The Financial Accounting Standards Board (FASB) has provided a practical expedient for private companies to reduce the complexity of determining the fair value of share-based awards.

The Accounting Standards Update (ASU), a consensus of the Private Company Council, was issued Oct. 25 in response to private company feedback FASB received about the cost and complexity of determining fair value of share-based awards, including options and restricted shares, when awards are granted or modified.

The ASU applies to all equity-classified share-based awards private companies issue to employees and nonemployees in the scope of Accounting Standards Codification Topic 718. The practical expedient lets private companies determine the current price of the shares underlying the share-based award using the “reasonable application of a reasonable valuation method” determined at the measurement date, FASB wrote in the ASU. It is not available for liability-classified awards.

When private companies apply an option-pricing model (like Black-Scholes) to determine fair value of share-based awards, one of the inputs is current price, which is the fair value of the shares underlying the awards. This input is difficult for private companies to estimate because their stock is not actively traded and there are no observable market prices to use.

The following are the characteristics the ASU uses to describe a reasonable application of a reasonable valuation method:

  • The valuation must take into consideration all available information that is material to the entity’s value.
  • The factors to be considered in determining reasonableness of application and method include the following:
    • The value of the entity’s assets (tangible and intangible);
    • The present value of the entity’s anticipated future cash flows;
    • The market value of stock or equity interests in similar entities engaged in substantially similar trades or businesses to the entity’s;
    • Recent arm’s-length transactions for the entity’s sale or transfer of stock or equity interests;
    • Other relevant factors relating to the stock’s marketability and the valuation’s purpose; and
    • Consistent use of a valuation method by the entity when valuing its stock or assets for other purposes.
  • An entity may use a previously calculated valuation if it was calculated no more than 12 months before the measurement date, and it must be updated for any information that becomes available after the calculation that may materially affect the valuation.

Section 409A of the Internal Revenue Code uses the same characteristics for a reasonable application of a reasonable valuation method for income tax purposes, so private companies can use one valuation for both requirements. The ASU notes it expects nonpublic entities will often use independent third-party appraisals for this purpose, although it is acceptable for companies to use an internally prepared valuation.

If elected, the practical expedient must be applied to all share-based awards with the same measurement date and underlying share. Companies that elect the practical expedient must disclose the election as part of their required disclosures under Topic 718.

The ASU is effective prospectively for all qualifying awards granted or modified during fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 15, 2022. Early application is permitted for financial statements not yet issued or made available for issuance as of Oct. 25, 2021.