ASC 505-50 states that the fair value of an equity instrument issued to a nonemployee (i.e., counterparty) should be measured by using the stock price and other measurement assumptions as of the earlier of the date at which either: (1) a commitment for performance by the counterparty has been reached; or (2) the counterparty's performance is complete.

A performance commitment is defined as a commitment under which performance by the counterparty to earn the equity instruments is probable because of sufficiently large disincentives for nonperformance. This disincentive must result from the relationship between the issuer and the counterparty, beyond the equity instruments themselves. Question SC 7-1A addresses the assessment an entity should perform to determine whether a performance commitment contains a “sufficiently large disincentive for nonperformance.”

The assessment of whether a performance commitment contains a "sufficiently large disincentive for nonperformance" should be based on both quantitative and qualitative factors. Generally, we believe situations in which "performance commitments" exist prior to performance being completed will be rare.

With respect to assessing if there exists a performance commitment, the guidance notes that forfeiture of the equity instrument as the sole remedy for nonperformance by the counterparty would not be considered a sufficiently large disincentive for nonperformance.

In addition, the ability to sue for nonperformance, in and of itself, does not present a sufficiently large disincentive to ensure that performance is probable. The guidance discusses that an entity can always sue for nonperformance but that it is not always clear if any significant damages would result. We believe that since ASC 505-50 specifically indicates that the mere ability to sue for damages is not considered a sufficiently large disincentive for nonperformance, there must be specific delineation of the potential penalties if the counterparty does not perform as specified in the contract.

The penalties (i.e., large disincentives for nonperformance) should be assessed against the value of the arrangement, not just the value of the equity award. In addition to these factors, other factors to consider may include, but are not limited to, the following:

The assessment of whether there is a counterparty performance commitment should be made at the time of grant; no reassessment is needed as the arrangement progresses.

If no performance commitment has been reached by the time the counterparty completes its performance, the issuer should ultimately measure the fair value of the equity instruments at the date the counterparty's performance is complete. The counterparty's performance is complete when the counterparty has delivered or, in the case of sales incentives, purchased the goods or services. Typically, the date the counterparty's performance is complete is also the date the equity instruments vest, because at that date, no further service or other action is required for the counterparty to receive the equity instruments. As noted in SC 7.2.3A, if there is an intervening service period between the initial grant of the award and the performance completion date, interim determinations of fair value should be utilized.

ASC 505-50-25-7 discusses situations in which counterparty performance may be required over a period of time but the equity award granted to the party performing the services is fully vested, exercisable, and nonforfeitable on the date the parties enter into the contract. The measurement date for such an award would generally be the date the parties enter into the contract, even though services have not yet been performed, because the counterparty's ability to exercise and benefit from the award is not contingent upon performing the services.

ASC 505-50 generally does not address the period(s) or the manner (that is, capitalize versus expense) in which SC Corporation should recognize the fair value of the equity instruments that will be issued. However, the guidance indicates that an asset, expense, or sales discount should be recognized in the same period and in the same manner as if SC Corporation paid cash to a vendor in exchange for goods or services, or paid cash to a customer as a sales incentive or discount.

Similar to the accounting for employee options, a recognized asset, expense, or sales discount should not be reversed if an award expires unexercised for which the counterparty has completed its performance and for which all the terms have been established.

The quantity and terms of the equity instruments may be known upfront. If this is the case and if it is appropriate under GAAP for the issuer to recognize any cost of the transaction during financial reporting periods before the measurement date, the equity instruments are measured at their then-current fair values at each of those financial reporting dates (i.e., the instruments are "marked-to-market" through the measurement date).

SC 7.2.4A through SC 7.2.5A discuss the accounting for awards if the quantity or terms of the equity instruments are not known upfront.

The quantity and/or terms of equity instruments may not be known upfront because they depend on counterparty performance conditions or market conditions. If the quantity and/or terms depend on either performance conditions or both performance and market conditions, and cost is recorded prior to the measurement date, the equity instruments should be measured at their then-current lowest aggregate fair value at each financial reporting date (i.e., the lowest amount at which the award may be earned if the conditions are not achieved). This amount may be zero.

Similarly, on the measurement date, if the quantity or any of the terms of the equity instruments depend on achieving counterparty performance conditions (or both performance and market conditions) that, based on the different possible outcomes, result in a range of aggregate fair values for the equity instruments as of that date, the issuer should utilize the lowest aggregate amount within that range for recognition purposes.

The examples in ASC 505-50-55-28 through ASC 505-50-55-40 illustrate the application of this guidance.

Question SC 7-2A addresses the application of ASC 505-50 to determine if a counterparty performance condition exists.

No, we do not believe that a counterparty performance condition exists, as defined in ASC 505-50.

For example, a nonemployee counterparty will receive 100 equity awards if it purchases 10,000 units of a particular product from the issuer (vendor). In this scenario, the counterparty can control the outcome (i.e., how many units it will purchase) and ultimately determine how many equity awards it will receive (similar to a service condition). We believe that this type of condition is not a counterparty performance condition as contemplated by ASC 505-50, and it would therefore not be appropriate to apply the "lowest aggregate fair value" guidance in ASC 505-50. In this arrangement, recognition of the then-current fair value of the equity awards prior to the measurement date should be assessed based on the probability that the counterparty will perform.

Conversely, if the event that determines the number of equity awards to be received by the counterparty is outside of the control of the counterparty, then the "lowest aggregate fair value" guidance in ASC 505-50 would apply. For example, a nonemployee counterparty will receive 100 equity awards if it resells 10,000 units of the issuer's (vendor's) product to end-user customers. In this scenario, the counterparty cannot typically control the number of units it will sell because the ability to sell the units depends on outside factors, including the level of customer demand. In this arrangement, the amount of cost recognized should be based on the lowest aggregate fair value, which may be zero, in periods prior to reaching the sales target. The issuer would not assess the probability that the performance condition will be achieved.

The accounting treatment of an award with a performance condition that is granted to a nonemployee differs from the guidance for awards granted to employees. For awards granted to employees, a probability assessment is generally made for all performance conditions. For awards granted to nonemployees, if performance is outside the control of the counterparty, the cost recognized may be zero (if zero is the lowest aggregate fair value) prior to the achievement of the performance condition, even if the issuer believes it is probable the performance condition will ultimately be achieved.

If the quantity or terms of an equity instrument depend only on market conditions, cost should be measured based on the then-current fair value of the equity instruments. ASC 505 describes an approach to calculate the fair value based on the fair value of the equity instruments without regard to the market condition plus the fair value of the issuer's commitment to change the quantity or terms of the equity instruments if the market condition is met. In other words, the fair value of the equity instruments should incorporate the market condition, similar to an employee award.

On the measurement date, the then-current fair value of the equity instrument should be determined, incorporating the market condition. Subsequent to the measurement date, the issuer should recognize and classify any future changes in the fair value (including the market condition) in accordance with the relevant accounting literature on financial instruments (e.g., ASC 815-40). ASC 505-50-55-14 illustrates the application of this guidance.

In some situations, the quantity and/or terms of an equity instrument may not be known until a point in time after the measurement date. After the measurement date, revisions in the quantity or terms of equity instruments should generally be recorded using modification accounting similar to ASC 718-20-35. The adjustment should be measured at the date of the revision of the terms of the equity instruments as the difference between (1) the then-current fair value of the modified award utilizing the then-known quantity and/or terms and (2) the then-current fair value of the original award immediately before the quantity and/or terms become known.

For transactions that involve only performance conditions, the then-current fair value is calculated using the assumptions that result in the lowest aggregate fair value if the quantity and/or any terms remain unknown. The example in ASC 505-50-55-22 through ASC 505-50-55-24 illustrates the application of this guidance.

For transactions that involve both performance and market conditions, modification accounting should be applied, as described above, for the resolution of both performance and market conditions, through the date the last performance condition is resolved. If, at the date the last performance-related condition is resolved, any market conditions remain, the issuer should measure the then-current fair value of the commitment related to the market condition. This amount is an additional cost of the transaction. Thereafter, the issuer should, to the extent necessary, recognize and classify future changes in the fair value of this commitment related to the market condition in accordance with the relevant accounting literature on financial instruments (e.g., ASC 815-40). The example in ASC 505-50-55-15 through ASC 505-50-55-16 illustrates the application of this guidance.

ASC 323-10-25-3 through ASC 323-10-25-6 requires an investee to apply the guidance in ASC 505-50 to measure compensation cost incurred by an investor on its behalf and to record a corresponding capital contribution. The investor should recognize an expense for the portion of the costs incurred that benefits other investors and recognize the remaining cost as an increase to its equity investment in the same period that compensation cost is recognized on the books of the investee.

Other non-contributing investors should recognize income equal to the amount that their interest in the investee's net book value has increased. In ASC 323-10-S99-4 the SEC observer to the EITF indicated that SEC registrant investors should classify any expense or income resulting from the application of this guidance in the same income statement caption as the equity in earnings (or losses) of the investee. The example in ASC 323-10-55-19 through ASC 323-10-55-26 illustrates this guidance.

ASC 323-10-25 does not apply to situations in which proportionate funding exists. In these cases, both investors are contributing stock-based awards (or other consideration) of proportionate value. Similarly, ASC 323-10-25 does not apply to arrangements established at the time of the investor's original investment in the investee. When the compensation cost for these arrangements is recorded on the investee's books, the investor would record the portion of the cost related to the equity investment as part of its ongoing equity in earnings accounting under the equity method.

Example SC 7-1A illustrates an investor's accounting treatment for stock-based compensation granted to employees of an equity method investee that would not be in the scope of the guidance in ASC 323-10-25-3 through ASC 323-10-25-6.

EXAMPLE SC 7-1A
Accounting by an investor for stock-based compensation granted to employees of an equity method investee

SC Corporation enters into an arrangement with Third Party Corporation (an unrelated third party) to form a joint venture. SC Corporation will contribute a subsidiary (which includes employees) to the venture and will receive a 50% interest, which will be accounted for under the equity method (the "investee").

Investee employees will be allowed to retain stock options in SC Corporation that were granted prior to the formation of the venture. Such awards will continue to vest based on the employees' service for the venture. Upon the exercise of the stock options, Third Party Corporation will pay to SC Corporation, in cash, its proportionate share (i.e. 50%) of the book compensation expense recorded on the investee's financial statements.

How should SC Corporation account for the cash received from Third Party Corporation for the options exercised subsequent to the formation of the joint venture?

ASC 323-10-25 addresses the accounting for stock-based compensation awards of the investor's stock granted to employees of an investee accounted for under the equity method, when no proportionate funding by the other investor occurs and the investor does not receive any increase in its relative ownership percentage of the investee. Further, ASC 323-10-25 assumes that the investor's grant of stock-based compensation to employees of the equity method investee was not agreed to in connection with the investor's original acquisition of its interest in the investee.

SC Corporation's fact pattern differs from ASC 323-10-25 because Third Party Corporation is funding its economic share of the award, and the arrangement was part of the original formation of the venture. However, this guidance provides a useful frame of reference for SC Corporation's situation. The value recognized over the vesting period for the options is measured under ASC 505-50 because the individuals are no longer considered employees of SC Corporation and is initially treated as an addition to the investment account in the investee on SC Corporation's books.

Going forward, 50% (its proportionate share) of the investment on SC Corporation's books attributable to the contributed options will be absorbed by the pick-up of a proportionate share of the stock-based compensation cost recorded by the venture, which will be measured and recorded by the venture with a corresponding capital contribution. To the extent the stock options are subsequently exercised by employees of the venture, Third Party Corporation will have an obligation to make cash payments to SC Corporation for 50% (its proportionate share) of the book compensation expense of the awards recognized by the venture. Such amounts received by SC Corporation would be recorded as a reduction of the remaining portion of the investment account that had been established when the awards were originally contributed to the venture.

In many arrangements, the issuer may be selling goods or services, issuing equity awards (e.g., warrants), and receiving cash payments from the nonemployee counterparty. We believe that in arrangements where a fixed amount of equity awards are issued to a nonemployee counterparty (i.e., a customer), in addition to providing the counterparty goods or services, and the counterparty is also paying a contractually required amount of cash to the issuer, the payments received from the counterparty should first be considered payment for the equity awards. In other words, the fair value of the equity awards (remeasured each period through the measurement date or the final determination of the terms of awards with counterparty performance conditions) should be considered a reduction of revenue (sales discount). Any cash in excess of the fair value of the equity awards should generally be considered revenue.

Equity awards issued to suppliers, customers or other providers may take various forms. ASC 605-50, as well as ASC 606-10-32-25 and RR 4.6, provide further guidance on the accounting for consideration given to a customer, which applies whether the payment is made in cash or in the form of equity instruments.

Consistent with the discussion in SC 7.2.9A, while there is no explicit guidance in ASC 505-50, we believe the classification of awards issued to nonemployees, although within the scope of ASC 505-50, would generally be the same as awards issued to employees. See SC 3 for discussion of features that cause an award to be liability-classified.

As discussed in SC 4.10, ASC 718-10-35 provides that an award originally granted as employee compensation will generally remain subject to ASC 718 for the life of the award. This guidance does not apply to equity instruments granted to nonemployees prior to adoption of ASU 2018-07. Nonemployee awards cease being subject to ASC 505-50 after the counterparty's performance is complete and, from that point forward, become subject to other applicable GAAP (e.g., ASC 480, Distinguishing Liabilities from Equity or ASC 815, Derivatives and Hedging). Depending on their terms, that guidance could require accounting for such instruments as liabilities. Refer to FG 5.5 and DH 2.

For example, assume a company grants a fully vested, nonforfeitable warrant to a nonemployee in exchange for services. The measurement date of the warrant is the grant date because no future performance is required by the holder to retain the warrant. However, because performance has been completed as of the grant date, the company would also need to assess the accounting for the warrant under other applicable GAAP, including ASC 480 and ASC 815.

Example SC 7-2A illustrates the application of ASC 505-50 to an award of stock options to a nonemployee that cliff vests. The quantity and terms of the equity instrument are known up front, and there is no performance commitment.

Tax implications have not been included in this example, refer to TX 17.

EXAMPLE SC 7-2A
Nonemployee stock option award that cliff vests at the end of a period

SC Corporation enters into an arrangement with an independent contractor to provide service. The contractor will be compensated by earning 1,000 non-qualified stock options with an exercise price of $30 and an exercise period of 10 years that cliff vest at the end of four years provided that service is rendered through that date. If the contractor does not complete the service, the award is forfeited. This transaction does not contain a performance commitment because the contractor has no disincentive for nonperformance other than the loss of stock options. The contractor commences work on January 1, 20X1 and completes service at the end of four years.

On December 31, 20X5, the contractor exercises all 1,000 options, when the market price of SC Corporation's common stock is $100 per share.

How should SC Corporation record the associated compensation expense in each reporting period over the service period and upon the subsequent exercise of the stock options?

A measurement date, as defined in ASC 505-50-30, does not occur until the end of the fourth year. The stock options should be revalued each period and measured at their then-current fair value at the end of each period, with a final measurement taking place at the end of the fourth year when performance is complete and the options are earned.

The following schedule presents the fair value per option and associated compensation expense at each reporting period over the service period. For illustrative purposes, only year-end reporting is shown; however, SC Corporation would also be required to perform interim reporting following a similar methodology.

SC Corporation would record the following journal entries:

On December 31, 20X4 when the contractor completes the service, the stock options vest. The award would be measured at its then-current fair value and would no longer be adjusted. Assume that SC Corporation evaluated the award under ASC 815-40 (as described in SC 7.2.11A) and determined that equity classification continued to be appropriate.

Upon exercise, SC Corporation would record the following entry.

In Example SC 7-2A, the award cliff vests, and therefore the entire award is marked to market each period until the measurement date is reached. Example SC 7-3A illustrates an instance in which the award vests in tranches over time as the service is provided.

EXAMPLE SC 7-3A
Nonemployee stock option award that vests in tranches

SC Corporation enters into an arrangement with an independent contractor to provide service. The contractor will be compensated by earning 1,000 non-qualified stock options with an exercise price of $30 and an exercise period of 10 years. 250 options vest at the end of each year over four years in conjunction with the contractor continuing to provide service through those dates. If the contractor does not complete the service, only the awards associated with the uncompleted service are forfeited.

How should SC Corporation record compensation expense at each reporting period over the service period?

A measurement date, as defined in ASC 505-50-30, for each tranche of options would occur at the end of each year when the work associated with that year was completed and the corresponding options vest. The fair value of the vested awards is fixed as of the vesting date. Unvested awards would continue to be marked to market until the relevant vesting date of each tranche. SC Corporation would record compensation expense on a straight-line basis over the service period, which is the same manner as if they had paid cash instead of share-based awards.

Assume the following fair value of each tranche:

The following schedule presents the fair value per option and an approach to record the associated compensation expense at each reporting period over the service period. For illustrative purposes, only year-end reporting is shown; however, SC Corporation would also be required to perform interim reporting following a similar methodology.

(1) The following schedule shows the calculation of the aggregate fair value of the options for each reporting period.

(2) Vested tranche—fixed value at vesting date

(3) Unvested tranche—then-current fair value

SC Corporation would record the following journal entries: