Over the summer, two recent actions taken by the Financial Accounting Standards Board (FASB) are directed at private companies and may bring at least a little bit of welcomed relief. One is near final and will provide some help in the valuation of certain share-based payment awards, and the other, still in the proposal stage, may provide some help with lease accounting.
A Little Help with Share-Based Payments
When issuing stock options or other share- or equity-based compensation arrangements, those awards are generally measured at fair value under Accounting Standards Codification (ASC) 718, Compensation – Stock Compensation (ASC 718). While there are some accommodations for private companies (such as the use of a “calculated value” noted in ASC 718 for nonpublic entities), a key model input into any compensation measurement is the fair value of the underlying share or equity interest. This input may be easy to find for a public company but is likely much more difficult to obtain for a private company where a market does not exist for the equity. Obtaining a true “fair value” of that equity, as the concept is expressed in Generally Accepted Accounting Principles (GAAP), can be time consuming, expensive and frustrating. Yet, there is some relief on the horizon for private companies.
Private companies are likely familiar with valuations of their equity performed for tax purposes under the Treasury Regulations in Section 409A of the U.S. Internal Revenue Code. A Section 409A valuation, performed under a “presumption of reasonableness,” has an objective of “fair market value” but may not be performed explicitly in compliance with the FASB’s definition of fair value in ASC 718. Importantly, Section 409A allows for three different valuation methods that may meet the presumption of reasonableness requirements, including, in certain circumstances, the use of a valuation that may be up to 12 months old. Of course, there are several caveats and other guidance to consider when evaluating whether a particular valuation complies with Section 409A.
In August, following a proposal and comment process with the FASB’s Private Company Council (PCC), the FASB endorsed a PCC consensus to allow a private company to use a practical expedient to determine the current price input for its equity under a valuation method that complies with Section 409A. This could eliminate the need for some duplicative valuation exercises for private companies.
While the FASB is working through the balloting process to release a final standard, it is expected that the final rule will allow for early adoption in financial statements that have not yet been issued. There are limitations on the use of the practical expedient, such as the inability to use it for liability-classified awards. But overall, the final standard is expected to result in reduced cost and complexity for private companies. We recommend keeping an eye out for updates on this project, formally PCC Issue No. 2018-01, “Practical Expedient to Measure Grant-Date Fair Value of Equity-Classified Share-Based Awards,” at the FASB’s website.
A Little Hope with Leases
While the adoption of ASC 842, Leases (ASC 842), was deferred for private companies, the day of reckoning is approaching. Fortunately, when it comes to one element of the application of the new lease accounting rules, the FASB has heard the cry of the private companies and has a project underway, which if ultimately approved and issued, will be of interest to many.
ASC 842 currently allows lessees that are not “public business entities” (as the FASB defines that term) to elect a practical expedient in identifying the discount rate to be used in lease accounting. The entity may elect to use, for all leases, the risk-free rate as the discount rate rather than the more complicated to derive incremental borrowing rate. While using a risk-free rate would be fairly easy to operationalize, because risk-free rates have been so low for an extended period of time, it could result in some potentially unintended consequences and accounting results (such as an unusually large lease liability or forcing what would be reasonably expected to be operating leases into a financing lease model).
The FASB is exploring the possibility of allowing these entities to elect the use of the practical expedient on an asset-class-by-asset-class basis rather than an all-in approach across the entity. This would allow a company to choose to use its incremental borrowing rate, which while more difficult to derive, could result in a more reasonable measurement for selected asset classes. A company may want to do this for its more significant asset classes where they perceive the cost to derive their incremental borrowing rate worth the benefit of a reduced liability. The FASB is also taking this opportunity to clarify that when the rate implicit in a lease is known or readily determinable, it must be used, even if the company has elected the risk-free rate practical expedient for the relevant asset class.
This project emerged from the FASB’s post-implementation review around ASC 842 rather than through the PCC process. However, some private companies are likely to find it appealing. The project has been re-deliberated by the FASB for the comments received on the exposure draft, and the FASB has affirmed the key conclusions and moved to the preparation of a final ballot draft for voting. Again, you can follow this project on the FASB’s website under its formal name “Leases (Topic 842) – Discount Rate for Lessees that are Not Public Business Entities.”
DHG has the professionals, both accounting and valuation, that can help you understand these standards and other issues of interest to private companies. Please reach out to us at firstname.lastname@example.org for more information.