of a Closely Held Entity*
8.01 In this case study, the entity is closely held and writes a put option indexed to its own stock. A put option on stock gives the holder of the option the right (but not the obligation) to sell a specified number of shares to the writer o f the option at a fixed price during a given period. Depending on the specific terms, the option contract may have characteristics o f both debt and equity for its writer.
8.02 The accounting considerations portion o f the case study illustrates the entity's accounting for the put option and discusses why the option is not subject to the requirements o f FASB Statement No. 133. The auditing consid erations section highlights the potential misstatements that can occur when accounting for the put option and how various inherent risk considerations affect substantive procedures.
Accounting Considerations1
8.03 Rosebud.com is a closely held start-up entity developing new technolo
gies for the filmmaking industry. Charles Foster, one of the entity's founders, has been negotiating the terms of a divorce from his wife. He has agreed to give her half o f his 500,000 shares in Rosebud.com. Mrs. Foster also has requested that the entity guarantee the value o f the stock by granting her the option to resell the stock to the entity for a stated price at a given future date. During 20X0, the stockholders agreed to grant Mrs. Foster the option of reselling her shares to the entity at $8 per share.
8.04 In effect, Rosebud.com has written a put option on its own stock. The put option is not a derivative as that term is defined in FASB Statement No. 133 since the option contract permits only physical settlement and there fore does not meet one of the net settlement criteria required to be considered a derivative. Guidance on the accounting for this transaction is provided by FASB
Statement No. 150, Accounting for Certain Financial Instruments with Charac
teristics o f both Liabilities and Equity. * 1 2 According to FASB Statement No. 150,
a financial instrument, other than an outstanding share, that, at inception (a)
embodies an obligation to repurchase the issuer's equity shares, or is indexed
* Refer to the Preface o f this Guide for important information about the applicability o f the pro fessional standards to audits o f issuers and nonissuers (see definitions in the Preface). As applicable, this chapter contains dual referencing to both the AICPA and the PCAOB's professional standards.
1 For simplicity, this case study ignores income tax consequences.
2 Freestanding written put options on the option writer's (issuer's) equity shares that require physical settlement were generally classified, before the issuance o f FASB Statement No. 150, as equity under EITF Issue No. 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock." In accordance with FASB Statement No. 150, written put options that require physical settlement are classified as liabilities because those instru ments embody obligations to repurchase the issuer's equity shares that require the issuer to settle by transferring its assets. Also, because written put options are classified as liabilities under FASB Statement No. 150, those instruments no longer meet the exception for equity derivatives o f the issuer in paragraph 11(a) o f FASB Statement No. 133. Consequently, they either are derivative instruments, if they meet other criteria in FASB Statement No. 133, or are required to be measured in accordance with FASB Statement No. 150.
to such an obligation, and (b) requires or may require the issuer to settle the obligation by transferring assets shall be classified as a liability (or an asset in some circumstances). Examples include forward purchase contracts or written put options on the issuer's equity shares that are to be physically settled or net cash settled. The put option contract in this case study requires physical set tlement. If Mrs. Foster exercises her option, Rosebud.com is required to deliver the full stated amount of cash to Mrs. Foster, and she is required to deliver her entire 250,000 shares to Rosebud.com.
8.05 Under the guidance contained in FASB Statement No. 150, a written put option requiring physical settlement should be reported as a liability and measured at fair value both initially and for subsequent periods. Subsequent changes in the fair value o f the option should be recognized in earnings. At the date the option was granted, Rosebud.com estimated that the fair value o f the option was $100,000 and made the following journal entry.
Other expense3 $100,000
Other liability $100,000
To record the put option
8.06 The option contract is a financial instrument.4 However, Rosebud.com is a nonpublic entity, and therefore FASB Statement No. 107 would not re quire disclosure about the contract's fair value if the entity has total assets less than $100 million and has no derivatives subject to the requirements o f FASB Statement No. 133. Rosebud.com is required under FASB Statement No. 150 to disclose the following:
• The nature, terms, rights, obligations, and settlement alternatives
(including the entity that controls the settlement alternatives) em bodied in the option.
• The amount that would be paid, or the number o f shares that
would be issued and their fair value, determined under the con ditions specified in the contract if the settlement were to occur at the reporting date.
• How changes in the fair value o f the issuer's equity shares would
affect those settlement amounts. For example, "the issuer is ob ligated to issue additional x shares or pay additional y dollars in cash for each $1 decrease in the fair value o f one share."
• The maximum amount that the issuer could be required to pay
in cash to redeem the instrument by physical settlement, if applicable.
3 The objective o f the discussion o f accounting considerations in this case study is to provide background information necessary to look at the auditing considerations. For illustrative purposes, this case study assumes that the fair value o f the option is recorded through other expense.
4 FASB Statement No. 107, as well as FASB Statement No. 133, defines a financial instrument as cash, evidence o f an ownership interest in an entity, or a contract that both—
a. Imposes on one entity a contractual obligation (i) to deliver cash or another financial instrument to a second entity or (ii) to exchange financial instruments on potentially unfavorable terms with the second entity.
b. Conveys to that second entity a contractual right (i) to receive cash or another financial instrument from the first entity or (ii) to exchange other financial instruments on potentially favorable terms with the first entity.
• The fact that a contract does not limit the amount the issuer could be required to pay or the number o f shares that the issuer could be required to issue, if applicable.
• The option strike price, the number o f issuer's shares to which the
contract is indexed, and the settlement date(s) o f the contract, as applicable.
8.07 At the date Mrs. Foster exercised her option, Rosebud.com made the
following entry (based on the sales price o f $8 per share and 250,000 shares).
Other liability $2,000,000
Cash $2,000,000
To record the payment due under the put option.
The net increase o f $1,900,000 in the liability represents the increase in the fair value o f the option over time and would have been reflected in earnings during the periods from the issuance o f the option to its exercise.
Auditing Considerations
Description of the Entity
8.08 Rosebud.com is a start-up entity in the process o f developing technol ogy to deliver movies over the Internet. The entity is actively pursuing venture capital financing.
8.09 Founders o f the entity have considerable technical expertise in the type of technology Rosebud.com is developing. The management group also has experience in managing a start-up technology entity and in taking that entity public. The entity has an outside board o f directors. It is advised by highly re garded professional services firms with expertise in intellectual property, initial public offerings, and SEC matters.
8.10 Because o f the quality o f the management team, its technical exper tise, and previous experience, the auditor assesses the entity’s control environ ment as good.
Summary of Accounting
8.11 The contract with Mrs. Foster should be reported as a liability and
measured at fair value. Any subsequent changes in the fair value o f the contract should be recognized in earnings.
Types of Potential Misstatements
8.12 Inaccurate estimate o f fair value. Estimating the value o f a non-
exchange-traded option usually is done using an options pricing model. Some o f the assumptions necessary to use the model may require a great deal o f judgment when the underlying stock is not publicly traded (in this case study, the volatility o f Rosebud.com's stock will be quite subjective.) Unsupportable assumptions may result in fair value estimates that are materially incorrect.
8.13 Improper classification. A written put option has the elements of both debt and equity. The entity may improperly classify the contract.
Inherent Risk Factors to Consider for This Transaction in
Planning the Audit
8.14 In assessing inherent risk, the auditor considered—
• The complexity o f the instrument. As described above, it will be difficult to determine the fair value of the option, since both the option and the underlying stock are not publicly traded.
• Whether the transaction involved the exchange o f cash. The con tract did not involve an initial exchange o f cash, which increases the risk that the transaction was not captured by the entity's ac counting system.
• The entity's experience with the instrument. Because the entity has no previous experience writing put options on its own stock, the risk that it would be accounted for improperly is increased. 8.15 Because of the presence o f these factors and the potential material impact the put option could have on the entity's financial position, the auditor assessed inherent risk as high and determined that the situation warranted the direct involvement of the most experienced firm members.
Control Risk
8.16 The transaction that resulted in the entity writing a put option was an unusual, one-time event. As such, it was reviewed and approved by the stockholders and board o f directors and was not subject to the entity's usual operating control procedures. Therefore, control risk was assessed at the max imum. When performing an integrated audit of financial statements and in ternal control over financial reporting in accordance with PCAOB standards, if the auditor assesses control risk as other than low for certain assertions or sig nificant accounts, the auditor should document the reasons for that conclusion
(AICPA, PCAOB Standards and Related Rules, Release No. 2004-008).†
Timing of Procedures
8.17 The relevant assertions associated with this transaction will be sub stantively tested at year end. This decision is influenced by the assessment of control risk at the maximum, the fact that this is an isolated transaction, and the design o f the substantive procedures (confirmation and recomputation) as discussed below.
Materiality
8.18 The transaction is considered material.