Accounting for Certain Modifications of Share-Based Arrangements

For some companies, share-based arrangements are a significant portion of an employee’s compensation. Due to the recent economic downturn related to the COVID-19 pandemic, many stock prices have been negatively impacted which may cause certain share-based arrangements to be underwater, wiping away any or much of their value for service and market-based awards. In addition, due to the economy being shut down for a period of time, performance targets relating to revenues, net income and EBITDA established at the beginning of the year may not achievable at year-end.

So What Are Some Options for a Company?

• Grant additional share-based arrangements to employees to make them ‘whole’ for their underwater awards. However, this would create additional dilution to shareholders. In addition, this may cause a company to be caught off guard with a shortage of shares available for grant in their long-term incentive plans and then they would have to ask their shareholders to approve amendments to increase the number of shares available for grant.

Or

• Reprice the exercise price or reduce performance targets.

If the company decides to reduce the exercise price or change vesting conditions, they would follow the modification accounting guidance under ASC 718, Compensation– Stock Compensation.

Modification Accounting for Share-Based Arrangements Classified as Equity

On the modification date, a company will have to calculate the fair value of the modified award and calculate the fair value of the original award immediately before the terms and conditions are modified. If the fair value of the modified award exceeds the fair value of the original award at the modification date, the excess is additional compensation cost (the incremental compensation cost), which is recognized over the remaining service or vesting period. In accounting for a modification, total compensation cost for the award should generally not be less than the award’s original fair value. Therefore, if the fair value of the modified award is less than the fair value of the original award on the modification date, the grant date fair value is not reduced. Total compensation cost is the award’s grant date fair value.

The compensation cost is recognized prospectively over the remaining requisite service period or, if the modified award is fully vested, the incremental compensation cost is recognized on the modification date. The effects of a modification are measured based on ASC 718-20-35-3(b) which states that the total recognized compensation cost for an equity award shall at least equal the fair value of the award at the grant date unless at the date of the modification the performance or service conditions of the original award are not expected to be satisfied. Thus, the total compensation cost measured at the date of a modification shall be the sum of the following:

1. The portion of the grant-date fair value of the original award for which the requisite service is expected to be rendered (or has already been rendered) at that date, and
2. The incremental cost resulting from the modification.

However, there is one exception to the general rule that total compensation cost cannot be less than the grant-date fair value of the award which is when the performance or service conditions of the original award are not expected to be satisfied as of the modification date.

Modifications that Affect Performance Targets (A Change in Vesting Conditions)

The accounting for the modification of the vesting condition of an award that vests on the achievement of a performance condition depends on the probability of achievement of the original performance condition immediately before and after the award is modified. At the date of the modification, both the original performance condition and the modified performance condition are assessed as either probable or not probable. If, at the date of the modification, it is probable that an award would vest under its original performance condition, compensation cost should be recognized using the grant-date fair value if either (1) the award vests under the modified vesting condition or (2) the award would have vested under the original vesting condition. Conversely, if, at the time of the modification, it is not probable that the award would vest under its original performance condition, compensation cost should be recognized only if the award vests under the modified vesting condition. Therefore, at the date of the modification, the likelihood that the original award would vest under its original terms is assessed as being either probable or not probable. Likewise, at the date of the modification, the likelihood that the modified award will vest under its terms is assessed as being either probable or not probable.

Modifications that Affect Market Conditions

When a market condition in an award is modified, the probability of satisfying the original condition does not affect the recognition of compensation cost because the market condition was incorporated into the grant-date fair value measurement. Accordingly, the total compensation cost recognized for the modification of a market condition is subject to the same floor considerations as an award with a service condition (the total recognized compensation cost for an modified equity award should at least equal the fair value of the original award at the grant date). Therefore, the compensation cost will not be reduced below the grant-date fair value of the original award.

Modifications that Affect Liability Classified Awards

No special guidance is necessary to evaluate the effect on compensation cost when an award classified as a liability remains a liability after the modification. This is because liability-classified awards are remeasured at their fair value at each reporting date. Therefore, when a liability-classified award is modified, any change in fair value (or intrinsic value or calculated value for a nonpublic entity that uses those methods) as a result of the modification will be reflected in compensation cost when the liability is remeasured at each reporting date.

Final Thoughts

The modification of share-based awards may be something that companies are considering in an effort the offset some of the impacts of the global pandemic. While different modification options are available, depending upon the nature of the original award, the accounting for these modifications can be complex and the impact to a company’s compensation expense (albeit non-cash in nature) can often be significant.  As such, it is worthwhile to assess the accounting impacts of potential modifications before they are finalized.