full recourse against the assets of the employee upon default. Generally, an exercise of a stock option or purchase of stock with a recourse note from a company to an employee is considered to be a substantive exercise or purchase. However, a company will need to determine whether a loan that is in the form of a recourse note is in substance that of a nonrecourse note.
In general, we believe the legal form of a recourse note should be respected (i.e., the stock option is considered to be exercised) unless any one of the following conditions exist:
- Although the employer has legal recourse to the employee's other assets, it does not intend to seek repayment beyond the shares issued,
- The employer has a history of not demanding repayment of loan amounts in excess of the fair value of the shares,
- The employee does not have sufficient assets or other means (beyond the shares) to justify the recourse nature of the loan, or
- The employer has accepted a recourse note upon exercise and subsequently converted the recourse note to a nonrecourse note in the past.
If any of the above conditions exist, the recourse note should generally be considered to be nonrecourse. In addition to the criteria above, all other relevant facts and circumstances should be evaluated when determining whether the note should be considered to be nonrecourse in nature.
If the loan is recourse in nature, the loan generally should be reported as a deduction from shareholders' equity; the shares relating to the loan should be included in the earnings and dividends per share computations, and dividends paid on the shares relating to the loan should be charged to retained earnings. See FG 4.5.2.2 for guidance on accounting for interest on the loan.
If the loan is considered nonrecourse in nature, the substance of the arrangement is that the stock option remains unexercised. Nonrecourse notes are discussed in more detail in SC 2.3.2.
2.3.1.1 Non-market interest rate on recourse note to buy stock
A company may permit an employee to purchase stock with a recourse note that is noninterest bearing or has a below-market interest rate. The issuance of such a note could result in a purchase price that is below fair value. Therefore, compensation cost will be recognized by the company for the difference between the fair value of the stock and the estimated present value of the note. The determination of the note's present value should be based on a market rate of interest that would be required for the employee.
2.3.1.2 Forgiveness of a recourse note to purchase stock
A company may subsequently decide to forgive a note and accrued interest that was initially presumed to be recourse. On the date of forgiveness, the company should record compensation cost for the amount of the note and accrued interest forgiven, offset by any recoveries. This event may also require the company to re-evaluate whether there was an intention to forgive the note when it was originally issued and whether other outstanding notes are, in substance, nonrecourse notes.
2.3.1.3 Extension of the term of recourse notes to purchase stock
A company may extend the payment terms on the principal of a recourse note. Such an extension of the terms of a recourse note does not necessarily result in the conversion of the recourse note to a nonrecourse note. However, the company would need to consider the reason for the term extension and whether the note is still, in substance, with recourse. Accordingly, on the date of the extension, the company should reconsider if any one of the four conditions found in SC 2.3.1 are met. If any of the conditions are present at the date of the extension, the recourse note should generally be considered to have been converted to a nonrecourse note (see SC 2.3.1.4 for more guidance). Further, a company should consider whether additional compensation cost should be recorded if the extension of the payment terms included the conveyance of additional value to the employee. This may occur, for example, if the new term includes an interest rate that is below-market for the employee at the time of the extension.
2.3.1.4 Conversion of a recourse note to a nonrecourse note
A company may legally change a recourse note to a nonrecourse note or determine that a recourse note has substantively changed to a nonrecourse note. Such conversions should be accounted for as the repurchase of the shares previously received by the employee upon exercise of the stock option or stock purchase and the grant of a new award in exchange for a nonrecourse note (which, as noted in SC 2.3.2 and ASC 718-10-25-3, is accounted for as a substantive stock option). 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. The repurchase amount is equal to the sum of (a) the then current unpaid principal balance of the recourse note, (b) the unpaid accrued interest and (c) the fair value of the new option (i.e., the nonrecourse note to purchase stock). Any compensation cost to be recognized should be recognized over the requisite service period of the new award, if any.
2.3.2 Nonrecourse note to purchase stock
A nonrecourse note issued by an employee to a company to satisfy the exercise price of an option or to purchase stock is neither collateralized by nor provides the company recourse to the assets of the employee, other than the stock issued. A nonrecourse note received by a company as consideration for the issuance of stock is considered a stock option for accounting purposes—i.e., it remains subject to settlement/exercise—as the substance is similar to a stock option. Similarly, exercising an option with a nonrecourse note essentially means that the option remains unexercised. In either case, the employee is effectively deferring the decision to "exercise" the "stock option" until they repay the loan. If the value of the shares declines below the loan amount, the "stock option" is underwater and the employee would generally not be expected to repay the loan since there is no recourse to the employee's assets other than the shares.
In these arrangements, the exercise price of the "stock option" is the principal and interest due on the note. The fair value of the "stock option" is recognized in a company's financial statements over the requisite service period through a charge to compensation cost and a corresponding credit to APIC or to a liability, depending on the classification of the award. The requisite service period is the period the employee is required to perform service in order to retain the shares, which may differ from the term of the note. For example, it is common for a company to have the right to repurchase the shares at the loan amount if an employee leaves within a specified period of time, which establishes a service period. The maturity date of the note reflects the contractual term of the option for purposes of valuing the award. If the employee is not required to provide future service (i.e., the employee can repay the note at any time and keep the shares), the company should recognize the fair value of the award as compensation cost on the grant date, rather than over the term of the note.
When a nonrecourse note is used to fund the exercise of a stock option, the stock option is not considered "exercised" for accounting purposes until the employee repays the loan. Prior to repayment of a nonrecourse loan, the outstanding shares received in exchange for the loan are excluded from the denominator of basic earnings per share. Additionally, the nonrecourse loan itself is not recorded on the company's balance sheet since the arrangement is, in substance, a stock option.
2.3.2.1 Nonrecourse note—interest linked to a third-party index
A company may permit an employee to exercise a stock option or purchase stock with a nonrecourse note that has a variable rate of interest that is linked to a third party index over the term of the note (e.g., a nonrecourse note that has an interest rate tied to LIBOR). Given the nonrecourse nature of the loan, the company should account for the transaction as a stock option and the exercise price of the "option" should include the principal and interest due on the note. Because the exercise price is linked to a third-party index, the award is indexed to a factor that is not a market, performance or service condition and the award would be classified as a liability based on the guidance in ASC 718-10-25-13.
2.3.2.2 Nonrecourse note to purchase stock with recourse interest
Typically, the interest on a nonrecourse note executed for the purchase of stock or exercise of a stock option is also nonrecourse. However, in certain circumstances, a company may receive a nonrecourse note that includes recourse interest. In such a case, the company should account for the transaction as a stock option. However, the company should not include the interest as part of the option's exercise price as it is subject to full recourse. As a result, the price of the option equals the principal amount of the note.
2.3.2.3 Dividends paid on nonrecourse notes to purchase stock
A company may pay dividends to an employee who purchased stock or exercised a stock option with a nonrecourse note. Because a nonrecourse note received as consideration for the issuance of stock is considered an outstanding stock option until the note's principal and interest are paid in full, any dividends paid by the company during the period the note is outstanding would be charged to retained earnings for the equity-classified awards that are expected to vest. For the equity-classified awards that are not expected to vest or do not ultimately vest, dividends paid would be recognized as an additional compensation cost.
See SC 2.9 for more guidance on accounting for dividends received by holders of options or shares issued.
2.3.2.4 Forgiveness of a nonrecourse note to purchase stock
A company may accept a nonrecourse note for the purchase of stock or the exercise of stock options but subsequently decide to forgive the nonrecourse note and accrued interest and not require the employee to return the shares. As the note was initially nonrecourse, the issuance of stock was considered a stock option for accounting purposes. Therefore, the forgiveness of the note is in effect a repricing of the options' exercise price to zero. As a result, on the forgiveness date, the company would apply modification accounting under ASC 718-20-35-3 through ASC 718-20-35-4 and calculate any incremental compensation cost to be recognized (see SC 4.3.4 for further discussion).
If a company forgives a nonrecourse note and accrued interest and requires the employee to return the shares, then the company should treat the forgiveness as a cancellation without the concurrent grant of a replacement award (i.e., a settlement with no consideration). Refer to SC 4.9 for the accounting related to cancellations without the concurrent grant of a replacement award.
2.3.2.5 Cash loans through a nonrecourse note secured by shares
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
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:
Loan proceeds
|
$1,000,000
|
|
Fair value of option
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$800,000
|
|
Total repurchase price
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$1,800,000
|
|
Fair value of pledged stock
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($1,500,000)
|
|
Total compensation cost to be recognized
|
$300,000
|
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:
Dr. Treasury stock
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$1,500,000
|
||
Cr. Cash
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$1,000,000
|
||
Cr. Additional paid-in capital
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$ 500,000
|
||
To recorded issuance of the loan
|
|||
Dr. Compensation expense
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$300,000
|
||
Cr. Additional paid-in capital
|
$300,000
|
||
To record compensation expense over the requisite service period associated with the arrangement, if any
|
|||
2.3.3 Part recourse and part nonrecourse note to purchase stock
Within superseded stock compensation literature (Issue 34 of EITF Issue 00-23), there was a discussion on loans that were part recourse and part nonrecourse. Such notes are occasionally used to obtain favorable tax consequences to the employee. Such notes should be accounted for as nonrecourse in their entirety if the note is not aligned with a corresponding percentage of the underlying shares (i.e., the note is not related to a pro-rata portion of the shares).
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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