3.4 Vesting Conditions
ASC 718-10 — Glossary
Vest
To earn the rights to. A share-based payment award becomes vested at the date that the grantee’s right to receive or retain shares, other instruments, or cash under the award is no longer contingent on satisfaction of either a service condition or a performance condition. Market conditions are not vesting conditions.
The stated vesting provisions of an award often establish the employee’s requisite service period or the nonemployee’s vesting period, and an award that has reached the end of the applicable period is vested. However, as indicated in the definition of requisite service period and equally applicable to a nonemployee’s vesting period, the stated vesting period may differ from those periods in certain circumstances. Thus, the more precise terms would be options, shares, or awards for which the requisite good has been delivered or service has been rendered and the end of the employee’s requisite service period or the nonemployee’s vesting period.
ASC 718-10
55-7 Note that performance and service conditions are vesting conditions for purposes of this Topic. Market conditions are not vesting conditions for purposes of this Topic but market conditions may affect exercisability of an award. Market conditions are included in the estimate of the grant-date fair value of awards (see paragraphs 718-10-55-64 through 55-66).
Market, Performance, and Service Conditions That Affect Vesting and Exercisability
55-60 A grantee’s share-based payment award becomes vested at the date that the grantee’s right to receive or retain equity shares, other equity instruments, or assets under the award is no longer contingent on satisfaction of either a performance condition or a service condition. This Topic distinguishes among market conditions, performance conditions, and service conditions that affect the vesting or exercisability of an award (see paragraphs 718-10-30-12 and 718-10-30-14). Exercisability is used for market conditions in the same context as vesting is used for performance and service conditions. Other conditions affecting vesting, exercisability, exercise price, and other pertinent factors in measuring fair value that do not meet the definitions of a market condition, performance condition, or service condition are discussed in paragraph 718-10-55-65.
Share-based payment awards may contain the following types of conditions that affect the vesting, exercisability, or other pertinent factors of the awards:
- Service conditions (e.g., the award vests upon the completion of four years of continued service).
- Performance conditions (e.g., the award vests when a specified amount of the entity’s product is sold).
- Market conditions (e.g., the award becomes exercisable when the market price of the entity’s stock reaches a specified level).
- Other conditions (those that affect an award’s vesting, exercisability, or other factors relevant to the fair-value-based measure that are not market, performance, or service conditions).
Service and performance conditions may be considered vesting conditions. That is, the service or performance condition must be satisfied for a grantee to earn (i.e., vest in) an award. Compensation cost is recognized only for awards that are earned or expected to be earned, not for awards that are forfeited or expected to be forfeited because a service or performance condition is not met.
Some awards may contain a market condition. Unlike a service or performance condition, a market condition is not a vesting condition. Rather, a market condition is directly factored into the fair-value-based measure of an award. Accordingly, regardless of whether the market condition is satisfied, an entity would still be required to recognize compensation cost for the award if the service is rendered or the good is delivered (i.e., the service or performance condition is met).
ASC 718-10-25-13 specifies that awards may be indexed to a factor in addition to the entity’s share price. If that additional factor is not a market, performance, or service condition, the award should be classified as a liability, and the additional factor (often referred to as an “other condition”) should be incorporated into the estimate of the fair-value-based measure of the award. See Sections 4.6.2 and 5.5 for additional information about other conditions.
3.4.1 Service Condition
ASC 718-10 — Glossary
Service Condition
A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that depends solely on an employee rendering service to the employer for the requisite service period or a nonemployee delivering goods or rendering services to the grantor over a vesting period. A condition that results in the acceleration of vesting in the event of a grantee’s death, disability, or termination without cause is a service condition.
ASC 718-10
35-3 The total amount of compensation cost recognized at the end of the requisite service period for an award of share-based compensation shall be based on the number of instruments for which the requisite service has been rendered (that is, for which the requisite service period has been completed). Previously recognized compensation cost shall not be reversed if an employee share option (or share unit) for which the requisite service has been rendered expires unexercised (or unconverted). To determine the amount of compensation cost to be recognized in each period, an entity shall make an entity-wide accounting policy election for all employee share-based payment awards to do either of the following:
- Estimate the number of awards for which the requisite service will not be rendered (that is, estimate the number of forfeitures expected to occur). The entity shall base initial accruals of compensation cost on the estimated number of instruments for which the requisite service is expected to be rendered. The entity shall revise that estimate if subsequent information indicates that the actual number of instruments is likely to differ from previous estimates. The cumulative effect on current and prior periods of a change in the estimated number of instruments for which the requisite service is expected to be or has been rendered shall be recognized in compensation cost in the period of the change.
- Recognize the effect of awards for which the requisite service is not rendered when the award is forfeited (that is, recognize the effect of forfeitures in compensation cost when they occur). Previously recognized compensation cost for an award shall be reversed in the period that the award is forfeited.
55-5 A restriction that continues in effect after the entity has issued instruments to grantees, such as the inability to transfer vested equity share options to third parties or the inability to sell vested shares for a period of time, is considered in estimating the fair value of the instruments at the grant date. For instance, if shares are traded in an active market, postvesting restrictions may have little, if any, effect on the amount at which the shares being valued would be exchanged. For share options and similar instruments, the effect of nontransferability (and nonhedgeability, which has a similar effect) is taken into account by reflecting the effects of grantees’ expected exercise and postvesting termination behavior in estimating fair value (referred to as an option’s expected term).
55-6 In contrast, a restriction that stems from the forfeitability of instruments to which grantees have not yet earned the right, such as the inability either to exercise a nonvested equity share option or to sell nonvested shares, is not reflected in the fair value of the instruments at the grant date. Instead, those restrictions are taken into account by recognizing compensation cost only for awards for which grantees deliver the goods or render the service.
ASC 718-20
Example 8: Employee Share Award Granted by a Nonpublic Entity
55-71
The Example illustrates the guidance in paragraphs 718-10-30-17 through 30-19
and 718-740-25-2 through 25-4 for employee awards. The accounting demonstrated
in this Example also would be applicable to a public entity that grants share
awards to its employees. The same measurement method and basis is used for
both nonvested share awards and restricted share awards (which are a subset of
nonvested share awards).
55-72 On January 1, 20X6, Entity W, a nonpublic entity, grants 100 shares of stock to each of its 100 employees. The shares cliff vest at the end of three years. Entity W estimates that the grant-date fair value of 1 share of stock is $7. The grant-date fair value of the share award is $70,000 (100 × 100 × $7). The fair value of shares, which is equal to their intrinsic value, is not subsequently remeasured. For simplicity, the example assumes that no forfeitures occur during the vesting period. Because the requisite service period is 3 years, Entity W recognizes $23,333 ($70,000 ÷ 3) of compensation cost for each annual period as follows.
55-73 After three years, all shares are vested. For simplicity, this Example assumes that no employees made an Internal Revenue Service (IRS) Code §83(b) election and Entity W has already recognized its income tax expense for the year in which the shares become vested without regard to the effects of the share award. (IRS Code §83(b) permits an employee to elect either the grant date or the vesting date for measuring the fair market value of an award of shares.)
55-74 The fair value per
share on the vesting date, assumed to be $20, is
deductible for tax purposes. Paragraph 718-740-35-2
requires that the tax effect be recognized as income tax
expense or benefit in the income statement for the
difference between the deduction for an award for tax
purposes and the cumulative compensation cost of that
award recognized for financial reporting purposes. With
the share price at $20 on the vesting date, the
deductible amount is $200,000 (10,000 × $20), and the
tax benefit is $70,000 ($200,000 × .35).
55-75 At vesting the journal entries would be as follows.
To satisfy an award’s service condition, the grantee must provide goods or services to the entity for a specified period. A service condition is typically included explicitly in the terms of an award and is usually in the form of a vesting condition.
A vesting condition that accelerates vesting of an award upon the death, disability, or
termination, without cause, of the grantee is considered a service condition. However,
such a service condition will have no impact on the requisite service period or the
nonemployee’s vesting period until the event that triggers acceleration becomes
probable.
If a grantee forfeits an award with a service condition that affects the award’s vesting and exercisability (i.e., does not satisfy the service condition), the grantee does not vest in (i.e., has not earned) the award, and the entity reverses any compensation cost previously recognized during the vesting period. That is, compensation cost is not recognized for awards that do not vest. Since the service condition affects the grantee’s ability to earn (i.e., vest in) the award, it is not directly factored into the award’s grant-date fair-value-based measure. However, a service condition can indirectly affect the grant-date fair-value-based measure by affecting the expected term of an award that is a stock option. Because an award’s expected term cannot be shorter than the vesting period, a longer vesting period would result in an increase in the award’s expected term. See Sections 4.1.1 and 4.6 for a discussion of how a service condition affects the valuation of share-based payment awards.
ASC 718 allows an entity to make an entity-wide accounting policy election to
either (1) estimate forfeitures when awards are granted (and update its estimate if
information becomes available indicating that actual forfeitures will differ from previous
estimates) or (2) account for forfeitures when they occur. This policy election, which an
entity would make separately for employee and nonemployee awards, applies only to
forfeitures associated with service conditions. An entity that is contemplating making
changes to its accounting policy for either employee or nonemployee awards must apply ASC
250, including its requirement that the new recognition policy be preferable to the
existing one. See the next section and Section 3.4.1.2 for examples illustrating the accounting for forfeitures.
If an entity adopts a policy to account for forfeitures as they occur, it would still need to estimate forfeitures when an award is (1) modified (the estimate applies to the original award in the measurement of the effects of the modification) or (2) exchanged in a business combination (the estimate applies to the amount attributed to precombination service). However, the accounting policy for forfeitures will apply to the subsequent accounting for awards that are modified or exchanged in a business combination. Further, if an entity elects to account for forfeitures when they occur, all nonforfeitable dividends are initially charged to retained earnings and reclassified to compensation cost only when forfeitures of the underlying awards occur.
3.4.1.1 Estimating Forfeitures
ASC 718-20
Example 1: Accounting for Share Options With Service Conditions
55-4 The following Cases illustrate the guidance in paragraphs 718-10-35-1D through 35-1E for nonemployee awards, paragraphs 718-10-35-2 through 35-7 for employee awards, and paragraphs 718-740-25-2 through 25-3 for both nonemployee and employee awards, except for the vesting provisions:
- Share options with cliff vesting and forfeitures estimated in initial accruals of compensation cost (Case A)
- Share options with graded vesting and forfeitures estimated in initial accruals of compensation cost (Case B)
- Share options with cliff vesting and forfeitures recognized when they occur (Case C).
55-4A
Cases A through C (see paragraphs 718-20-55-10 through 55-34G) describe
employee awards. However, the principles on accounting for employee awards,
except for the compensation cost attribution, are the same for nonemployee
awards. Consequently, all of the following in Case A are equally applicable
to nonemployee awards with the same features as the awards in Cases A
through C (that is, awards with a specified time period for vesting):
- The assumptions in paragraphs 718-20-55-6 through 55-9
- Total compensation cost considerations (including estimates of forfeitures) in paragraphs 718-20-55-10 through 55-12
- Changes in the estimation of forfeitures in paragraphs 718-20-55-14 through 55-15
- Exercise or expiration considerations in paragraphs 718-20-55-18 through 55-21 and 718-20-55-23.
Therefore, the guidance in those paragraphs may serve as implementation guidance for nonemployee awards. Similarly, an entity also may elect to account for nonemployee award forfeitures as they occur as illustrated in Case C (see paragraph 718-20-55-34A).
55-4B
Nonemployee awards may be similar to employee awards (that is, cliff vesting
or graded vesting). However, the compensation cost attribution for awards to
nonemployees may be the same as or different from employee awards. That is
because an entity is required to recognize compensation cost for nonemployee
awards in the same manner as if the entity had paid cash in accordance with
paragraph 718-10-25-2C. Additionally, valuation amounts used in the Cases
could be different because an entity may elect to use the contractual term
as the expected term of share options and similar instruments when valuing
nonemployee share-based payment transactions.
55-5 Cases A, B, and C share all of the assumptions in paragraphs 718-20-55-6 through 55-34G, with the following exceptions:
- In Case C, Entity T has an accounting policy to account for forfeitures when they occur in accordance with paragraph 718-10-35-3.
- In Cases A and B, Entity T has an accounting policy to estimate the number of forfeitures expected to occur, also in accordance with paragraph 718-10-35-3.
- In Case B, the share options have graded vesting.
- In Cases A and C, the share options have cliff vesting.
55-6 Entity T, a public entity, grants at-the-money employee share options with a contractual term of 10 years. All share options vest at the end of three years (cliff vesting), which is an explicit service (and requisite service) period of three years. The share options do not qualify as incentive stock options for U.S. tax purposes. The enacted tax rate is 35 percent. In each Case, Entity T concludes that it will have sufficient future taxable income to realize the deferred tax benefits from its share-based payment transactions.
55-7 The following table shows assumptions and information about the share options granted on January 1, 20X5 applicable to all Cases, except for expected forfeitures per year, which does not apply in Case C.
55-8 A suboptimal exercise factor of two means that exercise is generally expected to occur when the share price reaches two times the share option’s exercise price. Option-pricing theory generally holds that the optimal (or profit-maximizing) time to exercise an option is at the end of the option’s term; therefore, if an option is exercised before the end of its term, that exercise is referred to as suboptimal. Suboptimal exercise also is referred to as early exercise. Suboptimal or early exercise affects the expected term of an option. Early exercise can be incorporated into option-pricing models through various means. In this Case, Entity T has sufficient information to reasonably estimate early exercise and has incorporated it as a function of Entity T’s future stock price changes (or the option’s intrinsic value). In this Case, the factor of 2 indicates that early exercise would be expected to occur, on average, if the stock price reaches $60 per share ($30 × 2). Rather than use its weighted average suboptimal exercise factor, Entity T also may use multiple factors based on a distribution of early exercise data in relation to its stock price.
55-9 This Case assumes that each employee receives an equal grant of 300 options. Using as inputs the last 7 items from the table in paragraph 718-20-55-7, Entity T’s lattice-based valuation model produces a fair value of $14.69 per option. A lattice model uses a suboptimal exercise factor to calculate the expected term (that is, the expected term is an output) rather than the expected term being a separate input. If an entity uses a Black-Scholes-Merton option-pricing formula, the expected term would be used as an input instead of a suboptimal exercise factor.
Case A: Share Options With Cliff Vesting and Forfeitures Estimated in Initial Accruals of Compensation Cost
55-10 Total compensation cost recognized over the requisite service period (which is the vesting period in this Case) shall be the grant-date fair value of all share options that actually vest (that is, all options for which the requisite service is rendered). This Case assumes that Entity T’s accounting policy is to estimate the number of forfeitures expected to occur in accordance with paragraph 718-10-35-3. As a result, Entity T is required to estimate at the grant date the number of share options for which the requisite service is expected to be rendered (which, in this Case, is the number of share options for which vesting is deemed probable). If that estimate changes, it shall be accounted for as a change in estimate and its cumulative effect (from applying the change retrospectively) recognized in the period of change. Entity T estimates at the grant date the number of share options expected to vest and subsequently adjusts compensation cost for changes in the estimated rate of forfeitures and differences between expectations and actual experience. This Case also assumes that none of the compensation cost is capitalized as part of the cost of an asset.
55-11 The estimate of the number of forfeitures considers historical employee turnover rates and expectations about the future. Entity T has experienced historical turnover rates of approximately 3 percent per year for employees at the grantees’ level, and it expects that rate to continue over the requisite service period of the awards. Therefore, at the grant date Entity T estimates the total compensation cost to be recognized over the requisite service period based on an expected forfeiture rate of 3 percent per year. Actual forfeitures are 5 percent in 20X5, but no adjustments to cumulative compensation cost are recognized in 20X5 because Entity T still expects actual forfeitures to average 3 percent per year over the 3-year vesting period. As of December 31, 20X6, management decides that the forfeiture rate will likely increase through 20X7 and changes its estimated forfeiture rate for the entire award to 6 percent per year. Adjustments to cumulative compensation cost to reflect the higher forfeiture rate are made at the end of 20X6. At the end of 20X7 when the award becomes vested, actual forfeitures have averaged 6 percent per year, and no further adjustment is necessary.
55-12 The first set of calculations illustrates the accounting for the award of share options on January 1, 20X5, assuming that the share options granted vest at the end of three years. (Case B illustrates the accounting for an award assuming graded vesting in which a specified portion of the share options granted vest at the end of each year.) The number of share options expected to vest is estimated at the grant date to be 821,406 (900,000 × .973). Thus, the compensation cost to be recognized over the requisite service period at January 1, 20X5, is $12,066,454 (821,406 × $14.69), and the compensation cost to be recognized during each year of the 3-year vesting period is $4,022,151 ($12,066,454 ÷ 3). The journal entries to recognize compensation cost and related deferred tax benefit at the enacted tax rate of 35 percent are as follows for 20X5.
55-13 The net after-tax effect on income of recognizing compensation cost for 20X5 is $2,614,398 ($4,022,151 – $1,407,753).
55-14 Absent a change in
estimated forfeitures, the same journal entries
would be made to recognize compensation cost and
related tax effects for 20X6 and 20X7, resulting in
a net after-tax cost for each year of $2,614,398.
However, at the end of 20X6, management changes its
estimated employee forfeiture rate from 3 percent to
6 percent per year. The revised number of share
options expected to vest is 747,526 (900,000 ×
.943). Accordingly, the revised
cumulative compensation cost to be recognized by the
end of 20X7 is $10,981,157 (747,526 × $14.69). The
cumulative adjustment to reflect the effect of
adjusting the forfeiture rate is the difference
between two-thirds of the revised cost of the award
and the cost already recognized for 20X5 and 20X6.
The related journal entries and the computations
follow.
At December 31, 20X6, to adjust for new forfeiture rate.
55-15 The related journal entries are as follows.
55-16 Journal entries for 20X7 are as follows.
55-17 As of December 31, 20X7, the entity would examine its actual forfeitures and make any necessary adjustments to reflect cumulative compensation cost for the number of shares that actually vested.
55-18 All 747,526 vested share options are exercised on the last day of 20Y2. Entity T has already recognized its income tax expense for the year without regard to the effects of the exercise of the employee share options. In other words, current tax expense and current taxes payable were recognized based on income and deductions before consideration of additional deductions from exercise of the employee share options. Upon exercise, the amount credited to common stock (or other appropriate equity accounts) is the sum of the cash proceeds received and the amounts previously credited to additional paid-in capital in the periods the services were received (20X5 through 20X7). In this Case, Entity T has no-par common stock and at exercise, the share price is assumed to be $60.
55-19 At exercise the journal entries are as follows.
55-20 In this Case, the
difference between the market price of the shares
and the exercise price on the date of exercise is
deductible for tax purposes pursuant to U.S. tax law
in effect in 2004 (the share options do not qualify
as incentive stock options). Paragraph 718-740-35-2
requires that the tax effect be recognized as income
tax expense or benefit in the income statement for
the difference between the deduction for an award
for tax purposes and the cumulative compensation
cost of that award recognized for financial
reporting purposes. With the share price of $60 at
exercise, the deductible amount is $22,425,780
[747,526 × ($60 – $30)], and the tax benefit is
$7,849,023 ($22,425,780 × .35).
55-21 At exercise the journal entries are as follows.
55-22
Paragraph superseded by Accounting Standards Update No. 2016-09.
55-23 If instead the share options expired unexercised, previously recognized compensation cost would not be reversed. There would be no deduction on the tax return and, therefore, the entire deferred tax asset of $3,843,405 would be charged to income tax expense.
55-23A If employees terminated with out-of-the-money vested share options, the deferred tax asset related to those share options would be written off when those options expire.
If an entity chooses an accounting policy to estimate forfeiture rates when awards are granted, it can base its estimate of the number of share-based payment awards that eventually will vest on a number of different sources of information and data. For example, for employee awards, the entity may base its estimate on the following (among other sources):
- Historical rates of forfeiture (before vesting) for awards with similar terms.
- Historical rates of employee turnover (before vesting).
- The intrinsic value of the award on the grant date.
- The volatility of the entity’s share price.
- The length of the vesting period.
- The number and value of awards granted to individual employees.
- The nature and terms of the vesting condition(s) of the award.
- The characteristics of the employee (e.g., whether the employee is a member of executive management of the entity).
- A large population of relatively homogenous employee grants.
- Other relevant terms and conditions of the award that may affect forfeiture behavior (before vesting).
Different groups of grantees of the same award issuance may have forfeiture rate
assumptions that differ on the basis of the facts and circumstances. In addition, many
of these same sources of information and data could be relevant for nonemployee awards.
For more information, see Section
9.3.2.1.
In accordance with paragraph B166 of FASB Statement 123(R), entities that do not
have sufficient information may base forfeiture estimates on the experience of other
entities in the same industry until entity-specific information is available.
Estimated forfeiture rates should be reassessed throughout the grantee’s requisite
service period (or nonemployee’s vesting period), and changes in estimates should be
reflected by using a cumulative-effect adjustment. See Section 3.8 for more information about changes in estimates.
Entities that elect to estimate forfeitures should carefully consider whether they are
recognizing compensation that, in accordance with ASC 718-10-35-8, is at least equal to
the grant-date fair-value measure of the vested portion of that award (see Section 3.6.5). If actual forfeitures are lower than
estimated forfeitures, an entity may not be recognizing sufficient compensation to
satisfy this requirement.
Example 3-9
Entity A grants 1,000 at-the-money employee stock options, each with a
grant-date fair-value-based measure of $10. The options vest at the end of
the fourth year of service (cliff vesting). Entity A’s accounting policy is
to estimate the number of forfeitures expected to occur in accordance with
ASC 718-10-35-3. As of the grant date, A estimates that 100 of the stock
options will be forfeited during the service (vesting) period. However, 150
options are forfeited in year 3. There are no other forfeitures during the
service (vesting) period. The table below illustrates the compensation cost
that is recognized on the basis of the initial estimate of forfeitures and
revised when information becomes available suggesting that actual
forfeitures will differ.
See Section 3.8 for more information about
changes in estimates.
3.4.1.2 Accounting for Forfeitures When They Occur
The example below is based on the same facts as in Example 1 in ASC 718-20-55-4
through 55-9 (see Section
3.4.1.1).
ASC 718-20
Case C: Share Options With Cliff Vesting and Forfeitures Recognized When They Occur
55-34A This Case uses the same assumptions as Case A except that Entity T’s accounting policy is to account for forfeitures when they occur in accordance with paragraph 718-10-35-3. Consequently, compensation cost previously recognized for an employee share option is reversed in the period in which forfeiture of the award occurs. Previously recognized compensation cost is not reversed if an employee share option for which the requisite service has been rendered expires unexercised. This Case also assumes that none of the compensation cost is capitalized as part of the cost of an asset.
55-34B In 20X5, 20X6, and 20X7, share option forfeitures are 45,000, 47,344, and 60,130, respectively.
55-34C The compensation cost to be recognized over the requisite service period at January 1, 20X5, is $13,221,000 (900,000 × $14.69), and the compensation cost to be recognized (excluding the effect of forfeitures) during each year of the 3-year vesting period is $4,407,000 ($13,221,000 ÷ 3). The journal entries for 20X5 to recognize compensation cost and related deferred tax benefit at the enacted tax rate of 35 percent are as follows.
55-34D During 20X5, 45,000 share options are forfeited; accordingly, Entity T remeasures compensation cost to reflect the effect of forfeitures when they occur and recognizes compensation costs for 855,000 (900,000 – 45,000) share options (net of forfeitures) at an amount of $12,559,950 (855,000 × $14.69) over the 3-year vesting period, or $4,186,650 each year ($12,559,950 ÷ 3). Therefore, Entity T reverses recognized compensation cost of $220,350 (45,000 share options × $14.69 ÷ 3) to account for forfeitures that occurred during 20X5. The journal entries to recognize the effect of forfeitures during 20X5 and the related reduction in the deferred tax benefit are as follows.
55-34E As of January 1, 20X6, Entity T determines the compensation cost and related tax effects to recognize during 20X6. The journal entries for 20X6 to recognize compensation cost and related deferred tax benefit at the enacted tax rate of 35 percent are as follows (excluding the effect of forfeitures in 20X6).
55-34F In 20X6, 47,344 share options are forfeited (that is, 92,344 share options in total have been forfeited by December 31, 20X6); accordingly, Entity T would recognize compensation cost for 807,656 share options over the 3-year vesting period. On the basis of actual forfeitures in 20X5 and 20X6, Entity T should recognize a cumulative compensation cost of $11,864,467 (807,656 × $14.69) for the 3-year vesting period, or $3,954,822 a year ($11,864,467 ÷ 3 years). Therefore, Entity T reverses recognized compensation cost of $231,828 ($4,186,650 – $3,954,822) for 20X5 and 20X6, or $463,656 in total, to account for forfeitures that occurred during 20X6. The journal entries to recognize the effect of forfeitures during 20X6 and the related reduction in the deferred tax benefit are as follows.
55-34G Entity T follows the same approach in 20X7 as it applied in 20X6 to recognize compensation cost and related tax effects.
The vesting of an award upon the satisfaction of a service condition may become
improbable as a result of a planned future termination of employment or a nonemployee
arrangement to provide goods or services (e.g., a plant shutdown or executive separation
agreement). If an entity elects to account for forfeitures as they occur, the accounting
for planned future terminations depends on whether the award is modified and, if so,
when the modification occurs (i.e., whether the award is modified before or on the date
of termination). See Section
6.3.3.2 for further discussion of a modification in connection with a
termination. If the award is not modified, compensation cost is not reversed (i.e., the
forfeiture is not recognized) until the termination date.
3.4.2 Performance Condition
ASC 718-10 — Glossary
Performance Condition
A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that relates to both of the following:
- Rendering service or delivering goods for a specified (either explicitly or implicitly) period of time
- Achieving a specified performance target that is defined solely by reference to the grantor’s own operations (or activities) or by reference to the grantee’s performance related to the grantor’s own operations (or activities).
Attaining a specified growth rate in return on assets, obtaining regulatory approval to market a specified product, selling shares in an initial public offering or other financing event, and a change in control are examples of performance conditions. A performance target also may be defined by reference to the same performance measure of another entity or group of entities. For example, attaining a growth rate in earnings per share (EPS) that exceeds the average growth rate in EPS of other entities in the same industry is a performance condition. A performance target might pertain to the performance of the entity as a whole or to some part of the entity, such as a division, or to the performance of the grantee if such performance is in accordance with the terms of the award and solely relates to the grantor’s own operations (or activities).
Probable
The future event or events are likely to occur.
ASC 718-10
Market, Performance, and Service Conditions
25-20 Accruals of compensation cost for an award with a performance condition shall be based on the probable outcome of that performance condition — compensation cost shall be accrued if it is probable that the performance condition will be achieved and shall not be accrued if it is not probable that the performance condition will be achieved. If an award has multiple performance conditions (for example, if the number of options or shares a grantee earns varies depending on which, if any, of two or more performance conditions is satisfied), compensation cost shall be accrued if it is probable that a performance condition will be satisfied. In making that assessment, it may be necessary to take into account the interrelationship of those performance conditions. Example 2 (see paragraph 718-20-55-35) provides an illustration of how to account for awards with multiple performance conditions.
To satisfy an award’s performance condition, the grantee must (1) provide goods
or services for a specified period and (2) have the ability to earn the award on the basis
of the operations or activities of the grantor or the performance of the grantee related
to the grantor’s own operations or activities. The grantor’s operations or activities
could include the attainment of specified financial performance targets (e.g., revenue,
EPS); operating metrics (e.g., number of items produced); environmental, social, and
governance (ESG) targets (e.g., reduction in certain Scope 3 emissions); or other specific
actions (e.g., IPO, receipt of regulatory approval). The grantee’s activities could
include sales generated or other goals. Rendering service or delivering goods for a
specified period can be either explicitly stated or implied (e.g., the time it will take
for the performance condition to be met).
If (1) the grantee does not provide the necessary goods or services for the
specified period or (2) the entity or the grantee does not attain the specified
performance target, the grantee has not earned (i.e., has not vested in) the award. If the
grantee does not earn the award, the entity would reverse any compensation cost accrued
during the requisite service period or nonemployee’s vesting period. Ultimately,
compensation cost is not recognized for awards that do not vest. During the service or
vesting period, the entity must assess the probability that the performance condition will
be met (i.e., the probability that the grantee will earn the award) and adjust the
cumulative compensation cost recognized accordingly. If it is not probable that the
performance condition will be met, the entity should not record any compensation cost. See
Section 3.8 for more
information about changes in estimates.
Since the performance condition affects the grantee’s ability to earn (i.e.,
vest in) the award, it is not directly factored into the fair-value-based measure of the
award. However, a performance condition can indirectly affect the fair-value-based measure
by affecting the expected term of an award that is a stock option. Because the award’s
expected term cannot be shorter than the vesting period, a longer vesting period would
result in an increase in the award’s expected term. See the discussions in Sections 4.1.1 and 4.6 on how a performance condition affects the valuation of
share-based payment awards.
Although ASC 718-20-55-40 suggests that compensation cost could be recognized on the basis of “the relative satisfaction of the performance condition,” the FASB staff believes that it would be rare to recognize compensation cost for an employee award with only a performance condition in a manner other than ratably over the requisite service period.
Example 3-10
On January 1, 20X1, Entity A grants 1,000 at-the-money employee stock options. The options vest only if cumulative net income over the next three annual reporting periods exceeds $1 million and the employee is still in the employment of A.
The service period is explicitly stated in the terms of the options. The employee must provide three years of continuous service to A to earn the options. In addition, A must meet the specified performance target of cumulative net income in excess of $1 million over the next three annual reporting periods. If either (1) the employee does not remain in the employment of A for the specified period or (2) A does not attain the performance target, the options will be forfeited and any compensation cost previously recognized by A will be reversed. Compensation cost will be recognized on a straight-line basis (i.e., one-third for each year of service) over the three-year service period if it is probable that the performance condition will be met.
3.4.2.1 Performance Conditions Associated With Liquidity Events
A liquidity event (e.g., IPO or change in control) represents a performance condition under ASC 718 if the grantee’s ability to earn the award is contingent on the grantee’s rendering of service or delivery of goods and the entity’s attainment of the specified performance target (i.e., the liquidity event). Because a performance condition affects the grantee’s ability to earn the award, it is not directly factored into the award’s fair-value-based measure.
During the service or vesting period, the entity must assess the probability that the performance condition (e.g., liquidity event) will be met (i.e., the probability that the grantee will earn the award). A liquidity event such as a change in control or an IPO is generally not considered probable until it occurs. This position is consistent with the guidance in ASC 805-20-55-50 and 55-51 on liabilities that are triggered upon the consummation of a business combination. Accordingly, an entity generally does not recognize compensation cost related to awards that vest upon a change in control or an IPO until the event occurs.
One exception to the probability assessment is a performance condition that is related to a change-in-control event associated with an entity’s sale of its business unit (or subsidiary) to a third party. Such a sale may be considered probable before the change-in-control event occurs if the sale meets the held-for-sale criteria in ASC 360. If those criteria are satisfied, there is a presumption that the sale is probable. Therefore, a performance condition that is based on the sale of a business unit may be satisfied before the actual sale occurs if the business unit meets the held-for-sale criteria in ASC 360.
3.4.2.2 Performance Conditions Satisfied After the Requisite Service Period or the Nonemployee’s Vesting Period
ASC 718-10
30-28 In some cases, the terms of an award may provide that a performance target that affects vesting could be achieved after an employee completes the requisite service period or a nonemployee satisfies a vesting period. That is, the grantee would be eligible to vest in the award regardless of whether the grantee is rendering service or delivering goods on the date the performance target is achieved. A performance target that affects vesting and that could be achieved after an employee’s requisite service period or a nonemployee’s vesting period shall be accounted for as a performance condition. As such, the performance target shall not be reflected in estimating the fair value of the award at the grant date. Compensation cost shall be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the service or goods already have been provided. If the performance target becomes probable of being achieved before the end of the employee’s requisite service period or the nonemployee’s vesting period, the remaining unrecognized compensation cost for which service or goods have not yet been provided shall be recognized prospectively over the remaining employee’s requisite service period or the nonemployee’s vesting period. The total amount of compensation cost recognized during and after the employee’s requisite service period or the nonemployee’s vesting period shall reflect the number of awards that are expected to vest based on the performance target and shall be adjusted to reflect those awards that ultimately vest. An entity that has an accounting policy to account for forfeitures when they occur in accordance with paragraph 718-10-35-1D or 718-10-35-3 shall reverse compensation cost previously recognized, in the period the award is forfeited, for an award that is forfeited before completion of the employee’s requisite service period or the nonemployee’s vesting period. The employee’s requisite service period and the nonemployee’s vesting period end when the grantee can cease rendering service or delivering goods and still be eligible to vest in the award if the performance target is achieved. As indicated in the definition of vest, the stated vesting period (which includes the period in which the performance target could be achieved) may differ from the employee’s requisite service period or the nonemployee’s vesting period.
ASC 718-10-30-28 specifies that a shared-based payment award with established performance targets that affect vesting and that could be achieved after a grantee completes the requisite service or a nonemployee’s vesting period (i.e., the grantee would be eligible to vest in the award regardless of whether the grantee is delivering goods or rendering service on the date the performance target could be achieved) should be treated as a performance condition that is a vesting condition. Therefore, these performance targets should not be directly reflected in the award’s fair-value-based measure. For example, the terms of an award to an employee may allow the award to vest upon completion of an IPO (i.e., the performance target) even if the IPO occurs after the employee has completed the requisite service period. This may be the case for employee awards that permit continued vesting upon retirement; that is, an employee who is retirement-eligible (or who becomes retirement-eligible) can retain the award upon retirement and vest in the award if the performance target is achieved even if the target is achieved after the employee retires. See Section 3.6.6.1 for a discussion of the accounting for awards granted to retirement-eligible employees that vest only upon service conditions.
When a performance-based award is granted to a retirement-eligible employee or otherwise permits vesting after termination of employment, the performance condition will not be factored into the determination of the requisite service period if the period associated with the performance target falls after the retirement eligibility date or after the requisite service period. Instead, the requisite service period will be determined solely on the basis of the service condition.
In accordance with ASC 718-10-55-87 and 55-88, for awards that permit continued vesting upon retirement, the requisite service period will either be (1) immediate (for retirement-eligible employees) or (2) the shorter of (a) the time from the grant date until the employee becomes retirement-eligible or (b) any service period associated with the performance target. Because the performance target of the award is viewed as a performance condition, an entity must assess the probability that the performance condition will be met. If achievement of the performance target is not probable, an entity should not record any compensation cost.
If an entity recorded compensation cost (because achievement of the performance
target was deemed probable) and the performance target is not achieved, the entity would
reverse any previously recognized compensation cost, even if the holder of the award is
no longer providing goods or services (e.g., an employee had retired). Conversely, if
the entity did not record compensation cost (because achievement of the performance
target was not deemed probable) and the performance condition is met (or meeting it
became probable), the entity would record compensation cost on the date the performance
condition is met (or meeting it became probable), even if the holder of the award is no
longer providing goods or services.
Example 3-11
On January 1, 20X1, Entity A grants 1,000 at-the-money employee stock options, each with a grant-date fair-value-based measure of $9, to employees who are currently retirement-eligible. The options legally vest and become exercisable only if cumulative net income over the next three annual reporting periods exceeds $1 million. The employees can retain the options for the remaining contractual life of the options even if they elect to retire. However, the options only become exercisable upon the achievement of the cumulative net income target.
In this example, the three-year service period is nonsubstantive. That is, even though the performance condition implies a service period of three years, the employees could retire the next day and retain the options. However, for the options to legally vest and become exercisable the entity must meet the specified performance target of cumulative net income in excess of $1 million over the next three annual reporting periods. Therefore, A records the $9,000 ($9 grant-date fair-value-based measure × 1,000 options) of compensation cost immediately on the grant date if it is probable that the performance target will be met (i.e., it is probable the entity will achieve net income of $1 million over the next three annual reporting periods). If it becomes improbable that the performance target will be met or A does not achieve the performance target, the options will be forfeited and any compensation cost previously recognized by A will be reversed even if the employees are no longer employed (i.e., they retired).
3.4.3 Repurchase Features That Function as Vesting Conditions
Repurchase features included in a share-based payment award may at times
function in substance as vesting conditions. ASC 718-10-25-9 and 25-10 discuss the
appropriate classification (i.e., liability versus equity) of awards with certain
share-associated repurchase features. Specifically, these paragraphs discuss awards that
contain (1) a grantee’s right to require the entity to repurchase the share (a put option)
or (2) an entity’s right to repurchase the share from the grantee (a call option).
However, when a restricted stock award includes a repurchase feature associated with an
entity’s right to repurchase the underlying shares at either (1) cost (which often is
zero) or (2) the lesser of the fair value of the shares on the repurchase date or the cost
of the award, the restricted stock award should not be assessed under the provisions of
ASC 718-10-25-9 and 25-10. Likewise, when a stock option or similar instrument is capable
of being “early exercised” and includes a similar repurchase feature associated with an
entity’s right to repurchase the underlying shares, the stock option or similar instrument
should not be assessed under the provisions of ASC 718-10-25-9 and 25-10. See Section 5.3 for a discussion of share repurchase features
that should be assessed under the guidance in ASC 718-10-25-9 and 25-10.
An early exercise refers to a grantee’s ability to change his or her tax position by exercising an option or similar instrument and receiving shares before the award is vested. The early exercise of an award results in the grantee’s deemed ownership of the shares for U.S. federal income tax purposes, which in turn results in the commencement of the share’s holding period (under the tax law). Once the shares are held by the grantee for the required holding period, any gain realized upon the sale of those shares is taxed at a capital gains tax rate rather than an ordinary income tax rate.
Because the awards are exercised before they vest, if the grantee ceases to provide goods or services before the end of this period, the entity issuing the shares usually can repurchase the shares for either of the following:
- The lesser of the fair value of the shares on the repurchase date or the exercise price of the award.
- The exercise price of the award.
The purpose of the repurchase feature (whether for restricted stock or stock options) is effectively to require that before receiving any economic benefit from the award, the grantee must continue providing goods or services until the award vests. For stock options, the early exercise is therefore not considered to be a substantive exercise for accounting purposes; any payment received by the entity for the exercise price should be recognized as a deposit liability. The fact that the grantee was able to exercise the award early does not indicate that the vesting condition was satisfied, since the repurchase feature prevents the grantee from receiving any economic benefit from the award until the entity’s repurchase feature expires upon the award’s vesting. ASC 718-10-55-31(a) confirms this conclusion, stating, in part:
Under some share option arrangements, an option holder may exercise an option prior to vesting (usually to obtain a specific tax treatment); however, such arrangements generally require that any shares received upon exercise be returned to the entity (with or without a return of the exercise price to the holder) if the vesting conditions are not satisfied. Such an exercise is not substantive for accounting purposes.
In effect, the repurchase feature functions as a forfeiture provision rather than a cash settlement feature. That is, if the grantee continues to provide the goods or services until the award vests, the restriction (the repurchase feature) will lapse. By contrast, if the grantee ceases providing the goods or services before the awards vest, the entity will repurchase the shares (in effect, as though the shares were never issued).
An entity’s election not to repurchase an issued share if a grantee ceases to provide goods or services before the award vests is accounted for as a modification that, in effect, accelerates the vesting of the award. The modification is accounted for as a Type III improbable-to-probable modification. That is, on the date on which the grantee ceases to provide goods or services, the original award is not expected to vest. Accordingly, no compensation cost is recognized for the original award, and any previously recognized compensation cost is reversed. On the date the entity decides not to repurchase the shares (which generally is contemporaneous with the employee’s termination or the date on which a nonemployee ceases to provide goods or services), the entity would determine the fair-value-based measure of the modified award (i.e., the award that is fully vested). The fair-value-based measure of the modified award is recorded immediately, since the award’s vesting is effectively accelerated upon termination. See Section 6.3 for a discussion of the accounting for a modification of share-based payment awards with performance and service vesting conditions, and see Section 6.3.3 for examples illustrating improbable-to-probable modifications.
Example 3-12
Entity A grants 1,000 stock awards to an employee that are fully vested upon grant. However, if the employee voluntarily terminates employment within two years, A has the right to call the shares at the lower of cost or fair value.
Since the repurchase feature (i.e., the call option) functions as an in-substance service condition, the term that states that the awards are fully vested is not substantive. If the employee leaves within two years, the shares would be forfeited because A could exercise its call option. Accordingly, the requisite service period is two years.