It is not uncommon for employers that sponsor employee stock purchase plans under Internal Revenue Code section 423 (ESPPs) to run out of shares during an offering period ( a "Share Shortfall"). Typically, employers will increase the number of plan shares and submit the share increase to the shareholders for approval at the next shareholder meeting. As the result of a recent accounting pronouncement, companies in this situation could face significant earnings charges.
Historically, ESPPs have not been treated as "compensatory" plans under APB 25. As a result, employers sponsoring such plans have been able to sell stock to employees at significant discounts from fair market value without having to record compensation expense for financial accounting purposes. Last month, the emerging issues task force reached a different result in connection with Share Shortfalls. According to the EITF, if an ESPP runs out of shares during an offering period, the employer must record a compensation expense for any additional shares it makes available for that offering period (i.e., as a result of getting shareholder approval of a plan share increase). The compensation expense will be the difference between the value of the stock on the date of shareholder approval and the purchase price for that offering period (assuming the stock value increases over the course of the offering period).
For example, assume a company maintains a standard ESPP with a 6 month offering period that begins January 1 when the stock price is $20. The plan is short 50,000 shares for the offering period ending June 30. On March 22, the company's shareholders approve a plan share increase. On that date, the stock value is 25. Under the new accounting rule, the company must record a compensation expense of $400,000, which is 50,000 shares times the $8 spread on the date of shareholder approval ($25 value - the $17 "option price" (85% of the January 1 value)).
This new rule appears to be effective immediately, with no "grandfather" or other transitional relief. You should make your clients aware of this new rule immediately. Companies may want to consider adding provisions to their plans to avoid an inadvertent Share Shortfall, such as a provision that specifies a per offering period share limit.