'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.

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.

Because rules of thumb or best estimates by management are generally considered to be low-quality evidence of fair value in that typically they are unsupported by accepted valuation practices used by qualified valuation specialists, the company may be required to record a "cheap stock charge" for additional compensation expense. The additional expense reflects the presumably higher fair value of the equity securities at the time of issuance than the value the company used initially as the basis for recording expense.

Although the Practice Aid is neither a "how-to" guide nor does it represent authoritative guidance, it fills a void relating to numerous aspects of the valuation of private company securities and may therefore be viewed by some as being one of the best available sources of guidance on the subject.

Marc Simon, CPA, is a technical manager for the Accounting Standards Team of the AICPA. He can be contacted at [e-mail].

Unless otherwise noted, the views expressed above do not necessarily reflect the views of the AICPA. Official NCPA positions are determined through certain specific committee procedures, due process and deliberation.