Academic journal article Journal of Accountancy

'Cheap Stock' Questions Can Plague Growing Companies: A Rule of Thumb or Management's Best Estimate Aren't Good Enough Anymore. but the a New AICPA Practice Aid Unravels Some of the Mysteries and Exposes the Pitfalls

Academic journal article Journal of Accountancy

'Cheap Stock' Questions Can Plague Growing Companies: A Rule of Thumb or Management's Best Estimate Aren't Good Enough Anymore. but the a New AICPA Practice Aid Unravels Some of the Mysteries and Exposes the Pitfalls

Article excerpt

The AICPA has issued a Practice Aid entitled Valuation of Privately-Held-Company Equity Securities Issued as Compensation, in large part to deal with what is often called the "cheap stock" issue.

If you are with a private company issuing common stock or options to its employees as compensation, or if you are in public accounting and have private company clients that make or contemplate making such issuances, you would do Marc Simon well to be aware of what is contained in this Practice Aid.

Under the typical "cheap stock" scenario, a privately held company, which may be contemplating an eventual initial public offering (IPO), issues equity securities to its employees in exchange for services. The company must determine the fair value of those securities in order to measure the cost of the transaction and properly reflect it in the company's GAAP financial statements, typically as compensation expense. The company may use some sort of general "rule of thumb" or management's "best estimate" to determine that fair value and may or may not come up with a reasonable measurement.

If the company later undergoes an IPO, the IPO price for the securities may be significantly higher than the fair value the company used to record the compensation expense, and the size of the difference may call into question the initial, lower estimate of fair value. The IPO price represents an observable market transaction that is considered high quality evidence of fair value on the date of the IPO, and the company may be required to provide support for its determination of the noticeably lower fair value used to record compensation expense at the earlier date. …

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