10.3 Changes Reflected in Postcombination Compensation Cost

On January 1, 20X1, Entity D grants employees 100 nonqualified (tax-deductible) stock options that vest at the end of the fifth year of service (cliff vesting). On December 31, 20X4, Entity C acquires D in a transaction accounted for as a business combination and is obligated to replace the employees’ awards with 100 replacement awards that have the same service terms as D’s original awards (i.e., the replacement awards will vest at the end of one additional year of service). The fair-value-based measure of each award on the acquisition date is $10. Accordingly, the fair-value-based measure of both C’s awards (the replacement awards) and D’s awards (the replaced awards) is $1,000 as of the acquisition date. Entity C attributes $800 of the acquisition-date fair-value-based measure of the replacement awards to precombination service and the remaining $200 to postcombination service. The $200 attributed to the postcombination service is recognized as postcombination compensation cost over the replacement awards’ remaining one-year service period. On the acquisition date, C estimates that 25 percent of the replacement awards granted will be forfeited. Entity C’s applicable tax rate is 25 percent and its policy is to estimate forfeitures.

During the third quarter, C goes through a restructuring, and many of D’s former employees terminate their employment before their replacement awards vest. Accordingly, C changes its forfeiture estimate for the replacement awards from 25 percent to 80 percent.

There were no additional changes to the forfeiture estimate in the fourth quarter; therefore, 20 of the 100 replacement awards vested.

Assume the same facts as in the example above. Under View B, there is no difference in the accounting as of the acquisition date and for the first two quarters of service in the postcombination period (i.e., the journal entries are the same). However, Entity C’s accounting in the third quarter for the change in forfeiture estimate will differ from that under View A.

Because C’s forfeiture estimate has increased to 80 percent in the third quarter, only $200 of the $1,000 acquisition-date fair-value-based measure of the replacement awards should be allocated between the precombination and postcombination service periods. Accordingly, C recognizes an adjustment in postcombination compensation cost for the sum of (1) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in consideration transferred but that is associated with replacement awards of $440 that are no longer expected to vest — ($800 acquisition-date fair-value-based measure allocated to precombination service × 20% revised awards expected to vest) – $600 previously recognized as consideration transferred — and (2) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in postcombination compensation cost but that is associated with replacement awards of $45 that are no longer expected to vest: ($200 acquisition-date fair-value-based measure allocated to postcombination service × 20% revised awards expected to vest × 75% service rendered) – $75 previously recognized as compensation cost.

With respect to the income tax adjustments, the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in consideration transferred would be recorded in the income tax provision along with the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in postcombination compensation cost.

As in the example above, there were no additional changes to the forfeiture estimate in the fourth quarter; therefore, 20 of the 100 originally issued awards vested.

Assume the same facts as in Example 10-6, except that Entity C elects to account for forfeitures as they occur, and all forfeitures (80 awards) occur in the quarter ended September 30, 20X5. Entity C is still required to estimate the number of awards that will vest in calculating the portion of the fair-value-based measure of the replacement awards included in consideration transferred (i.e., attributable to precombination service). In addition, in a manner consistent with its accounting policy election, C recognizes compensation cost of $200 for the portion of all outstanding awards attributable to postcombination service. However, C is also required to include the amount ($200) excluded from consideration transferred (on the basis of C’s estimate of forfeitures as of the acquisition date) as compensation cost attributed to postcombination service ($800 acquisition-date fair-value-based measure initially allocated to precombination service × 25% awards not expected to vest).

There is no difference in the accounting as of the acquisition date (i.e., the journal entries are the same) because C is still required to estimate forfeitures to determine the portion of the acquisition-date fair-value-based measure of the replacement awards attributed to precombination service.

Since C’s accounting policy is to account for forfeitures as they occur, and it was required to recognize as compensation cost the amount excluded from consideration transferred related to its estimate of forfeitures as of the acquisition date, it also makes an adjustment to recognize an increase in actual forfeitures related to the amount it would have recognized as consideration transferred if the acquisition-date estimate of forfeitures were equal to actual forfeitures. Because C’s actual forfeitures are 80 percent in the third quarter, it should allocate only $200 of the $1,000 acquisition-date fair-value-based measure of the replacement awards between the precombination and postcombination service periods. Accordingly, C recognizes an adjustment in postcombination compensation cost for the sum of (1) the amount of the acquisition-date fair-value-based measure of the replacement awards that was initially allocated to precombination service and is associated with replacement awards of $540 that are forfeited — ($800 acquisition-date fair-value-based measure initially allocated to precombination service × 20% of awards outstanding) – $600 previously recognized as consideration transferred – $100 previously recognized as compensation cost for the amount excluded from consideration transferred — and (2) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in postcombination compensation cost but that is associated with replacement awards of $70 that are now forfeited: ($200 acquisition-date fair-value-based measure allocated to postcombination service × 20% of awards outstanding × 75% service rendered) – $100 previously recognized as compensation cost. However, under View A, the adjustment is limited to the $100 previously recognized as compensation cost (based on the amount excluded from consideration transferred related to A’s estimate of forfeitures at the acquisition date). In addition, an adjustment related to the DTA previously recorded in purchase accounting (attributable to precombination service) is recognized because actual forfeitures during the third quarter exceeded the amount of forfeitures estimated as of the acquisition date.

Because all the forfeitures occurred in the third quarter, there are no additional adjustments, and 20 of the 100 replacement awards vested.

View B — Entity Elects to Account for Forfeitures as They Occur

Assume the same facts as in the previous example. Under View B, there is no difference in the accounting as of the acquisition date and for the first two quarters of service in the postcombination period (i.e., the journal entries are the same). However, Entity C’s accounting in the third quarter for the change in actual forfeitures will differ from the accounting under View A because the adjustment is not limited to the amount previously recognized as compensation cost.

As in the previous example, because all the forfeitures occurred in the third quarter, there are no additional adjustments, and 20 of the 100 replacement awards vested.

On January 1, 20X1, Entity D grants employees 100 nonqualified (tax-deductible) stock options that vest only if D’s cumulative net income over the succeeding five years is greater than $5 million. On the grant date, it is deemed probable that the performance condition will be met. Accordingly, D begins to recognize compensation cost on a straight-line basis over the five-year service period.

On December 31, 20X4, Entity C acquires D in a transaction accounted for as a business combination and is obligated to replace the employees’ awards with 100 new awards that have the same terms as D’s original awards (i.e., the replacement awards will vest at the end of one additional year of service if the performance condition is met). The fair-value-based measure of each award on the acquisition date is $10. Accordingly, the fair-value-based measure of both C’s awards (the replacement awards) and D’s awards (the replaced awards) is $1,000 as of the acquisition date.

Entity C attributes $800 of the acquisition-date fair-value-based measure of the replacement awards to precombination service and the remaining $200 to postcombination service. The $200 attributed to the postcombination service is recognized as postcombination compensation cost over the replacement awards’ remaining one-year service period. On the acquisition date, it is still probable that the performance condition will be met. Assume that C’s applicable tax rate is 25 percent.

During the third quarter, C loses one of its largest customers and no longer believes that meeting the performance condition is probable.

Entity C ultimately did not meet the performance condition. Therefore, none of the awards vested, and no additional journal entries were necessary.

View B

Assume all the same facts as in the example above. Under View B, there is no difference in the accounting as of the acquisition date and for the first two quarters of service in the postcombination period (i.e., the journal entries are the same). However, Entity C’s accounting in the third quarter for the change in the expected outcome of the performance condition from probable to improbable will differ from its accounting under View A.

Because C has now determined that meeting the performance condition is no longer probable, it recognizes an adjustment to postcombination compensation cost for the sum of (1) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in consideration transferred but that is associated with replacement awards of $800 that are no longer expected to vest and (2) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in postcombination compensation cost but that is associated with replacement awards of $100 that are no longer expected to vest ($200 acquisition-date fair-value-based measure allocated to postcombination service × 50% of service rendered).

With respect to the income tax adjustments, the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in consideration transferred would be recorded in the income tax provision along with the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in postcombination compensation cost.

As in the example above, C ultimately did not meet the performance condition. Therefore, none of the awards vested, and no additional journal entries were necessary.