ASC 480 provides guidance for determining whether certain freestanding financial instruments are classified as liabilities and generally excludes stock-based compensation from its scope. However, ASC 718 requires companies to apply the classification criteria in ASC 480-10-25 and paragraphs ASC 480-10-15-3 through ASC 480-10-15-4 when determining whether stock-based compensation awards should be classified as a liability unless ASC 718-10-25-6 through ASC 718-10-25-18 require otherwise.

A repurchase feature gives the employee the ability to put (redeem) the shares to the company for cash or gives the company the ability to call (repurchase) the shares for cash. Under ASC 718, companies should evaluate the terms of their share awards that contain repurchase features in order to determine whether liability classification of an award is required, as described below.

A company should classify a share that is puttable by the employee or callable by the employer as a liability if either of the following conditions is met:

An employee begins to bear the risks and rewards of stock ownership when, for example, an employee receives shares upon exercise of an option or vests in a restricted stock award. ASC 718 defines a reasonable period as a minimum of six months.

An employee put right would allow the employee to avoid bearing the risks and rewards of stock ownership for a reasonable period if the employee can put shares to the company (1) at fair value within six months after the employee vests in the shares (or exercises a vested option) or (2) either before or after six months, at a fixed redemption amount or another amount that is not based on variations in the company’s stock price. The probability of the employee exercising the put right is not a relevant factor. If the repurchase price is an amount other than fair value (e.g., derived using a formula), the share-based arrangement should generally be classified as a liability because the price is not based on variations in the company’s stock price, and, therefore, the employee is not bearing the risks and rewards of stock ownership (regardless of how long the employee holds the shares). There is a limited exception for certain nonpublic company plans that qualify as book value plans. Refer to SC 6.4 for a discussion of book value plans. If a repurchase feature gives the employee the right to put shares back to the company after six months for the fair value of the shares at the date of repurchase plus a fixed amount, the repurchase feature would not cause the award to be classified as a liability; however, ASC 718-10-55-85 provides that the fixed amount over the fair value should be recognized as additional compensation cost over the requisite service period with a corresponding liability.

An employer call right may require liability classification of an award if it is probable that the employer will exercise the call right (1) within six months of the issuance of a vested share (or exercise of a vested option) or (2) either before or after six months at a fixed redemption amount or another amount that is not based on variations in the company’s stock price . When assessing whether it is probable that an employer will prevent the employee from bearing the risks and rewards of stock ownership, we believe the following factors should be considered:

If a share award is classified as a liability because of a repurchase feature and either (a) the put or call feature expires unexercised or (b) at least six months have passed since the employee began bearing the risks and rewards of stock ownership, the award should be reclassified as equity (assuming it meets all other requirements for equity classification). A change in classification to an equity award should be accounted for as a modification (see guidance in SC 4.4).

If a share award with repurchase features is classified as equity, SEC registrants should also consider whether classification of the award as temporary equity is appropriate. See SC 3.3.10 for further guidance.

Example SC 3-4 illustrates the accounting for an award that has an in-substance put option exercisable by the employee immediately upon vesting.

EXAMPLE SC 3-4
Classification of an award that may be deferred upon vesting and placed in a rabbi trust

SC Corporation grants an employee nonvested stock that vests in three years. Upon vesting, the employee may choose to take delivery of the stock, or defer receipt of the stock and have the shares placed in a rabbi trust.

The terms of the rabbi trust permit the employee to immediately diversify by exchanging the shares into investments in nonemployer securities held by the rabbi trust. In that circumstance, the arrangement will ultimately be settled in the future in cash in relation to the value of the diversified investments.

Prior to vesting and deferral in the rabbi trust, should the nonvested stock award be classified as a liability under ASC 718?

Yes. Because the employee has the ability, immediately upon vesting, to elect to diversify the stock into nonemployer securities, which will ultimately be settled in cash, we believe the stock compensation arrangement should be classified as a liability. While this fact pattern is not technically an employee put feature, we believe the substance is the same, in that it allows the employee to elect cash settlement from SC Corporation without bearing the risks and rewards of share ownership for six months from the vesting date.

An option or similar instrument that is required to be settled in cash or other assets is classified as a liability. For example, the awards in Example SC 3-1 (cash-settled SARs) are classified as liabilities because the awards will be settled in cash. A stock-settled SAR would be classified as equity (assuming the award meets all other requirements for equity classification). Similarly, a feature that allows an option to be net-share settled (i.e., shares are issued equal to the difference in value between the fair value of the shares and exercise price of the option on the exercise date) does not on its own cause the option to be classified as a liability.

If a company grants an award that offers a choice of settlement in stock or in cash (sometimes referred to as a tandem award), the classification of the award depends on whether the employee or the company has the choice. If the employee can choose the form of settlement and can potentially require the company to settle the award in cash, the award should be classified as a liability. If the company has the choice of settlement, it can avoid transferring assets by electing to issue stock. In that case, as long as the company has the ability to deliver shares (i.e., sufficient authorized shares) the award would be classified as equity. ASC 718-10-25-15(a) clarifies that when assessing the company’s ability to deliver shares, a requirement to deliver registered shares should not, on its own, result in liability classification of the award.

The written terms of a stock-based compensation award are generally the best evidence to indicate that the award is a liability. However, a company's past practice of settlement may outweigh the written terms, resulting in a conclusion that an award that in form appears to be equity is, in substance a liability. For example, if a company's past practice has been to predominantly settle options in cash or it usually settles in cash whenever an employee asks for cash settlement, this would likely indicate that the options are in substance liabilities, even when the company retains the choice of settling the option in shares.

Additionally, when considering the company's ability to settle in shares, the company should consider the amount of shares currently authorized and available for issuance in its stock option plan. The number of shares that the company needs to have available for issuance may depend on whether it has the ability to settle stock options on a net basis (i.e., net of the exercise price). If the company does not have sufficient shares authorized and available for issuance to settle its outstanding awards, the amount that the company could not settle in shares should be accounted for as a liability.

Example SC 3-6 and Example SC 3-7 illustrate the considerations in evaluating a company's ability to deliver shares.

EXAMPLE SC 3-6
Grant of more than the current number of authorized shares

SC Corporation currently has one million shares authorized and unissued for its stock option plan. If additional authorized shares were needed to settle stock compensation awards, shareholder approval would be required.

SC Corporation granted two million at-the-money stock options on January 1, 20X1, which under the terms of the option plan may be settled in any of the following ways at SC Corporation’s election:

As SC Corporation does not have a sufficient number of authorized shares to satisfy the gross settlement alternative, should some or all of the award be classified as a liability?

Not necessarily. The analysis will depend on SC Corporation's intent. In this scenario, although SC Corporation may not currently have the ability to deliver shares to satisfy gross settlement of all of the options, the terms of the plan permit net share settlement at SC Corporation's election. Thus, we believe it would be appropriate to determine whether SC Corporation intends to settle the awards net and if sufficient shares are authorized to satisfy net settlement.

If at some point the number of shares needed to net share settle the award exceeds the total shares authorized, the incremental portion would be accounted for as a liability, as the only other alternative is to cash settle the award. In that circumstance, equity to liability modification accounting should be applied; refer to SC 4.4.1.

EXAMPLE SC 3-7
Grant of awards subject to shareholder approval

SC Corporation grants awards to employees. In order for SC Corporation to settle the awards in equity, SC Corporation's shareholders must annually approve the release of the appropriate number of shares to satisfy the equity settlement. Although this generally occurs on or near the vesting date of the awards, management and the Board do not control enough votes to ensure this outcome. In the absence of shareholder approval, SC Corporation would be obligated to deliver cash to settle the awards.

On the grant date, does SC Corporation have the ability to deliver shares to support equity classification?

Options or similar instruments are also classified as liabilities when the underlying shares would be classified as liabilities. Therefore, if the shares underlying an option have repurchase features, a company should first consider whether the underlying shares would be classified as liabilities. For example, a public company may grant an option that it would settle by issuing a mandatorily redeemable share that is not subject to the scope exception in ASC 480. Because the underlying shares would be classified as a liability, options on those shares would also be classified as a liability in accordance with ASC 718.

Many public companies offer their employees broker-assisted cashless exercise programs to help the employees exercise their stock options without having to use their personal funds to pay for the exercise price. A broker-assisted cashless exercise is the simultaneous exercise of a stock option by an employee and a sale of the shares through a broker.

A broker-assisted cashless exercise generally occurs as follows:

A broker-assisted cashless exercise of an employee stock option does not result in liability classification for the award if both of the following criteria in ASC 718-10-25-16 through ASC 718-10-25-17 are satisfied:

Employees can sell shares from the exercise of options or vesting of restricted stock through a broker into the market and remit proceeds from the sale to the company in an amount that exceeds the amount permitted to be withheld for tax purposes without causing the award to become classified as a liability (see SC 3.3.6). In this situation, the company has not cash settled the awards; rather the company has delivered shares to settle the award and the employee has sold those shares in the market and remitted cash back to the company to settle the tax liability.

ASC 718 requires that an award that is indexed to a factor that is not a market, performance, or service condition, should be classified as a liability (refer to SC 3.3.1). However, ASC 718-10-25-14 provides an exception to allow equity classification of certain awards with an exercise price denominated in currencies other than the currency in which the shares trade. This exception would apply to a company that grants an award to its employees resident in foreign jurisdictions with an exercise price that is denominated in either (1) the functional currency of the company's foreign operation; (2) the currency in which the employee is paid; or (3) the currency of a market in which a substantial portion of the entity's equity securities trades. If one of these exceptions is met, then the award would not be considered dual-indexed for purposes of ASC 718 and equity classification would be appropriate, assuming all other criteria for equity classification were met.

In some instances, companies grant awards to employees that are exercisable at the grant date, but contain a repurchase feature that enables the company to reacquire the shares for an amount equal to the original exercise price (or the lower of the current fair value and the original exercise price) if the employee terminates employment within a specified time period. The purpose of the repurchase feature is often to permit the employee to “early exercise” an option so that the employee’s holding period for the underlying stock begins at an earlier date to achieve a more favorable tax position.

The repurchase feature described above may be equivalent to a forfeiture provision and would not automatically be analyzed as a call right. This feature would not, on its own, require liability classification of the award. However, the repurchase feature creates an in-substance service period because the employer can repurchase the shares at the original purchase price if the employee terminates within the specified time period. Therefore, the requisite service period for such an award would include the period until the repurchase feature expires. The “early exercise” of an option during this period would not be considered substantive for accounting purposes and any cash received upon “early exercise” would be recognized as a deposit liability. Companies should assess the terms of an award and the surrounding facts and circumstances when determining whether a repurchase feature such as the one described above represents a forfeiture provision.

SEC registrants should also consider the requirements of SEC Accounting Series Release No. 268, Presentation in Financial Statements of “Redeemable Preferred Stocks,” (“ASR 268”) when determining the appropriate classification of an award. The SEC staff clarified in SAB Topic 14E (codified in ASC 718-10-S99-1) that ASR 268 (codified in ASC 480-10-S99-1) and related guidance (including ASC 480-10-S99-3A) are applicable to stock-based compensation. Under this guidance, SEC registrants with outstanding equity instruments that are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer are required to classify these securities outside of permanent equity (i.e., as temporary equity in the mezzanine section of the balance sheet).

Although non-SEC registrants (i.e., nonpublic companies) are not explicitly subject to the requirements of ASC 480-10-S99-1 and ASC 480-10-S99-3A, we believe the most appropriate classification for these types of instruments for all entities is outside of the equity section.

Certain awards that qualify for equity classification under ASC 718 may require classification as temporary equity under ASC 480-10-S99-3A, including:

SAB Topic 14E clarifies that companies should present as temporary equity an amount that is based on the redemption amount of the instrument, but takes into account the portion of the award that is vested. The redemption amount would differ if an award is an option (which generally requires an exercise price) compared to a restricted share (which generally has no exercise price). Intrinsic value is the redemption amount of an option because when an option is settled, the holder receives the difference between the fair value of the underlying shares and the exercise price of the option. If the shares underlying an option are redeemable, the holder pays the exercise price upon exercise of the option and then, upon redemption of the underlying shares, the holder receives the fair value of those shares. The net cash to the holder from the award, in either scenario, equals the stock option's intrinsic value. For a restricted stock award, the redemption amount is fair value, which is generally equal to intrinsic value because restricted stock does not have an exercise price.

Awards that are subject to the classification requirements of ASC 480-10-S99-3A should be presented as follows on the grant date:

Under ASC 480-10-S99-3A, if the award is not redeemable currently (e.g., because a contingency has not been met), and it is not probable that the award will become redeemable, adjusting the amount recognized in temporary equity is not required until it becomes probable that the award will become redeemable. However, for such awards that are unvested on the grant date, the redemption amount of the award as of the grant date (i.e., intrinsic value for options and fair value for restricted stock) should be reclassified to temporary equity over the requisite service period as the award vests. After the award is vested, the amount presented as temporary equity should be equal to the redemption amount of the award as of the grant date. For options that are granted at-the-money (no intrinsic value on the grant date), no amount will be presented as temporary equity as long as it is not probable that the option or underlying shares will become redeemable.

Once it becomes probable that the share or option will be redeemed, ASC 718 may require liability classification of the award. For example, shares and options with redemption features based on contingent events could be classified as equity under ASC 718 if the contingent event is not probable of occurring. Once the occurrence of the contingent event becomes probable, the award generally becomes a liability and, therefore, ASC 480-10-S99-3A is no longer applicable.

If the award is redeemable currently or it is probable that the award will become redeemable and the award would still be equity-classified under ASC 718 (e.g., a share that is redeemable at the employee's discretion after a six-month holding period), the redemption amount presented as temporary equity should be adjusted at each reporting date by reclassifying the change in the award's redemption amount from permanent equity to temporary equity without consideration of the amount of compensation cost previously recognized in equity. For example:

Figure SC 3-2 summarizes the amounts that should be presented as temporary equity for four different stock-based compensation awards. The examples assume that the awards meet the criteria for equity classification under ASC 718.

Figure SC 3-2
Impact of ASC 480-10-S99-3A on four different stock-based compensation awards

Application of the guidance in ASC 480-10-S99-3A does not affect the amount or timing of recognition of compensation cost in the financial statements. Rather, application of this guidance could result in the reclassification of amounts from permanent equity to temporary equity to highlight the company’s redemption obligations. Additionally, as long as the redemption amount is at fair value (or for an option, the market price of the stock less the exercise price of the option), we believe that the redemption right does not represent a preferential distribution under ASC 480-10-S99-3A, and, therefore, the company would not be required to apply the two-class method of calculating earnings per share described in ASC 260-10-45-60B.

Figure SC 3-3 and Figure SC 3-4 summarize the basic criteria for determining the appropriate classification of a share award and a stock option, respectively. These flowcharts may not address the appropriate classification of awards with complex or unusual terms.

Figure SC 3-3
Liability and equity classification of a share award

* Companies should also apply the classification and measurement provisions of ASC 480-10-S99-1 and ASC 480-10-S99-3A, which may require classification of certain amounts outside of permanent equity.

Figure SC 3-4
Liability and equity classification of a stock option

* Companies should also apply the classification and measurement provisions of ASC 480-10-S99-1 and ASC 480-10-S99-3A, which may require classification of certain amounts outside of permanent equity.