Chapter 3 — Recognition
Chapter 3 — Recognition
3.1 General Recognition Principles
ASC 718-10
Recognition Principle for Share-Based Payment Transactions
25-2 An entity shall recognize the goods acquired or services received in a share-based payment transaction when it obtains the goods or as services are received, as further described in paragraphs 718-10-25-2A through 25-2B. The entity shall recognize either a corresponding increase in equity or a liability, depending on whether the instruments granted satisfy the equity or liability classification criteria (see paragraphs 718-10-25-6 through 25-19A).
25-2A
Employee services themselves are not recognized before they
are received. As the services are consumed, the entity shall
recognize the related cost. For example, as services are
consumed, the cost usually is recognized in determining net
income of that period, for example, as expenses incurred for
employee services. In some circumstances, the cost of
services may be initially capitalized as part of the cost to
acquire or construct another asset, such as inventory, and
later recognized in the income statement when that asset is
disposed of or consumed. This Topic refers to recognizing
compensation cost rather than compensation expense because
any compensation cost that is capitalized as part of the
cost to acquire or construct an asset would not be
recognized as compensation expense in the income
statement.
25-2B
Transactions with nonemployees in which share-based payment
awards are granted in exchange for the receipt of goods or
services may involve a contemporaneous exchange of the
share-based payment awards for goods or services or may
involve an exchange that spans several financial reporting
periods. Furthermore, by virtue of the terms of the exchange
with the grantee, the quantity and terms of the share-based
payment awards to be granted may be known or not known when
the transaction arrangement is established because of
specific conditions dictated by the agreement (for example,
performance conditions). Judgment is required in determining
the period over which to recognize cost, otherwise known as
the nonemployee’s vesting period.
25-2C This guidance does not
address the period(s) or the manner (that is, capitalize
versus expense) in which an entity granting the share-based
payment award (the purchaser or grantor) to a nonemployee
shall recognize the cost of the share-based payment award
that will be issued, other than to require that an asset or
expense be recognized (or previous recognition reversed) in
the same period(s) and in the same manner as if the grantor
had paid cash for the goods or services instead of paying
with or using the share-based payment award. A share-based
payment award granted to a customer shall be reflected as a
reduction of the transaction price and, therefore, of
revenue as described in paragraph 606-10-32-25 unless the
payment to the customer is in exchange for a distinct good
or service, in which case the guidance in paragraph
606-10-32-26 shall apply.
A share-based payment arrangement is an exchange between an entity and a grantee
who provides goods or services. The entity
recognizes the effect of that exchange in the
balance sheet and income statement as goods are
delivered or services are rendered. The
share-based payment transaction is measured on the
basis of the fair value (or sometimes the
calculated or intrinsic value) of the equity
instrument issued. While an entity uses the
fair-value-based measurement method in ASC 718 to
determine the value of a share-based payment, that
method does not take into account the effects of
vesting conditions and other types of features
that would be included in a true fair value
measurement. The objectives of accounting for
equity instruments issued to grantees are to (1)
measure the cost of the goods or services received
(i.e., compensation cost) in exchange for an award
of equity instruments on the basis of the
fair-value-based measure of the award on the grant
date and (2) recognize that measured compensation
cost in the financial statements over the
requisite service period or the nonemployee’s
vesting period. The term “nonemployee’s vesting
period” is used throughout ASC 718 and this
publication. Compensation cost for a nonemployee’s
award is recognized over the nonemployee’s vesting
period(s) (i.e., the same period(s) are used as if
the grantor had paid cash for the goods or
services instead of paying with the share-based
payment award).
The classification of the award dictates the corresponding credit in the balance sheet and affects the amount of compensation cost recognized over the requisite service or the nonemployee’s vesting period. If the award is classified as equity, the corresponding credit is recorded in equity — typically as paid-in capital. If the award is classified as a liability, the corresponding credit is recorded as a share-based liability. Equity-classified awards are generally recognized as compensation cost over the requisite service or nonemployee’s vesting period on the basis of the fair-value-based measure of the award on the grant date. On the other hand, liability-classified awards are remeasured at their fair-value-based amount in each reporting period until settlement. That is, the changes in the fair-value-based measure of the liability at the end of each reporting period are recognized as compensation cost, either immediately or over the remaining requisite service period or nonemployee’s vesting period, depending on the vested status of the award. See Chapter 7 for a discussion of the differences between the accounting for equity-classified awards and that for liability-classified awards.
Like other compensation costs (e.g., cash compensation), those associated with share-based payment awards are usually recognized as an expense. In some instances, such costs may be capitalized as part of an asset and later recognized as an expense. For example, if a grantee’s compensation is included in the cost of acquiring or constructing an asset, the compensation cost arising from share-based payment awards would be capitalized in the same manner as cash compensation. The capitalized compensation cost would subsequently be recognized as cost of goods sold or as depreciation or amortization expense.
3.2 Determining the Grant Date
ASC 718-10 — Glossary
Grant Date
The date at which a grantor and a grantee reach a mutual understanding of the
key terms and conditions of a share-based payment award. The
grantor becomes contingently obligated on the grant date to
issue equity instruments or transfer assets to a grantee who
delivers goods or renders services or purchases goods or
services as a customer. Awards made under an arrangement
that is subject to shareholder approval are not deemed to be
granted until that approval is obtained unless approval is
essentially a formality (or perfunctory), for example, if
management and the members of the board of directors control
enough votes to approve the arrangement. Similarly,
individual awards that are subject to approval by the board
of directors, management, or both are not deemed to be
granted until all such approvals are obtained. The grant
date for an award of equity instruments is the date that a
grantee begins to benefit from, or be adversely affected by,
subsequent changes in the price of the grantor’s equity
shares. Paragraph 718-10-25-5 provides guidance on
determining the grant date. See Service Inception Date.
ASC 718-10
Determining the Grant Date
25-5 As a practical accommodation, in determining the grant date of an award subject to this Topic, assuming all other criteria in the grant date definition have been met, a mutual understanding of the key terms and conditions of an award to an individual grantee shall be presumed to exist at the date the award is approved in accordance with the relevant corporate governance requirements (that is, by the Board or management with the relevant authority) if both of the following conditions are met:
- The award is a unilateral grant and, therefore, the recipient does not have the ability to negotiate the key terms and conditions of the award with the grantor.
- The key terms and conditions of the award are expected to be communicated to an individual recipient within a relatively short time period from the date of approval. A relatively short time period is that period in which an entity could reasonably complete all actions necessary to communicate the awards to the recipients in accordance with the entity’s customary practices.
For additional guidance see paragraphs 718-10-55-80 through 55-83.
Determination of Grant Date
55-80 This guidance expands on the guidance provided in paragraph 718-10-25-5.
55-81 The definition of grant date requires that a grantor and a grantee have a mutual understanding of the key terms and conditions of the share-based compensation arrangement. Those terms may be established through any of the following:
- A formal, written agreement
- An informal, oral arrangement
- An entity’s past practice.
55-82 A mutual understanding of the key terms and conditions means that there is sufficient basis for both the grantor and the grantee to understand the nature of the relationship established by the award, including both the compensatory relationship and the equity relationship subsequent to the date of grant. The grant date for an award will be the date that a grantee begins to benefit from, or be adversely affected by, subsequent changes in the price of the grantor’s equity shares. In order to assess that financial exposure, the grantor and grantee must agree to the terms; that is, there must be a mutual understanding. Awards made under an arrangement that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality (or perfunctory). Additionally, to have a grant date for an award to an employee, the recipient of that award must meet the definition of an employee.
55-83 The determination of the grant date shall be based on the relevant facts and circumstances. For instance, a look-back share option may be granted with an exercise price equal to the lower of the current share price or the share price one year hence. The ultimate exercise price is not known at the date of grant, but it cannot be greater than the current share price. In this case, the relationship between the exercise price and the current share price provides a sufficient basis to understand both the compensatory and equity relationship established by the award; the recipient begins to benefit from subsequent changes in the price of the grantor’s equity shares. However, if the award’s terms call for the exercise price to be set equal to the share price one year hence, the recipient does not begin to benefit from, or be adversely affected by, changes in the price of the grantor’s equity shares until then. Therefore, grant date would not occur until one year hence. Awards of share options whose exercise price is determined solely by reference to a future share price generally would not provide a sufficient basis to understand the nature of the compensatory and equity relationships established by the award until the exercise price is known.
Generally, compensation cost is recognized over the requisite service period or
nonemployee’s vesting period on the basis of the fair-value-based measure of the
share-based payment award on the grant date (see Section 3.6 for a discussion of the requisite
service period and Section
9.3 for a discussion of the nonemployee’s vesting period). The
exchange between the entity and the grantee of share-based payments for goods or
services begins on the service inception date, which is defined as the date on which
the requisite service period or nonemployee’s vesting period begins. The service
inception date is typically the grant date; however, it may precede the grant date
if certain conditions are met. Accordingly, an entity may begin to recognize
compensation cost before the grant date. (See Section 3.6.4 for a discussion of the
conditions that must be met for the service inception date to precede the grant date
for an employee award.)
For a grant date to be established, all of the following conditions must be met:
- The entity and grantee have reached a mutual understanding of the key terms and conditions of the award.
- The grantee begins to benefit from, or be adversely affected by, subsequent changes in the price of the entity’s equity shares for equity instruments. See Section 3.2.4 for a discussion of establishing a grant date in situations in which the exercise price is unknown. See Section 3.2.6 for a discussion of establishing a grant date for awards to be settled in a variable number of shares.
- All necessary approvals have been obtained. Awards issued under a share-based payment arrangement that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality (or perfunctory). For example, if shareholder approval is required but management or the members of the board of directors control enough votes to approve the arrangement, shareholder approval is essentially a formality or perfunctory. Individual awards that are subject to approval by the board of directors, management, or both, are not considered granted until all such approvals are obtained. See Section 3.2.1 for a discussion of establishing a grant date in situations in which the awards are subject to approval by the entity’s shareholders, board of directors, or both.
- For employee awards, the recipient must meet the definition of an employee. See ASC 718-10-20 for the definition of an employee and Section 2.2 for a discussion of the definition of a common law employee. Irrespective of the employment contract grant date (agreed upon between an employer and future employee), the grant date and the service inception date, as described at Section 3.6.4, cannot occur until employee services are provided as illustrated in Example 3-1.
Although formal, written agreements (e.g., plan documents, award agreements, or
employment agreements) provide the best evidence of the key terms of an arrangement,
oral arrangements or past practice may also establish key terms and, in some
instances, may suggest that the substantive arrangement differs from the written
arrangement. For example, if the written terms of a share-based payment plan provide
for settlement in stock but the entity has historically settled awards in cash, that
past practice may suggest that the arrangement should be accounted for as being
settled in cash and should therefore be classified as a liability award, despite the
terms established in the written arrangement. In addition, if all of the conditions
for establishing a grant date have been met, a grant date has been established for
accounting purposes even if the written terms of a share-based payment state that
such a date is in the future. Similarly, unless all of the conditions for
establishing a grant date have been met, a grant date has not been established for
accounting purposes even if the written terms of a share-based payment state that
such a date has been established.
See the following for additional discussions of reaching a mutual understanding
of key terms and conditions:
-
Section 3.2.2 — Award in which the approval date precedes the communication date.
-
Section 3.2.3 — Award in which the vesting conditions are unknown.
-
Section 3.2.5 — Award in which a discretionary provision is included in the terms of the award.
Example 3-1
On January 1, 20X1, an individual is issued stock options upon signing an employment agreement. The options vest at the end of the third year of service on December 31, 20X3 (cliff vesting). However, the individual does not begin to work (i.e., provide service in exchange for the options) for the entity until February 15, 20X1, and therefore does not meet the definition of an employee before this date. Accordingly, provided that all other conditions for establishing a grant date have been met, the grant date does not occur until February 15, 20X1. Compensation cost would be determined on the basis of the fair-value-based measure of the options on February 15, 20X1. Because the service inception date cannot begin before the individual provides service to the entity, compensation cost is recognized ratably over the period from February 15, 20X1, through December 31, 20X3.
3.2.1 Approval
When share-based payment awards are subject to approval by an entity’s shareholders, board of directors, or both, generally a grant date is not established before such approval is granted. Before establishing a grant date for a share-based payment transaction with a grantee, an entity generally must obtain all necessary approvals unless such approvals are essentially perfunctory or a formality. Accordingly, unless management (1) controls enough votes to ensure shareholder approval (when shareholder approval is required) or controls the board of directors (when board approval is required) and (2) has approved the awards, a grant date has not been established until the necessary approvals have been obtained and all other grant-date conditions have been met.
In most cases, the key terms and conditions of awards are determined by the
issuing entity’s management and approved by the board of directors (or the
compensation committee of the board of directors). A grantee’s failure to
formally accept the award may not preclude the grant date from being
established. However, if a grantee is in a position to negotiate the key terms
and conditions of its awards, a grant date cannot occur until both parties agree
on those terms and conditions.
Example 3-2
On January 1, 20X1, Entity A’s management approves the issuance of 1,000 shares of restricted stock to an executive (all terms are known and communicated to the executive) in accordance with A’s executive stock incentive plan. The terms of the plan require A’s board of directors to approve all individual awards, and management does not control the board. However, on the basis of past practice, it is reasonably likely that the board will approve the award.
The board meets on March 1, 20X1, and approves the award. Therefore, if all other conditions for establishing a grant date have been met, the grant date would be March 1, 20X1. Note that even though it is likely that approval will be granted, this does not affect the determination of whether an approval is perfunctory and, therefore, of whether a grant date can be established before such approval is obtained. Rather, the approval in this example would not be considered perfunctory because management does not control the outcome of the board’s vote.
Example 3-3
Entity A’s board of directors has formally delegated to management the right to grant share-based payment awards to employees when certain conditions are met. On February 1, 20X1, A’s management approves and communicates the award of 100 stock options to a newly hired employee (all terms are known and the employee begins working for A on February 1, 20X1). Because the board has delegated to management the responsibility of granting awards, the board does not need to provide further approval for the award. However, at its March 1, 20X1, meeting, the board acknowledges, in the minutes to the board meeting, the award that was granted by management on February 1, 20X1.
If all other conditions for establishing a grant date have been met, the grant date would be February 1, 20X1, since board approval is not required (it was merely “acknowledged” in the minutes to the board meeting), and A’s management was given the authority to award the stock options. However, A should exercise caution in determining the grant date whenever board approval is subsequently obtained, even when it is not required.
3.2.2 Communication Date
A grant date may be established on the approval date if that date precedes the
date on which the award is communicated to the recipient (i.e., the
communication date). ASC 718-10-25-5 provides a practical accommodation for
determining a grant date and states that as long as all other criteria for
establishing a grant date have been met, a mutual understanding, and therefore a
grant date, is presumed to exist on the date the award is approved in accordance
with the relevant corporate governance requirements if both of the following
conditions are met:
-
The award is a unilateral grant and, therefore, the recipient does not have the ability to negotiate the key terms and conditions of the award with the grantor.
-
The key terms and conditions of the award are expected to be communicated to an individual recipient within a relatively short time period from the date of approval. A relatively short time period is that period in which an entity could reasonably complete all actions necessary to communicate the awards to the recipients in accordance with the entity’s customary practices.
Entities should carefully assess whether an award recipient is
able to negotiate the key terms and conditions of a grant. Note that while most
existing employees are generally unable to negotiate the terms of share-based
payment awards that are determined by an entity’s compensation committee, new
hires and senior executives may have such ability.
The definition of a “relatively short time period” is a matter of professional
judgment and depends on how an entity communicates the terms and conditions of
its awards to its grantees. For example, if an entity communicates the terms and
conditions of its awards via an employee benefits Web site or by e-mail, a
relatively short time period may be a few days or the amount of time it would
reasonably take to post the information on the Web site and communicate to the
grantees that the information is available. On the other hand, if the terms and
conditions of the awards are usually communicated to each grantee individually,
the relatively short time period may be a few weeks. However, the FASB Staff
Position on which the practical accommodation guidance in ASC 718-10-25-5 was
based cautioned that the concepts should not be applied by analogy to other
areas.
If, in accordance with ASC 718-10-25-5, the approval date is considered to be
the grant date, any change in the terms or conditions of the award between the
approval date and the communication date should be accounted for as a
modification of the award under ASC 718-20-35-2A through 35-4. See Chapter 6 for examples of
the accounting for the modification of a share-based payment award.
3.2.3 Unknown Conditions
ASC 718-10
Example 3: Employee Share-Based Payment Award With a Performance Condition and Multiple Service Periods
55-92 The following Cases illustrate employee share-based payment awards with a performance condition (see paragraphs 718-10-25-20 through 25-21; 718-10-30-27; and 718-10-35-4) and multiple service dates:
- Performance targets are set at the inception of the arrangement (Case A).
- Performance targets are established at some time in the future (Case B).
- Performance targets established up front but vesting is tied to the vesting of a preceding award (Case C).
55-93 Cases A, B, and C share the following assumptions:
- On January 1, 20X5, Entity T enters into an arrangement with its chief executive officer relating to 40,000 share options on its stock with an exercise price of $30 per option.
- The arrangement is structured such that 10,000 share options will vest or be forfeited in each of the next 4 years (20X5 through 20X8) depending on whether annual performance targets relating to Entity T’s revenues and net income are achieved.
Case A: Performance Targets Are Set at the Inception of the Arrangement
55-94 All of the annual performance targets are set at the inception of the arrangement. Because a mutual understanding of the key terms and conditions is reached on January 1, 20X5, each tranche would have a grant date and, therefore, a measurement date, of January 1, 20X5. However, each tranche of 10,000 share options should be accounted for as a separate award with its own service inception date, grant-date fair value, and 1-year requisite service period, because the arrangement specifies for each tranche an independent performance condition for a stated period of service. The chief executive officer’s ability to retain (vest in) the award pertaining to 20X5 is not dependent on service beyond 20X5, and the failure to satisfy the performance condition in any one particular year has no effect on the outcome of any preceding or subsequent period. This arrangement is similar to an arrangement that would have provided a $10,000 cash bonus for each year for satisfaction of the same performance conditions. The four separate service inception dates (one for each tranche) are at the beginning of each year.
Case B: Performance Targets Are Established at Some Time in the Future
55-95 If the arrangement had instead provided that the annual performance targets would be established during January of each year, the grant date (and, therefore, the measurement date) for each tranche would be that date in January of each year (20X5 through 20X8) because a mutual understanding of the key terms and conditions would not be reached until then. In that case, each tranche of 10,000 share options has its own service inception date, grant-date fair value, and 1-year requisite service period. The fair value measurement of compensation cost for each tranche would be affected because not all of the key terms and conditions of each award are known until the compensation committee sets the performance targets and, therefore, the grant dates are those dates.
The key differences between Case A and Case B in ASC 718-10-55-94 and 55-95 are related to when a mutual understanding of key terms and conditions has been established. The entity in Case A established performance conditions with the CEO when both parties entered the arrangement, which resulted in the establishment of a grant date at the inception of the award arrangement. The award will have four independent tranches with four separate inception dates, but the fair value of the entire award will be established on the grant date (i.e., January 1, 20X5). In Case B, a mutual understanding of key terms and conditions has not been established at the time both parties entered into the arrangement because the performance conditions associated with the award granted have not been established. The performance conditions will be established at the beginning of each year. Therefore, each of the four vesting tranches of the award will have its own service inception date and grant date at the time a performance condition is established for each tranche. In other words, the awards in Case B will have different fair values established for each vesting tranche.
Accordingly, all the key terms and conditions of the award must be known,
including any vesting conditions (i.e., service or performance conditions) or
market conditions. In addition, if the vesting or market conditions are too
subjective or discretionary, the terms and conditions of the award may not be
mutually understood (see Example 3-5).
Example 3-4
On January 1, 20X1, Entity A issues 1,000 shares of restricted stock to its employees. The shares will vest in 25 percent increments (tranches) each year over the next four years if A’s actual earnings for each year exceed its annual budgeted earnings by 10 percent (i.e., a graded vesting schedule). Entity A set its annual budget in November of the previous year.
In this scenario, a grant date has been established for only 250 of the shares on January 1, 20X1 (all other conditions for establishing a grant date must also be met). A grant date has not been established for the other 750 shares because the performance conditions for the shares have not been established yet. The grant dates for those shares will occur once A’s annual budget for the appropriate year has been established and the employee is aware of the performance target (or the performance target is communicated to the employee within a “relatively short time period” thereafter in accordance with ASC 718-10-25-5). Accordingly, the grant dates will most likely be January 1, 20X1, for the first tranche of 250 shares; November 20X1 for the second tranche of 250 shares; November 20X2 for the third tranche of 250 shares; and November 20X3 for the last tranche of 250 shares.
Example 3-5
On January 1, 20X1, Entity A issues 1,000 employee stock options. The options vest at the end of one year of service but only if the employee receives a performance rating of at least 4. Performance ratings are established at the end of the year on a scale of 1 through 5 (with 5 being the highest).
In this scenario, whether a grant date has been established on January 1, 20X1, depends on the facts and circumstances. Generally, if performance conditions are too subjective or discretionary, there is a lack of mutual understanding of the key terms and conditions of the award and, therefore, no grant date is established. If a performance condition is based on individual performance evaluations, an entity may consider the following items, among others, in determining whether it can be objectively established that the performance condition has been met (i.e., whether there has been a mutual understanding of the key terms and conditions):
- Whether there is a well-established, rigorous system for performance evaluations.
- Whether there are objective goals and specific criteria in place.
- Whether, in addition to determining vesting of share-based payment awards, the evaluations are used for other purposes (e.g., annual raises, promotions).
- Whether overall evaluations are subject to requirements that force a specific distribution (e.g., a rating of 5 is limited to a specified percentage of employees within the group).
- Whether evaluations are completed by direct supervisors.
An award may contain a performance condition or market condition whose achievement
depends on future events that are not within the control of the issuing entity.
For example, to satisfy a performance condition, an entity may have to attain an
EPS growth rate that outperforms the average EPS growth rate of a peer group in
the same industry. Unlike the scenario in Example
3-4, the fact that the entity and grantee do not know the EPS
growth rate that the peer group will achieve does not prevent them from mutually
understanding the award’s key terms and conditions. For a grant date to be
established, the performance condition or market condition must be objectively
determinable and nondiscretionary.
Example 3-6
On November 1, 20X1, Entity B issues
RSUs to Employee E. The RSUs will vest in 1,000 shares
of common stock if (1) B’s stock price increases 15
percent from January 1, 20X2, to December 31, 20X2, and
(2) E is still employed on December 31, 20X2.
As of November 1, 20X1, E understands
what stock price increase must be achieved to earn the
award relative to the stock price as of January 1, 20X2.
Accordingly, on November 1, 20X1, a grant date may be
established even if the stock price on January 1, 20X2,
is unknown when the RSUs are issued because the market
condition is objectively determinable and
nondiscretionary.
3.2.4 Unknown Exercise Price
ASC 718-10
Example 4: Employee Share-Based Payment Award With a Service Condition and Multiple Service Periods
55-97 The following Cases illustrate the guidance in paragraph 718-10-30-12 to determine the service period for employee awards with multiple service periods:
- Exercise price established at subsequent dates (Case A)
- Exercise price established at inception (Case B).
Case A: Exercise Price Established at Subsequent Dates
55-98 The chief executive officer of Entity T enters into a five-year employment contract on January 1, 20X5. The contract stipulates that the chief executive officer will be given 10,000 fully vested share options at the end of each year (50,000 share options in total). The exercise price of each tranche will be equal to the market price at the date of issuance (December 31 of each year in the five-year contractual term). In this Case, there are five separate grant dates. The grant date for each tranche is December 31 of each year because that is the date when there is a mutual understanding of the key terms and conditions of the agreement — that is, the exercise price is known and the chief executive officer begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer’s equity shares (see paragraphs 718-10-55-80 through 55-83 for additional guidance on determining the grant date). Because the awards’ terms do not include a substantive future requisite service condition that exists at the grant date (the options are fully vested when they are issued), and the exercise price (and, therefore, the grant date) is determined at the end of each period, the service inception date precedes the grant date. The requisite service provided in exchange for the first award (pertaining to 20X5) is independent of the requisite service provided in exchange for each consecutive award. The terms of the share-based compensation arrangement provide evidence that each tranche compensates the chief executive officer for one year of service, and each tranche shall be accounted for as a separate award with its own service inception date, grant date, and one-year service period; therefore, the provisions of paragraph 718-10-35-8 would not be applicable to this award because of its structure.
The conclusion in Case A (see ASC 718-10-55-98 above) is that the stock options
granted to the CEO will have five separate grant dates established on December
31 of each year. The grant date for each tranche is December 31 of each year
because that is when the exercise price will be known for the fully vested stock
options that are annually awarded to the CEO. Accordingly, December 31 is the
date on which there is a mutual understanding of key terms and conditions
(provided that all other terms and conditions are known) between the grantee
(i.e., the CEO) and the grantor (i.e., the entity). In addition to their five
separate grant dates, the fully vested stock options have five separate service
inception dates, which are one year before each grant date. Accordingly, in such
situations, the entity may be required to begin recognizing compensation cost
before the grant date. From the service inception date until the grant date, the
entity remeasures the options at their fair-value-based measure at the end of
each reporting period on the basis of the assumptions that exist on those dates.
Once the grant date is established, the entity discontinues remeasuring the
options at the end of each reporting period. That is, the final measure of
compensation cost is based on the fair-value-based measure on the grant date.
(See Section 3.6.4
and Example 6 in ASC 718-10-55-107 through 55-115 for a discussion and examples
of the conditions that must be met for a service inception date to precede the
grant date.) Since each tranche has a separate grant date at one-year intervals
and separate service inception dates at one-year intervals, the grantor does not
have the option to apply either the straight-line attribution method or the
accelerated attribution method when recognizing compensation cost (as discussed
in ASC 718-10-35-8) that is associated with the options awarded.
Example 3-7
On January 1, 20X1, Entity A issues 1,000 employee stock options that vest at the end of one year of service (cliff vesting). All terms of the options are known except for the exercise price, which is set equal to the lower of the market price of A’s shares on January 1, 20X1, or its market price on December 31, 20X1 (i.e., the employee is given a look-back option).
In this scenario, a grant date has been established for January 1, 20X1, if all
other conditions for establishing a grant date have also
been met. In a manner consistent with ASC 718-10-55-83,
while the ultimate exercise price is not known, it
cannot be greater than the current market price of A’s
shares. In this case, the relationship between the
exercise price and the current market price of A’s
shares constitutes a sufficient basis for understanding
both the compensatory and the equity relationships
established by the award. While the employee may not be
adversely affected by any decreases in A’s share price,
the employee will begin to benefit from subsequent
increases in the price of A’s shares.
A common issue observed in practice is related to whether a grant date has been established when a nonpublic entity issues stock options to grantees and the valuation of the entity’s common shares is not completed until after the issuance date. Generally, the terms of the option agreement require that the exercise price of the options equal the fair value of a common share of the entity on the issuance date. To determine the fair value of its common shares, the entity will often hire an independent expert to perform a valuation of the entity, which will be based solely on information available as of the issuance date. However, since the valuation is not completed until after the issuance date, the entity may question whether a grant date has been established for the stock options.
An entity’s need to finalize the valuation of the underlying common shares as of a specific date (and therefore to set the exercise price of the award) would generally not prevent the entity from establishing a grant date for a share-based payment award with a grantee if all other conditions for establishing a grant date have been met. The result of the valuation, based solely on information available as of the issuance date, should be identical, regardless of whether the valuation work is completed on the issuance date (i.e., all of the work is hypothetically performed instantaneously) or as of a subsequent date.
One factor that could cause uncertainty about whether a grant date is established is the amount of time it takes, after the issuance of the award, to complete the valuation. A lengthy period between the purported valuation date and the completion of the valuation work may call into question whether an entity has used hindsight in selecting the underlying assumptions. Note that even if the final valuation is completed after the grant date, an entity is required to use the information available as of the established grant date. In other words, to prevent biased estimates, an entity should not factor hindsight into the valuation.
Note also that if an entity were to change the original terms of the award after the established grant date but before completion of the valuation, the entity would account for the changes as a modification. See Chapter 6 for a discussion of the accounting for a modification of a share-based payment award.
3.2.5 Discretionary Provisions
If an entity that issues share-based payment awards can, in the future, exercise discretion regarding any of the key terms or conditions that were established when the awards were issued, a grant date may not have been established. The existence of such discretion may indicate uncertainty about whether a mutual understanding of the key terms and conditions was reached. For example, specific and objective performance metrics for determining vesting could be established when the awards were issued, but the entity may have discretion to adjust the performance metrics or the items that comprise the performance metrics at the end of the performance period. If there are few or no limitations on when and how such adjustments are to be made, a grantee may not have a sufficient understanding of the performance condition (i.e., the vesting condition) because the entity at its discretion could adjust it at the end of the performance period. By contrast, the existence of a provision that requires specific and objective adjustments to be made upon the occurrence of stated triggering events would most likely not, by itself, indicate that the key terms and conditions of the award are uncertain. A determination of whether a grantee sufficiently understands the award’s key terms and conditions should be based on the facts and circumstances (e.g., past practice, other communications).
In addition, an award may contain a clawback provision that gives the entity discretion to determine how much of the award is returned if the clawback provision is violated (e.g., a noncompete or nonsolicitation provision is violated). Even if the event or events that trigger the clawback provision are objective and specific, the entity should evaluate whether its ability to determine the amount subject to the clawback is a “key” term or condition that might affect whether a mutual understanding is reached.
A “negative-discretion” provision is a common feature of share-based payment plans that allows management or the board of directors to reduce the number of awards due to a grantee. For example, a plan might state that 100 awards will be earned if EBITDA increases by at least 10 percent each year over a three-year period, with more or fewer awards issued for performance above or below that threshold. A negative-discretion provision would give management or the board of directors the discretion to reduce the number of awards below the amount determined by the plan’s stated terms at the end of the performance period.
Entities must carefully consider whether a negative-discretion provision in a
share-based payment plan will preclude the entity from establishing a grant date
under ASC 718 until management or the board of directors determines the number
of awards due to a grantee at the end of the performance period. Since a
criterion for establishing a grant date for a share-based payment transaction
with a grantee is that the entity and grantee reach a mutual understanding of
the key terms and conditions of the share-based payment award, entities should
consider whether a plan’s negative-discretion provision is a “key” term or
condition that could result in uncertainty in the number of awards to be earned.
Factors to consider, among others, include the following:
-
Management’s intent and the purpose of the provision, including circumstances in which management believes it will exercise its right under the negative-discretion provision.
-
Whether, in the past, management has exercised its right under the negative-discretion provision.
-
Frequency of use of the negative-discretion provision, including when it was used and the reasons for using it.
-
Grantees’ awareness of the negative-discretion provision. All communications to grantees, including verbal representations, should be considered.
Example 3-8
An employee is awarded 100 shares of restricted stock on January 1, 20X7. The shares vest on the basis of a service condition and a performance condition. While both the service and performance conditions have been specified, management retains the discretion to increase or decrease the number of shares that vest by up to 25 percent on the basis of the entity’s performance. Management has not provided guidance on what performance criteria would trigger the use of discretion. Furthermore, management has previously exercised discretion provisions for similar share-based payment awards granted to employees.
The discretion provision will not affect the entity’s ability to establish a grant date for the 75 percent of shares that are not subject to the discretion provision and, if all the other criteria for establishing a grant date have been met, a grant date has been established on January 1, 20X7, for these 75 shares. However, for the remaining 25 percent of shares that are subject to the discretion provision, these 25 shares do not have the same terms and conditions as the other 75 shares. Thus, the entity should separately evaluate the 25 shares subject to the discretion provision to determine whether the discretion provision for those shares affects the entity’s ability to establish a grant date (a grant date has most likely not been established for the 25 shares).
3.2.6 Awards Settled in a Variable Number of Shares
As Chapter 5
discusses in more detail, while share-based payment awards subject to ASC 718
are outside the scope of ASC 480, ASC 718-10-25-7 requires entities to apply the
classification criteria in ASC 480-10-25 and in ASC 480-10-15-3 and 15-4 unless
ASC 718-10-25-8 through 25-19A require otherwise. As a result, certain awards
may be classified as a liability because an entity has an obligation to issue a
variable number of shares that are based on a fixed monetary amount known at
inception. In this circumstance, the grantee will not begin to benefit from, or
be adversely affected by, subsequent changes in the price of the entity’s equity
shares until the number of shares is determined. However, because the liability
is based on a fixed amount, we do not believe that the ability to benefit from,
or be adversely affected by, subsequent changes in the price of the entity’s
equity shares is necessary to establish a grant date. Thus, if all other grant
date criteria have been met, an entity would not be precluded from establishing
a grant date for share-based liabilities that are based on a fixed monetary
amount known at inception.
3.3 Nonvested Shares Versus Restricted Shares
ASC 718-10 — Glossary
Nonvested Shares
Shares that an entity has not yet issued because the agreed-upon consideration, such as the delivery of specified goods or services and any other conditions necessary to earn the right to benefit from the instruments, has not yet been satisfied. Nonvested shares cannot be sold. The restriction on sale of nonvested shares is due to the forfeitability of the shares if specified events occur (or do not occur).
Restricted Share
A share for which sale is contractually or governmentally prohibited for a
specified period of time. Most grants of shares to grantees
are better termed nonvested shares because the limitation on
sale stems solely from the forfeitability of the shares
before grantees have satisfied the service, performance, or
other condition(s) necessary to earn the rights to the
shares. Restricted shares issued for consideration other
than for goods or services, on the other hand, are fully
paid for immediately. For those shares, there is no period
analogous to an employee’s requisite service period or a
nonemployee’s vesting period during which the issuer is
unilaterally obligated to issue shares when the purchaser
pays for those shares, but the purchaser is not obligated to
buy the shares. The term restricted shares refers only to
fully vested and outstanding shares whose sale is
contractually or governmentally prohibited for a specified
period of time. Vested equity instruments that are
transferable to a grantee’s immediate family members or to a
trust that benefits only those family members are restricted
if the transferred instruments retain the same prohibition
on sale to third parties. See Nonvested Shares.
A nonvested share is an award that a grantee earns once the grantee has provided
the requisite goods or services as specified under the terms of the share-based
payment arrangement (i.e., once the vesting conditions are met). For example, a
grantee may be issued shares of common stock but may not be able to retain the
shares unless the grantee provides three years of service (service condition) and
revenue has grown by a specified percentage during that three-year period
(performance condition). If the grantee fails to provide the required three years of
service, or the revenue growth target is not met, the shares would be forfeited to
the entity.
While a nonvested share is often referred to as “restricted stock,” it should not be
confused with restricted shares, which ASC 718-10-20 defines as “fully vested and
outstanding shares whose sale is . . . prohibited for a specified period of time.”
For example, a grantee may be issued a fully vested share but may be restricted from
selling it for a two-year period. If the grantee ceases to provide goods or services
before the end of the two-year period, the grantee retains the share. However, the
grantee’s ability to sell the share remains contingent on the lapse of the two-year
period.
When determining a share-based payment award’s fair-value-based measure, an entity
should generally consider restrictions that are in effect after a grantee has vested
in the award, such as the inability to transfer or sell vested shares for a
specified period. This restriction may result in a discount relative to the
fair-value-based measure of the shares without a postvesting restriction. See
Section 4.8.
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.
3.5 Market Condition
ASC 718-10 — Glossary
Market Condition
A condition affecting the exercise price, exercisability, or other pertinent factors used in determining the fair value of an award under a share-based payment arrangement that relates to the achievement of either of the following:
- A specified price of the issuer’s shares or a specified amount of intrinsic value indexed solely to the issuer’s shares
- A specified price of the issuer’s shares in terms of a similar (or index of similar) equity security (securities). The term similar as used in this definition refers to an equity security of another entity that has the same type of residual rights. For example, common stock of one entity generally would be similar to the common stock of another entity for this purpose.
ASC 718-10
Market Conditions
30-14 Some awards contain a market condition. The effect of a market condition is reflected in the grant-date fair value of an award. (Valuation techniques have been developed to value path-dependent options as well as other options with complex terms. Awards with market conditions, as defined in this Topic, are path-dependent options.) Compensation cost thus is recognized for an award with a market condition provided that the good is delivered or the service is rendered, regardless of when, if ever, the market condition is satisfied.
Market, Performance, and Service Conditions
30-27 Performance or service conditions that affect vesting are not reflected in estimating the fair value of an award at the grant date because those conditions are restrictions that stem from the forfeitability of instruments to which grantees have not yet earned the right. However, the effect of a market condition is reflected in estimating the fair value of an award at the grant date (see paragraph 718-10-30-14). For purposes of this Topic, a market condition is not considered to be a vesting condition, and an award is not deemed to be forfeited solely because a market condition is not satisfied.
Recognition of Employee Compensation Costs Over the
Requisite Service Period
35-4 An entity shall reverse previously recognized compensation cost for an award with a market condition only if the requisite service is not rendered.
Implementation Guidance
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
55-61 Analysis of the market, performance, or service conditions (or any combination thereof) that are explicit or implicit in the terms of an award is required to determine the employee’s requisite service period or the nonemployee’s vesting period over which compensation cost is recognized and whether recognized compensation cost may be reversed if an award fails to vest or become exercisable (see paragraph 718-10-30-27). If exercisability or the ability to retain the award (for example, an award of equity shares may contain a market condition that affects the grantee’s ability to retain those shares) is based solely on one or more market conditions compensation cost for that award is recognized if the grantee delivers the promised good or renders the service, even if the market condition is not satisfied. If exercisability (or the ability to retain the award) is based solely on one or more market conditions, compensation cost for that award is reversed if the grantee does not deliver the promised good or render the service, unless the market condition is satisfied prior to the end of the employee’s requisite service period or the nonemployee’s vesting period, in which case any unrecognized compensation cost would be recognized at the time the market condition is satisfied. If vesting is based solely on one or more performance or service conditions, any previously recognized compensation cost is reversed if the award does not vest (that is, the good is not delivered or the service is not rendered or the performance condition is not achieved). Examples 1 through 4 (see paragraphs 718-20-55-4 through 55-50) provide illustrations of awards in which vesting is based solely on performance or service conditions.
55-62 Vesting or exercisability may be conditional on satisfying two or more types of conditions (for example, vesting and exercisability occur upon satisfying both a market and a performance or service condition). Vesting also may be conditional on satisfying one of two or more types of conditions (for example, vesting and exercisability occur upon satisfying either a market condition or a performance or service condition). Regardless of the nature and number of conditions that must be satisfied, the existence of a market condition requires recognition of compensation cost if the good is delivered or the service is rendered, even if the market condition is never satisfied.
Unlike a service or performance condition, a market condition is not a vesting condition but is directly factored into the fair-value-based measure of an award. See Section 4.5 for a discussion of how a market condition affects the valuation of a share-based payment award. Examples of market conditions include:
- The achievement of a specified price of an entity’s stock.
- A specified return on an entity’s stock (often referred to as total shareholder return, or TSR) that exceeds the average return of a peer group of entities or a specified index (such as the S&P 500).
- A percentage increase in an entity’s stock price that is greater than the average percentage increase of the stock price of a peer group of entities or a specified index.
-
A specified return on an entity’s stock based on invested capital (such as a realized IRR or multiples of invested capital for private-equity investors).
Certain awards contain only a market condition. That is, they do not specify a
service or vesting period but require the grantee
to provide goods or services until the market
condition is met. When an employee award contains
only a market condition, the entity must use a
derived service period to determine whether the
employee has provided the requisite service to
earn the award. While determining the derived
service period applies to employee awards only,
for certain nonemployee awards, an entity may
analogize to the guidance on calculating a derived
service period when assessing whether it should
recognize compensation cost. See Section
3.6.3 for a discussion of an employee’s
derived service period.
If an employee does not remain employed for the derived
service period (i.e., the employee forfeits the
award during the derived service period), the
employee has not earned (i.e.,has not vested in)
the award. An entity accrues compensation cost
over the derived service period if the requisite
service is rendered; however, the entity will reverse any previously
recognized compensation cost if the employee
leaves before the completion of the derived
service period. This is true unless the market
condition affects the employee’s ability to
exercise or retain the award and the market
condition is satisfied before the end of the
derived service period (i.e., the market condition
is satisfied sooner than originally anticipated
and the employee is still employed as of the
actual date of satisfaction). In that case, any
unrecognized compensation cost is recognized
immediately when the market condition is
satisfied. However, if an entity instead
determines that the market condition is expected
to be satisfied later than originally anticipated,
the entity would not
revise its estimate of the requisite service
period.
Conversely, if an employee does remain employed for the
derived service period, the employee has earned (i.e., vested in) the award. In this
circumstance, recognition of compensation cost will depend on whether the award is
classified as equity or liability. For an equity-classified award, an entity will not reverse any previously recognized compensation cost
even if the market condition is never satisfied. For a liability-classified award
(see Section 7.2.2),
although the effect of a market condition is reflected in the award’s
fair-value-based measure, its remeasurement is performed at the end of each
reporting period until settlement. Therefore, even if the goods and services are
rendered for a liability-classified award, the final compensation cost will be zero
if the award is not earned because a market condition was not satisfied (i.e., its
fair-value-based measure would be zero upon the date of settlement). In addition,
cumulative compensation cost recognized for a liability-classified award that was
modified from an equity-classified award cannot be less than the grant-date fair
value of the original equity-classified award unless, as of the modification date,
vesting of the original award was not probable. See Section 6.8.1 for more information.
3.6 Requisite Service Period for Employee Awards
Determining the requisite service period is only applicable to
employee awards. However, for certain nonemployee awards, an entity may analogize to
the guidance on calculating a requisite service period and determining the service
inception date when relevant to determining the nonemployee’s vesting period. For
additional discussion of a nonemployee’s vesting period, see Section 9.3.2.
ASC 718-10 — Glossary
Requisite Service Period
The period or periods during which an
employee is required to provide service in exchange for an
award under a share-based payment arrangement. The service
that an employee is required to render during that period is
referred to as the requisite service. The requisite service
period for an award that has only a service condition is
presumed to be the vesting period, unless there is clear
evidence to the contrary. If an award requires future
service for vesting, the entity cannot define a prior period
as the requisite service period. Requisite service periods
may be explicit, implicit, or derived, depending on the
terms of the share-based payment award.
ASC
718-10
25-21 If
an award requires satisfaction of one or more market,
performance, or service conditions (or any combination
thereof), compensation cost shall be recognized if the good
is delivered or the service is rendered, and no compensation
cost shall be recognized if the good is not delivered or the
service is not rendered. Paragraphs 718-10-55-60 through
55-63 provide guidance on applying this provision to awards
with market, performance, or service conditions (or any
combination thereof).
Requisite Service Period
30-25 An entity shall make its
initial best estimate of the requisite service period at the
grant date (or at the service inception date, if that date
precedes the grant date) and shall base accruals of
compensation cost on that period.
30-26 The
initial best estimate and any subsequent adjustment to that
estimate of the requisite service period for an award with a
combination of market, performance, or service conditions
shall be based on an analysis of all of the following:
- All vesting and exercisability conditions
- All explicit, implicit, and derived service periods
- The probability that performance or service conditions will be satisfied.
Recognition of Employee Compensation
Costs Over the Requisite Service Period
35-2 The compensation cost for
an award of share-based employee compensation classified as
equity shall be recognized over the requisite service
period, with a corresponding credit to equity (generally,
paid-in capital). The requisite service period is the period
during which an employee is required to provide service in
exchange for an award, which often is the vesting period.
The requisite service period is estimated based on an
analysis of the terms of the share-based payment
award.
Estimating the Requisite Service Period
for Employee Awards
35-5 The
requisite service period for employee awards may be explicit
or it may be implicit, being inferred from an analysis of
other terms in the award, including other explicit service
or performance conditions. The requisite service period for
an award that contains a market condition can be derived
from certain valuation techniques that may be used to
estimate grant-date fair value (see paragraph 718-10-55-71).
An award may have one or more explicit, implicit, or derived
service periods; however, an award may have only one
requisite service period for accounting purposes unless it
is accounted for as in-substance multiple awards. An award
with a graded vesting schedule that is accounted for as
in-substance multiple awards is an example of an award that
has more than one requisite service period (see paragraph
718-10-35-8). Paragraphs 718-10-55-69 through 55-79 and
718-10-55-93 through 55-106 provide guidance on estimating
the requisite service period and provide examples of how
that period shall be estimated if an award’s terms include
more than one explicit, implicit, or derived service
period.
Market,
Performance, and Service Conditions That Affect Vesting and
Exercisability
55-61
Analysis of the market, performance, or service conditions
(or any combination thereof) that are explicit or implicit
in the terms of an award is required to determine the
employee’s requisite service period or the nonemployee’s
vesting period over which compensation cost is recognized
and whether recognized compensation cost may be reversed if
an award fails to vest or become exercisable (see paragraph
718-10-30-27). If exercisability or the ability to retain
the award (for example, an award of equity shares may
contain a market condition that affects the grantee’s
ability to retain those shares) is based solely on one or
more market conditions compensation cost for that award is
recognized if the grantee delivers the promised good or
renders the service, even if the market condition is not
satisfied. If exercisability (or the ability to retain the
award) is based solely on one or more market conditions,
compensation cost for that award is reversed if the grantee
does not deliver the promised good or render the service,
unless the market condition is satisfied prior to the end of
the employee’s requisite service period or the nonemployee’s
vesting period, in which case any unrecognized compensation
cost would be recognized at the time the market condition is
satisfied. If vesting is based solely on one or more
performance or service conditions, any previously recognized
compensation cost is reversed if the award does not vest
(that is, the good is not delivered or the service is not
rendered or the performance condition is not achieved).
Examples 1 through 4 (see paragraphs 718-20-55-4 through
55-50) provide illustrations of awards in which vesting is
based solely on performance or service
conditions.
55-61A
An employee award containing one or more market conditions
may have an explicit, implicit, or derived service period.
Paragraphs 718-10-55-69 through 55-79 provide guidance on
explicit, implicit, and derived service periods.
Estimating the Employee’s Requisite Service Period
55-67 Paragraph 718-10-35-2
requires that compensation cost be recognized over the
requisite service period. The requisite service period for
an award that has only a service condition is presumed to be
the vesting period, unless there is clear evidence to the
contrary. The requisite service period shall be estimated
based on an analysis of the terms of the award and other
relevant facts and circumstances, including co-existing
employment agreements and an entity’s past practices; that
estimate shall ignore nonsubstantive vesting conditions. For
example, the grant of a deep out-of-the-money share option
award without an explicit service condition will have a
derived service period. Likewise, if an award with an
explicit service condition that was at-the-money when
granted is subsequently modified to accelerate vesting at a
time when the award is deep out-of-the-money, that
modification is not substantive because the explicit service
condition is replaced by a derived service condition. If a
market, performance, or service condition requires future
service for vesting (or exercisability), an entity cannot
define a prior period as the requisite service period. The
requisite service period for awards with market,
performance, or service conditions (or any combination
thereof) shall be consistent with assumptions used in
estimating the grant-date fair value of those
awards.
55-68 An
employee’s share-based payment award becomes vested at the
date that the employee’s right to receive or retain equity
shares, other equity instruments, or cash under the award is
no longer contingent on satisfaction of either a performance
condition or a service condition. Any unrecognized
compensation cost shall be recognized when an award becomes
vested. If an award includes no market, performance, or
service conditions, then the entire amount of compensation
cost shall be recognized when the award is granted (which
also is the date of issuance in this case). Example 1 (see
paragraph 718-10-55-86) provides an illustration of
estimating the requisite service period.
3.6.1 Explicit Service Period for Employee Awards
ASC 718-10 — Glossary
Explicit Service Period
A service period that is explicitly stated in the terms of a share-based payment
award. For example, an award stating that it vests after
three years of continuous employee service from a given
date (usually the grant date) has an explicit service
period of three years. . . .
ASC
718-10
Explicit, Implicit, and Derived Employee’s Requisite
Service Periods
55-69 A
requisite service period for an employee may be
explicit, implicit, or derived. An explicit service
period is one that is stated in the terms of the
share-based payment award. For example, an award that
vests after three years of continuous employee service
has an explicit service period of three years, which
also would be the requisite service period.
An explicit service period is the period stated in the terms of
a share-based payment award during which the employee is required to provide
continuous service to earn the award. For example, an award stating that it
vests after two years of continuous service has an explicit service period of
two years.
3.6.2 Implicit Service Period for Employee Awards
ASC 718-10 — Glossary
Implicit Service Period
A service period that is not explicitly stated in the terms of a share-based
payment award but that may be inferred from an analysis
of those terms and other facts and circumstances. For
instance, if an award of share options vests upon the
completion of a new product design and it is probable
that the design will be completed in 18 months, the
implicit service period is 18 months. . . .
ASC
718-10
55-70
An implicit service period is one that may be inferred
from an analysis of an award’s terms. For example, if an
award of share options vests only upon the completion of
a new product design and the design is expected to be
completed 18 months from the grant date, the implicit
service period is 18 months, which also would be the
requisite service period.
An award may have a performance condition (see Section 3.4.2) that
specifies an explicit service period, an implicit service period, or both. If
the award vests upon the satisfaction of a performance target over a two-year
period and the employee is required to be employed during that period, the
service period is explicit. If, instead, the award vests when a performance
target is met and the employee is required to be employed until such time, the
service period is implicit. The period during which the performance condition is
expected to be met is the implicit service period.
3.6.3 Derived Service Period for Employee Awards
ASC 718-10 — Glossary
Derived Service Period
A service period for an award with a market condition that is inferred from the
application of certain valuation techniques used to
estimate fair value. For example, the derived service
period for an award of share options that the employee
can exercise only if the share price increases by 25
percent at any time during a 5-year period can be
inferred from certain valuation techniques. In a lattice
model, that derived service period represents the
duration of the median of the distribution of share
price paths on which the market condition is satisfied.
That median is the middle share price path (the midpoint
of the distribution of paths) on which the market
condition is satisfied. The duration is the period of
time from the service inception date to the expected
date of satisfaction (as inferred from the valuation
technique). If the derived service period is three
years, the estimated requisite service period is three
years and all compensation cost would be recognized over
that period, unless the market condition was satisfied
at an earlier date. Compensation cost would not be
recognized beyond three years even if after the grant
date the entity determines that it is not probable that
the market condition will be satisfied within that
period. Further, an award of fully vested, deep
out-of-the-money share options has a derived service
period that must be determined from the valuation
techniques used to estimate fair value. . . .
ASC
718-10
55-71 A
derived service period is based on a market condition in
a share-based payment award that affects exercisability,
exercise price, or the employee’s ability to retain the
award. A derived service period is inferred from the
application of certain valuation techniques used to
estimate fair value. For example, the derived service
period for an award of share options that an employee
can exercise only if the share price doubles at any time
during a five-year period can be inferred from certain
valuation techniques that are used to estimate fair
value. This example, and others noted in this Section,
implicitly assume that the rights conveyed by the
instrument to the holder are dependent on the holder’s
being an employee of the entity. That is, if the
employment relationship is terminated, the award lapses
or is forfeited shortly thereafter. In a lattice model,
that derived service period represents the duration of
the median of the distribution of share price paths on
which the market condition is satisfied. That median is
the middle share price path (the midpoint of the
distribution of paths) on which the market condition is
satisfied. The duration is the period of time from the
service inception date to the expected date of market
condition satisfaction (as inferred from the valuation
technique). For example, if the derived service period
is three years, the requisite service period is three
years and all compensation cost would be recognized over
that period, unless the market condition is satisfied at
an earlier date, in which case any unrecognized
compensation cost would be recognized immediately upon
its satisfaction. If the requisite service is not
rendered, all previously recognized compensation cost
would be reversed. If the requisite service is rendered,
the recognized compensation is not reversed even if the
market condition is never satisfied. An entity that uses
a closed-form model to estimate the grant-date fair
value of an award with a market condition may need to
use another valuation technique to estimate the derived
service period.
A derived service period is unique to share-based payment awards
that contain a market condition. As described in ASC 718-10-55-71 and defined in
ASC 718-10-20, a derived service period is the “time from the service inception
date to the expected date of satisfaction” of the market condition. Entities can
infer this period by using a valuation technique (such as a lattice-based model)
to estimate the fair-value-based measure of an award with a market condition.
For example, an award may have a condition making the award exercisable only
when the share price increases by 25 percent. In a lattice-based model, there
will be a number of possible paths that reflect an increase in share price by 25
percent. Entities infer the derived service period by using the median share
price path or, in other words, the midpoint period over which the share price is
expected to increase by 25 percent.
When an award only has a market condition without an explicit
service period (i.e., it requires the employee to remain employed until the
market condition is met), the derived service period is the requisite service
period. That is, the derived service period establishes the period over which an
entity recognizes the compensation cost for a share-based payment award with
only a market condition. If the market condition is satisfied on an earlier
date, any unrecognized compensation cost is recognized immediately on the date
of satisfaction of the market condition. See Section 3.7 for a more detailed discussion
of the requisite service period of awards with multiple conditions.
In addition, see Section 3.5 for a discussion of the
accounting for awards with only a market condition.
3.6.4 Service Inception Date
ASC 718-10 — Glossary
Service Inception Date
The date at which the employee’s
requisite service period or the nonemployee’s vesting
period begins. The service inception date usually is the
grant date, but the service inception date may differ
from the grant date (see Example 6 [see paragraph
718-10-55-107] for an illustration of the application of
this term to an employee award).
ASC
718-10
35-6
The service inception date is the beginning of the
requisite service period. If the service inception date
precedes the grant date (see paragraph 718-10-55-108),
accrual of compensation cost for periods before the
grant date shall be based on the fair value of the award
at the reporting date. In the period in which the grant
date occurs, cumulative compensation cost shall be
adjusted to reflect the cumulative effect of measuring
compensation cost based on fair value at the grant date
rather than the fair value previously used at the
service inception date (or any subsequent reporting
date). Example 6 (see paragraph 718-10-55-107)
illustrates the concept of service inception date and
how it is to be applied.
Example 6: Service Inception
Date and Grant Date for Employee
Awards
55-107
The following Example illustrates the guidance in
paragraph 718-10-35-6.
55-108
This Topic distinguishes between service inception date
and grant date. The service inception date is the date
at which the requisite service period begins. The
service inception date usually is the grant date, but
the service inception date precedes the grant date if
all of the following criteria are met:
- An award is authorized. (Compensation cost would not be recognized before receiving all necessary approvals unless approval is essentially a formality [or perfunctory].)
- Service begins before a mutual understanding of the key terms and conditions of a share-based payment award is reached.
- Either of the following conditions applies:
- The award’s terms do not include a substantive future requisite service condition that exists at the grant date (see paragraph 718-10-55-113 for an example illustrating that condition).
- The award contains a market or performance condition that if not satisfied during the service period preceding the grant date and following the inception of the arrangement results in forfeiture of the award (see paragraph 718-10-55-114 for an example illustrating that condition).
55-109
In certain circumstances the service inception date may
begin after the grant date (see paragraphs 718-10-55-93
through 55-94 for an example illustrating that
circumstance).
55-110
For example, Entity T offers a position to an individual
on April 1, 20X5, that has been approved by the chief
executive officer and board of directors. In addition to
salary and other benefits, Entity T offers to grant
10,000 shares of Entity T stock that vest upon the
completion of 5 years of service (the market price of
Entity T’s stock is $25 on April 1, 20X5). The share
award will begin vesting on the date the offer is
accepted. The individual accepts the offer on April 2,
20X5, but is unable to begin providing services to
Entity T until June 2, 20X5 (that is, substantive
employment begins on June 2, 20X5). The individual also
does not receive a salary or participate in other
employee benefits until June 2, 20X5. On June 2, 20X5,
the market price of Entity T stock is $40. In this
Example, the service inception date is June 2, 20X5, the
first date that the individual begins providing
substantive employee services to Entity T. The grant
date is the same date because that is when the
individual would meet the definition of an employee. The
grant-date fair value of the share award is $400,000
(10,000 × $40).
55-111
If necessary board approval of the award described in
the preceding paragraph was obtained on August 5, 20X5,
two months after substantive employment begins (June 2,
20X5), both the service inception date and the grant
date would be August 5, 20X5, as that is the date when
all necessary authorizations were obtained. If the
market price of Entity T’s stock was $38 per share on
August 5, 20X5, the grant-date fair value of the share
award would be $380,000 (10,000 × $38). Additionally,
Entity T would not recognize compensation cost for the
shares for the period between June 2, 20X5, and August
4, 20X5, neither during that period nor cumulatively on
August 5, 20X5, when both the service inception date and
the grant date occur. This is consistent with the
definition of requisite service period, which states
that if an award requires future service for vesting,
the entity cannot define a prior period as the requisite
service period. Future service in this context
represents the service to be rendered beginning as of
the service inception date.
55-112
If the service inception date precedes the grant date,
recognition of compensation cost for periods before the
grant date shall be based on the fair value of the award
at the reporting dates that occur before the grant date.
In the period in which the grant date occurs, cumulative
compensation cost shall be adjusted to reflect the
cumulative effect of measuring compensation cost based
on the fair value at the grant date rather than the fair
value previously used at the service inception date (or
any subsequent reporting dates) (see paragraph
718-10-35-6).
55-113
If an award’s terms do not include a substantive future
requisite service condition that exists at the grant
date, the service inception date can precede the grant
date. For example, on January 1, 20X5, an employee is
informed that an award of 100 fully vested options will
be made on January 1, 20X6, with an exercise price equal
to the share price on January 1, 20X6. All approvals for
that award have been obtained as of January 1, 20X5.
That individual is still an employee on January 1, 20X6,
and receives the 100 fully vested options on that date.
There is no substantive future service period associated
with the options after January 1, 20X6. Therefore, the
requisite service period is from the January 1, 20X5,
service inception date through the January 1, 20X6,
grant date, as that is the period during which the
employee is required to perform service in exchange for
the award. The relationship between the exercise price
and the current share price that provides a sufficient
basis to understand the equity relationship established
by the award is known on January 1, 20X6. Compensation
cost would be recognized during 20X5 in accordance with
the preceding paragraph.
55-114
If an award contains either a market or a performance
condition, which if not satisfied during the service
period preceding the grant date and following the date
the award is given results in a forfeiture of the award,
then the service inception date may precede the grant
date. For example, an authorized award is given on
January 1, 20X5, with a two-year cliff vesting service
requirement commencing on that date. The exercise price
will be set on January 1, 20X6. The award will be
forfeited if Entity T does not sell 1,000 units of
product X in 20X5. In this Example, the employee earns
the right to retain the award if the performance
condition is met and the employee renders service in
20X5 and 20X6. The requisite service period is two years
beginning on January 1, 20X5. The service inception date
(January 1, 20X5) precedes the grant date (January 1,
20X6). Compensation cost would be recognized during 20X5
in accordance with paragraph 718-10-55-112.
55-115
In contrast, consider an award that is given on January
1, 20X5, with only a three-year cliff vesting explicit
service condition, which commences on that date. The
exercise price will be set on January 1, 20X6. In this
Example, the service inception date cannot precede the
grant date because there is a substantive future
requisite service condition that exists at the grant
date (two years of service). Therefore, there would be
no attribution of compensation cost for the period
between January 1, 20X5, and December 31, 20X5, neither
during that period nor cumulatively on January 1, 20X6,
when both the service inception date and the grant date
occur. This is consistent with the definition of
requisite service period, which states that if an award
requires future service for vesting, the entity cannot
define a prior period as the requisite service period.
The requisite service period would be two years,
commencing on January 1, 20X6.
ASC 718 distinguishes between service inception date and grant
date. The service inception date is the date on which the employee’s requisite
service period or the nonemployee’s vesting period begins and is usually the
grant date. However, sometimes the service inception date can precede the grant
date. For employee awards, ASC 718-10-55-108 states that if all of the following
criteria are met, the service inception date precedes the grant date:
- An award is authorized. . . . [See Section 3.6.4.1.]
- Service begins before a mutual understanding of the key terms and conditions of a share-based payment award is reached. [See Section 3.6.4.2.]
- Either of the following conditions applies:
- The award’s terms do not include a substantive future requisite service condition . . . at the grant date. [See Section 3.6.4.3.]
- The award contains a market or performance condition that if not satisfied during the service period preceding the grant date . . . results in forfeiture of the award. [See Section 3.6.4.4.]
All three criteria in ASC 718-10-55-108(a)–(c) must be met for
the service inception date to precede the grant date; however, only one of the
two conditions in ASC 718-10-55-108(c) must be satisfied.
If it is determined that the service inception date precedes the grant date,
compensation cost should be recognized as described in Section 3.6.4.5.
3.6.4.1 Award Authorization
Typically, the approvals necessary for establishing a
service inception date under ASC 718-10-55-108(a) are the same as those
required for establishing a grant date (see Section 3.2.1). However, some entities
have performance-based compensation arrangements in which the terms of the
plan or strategy have received the necessary approvals but the final
compensation amount that each individual employee will receive will not be
finalized by a board of directors, a compensation committee, or other
governance body until after the performance period. For example, an entity
may have an annual bonus program that is (1) settled in a combination of
cash and shares and (2) based on the achievement of performance or market
metrics for a particular year, but the program may not be finalized by the
compensation committee and communicated to employees until shortly after the
annual performance period. Generally, a grant date for the amount settled in
shares1 will not be established until, at the earliest, the compensation
committee finalizes the compensation amount and the number of shares
allocated to each employee after the performance period. We believe that the
following two views are acceptable in the assessment of whether the
authorization criterion has been met in an entity’s determination of whether
a service inception date has been established before the grant date:
-
Narrow view — Under this view, the awards are authorized on the date on which (1) all required approvals are obtained (including any required actions of the compensation committee or other governance body) and (2) the key terms and conditions of the awards are finalized (including the portion settled in shares to be issued to each employee). That is, satisfaction of the authorization criterion related to determining the service inception date would be evaluated in the same manner as the entity’s determination of when the grant date approval requirement is met for each employee’s award. See Section 3.2.1 for further discussion of the approval requirement in establishing a grant date.
-
Broad view — In establishing the service inception date, an entity does not need to have finalized the specific details of the award at the individual-employee level to conclude that the awards have been authorized. The entity may instead consider factors that provide evidence to support that the awards have been authorized, such as:
-
Whether the board of directors, compensation committee, or other governance body has approved an overall compensation plan or strategy that includes the awards.
-
Whether the employees have a sufficient understanding of the compensation plan or strategy, including an awareness that they are working toward certain performance metrics or goals and have an expectation that the awards will be granted if the related performance metrics or goals are achieved.
-
Whether the compensation plan or strategy outlines how the awards will be allocated to each employee, and how the amount (quantity or monetary amount) of each employee’s award will be determined. A formally authorized policy or established past practices that define or create an understanding by the board of directors or compensation committee of the performance metrics for determining the awards allocated to each employee may support a conclusion that the initial authorization is substantive.
-
Whether the board of directors’ or compensation committee’s approval process for finalizing the awards after the performance period has ended is substantive relative to the initial authorization, including the nature and degree of discretion the board or committee has and uses to deviate from the compensation plan or strategy previously approved and understood. In certain cases, such discretion may cause the initial approval process to be considered less substantive, calling into question whether the authorization criterion has been met.
-
The evaluation and interpretation of whether proper
authorization has occurred may involve considerable judgment and should be
based on all relevant facts and circumstances. An entity must elect, as an
accounting policy, to use either the narrow or broad view of authorization,
and it must apply its elected view consistently and provide appropriate
disclosures.
3.6.4.2 Service Begins
If the recipient of an award has commenced employment before
a mutual understanding of the key terms and conditions is reached, service
will have begun under ASC 718-10-55-108(b). See Section 3.2 for additional discussion
of reaching a mutual understanding of key terms and conditions.
3.6.4.3 No Substantive Future Requisite Service as of the Grant Date
An award satisfies ASC 718-10-55-108(c)(1) if it has no service
condition after the grant date. Even if the award has a stated vesting period,
the service condition might not be substantive (e.g., retirement-eligible
employees). See Section
3.6.6 for further discussion of nonsubstantive service
conditions.
Example 3-13
On
January 1, 20X1, an entity informs one of its employees
that it will grant 1,000 fully vested equity-classified
stock options to the employee on January 1, 20X2, as
long as the employee is still employed on that date. The
exercise price of the options will equal the market
price of the entity’s shares on January 1, 20X2. All
necessary approvals for the future grant of these
options are received by January 1, 20X1.
The grant date is January 1, 20X2,
since the employee neither benefits from, nor is
adversely affected by, subsequent changes in the price
of the entity’s shares until that date. There is no
substantive requirement for additional service to be
rendered after December 31, 20X1. Accordingly, the
service inception is January 1, 20X1, and compensation
cost is recorded from January 1, 20X1, to December 31,
20X1.
Example 3-14
On
January 1, 20X1, an entity informs one of its employees
that it will grant 1,000 fully vested equity-classified
stock options to the employee on January 1, 20X3, as
long as the employee is still employed on that date. The
exercise price of the options will equal the market
price of the entity’s shares on January 1, 20X2. All
necessary approvals for the future grant of these
options are received by January 1, 20X1.
The grant date is January 1, 20X2, since the employee neither benefits from, nor
is adversely affected by, subsequent changes in the
price of the entity’s shares until that date. Because
there is a requirement for the employee to provide
service from January 1, 20X2, to December 31, 20X2, the
options contain a “substantive future requisite service
condition . . . at the grant date.” Further, there are
no market or performance conditions that may result in
forfeiture of the options before the grant date.
Accordingly, the service inception date is January 1,
20X2 — the grant date. Compensation cost would be
recognized over the period from January 1, 20X2, to
December 31, 20X2.
3.6.4.4 Forfeiture Because a Market or Performance Condition Was Not Satisfied Before the Grant Date
To determine whether the service inception date precedes the
grant date, an entity that concludes that an award has a substantive future
service requirement after the grant date must evaluate whether the award
contains a market or performance condition that could result in its
forfeiture before the grant date under ASC 718-10-55-108(c)(2). In other
words, the service inception date may still precede the grant date despite
the presence of a substantive future service requirement if the award
contains a market or performance condition that must be met before the grant
date.
Example 3-15
On January 1, 20X1, an entity informs one of its
employees that it will grant 1,000 fully vested
equity-classified stock options to the employee on
January 1, 20X3, as long as the employee (1) is
still employed on that date and (2) sells 1,000
units of product during 20X1. The exercise price of
the options will equal the market price of the
entity’s shares on January 1, 20X2. All necessary
approvals for the future grant of these options are
received by January 1, 20X1.
The grant date is January 1, 20X2, since the employee neither benefits from, nor
is adversely affected by, subsequent changes in the
price of the entity’s shares until that date.
Because the employee could forfeit the options by
not selling enough units of product before January
1, 20X2 (the grant date), the service inception date
precedes the grant date (i.e., condition (c)(2),
discussed above, is met). Accordingly, the service
inception date is January 1, 20X1, and the grant
date is January 1, 20X2. Compensation cost would be
recognized over the period from January 1, 20X1, to
December 31, 20X2.
In some cases, the performance or market condition
associated with each employee’s award may be specific and well-defined. In
other cases, a specific and well-defined performance or market condition may
be associated with an entity’s overall plan or strategy but not with each
employee’s award. In a manner similar to its selection of a broad or narrow
view regarding award authorization under ASC 718-10-55-108(a) (see Section 3.6.4.1), an
entity would make an accounting policy election related to its evaluation
under ASC 718-10-55-108(c)(2) as follows:
- Narrow view — The terms of each employee’s award must include a performance or market condition that is sufficiently specific or defined.
- Broad view — The performance or market condition associated with the overall plan or strategy must be sufficiently specific or defined even though the amount that will be allocated to each employee is not.
An entity may elect a different policy under ASC
718-10-55-108(a) for award authorization than it elects under ASC
718-10-55-108(c)(2) for evaluation of a performance or market condition.
That is, an entity that has elected to apply a broad view of ASC
718-10-55-108(a) may elect to apply a narrow view of ASC 718-10-55-108(c)(2)
and vice versa. However, the entity must consistently apply the approach it
selects for each condition and must make the appropriate disclosures.
Depending on an award’s substantive terms and how those
terms vary among employees, an entity may end up applying ASC
718-10-55-108(c)(1) to one group of employees and ASC 718-10-55-108(c)(2) to
another. A commonly cited example is the issuance of awards that permit
retirement-eligible employees to continue to vest after retirement. In this
instance, if an entity (1) applies a broad view related to both
authorization and whether a performance or market condition exists and (2)
concludes that a service inception date precedes the grant date for both
groups of employees, it could end up applying ASC 718-10-55-108(c)(1) to
retirement-eligible employees while applying ASC 718-10-55-108(c)(2) to
those employees who are not retirement-eligible. However, in other
circumstances, the entity’s conclusions regarding whether a service
inception date has been established before the grant date may be different
for the two sets of employees. For example, if an entity applies a broad
view related to authorization but a narrow one for determining whether a
performance or market condition exists, it may end up concluding that a
service inception date precedes the grant date for retirement-eligible
employees but not for employees who are not retirement-eligible.
It is also common for awards to have graded vesting. If an
entity applies a broad view regarding both authorization and determining
whether a performance or market condition exists, and there is a substantive
service requirement on a graded-vesting schedule, the entity may be
precluded from electing a straight-line attribution method as its accounting
policy under ASC 718-10-35-8. The straight-line attribution method is
permitted for awards that only have service conditions and would therefore
not apply to awards with other conditions (e.g., a market condition or a
performance condition, unless the only performance condition is a change in
control or an IPO that accelerates vesting). See Section 3.6.5 for further discussion
of attribution methods for awards with graded vesting.
3.6.4.5 Recognition of Compensation Cost
If the service inception date precedes the grant date,
compensation cost is remeasured on the basis of the award’s estimated
fair-value-based measure at the end of each reporting period until the grant
date, to the extent that service has been rendered in proportion to the
total requisite service period. In the period in which the grant date
occurs, cumulative compensation cost is adjusted to reflect the cumulative
effect of measuring compensation cost on the basis of the fair-value-based
measure of the award on the grant date and is not subsequently remeasured
(provided that the award is equity classified).
Example 3-16
On January 1, 20X1, an entity informs one of its
employees that it will grant 1,000 fully vested
equity-classified stock options to the employee on
January 1, 20X3, as long as the employee (1) is
still employed on that date and (2) sells 1,000
units of product during 20X1. The exercise price of
the options will equal the market price of the
entity’s shares on January 1, 20X2. All necessary
approvals for the future grant of these options are
received by January 1, 20X1. Accordingly, the
service inception date is January 1, 20X1, and the
grant date is January 1, 20X2.
Compensation cost is recognized on
the basis of the proportion of service rendered over
the period from January 1, 20X1, to December 31,
20X2 (assuming that the performance condition is
probable). From the service inception date until the
grant date (January 1, 20X1, to December 31, 20X1),
the entity remeasures the options at their
fair-value-based measure at the end of each
reporting period on the basis of the assumptions
that exist on those dates. Once the grant date is
established (January 1, 20X2), the entity
discontinues remeasuring the options at the end of
each reporting period. That is, the compensation
cost that is recognized over the remaining service
period (January 1, 20X2, to December 31, 20X2) is
based on the fair-value-based measure on the grant
date.
3.6.5 Graded Vesting for Employee Awards
ASC
718-10
Graded Vesting Employee
Awards
35-8 An
entity shall make a policy decision about whether to
recognize compensation cost for an employee award with
only service conditions that has a graded vesting
schedule in either of the following ways:
- On a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in-substance, multiple awards
- On a straight-line basis over the requisite service period for the entire award (that is, over the requisite service period of the last separately vesting portion of the award). . . .
However, the amount of compensation cost recognized at
any date must at least equal the portion of the
grant-date value of the award that is vested at that
date. Example 1, Case B (see paragraph 718-20-55-25)
provides an illustration of the accounting for an award
with a graded vesting schedule.
The example below is based on the same facts as in Case A of
Example 1 in ASC 718-20-55-4 through 55-9 (see Section 3.4.1.1).
ASC 718-20
55-4C
Because of the differences in compensation cost
attribution, the accounting policy election illustrated
in Case B (see paragraph 718-20-55-25) does not apply to
nonemployee awards.
Case
B: Share Options With Graded Vesting
55-25 Paragraph 718-10-35-8
provides for the following two methods to recognize
compensation cost for awards with graded vesting:
- On a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in-substance, multiple awards (graded vesting attribution method)
- On a straight-line basis over the requisite service period for the entire award (that is, over the requisite service period of the last separately vesting portion of the award), subject to the limitation noted in paragraph 718-10-35-8.
55-26
The choice of attribution method for awards with graded
vesting schedules is a policy decision that is not
dependent on an entity’s choice of valuation technique.
In addition, the choice of attribution method applies to
awards with only service conditions.
55-27
The accounting is illustrated below for both methods and
uses the same assumptions as those noted in Case A
except for the vesting provisions.
55-28
Entity T awards 900,000 share options on January 1,
20X5, that vest according to a graded schedule of 25
percent for the first year of service, 25 percent for
the second year, and the remaining 50 percent for the
third year. Each employee is granted 300 share options.
The following table shows the calculation as of January
1, 20X5, of the number of employees and the related
number of share options expected to vest. Using the
expected 3 percent annual forfeiture rate, 90 employees
are expected to terminate during 20X5 without having
vested in any portion of the award, leaving 2,910
employees to vest in 25 percent of the award (75
options). During 20X6, 87 employees are expected to
terminate, leaving 2,823 to vest in the second 25
percent of the award. During 20X7, 85 employees are
expected to terminate, leaving 2,738 employees to vest
in the last 50 percent of the award. That results in a
total of 840,675 share options expected to vest from the
award of 900,000 share options with graded
vesting.
55-29
The value of the share options that vest over the
three-year period is estimated by separating the total
award into three groups (or tranches) according to the
year in which they vest (because the expected life for
each tranche differs). The following table shows the
estimated compensation cost for the share options
expected to vest. The estimates of expected volatility,
expected dividends, and risk-free interest rates are
incorporated into the lattice, and the graded vesting
conditions affect only the earliest date at which
suboptimal exercise can occur (see paragraph 718-20-55-8
for information on suboptimal exercise). Thus, the fair
value of each of the 3 groups of options is based on the
same lattice inputs for expected volatility, expected
dividend yield, and risk-free interest rates used to
determine the value of $14.69 for the cliff-vesting
share options (see paragraphs 718-20-55-7 through 55-9).
The different vesting terms affect the ability of the
suboptimal exercise to occur sooner (and affect other
factors as well, such as volatility), and therefore
there is a different expected term for each
tranche.
55-30
Compensation cost is recognized over the periods of
requisite service during which each tranche of share
options is earned. Thus, the $2,933,280 cost
attributable to the 218,250 share options that vest in
20X5 is recognized in 20X5. The $3,000,143 cost
attributable to the 211,725 share options that vest at
the end of 20X6 is recognized over the 2-year vesting
period (20X5 and 20X6). The $6,033,183 cost attributable
to the 410,700 share options that vest at the end of
20X7 is recognized over the 3-year vesting period (20X5,
20X6, and 20X7).
55-31
The following table shows how the $11,966,606 expected
amount of compensation cost determined at the grant date
is attributed to the years 20X5, 20X6, and 20X7.
55-32
Entity T could use the same computation of estimated
cost, as in the preceding table, but could elect to
recognize compensation cost on a straight-line basis for
all graded vesting awards. In that case, total
compensation cost to be attributed on a straight-line
basis over each year in the 3-year vesting period is
approximately $3,988,868 ($11,966,606 ÷ 3). Entity T
also could use a single weighted-average expected life
to value the entire award and arrive at a different
amount of total compensation cost. Total compensation
cost could then be attributed on a straight-line basis
over the three-year vesting period. However, this Topic
requires that compensation cost recognized at any date
must be at least equal to the amount attributable to
options that are vested at that date. For example, if 50
percent of this same option award vested in the first
year of the 3-year vesting period, 436,500 options
[2,910 × 150 (300 × 50%)] would be vested at the end of
20X5. Compensation cost amounting to $5,866,560 (436,500
× $13.44) attributable to the vested awards would be
recognized in the first year.
55-33 Compensation cost is
adjusted for awards with graded vesting to reflect
differences between estimated and actual forfeitures as
illustrated for the cliff-vesting options, regardless of
which method is used to estimate value and attribute
cost.
55-34
Accounting for the tax effects of awards with graded
vesting follows the same pattern illustrated in
paragraphs 718-20-55-20 through 55-23. However, unless
Entity T identifies and tracks the specific tranche from
which share options are exercised, it would not know the
recognized compensation cost that corresponds to
exercised share options for purposes of calculating the
tax effects resulting from that exercise. If an entity
does not know the specific tranche from which share
options are exercised, it should assume that options are
exercised on a first-vested, first-exercised basis
(which works in the same manner as the first-in,
first-out [FIFO] basis for inventory
costing).
Some share-based payment awards may have a graded vesting
schedule (i.e., awards that are split into multiple tranches in which each
tranche legally vests separately) instead of cliff vesting (i.e., all awards
vest at the end of the vesting period). For example, an entity may grant an
employee 1,000 awards in which 250 of the awards legally vest for each of four
years of service provided. Under ASC 718-10-35-8, an entity may recognize
compensation cost for an award with only a service condition that has a graded
vesting schedule on either (1) an accelerated basis as though each separately
vesting portion of the award was, in substance, a separate award or (2) a
straight-line basis over the total requisite service period for the entire
award.
As a result of an entity’s use of certain valuation techniques
to determine the fair-value-based measure of a share-based payment award of
stock options with only a service condition that has a graded vesting schedule,
each portion of the award that vests separately may directly or indirectly be
valued as an individual award. That is, directly or indirectly, certain
valuation techniques may cause an award with a graded vesting schedule to be
characterized as multiple awards instead of a single award. (See ASC
718-20-55-25 through 55-34 [Case B: Share Options
With Graded Vesting] for an example of the type of valuation
techniques that may cause an award with a graded vesting schedule to be
characterized as multiple awards, and see Section
4.10 for more information about the valuation of awards with a
graded vesting schedule.) Notwithstanding its use of such valuation techniques,
the entity can still make an accounting policy election to record compensation
cost on a straight-line basis over the total requisite service period for the
entire award. If straight-line attribution is used, however, ASC 718-10-35-8
requires that “the amount of compensation cost recognized at any date must at
least equal the portion of the grant-date value of the award that is vested at
that date.” The examples below illustrate the attribution of compensation cost
under a straight-line method for graded vesting awards.
Example 3-17
Entity A grants 1,000 stock options to each of its 100
employees. The grant-date fair-value-based measure of
each option is $12. The options vest in 25 percent
increments (tranches) each year over the next four years
(i.e., a graded vesting schedule). To determine the
grant-date fair-value-based measure, A uses a valuation
technique in which the award is treated as a single
award rather than as multiple awards. Entity A has
elected, as an accounting policy, to estimate the amount
of total stock options for which the requisite service
period will not be rendered. Assume that no employees
will leave in year 1, three employees will leave in year
2, five employees will leave in year 3, and seven
employees will leave in year 4.
Entity A elected, as an accounting policy, to use the
straight-line attribution method to recognize
compensation cost. Under this method, the award is
treated as a single award.
The
following table summarizes the calculation of total
compensation cost by taking into account the estimated
forfeitures noted above:
On the basis of the calculation of total compensation cost above, A should
recognize $280,500 ($1,122,000 total compensation cost ÷
4 years of service) of compensation cost each year over
the next four years under the straight-line attribution
method for the aggregate 93,500 options that are
expected to vest. However, because, at the end of the
first, second, and third years, 25,000, 24,250, and
23,000 employee stock options have legally vested, A
would have to ensure that, at a minimum, $300,000,
$591,000 ($300,000 + $291,000), and $867,000 ($300,000 +
$291,000 + $276,000) of cumulative compensation cost is
recognized at the end of the first, second, and third
years, respectively. Accordingly, A would recognize
$300,000 of compensation cost in year 1, $291,000 in
year 2, $276,000 in year 3, and $255,000 in year 4,
rather than the $280,500 that would have been recognized
under a straight-line attribution method. Note that if
A’s estimate of forfeitures changes, the cumulative
effect of that change on current and prior periods would
be recognized as compensation cost in the period of the
change.
Example 3-18
Assume the same facts as in the example above, except that the options vest over
three years in increments (tranches) of 50 percent for
the first year of service, 25 percent for the second
year of service, and 25 percent for the third year of
service (i.e., a graded vesting schedule).
The following
table summarizes the calculation of total compensation
cost by taking into account the estimated forfeitures
noted above:
On the basis of the calculation of total compensation cost above, Entity A
should recognize $389,000 ($1,167,000 total compensation
cost ÷ 3 years of service) of compensation cost each
year over the next three years under the straight-line
attribution method for the aggregate 97,250 options that
are expected to vest. However, because, at the end of
the first and second years, 50,000 and 24,250 employee
stock options have legally vested, A would have to
ensure that a minimum of $600,000 and $891,000 ($600,000
+ $291,000) of cumulative compensation cost is
recognized at the end of the first and second years,
respectively. Accordingly, A would recognize $600,000 of
compensation cost in year 1, $291,000 in year 2, and
$276,000 in year 3, rather than the $389,000 that would
have been recognized under a straight-line attribution
method. Note that if A’s estimate of forfeitures
changes, the cumulative effect of that change on current
and prior periods would be recognized as compensation
cost in the period of the change.
The examples below illustrate the attribution of compensation
cost under the graded vesting (i.e., accelerated) attribution model for graded
vesting awards.
Example 3-19
Entity A grants 1,000 stock options to 100 employees,
each with a grant-date fair-value-based measure of $12.
The options vest in 25 percent increments (tranches)
each year over the next four years (i.e., a graded
vesting schedule). To determine the grant-date
fair-value-based measure, A used a valuation technique
that treated the award as a single award rather than as
multiple awards. Entity A has elected, as an accounting
policy, to estimate the amount of total stock options
for which the requisite service period will not be
rendered. Assume that no employee will leave in year 1,
three employees will leave in year 2, five employees
will leave in year 3, and seven employees will leave in
year 4.
Entity A elected, as an
accounting policy, to use the graded vesting attribution
method to recognize compensation cost. Under the graded
vesting attribution method, each tranche that vests
separately is treated as an individual award. In this
example, since a portion of the options vests annually,
there are four tranches (i.e., four separate awards).
However, if 1/48 of the options vested each month over a
four-year period, the grant would contain 48 separate
tranches (i.e., 48 separate awards).
The following table summarizes the
calculation of total compensation cost by tranche:
The table below summarizes the
allocation of total compensation cost over each of the
four years of service.
Example 3-20
Assume the same facts as in the example above, except that the options vest over
three years in increments (tranches) of 50 percent for
the first year of service, 25 percent for the second
year of service, and 25 percent for the third year of
service (i.e., a graded vesting schedule).
The following
table summarizes the calculation of total compensation
cost by tranche:
The
table below summarizes the allocation of total
compensation cost over each of the three years of
service.
For a graded vesting award with both a service and a performance
condition or a market condition, an entity is generally precluded from using a
straight-line attribution method over the requisite service period for the
entire award. ASC 718-10-35-5 requires an entity to treat awards with graded
vesting as, in substance, multiple awards with more than one requisite service
period, and ASC 718-10-35-8 provides an exception to that requirement for awards
with “only service conditions.” Accordingly, ASC 718-10-35-8 cannot be applied
broadly to awards that contain conditions beyond service conditions.
However, on the basis of discussions with the FASB staff, we
believe that ASC 718 does not intend to preclude straight-line attribution when
the only performance condition is a change in control or an IPO that accelerates
vesting when the awards otherwise vest solely on the basis of service
conditions. Although ASC 718-10-35-8 outlines two acceptable methods for
recognizing compensation cost for graded vesting awards “with only service
conditions,” we believe that the two acceptable methods can also be applied when
the performance condition is related to a change in control or an IPO that
accelerates vesting when the awards otherwise vest solely on the basis of
service conditions.
As discussed in Section 3.4.2.1, (1) it is generally not
probable that an IPO will occur until the IPO is effective and (2) if it is not
probable that an IPO performance condition will be met, an entity should
disregard that condition in determining the requisite service period. Similarly,
it generally2 is not probable that a change in control will occur until the change in
control is consummated. When the change in control or IPO performance condition
accelerates (but does not preclude) vesting, the performance condition generally
does not affect vesting or the related attribution method unless a change in
control or IPO occurs. Therefore, an entity may elect to apply a straight-line
attribution method for graded vesting awards with service conditions and a
change in control or IPO performance condition that accelerates vesting. If the
change in control or IPO becomes effective, the awards would accelerate vesting,
and the entity would recognize the remaining compensation cost upon
occurrence.
It may not be appropriate to recognize compensation cost for a
graded vesting award with only a service condition by using an approach in which
the compensation cost recognized in a given reporting period is aligned with the
percentage of awards that are legally vesting in that reporting period.
Specifically, the use of this method is not acceptable when a graded vesting
award with only a service condition has a back-loaded vesting schedule (e.g., an
award that vests 25 percent in year 1, 25 percent in year 2, and 50 percent in
year 3). Such a recognition method could result in an entity’s delaying a
portion of compensation cost toward the latter part of the requisite service
period. ASC 718-10-35-8 provides just two acceptable approaches for recognizing
compensation cost for a graded vesting award with only a service condition: (1)
straight-line attribution and (2) accelerated attribution. The examples below
illustrate the differences between the methods.
Example 3-21
Assumptions
Straight-Line Attribution Method
Under this method, the
three tranches are treated as one award and the total
compensation cost is recognized on a straight-line basis
over the three-year service period.
Accelerated Attribution Method
Under this method, each tranche is
treated as a separate award, and the total compensation
cost is recognized on an accelerated basis over the
three-year service period.
Unacceptable Attribution Method
Under this method (which is not acceptable),
compensation cost is recognized for the portion of the
award that legally vests in a particular period.
Comparison of Methods
An entity’s use of either a straight-line or an accelerated
attribution method represents an accounting policy election and thus should be
applied consistently to all similar awards (e.g., all employee share-based
payment awards subject to graded vesting and with only service conditions). For
example, if an entity elects to use the straight-line attribution method to
account for awards with only service conditions, it should consistently apply
this policy to all awards with only service conditions, including those that
have been modified to remove market and performance conditions. Further, if an
entity uses the accelerated attribution method for an award with a market or
performance condition and a service condition but then subsequently modifies the
award to remove the market or performance condition, the entity should apply the
straight-line vesting method prospectively to the modified award.
When contemplating making changes to its accounting policy, an entity must apply
ASC 250, including its requirement that the new recognition policy be preferable
to the existing one. ASC 718 does not specify which attribution method is
preferable. Therefore, the preferability assessment should be based on the
entity’s specific facts and circumstances.
3.6.6 Nonsubstantive Service Condition for Employee Awards
3.6.6.1 Retirement Eligibility
ASC 718-10
Illustrations
Example 1:
Estimating the Employee's Requisite Service
Period
55-86
This Example illustrates the guidance in paragraphs
718-10-30-25 through 30-26.
55-87 Assume that Entity A
uses a point system for retirement. An employee who
accumulates 60 points becomes eligible to retire
with certain benefits, including the retention of
any nonvested share-based payment awards for their
remaining contractual life, even if another explicit
service condition has not been satisfied. In this
case, the point system effectively accelerates
vesting. On January 1, 20X5, an employee receives
at-the-money options on 100 shares of Entity A’s
stock. All options vest at the end of 3 years of
service and have a 10-year contractual term. At the
grant date, the employee has 60 points and,
therefore, is eligible to retire at any
time.
55-88 Because the employee is
eligible to retire at the grant date, the award’s
explicit service condition is nonsubstantive.
Consequently, Entity A has granted an award that
does not contain a service condition for vesting,
that is, the award is effectively vested, and thus,
the award’s entire fair value should be recognized
as compensation cost on the grant date. All of the
terms of a share-based payment award and other
relevant facts and circumstances must be analyzed
when determining the requisite service
period.
In some cases, an entity may grant share-based payment
awards with an explicit service condition to employees who are eligible for
retirement as of the grant date. These awards may contain a clause that
allows an employee who is retirement-eligible (or who becomes
retirement-eligible) to (1) retain the award and (2) continue to vest in the
award after the employee retires.
The existence of a retirement provision such as that
described above causes the explicit service condition to become
nonsubstantive. ASC 718-10-20 defines the “terms of a share-based payment
award” as follows, in part:
The substantive terms of a
share-based payment award . . . provide the basis for determining the
rights conveyed to a party and the obligations imposed on the issuer,
regardless of how the award and related arrangement, if any, are
structured.
Because the retirement-eligible employee is not required to
provide services during the explicit service period, the explicit service
condition is not considered substantive and does not affect the requisite
service period of the award. The entity has granted an award that does not
contain any vesting conditions and is effectively fully vested on the grant
date. Accordingly, the award’s entire grant-date fair-value-based measure
should be recognized as compensation cost on the grant date.
The award may contain a provision that delays the ability to
sell or exercise the award through the end of the explicit service period.
However, because the employee is not required to provide services after
becoming retirement-eligible, such a provision represents a postvesting
transfer restriction or exercisability condition and does not change the
requisite service period of the award.
Example 3-22
On January 1, 20X1, an entity grants 1,000
at-the-money employee stock options, each with a
grant-date fair value of $6, to employees who are
currently retirement-eligible. The awards legally
vest and become exercisable after three years of
service. The terms of the award also stipulate that
the employees continue to vest after a qualifying
retirement, as defined in their employment
agreements. Because the employees are
retirement-eligible on the grant date, the entity
should recognize compensation cost of $6,000
immediately on the grant date, since the employees
are not required to work during the stated service
period to earn the award.
Example 3-23
On January 1, 20X1, an entity grants 1,000
at-the-money employee stock options, each with a
grant-date fair value of $6, to employees who will
become retirement-eligible two years later on
December 31, 20X2. The awards legally vest and
become exercisable after three years of service. The
terms of the award also stipulate that the employees
continue to vest after a qualifying retirement, as
defined in their employment agreements. Because the
employees are retirement-eligible two years after
the grant on December 31, 20X2, the entity should
recognize compensation cost of $6,000 over the
two-year period from the grant date (January 1,
20X1) to the date on which the employees become
retirement-eligible (December 31, 20X2), since the
employees are not required to provide employee
services during the remainder of the stated service
period (January 1, 20X3, through December 31, 20X3)
to earn the award.
3.6.6.2 Noncompete Agreements
ASC 718-20
Example 10: Share Award
With a Clawback Feature
55-84 This Example
illustrates the guidance in paragraph
718-20-35-2.
55-84A
This Example (see paragraphs 718-20-55-85 through
55-86) describes employee awards. However, the
principles on how to account for the various aspects
of employee awards, except for the compensation cost
attribution and certain inputs to valuation, are the
same for nonemployee awards. Consequently, the
accounting for a contingent feature (such as a
clawback) of an award that might cause a grantee to
return to the entity either equity instruments
earned or realized gains from the sale of the equity
instruments earned is equally applicable to
nonemployee awards with the same feature as the
awards in this Example (that is, the clawback
feature). Therefore, the guidance in this Example
also serves as implementation guidance for similar
nonemployee awards.
55-84B
Compensation cost attribution for awards to
nonemployees may be the same or different for
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 this Example 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.
55-85 On January 1, 20X5,
Entity T grants its chief executive officer an award
of 100,000 shares of stock that vest upon the
completion of 5 years of service. The market price
of Entity T’s stock is $30 per share on that date.
The grant-date fair value of the award is $3,000,000
(100,000 × $30). The shares become freely
transferable upon vesting; however, the award
provisions specify that, in the event of the
employee’s termination and subsequent employment by
a direct competitor (as defined by the award) within
three years after vesting, the shares or their cash
equivalent on the date of employment by the direct
competitor must be returned to Entity T for no
consideration (a clawback feature). The chief
executive officer completes five years of service
and vests in the award. Approximately two years
after vesting in the share award, the chief
executive officer terminates employment and is hired
as an employee of a direct competitor. Paragraph
718-10-55-8 states that contingent features
requiring an employee to transfer equity shares
earned or realized gains from the sale of equity
instruments earned as a result of share-based
payment arrangements to the issuing entity for
consideration that is less than fair value on the
date of transfer (including no consideration) are
not considered in estimating the fair value of an
equity instrument on the date it is granted. Those
features are accounted for if and when the
contingent event occurs by recognizing the
consideration received in the corresponding balance
sheet account and a credit in the income statement
equal to the lesser of the recognized compensation
cost of the share-based payment arrangement that
contains the contingent feature ($3,000,000) and the
fair value of the consideration received. This
guidance does not apply to cancellations of awards
of equity instruments as discussed in paragraphs
718-20-35-7 through 35-9. The former chief executive
officer returns 100,000 shares of Entity T’s common
stock with a total market value of $4,500,000 as a
result of the award’s provisions. The following
journal entry accounts for that event.
55-86 If instead of
delivering shares to Entity T, the former chief
executive officer had paid cash equal to the total
market value of 100,000 shares of Entity T’s common
stock, the following journal entry would have been
recorded.
Example 11: Certain
Noncompete Agreements and Requisite Service for
Employee Awards
55-87
Paragraphs 718-10-25-3 through 25-4 require that the
accounting for all share-based payment transactions
with employees or others reflect the rights conveyed
to the holder of the instruments and the obligations
imposed on the issuer of the instruments, regardless
of how those transactions are structured. Some
share-based compensation arrangements with employees
may contain noncompete provisions. Those noncompete
provisions may be in-substance service conditions
because of their nature. Determining whether a
noncompete provision or another type of provision
represents an in-substance service condition is a
matter of judgment based on relevant facts and
circumstances. This Example illustrates a situation
in which a noncompete provision represents an
in-substance service condition.
55-88 Entity K is a
professional services firm in which retention of
qualified employees is important in sustaining its
operations. Entity K’s industry expertise and
relationship networks are inextricably linked to its
employees; if its employees terminate their
employment relationship and work for a competitor,
the entity’s operations may be adversely
impacted.
55-89 As part of its
compensation structure, Entity K grants 100,000
restricted share units to an employee on January 1,
20X6. The fair value of the restricted share units
represents approximately four times the expected
future annual total compensation of the employee.
The restricted share units are fully vested as of
the date of grant, and retention of the restricted
share units is not contingent on future service to
Entity K. However, the units are transferred to the
employee based on a 4-year delayed-transfer schedule
(25,000 restricted share units to be transferred
beginning on December 31, 20X6, and on December 31
in each of the 3 succeeding years) if and only if
specified noncompete conditions are satisfied. The
restricted share units are convertible into
unrestricted shares any time after
transfer.
55-90 The noncompete
provisions require that no work in any capacity may
be performed for a competitor (which would include
any new competitor formed by the employee). Those
noncompete provisions lapse with respect to the
restricted share units as they are transferred. If
the noncompete provisions are not satisfied, the
employee loses all rights to any restricted share
units not yet transferred. Additionally, the
noncompete provisions stipulate that Entity K may
seek other available legal remedies, including
damages from the employee. Entity K has determined
that the noncompete is legally enforceable and has
legally enforced similar arrangements in the
past.
55-91 The nature of the
noncompete provision (being the corollary condition
of active employment), the provision’s legal
enforceability, the employer’s intent to enforce and
past practice of enforcement, the delayed-transfer
schedule mirroring the lapse of noncompete
provisions, the magnitude of the award’s fair value
in relation to the employee’s expected future annual
total compensation, and the severity of the
provision limiting the employee’s ability to work in
the industry in any capacity are facts that provide
a preponderance of evidence suggesting that the
arrangement is designed to compensate the employee
for future service in spite of the employee’s
ability to terminate the employment relationship
during the service period and retain the award
(assuming satisfaction of the noncompete provision).
Consequently, Entity K would recognize compensation
cost related to the restricted share units over the
four-year substantive service period.
55-92 Example 10 (see
paragraph 718-20-55-84) provides an illustration of
another noncompete agreement. That Example and this
one are similar in that both noncompete agreements
are not contingent upon employment termination (that
is, both agreements may activate and lapse during a
period of active employment after the vesting date).
A key difference between the two Examples is that
the award recipient in that Example must provide
five years of service to vest in the award (as
opposed to vesting immediately). Another key
difference is that the award recipient in that
Example receives the shares upon vesting and may
sell them immediately without restriction as opposed
to the restricted share units, which are transferred
according to the delayed-transfer schedule. In that
Example, the noncompete provision is not deemed to
be an in-substance service condition. In making a
determination about whether a noncompete provision
may represent an in-substance service condition, the
provision’s legal enforceability, the entity’s
intent to enforce the provision and its past
practice of enforcement, the employee’s rights to
the instruments such as the right to sell them, the
severity of the provision, the fair value of the
award, and the existence or absence of an explicit
employee service condition are all factors that
shall be considered. Because noncompete provisions
can be structured differently, one or more of those
factors (such as the entity’s intent to enforce the
provision) may be more important than others in
making that determination. For example, if Entity K
did not intend to enforce the provision, then the
noncompete provision would not represent an
in-substance service condition.
Some awards may contain noncompete provisions that require
an employee to forfeit stock options, return shares, or return any gain
realized on the sale of the options or shares if the employee goes to work
for a competitor within a specified period. Generally, the existence of a
noncompete provision does not create an in-substance service condition that
an entity must consider in determining the requisite service period of an
award.
The existence of a noncompete provision alone does not
result in an in-substance service condition. For a noncompete provision to
represent an in-substance service condition, the provision must compel the
individual employee to provide future services to the entity to receive the
benefits of the award. Further, it must be so restrictive that the employee
is unlikely to be able to terminate and retain the award because any new
employment opportunity the individual would reasonably pursue would result
in the award’s forfeiture.
The evaluation of whether a noncompete arrangement creates
an in-substance service condition goes beyond the determination that the
noncompete arrangement is a substantive agreement. An entity must consider
all other terms of the award when determining the requisite service period
(e.g., whether the explicit service period is nonsubstantive). The entity
should consider the following factors when determining whether the
noncompete arrangement creates an in-substance service condition:
- The nature and legal enforceability of the arrangement.
- The lack of an explicit service condition.
- The employee’s rights under the arrangement (e.g., the right to sell).
- The entity’s intent to enforce the arrangement, and its past practice of enforcement.
- The expiration of any transferability or exercisability restriction mirroring the lapse of the arrangement.
- The nature of the entity’s operations, industry, and employee relationships.
- The award’s fair value relative to the employee’s expected future annual total compensation.
- Limitations on the employee’s ability to work in the industry in any capacity.
In Example 11 in ASC 718-20-55-87 through 55-92, the noncompete arrangement represents an in-substance service condition because the outcome for the employee would be essentially the same if there was an explicit vesting period. Although the award was fully vested, compensation cost would be recognized over the term of the noncompete agreement. However, at a meeting of the FASB Statement 123(R) Resource Group, the FASB staff
indicated that Example 11 was intended to be an anti-abuse provision that
would apply in limited circumstances and that an entity must use judgment in
evaluating whether a noncompete provision represents an in-substance service
condition. Accordingly, we believe that it would be rare for a noncompete
arrangement to represent an in-substance service condition.
Example 10 in ASC 718-20-55-84 through 55-86 illustrates a
situation in which the existence of a noncompete arrangement does not compel
the employee to provide services and therefore does not result in an in-substance service condition that would affect
the requisite service period. The noncompete provision is treated as a
clawback feature (see Section 3.9) if and when the employee violates the provision
and returns the award or its cash equivalent. The entity does not consider
the existence of the provision in determining the requisite service period,
and the award is recognized on the basis of the stated vesting terms. In
Example 10, if the award were fully vested, or if the employee were
retirement-eligible and the award continued to vest after retirement or was
allowed to immediately vest upon retirement (see Section 3.6.6.1), compensation cost
would be recognized immediately.
3.6.6.3 Deep Out-of-the-Money Stock Options
ASC 718-10
Estimating the Employee’s Requisite Service Period
55-67
Paragraph 718-10-35-2 requires that compensation
cost be recognized over the requisite service
period. The requisite service period for an award
that has only a service condition is presumed to be
the vesting period, unless there is clear evidence
to the contrary. The requisite service period shall
be estimated based on an analysis of the terms of
the award and other relevant facts and
circumstances, including co-existing employment
agreements and an entity’s past practices; that
estimate shall ignore nonsubstantive vesting
conditions. For example, the grant of a deep
out-of-the-money share option award without an
explicit service condition will have a derived
service period. Likewise, if an award with an
explicit service condition that was at-the-money
when granted is subsequently modified to accelerate
vesting at a time when the award is deep
out-of-the-money, that modification is not
substantive because the explicit service condition
is replaced by a derived service condition. If a
market, performance, or service condition requires
future service for vesting (or exercisability), an
entity cannot define a prior period as the requisite
service period. The requisite service period for
awards with market, performance, or service
conditions (or any combination thereof) shall be
consistent with assumptions used in estimating the
grant-date fair value of those awards.
A grant of fully vested, deep out-of-the-money stock options
is deemed equivalent to a grant of an award with a market condition. The
stock option awards effectively contain a market condition because the
market price on the grant date is significantly below the exercise price. As
a result, the share price must increase to a level above the exercise price
before the employee receives any value from the award. The market condition
would be reflected in the estimate of the fair-value-based measure on the
grant date. Because ASC 718 does not provide guidance on determining whether
an option is deep out-of-the-money, an entity must use judgment in making
this determination. Factors that an entity may consider include those
affecting the value of the award (e.g., volatility of the underlying stock,
exercise price) and their impact on the expected period required for the
award to become at-the-money.
Because the stated service period is zero (i.e., the award
is fully vested) and the award contains a market condition, the requisite
service period equals the derived service period associated with the market
condition, which is calculated by using a valuation technique (see Section 3.6.3). The lack
of an explicit service period is nonsubstantive because the employee must
continue to work for the entity until the stock option award is in-the-money
to receive any value from the award, since it is customary for awards to
have features that limit exercisability upon termination (the term of the
option typically truncates, such as 30 days after termination). Compensation
cost should be recognized over the derived service period if the requisite
service is expected to be rendered, unless the market condition is satisfied
on an earlier date, in which case any unrecognized compensation cost is
recognized immediately.
Footnotes
1
In some cases, the portion settled in shares may not
be determined up front but could be estimated on the basis of past
practice, plan terms, or communications to employees. Note that the
portion settled in cash is typically accounted for under other U.S.
GAAP unless it meets the scope requirements of ASC 718.
2
One exception to the probability assessment is when the
performance condition is related to a change in control event associated
with an entity’s sale of its business unit (or subsidiary) to a third
party. See Section
3.4.2.1 for further discussion.
3.7 Multiple Conditions for Employee Awards
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.
25-21 If
an award requires satisfaction of one or more market,
performance, or service conditions (or any combination
thereof), compensation cost shall be recognized if the good
is delivered or the service is rendered, and no compensation
cost shall be recognized if the good is not delivered or the
service is not rendered. Paragraphs 718-10-55-60 through
55-63 provide guidance on applying this provision to awards
with market, performance, or service conditions (or any
combination thereof).
Performance or Service
Conditions
30-12
Awards of share-based compensation ordinarily specify a
performance condition or a service condition (or both) that
must be satisfied for a grantee to earn the right to benefit
from the award. No compensation cost is recognized for
instruments forfeited because a service condition or a
performance condition is not satisfied (for example,
instruments for which the good is not delivered or the
service is not rendered). Examples 1 through 2 (see
paragraphs 718-20-55-4 through 55-40) and Example 1 (see
paragraph 718-30-55-1) provide illustrations of how
compensation cost is recognized for awards with service and
performance conditions
Market,
Performance, and Service Conditions That Affect Vesting and
Exercisability
55-61 Analysis
of the market, performance, or service conditions (or any
combination thereof) that are explicit or implicit in the
terms of an award is required to determine the employee’s
requisite service period or the nonemployee’s vesting period
over which compensation cost is recognized and whether
recognized compensation cost may be reversed if an award
fails to vest or become exercisable (see paragraph
718-10-30-27). If exercisability or the ability to retain
the award (for example, an award of equity shares may
contain a market condition that affects the grantee’s
ability to retain those shares) is based solely on one or
more market conditions compensation cost for that award is
recognized if the grantee delivers the promised good or
renders the service, even if the market condition is not
satisfied. If exercisability (or the ability to retain the
award) is based solely on one or more market conditions,
compensation cost for that award is reversed if the grantee
does not deliver the promised good or render the service,
unless the market condition is satisfied prior to the end of
the employee’s requisite service period or the nonemployee’s
vesting period, in which case any unrecognized compensation
cost would be recognized at the time the market condition is
satisfied. If vesting is based solely on one or more
performance or service conditions, any previously recognized
compensation cost is reversed if the award does not vest
(that is, the good is not delivered or the service is not
rendered or the performance condition is not achieved).
Examples 1 through 4 (see paragraphs 718-20-55-4 through
55-50) provide illustrations of awards in which vesting is
based solely on performance or service
conditions.
55-61A
An employee award containing one or more market conditions
may have an explicit, implicit, or derived service period.
Paragraphs 718-10-55-69 through 55-79 provide guidance on
explicit, implicit, and derived service periods.
55-62 Vesting or exercisability
may be conditional on satisfying two or more types of
conditions (for example, vesting and exercisability occur
upon satisfying both a market and a performance or service
condition). Vesting also may be conditional on satisfying
one of two or more types of conditions (for example, vesting
and exercisability occur upon satisfying either a market
condition or a performance or service condition). Regardless
of the nature and number of conditions that must be
satisfied, the existence of a market condition requires
recognition of compensation cost if the good is delivered or
the service is rendered, even if the market condition is
never satisfied.
55-63
Even if only one of two or more conditions must be satisfied
and a market condition is present in the terms of the award,
then compensation cost is recognized if the good is
delivered or the service is rendered, regardless of whether
the market, performance, or service condition is satisfied
(see Example 5 [paragraph 718-10-55-100] for an example of
such an employee award).
55-66 The
following flowchart provides guidance on determining how to
account for an award based on the existence of market,
performance, or service conditions (or any combination
thereof).
Accounting for Awards With
Market, Performance, or Service Conditions
(a) The award shall be classified and
accounted for as equity. Market conditions are included in
the grant-date fair value estimate of the award.
(b) Performance and service conditions that
affect vesting are not included in estimating the grant-date
fair value of the award. Performance and service conditions
that affect the exercise price, contractual term, conversion
ratio, or other pertinent factors affecting the fair value
of an award are included in estimating the grant-date fair
value of the award.
55-72 An
award with a combination of market, performance, or service
conditions may contain multiple explicit, implicit, or
derived service periods. For such an award, the estimate of
the requisite service period shall be based on an analysis
of all of the following:
- All vesting and exercisability conditions
- All explicit, implicit, and derived service periods
- The probability that performance or service conditions will be satisfied.
55-73 Thus,
if vesting (or exercisability) of an award is based on
satisfying both a market condition and a performance or
service condition and it is probable that the performance or
service condition will be satisfied, the initial estimate of
the requisite service period generally is the longest of the
explicit, implicit, or derived service periods. If vesting
(or exercisability) of an award is based on satisfying
either a market condition or a performance or service
condition and it is probable that the performance or service
condition will be satisfied, the initial estimate of the
requisite service period generally is the shortest of the
explicit, implicit, or derived service periods.
55-74 For
example, a share option might specify that vesting occurs
after three years of continuous employee service or when the
employee completes a specified project. The employer
estimates that it is probable that the project will be
completed within 18 months. The employer also believes it is
probable that the service condition will be satisfied. Thus,
that award contains an explicit service period of 3 years
related to the service condition and an implicit service
period of 18 months related to the performance condition.
Because it is considered probable that both the performance
condition and the service condition will be achieved, the
requisite service period over which compensation cost is
recognized is 18 months, which is the shorter of the
explicit and implicit service periods.
55-75 As
illustrated in the preceding paragraph , if an award vests
upon the earlier of the satisfaction of a service condition
(for example, four years of service) or the satisfaction of
one or more performance conditions, it will be necessary to
estimate when, if at all, the performance conditions are
probable of achievement. For example, if initially the
four-year service condition is probable of achievement and
no performance condition is probable of achievement, the
requisite service period is four years. If one year into the
four-year requisite service period a performance condition
becomes probable of achievement by the end of the second
year, the requisite service period would be revised to two
years for attribution of compensation cost (at that point in
time, there would be only one year of the two-year requisite
service period remaining).
55-76 If an
award vests upon the satisfaction of both a service
condition and the satisfaction of one or more performance
conditions, the entity also must initially determine which
outcomes are probable of achievement. For example, an award
contains a four-year service condition and two performance
conditions, all of which need to be satisfied. If initially
the four-year service condition is probable of achievement
and no performance condition is probable of achievement,
then no compensation cost would be recognized unless the two
performance conditions and the service condition
subsequently become probable of achievement. If both
performance conditions become probable of achievement one
year after the grant date and the entity estimates that both
performance conditions will be achieved by the end of the
second year, the requisite service period would be four
years as that is the longest period of both the explicit
service period and the implicit service periods. Because the
performance conditions are now probable of achievement,
compensation cost will be recognized in the period of the
change in estimate (see paragraph 718-10-35-3) as the
cumulative effect on current and prior periods of the change
in the estimated number of awards for which the requisite
service is expected to be rendered. Therefore, compensation
cost for the first year will be recognized immediately at
the time of the change in estimate for the awards for which
the requisite service is expected to be rendered. The
remaining unrecognized compensation cost for those awards
would be recognized prospectively over the remaining
requisite service period. An entity that has an accounting
policy to account for forfeitures when they occur in
accordance with paragraph 718-10-35-3 would assume that the
achievement of a service condition is probable when
determining the amount of compensation cost to recognize
unless the award has been forfeited.
If a share-based payment award contains multiple conditions
(service, performance, or market) that affect a grantee’s ability to vest in or
exercise the award, an entity recognizes compensation cost associated with the award
on the basis of whether all or just one of the conditions must be met for the
grantee to vest in or exercise the award. For employee awards, this analysis also
affects the requisite service period. As discussed in Section 3.6, for certain nonemployee awards,
an entity may analogize to the guidance on calculating a requisite service period
when that guidance is relevant to the entity’s determination of whether it should
recognize compensation cost. For additional discussion of a nonemployee’s vesting
period, see Section
9.3.2.
The table below contains answers to questions about various
scenarios in which an award has two conditions that affect an employee’s requisite
service period and the subsequent recognition of compensation cost.
|
Answer if the award consists of:
| ||||
|---|---|---|---|---|
|
Question
|
A market condition or a performance/
service condition that must be met for the employee to vest
in or exercise the award
|
A market condition and a performance/
service condition that must be met for the employee to vest
in or exercise the award
|
A service condition or a performance
condition that must be met for the employee to vest in or
exercise the award
|
A service condition and a performance
condition that must be met for the employee to vest in or
exercise the award
|
|
What is the requisite service period if all
performance/service conditions are probable?
|
The shortest of the
derived, implicit, or explicit service period.
|
The longest of the
derived, implicit, or explicit service period.
|
The shorter of the
implicit or explicit service period.
|
The longer of the
implicit or explicit service period.
|
|
How is the requisite service period affected
if one of the performance/service conditions is not
probable?
|
The derived service period is the requisite
service period because the performance/service condition is
excluded from the assessment of the requisite service
period. However, If an entity has a policy of recognizing
forfeitures when they occur, and there is not a performance
condition (i.e., there is a market condition and a service
condition), the requisite service period is the shorter of the derived or explicit
service period.
|
Compensation cost is not recorded until it
is probable that the award will vest. However, if an entity
has a policy of recognizing forfeitures when they occur, and
there is not a performance condition (i.e., there is a
market condition and a service condition), the requisite
service period is the longer of the
derived or explicit service period.
|
The implicit/explicit service period
associated with the other vesting condition is the requisite
service period. Since meeting the performance/service
condition is not probable, it is excluded from the
assessment of the requisite service period. However, if an
entity has a policy of recognizing forfeitures when they
occur and the performance condition is probable, the
requisite service period is the shorter of the implicit or explicit service
period.
|
Compensation cost is not recorded until it
is probable that the award will vest. If an entity has a
policy of recognizing forfeitures when they occur, and
meeting the performance condition is probable, the requisite
service period is the longer of the
implicit or explicit service period.
|
|
Under what circumstances can an entity
reverse previously accrued compensation cost and record no
compensation cost for the award?
|
The employee is expected to forfeit the
award (if an entity’s policy is to estimate forfeitures) or
actually forfeits the award (if an entity’s policy is to
recognize forfeitures when they occur) before the end of the
derived service period and before
the performance/service condition is met.
|
The employee is expected to forfeit the
award (if an entity’s policy is to estimate forfeitures) or
actually forfeits the award (if an entity’s policy is to
recognize forfeitures when they occur) before the end of the
derived service period or before the
performance/service condition is met.
|
The employee is expected to forfeit the
award (if an entity’s policy is to estimate forfeitures) or
actually forfeits the award (if an entity’s policy is to
recognize forfeitures when they occur) before the service and performance conditions are
met.
|
The employee is expected to forfeit the
award (if an entity’s policy is to estimate forfeitures) or
actually forfeits the award (if an entity’s policy is to
recognize forfeitures when they occur) before the service or performance condition is
met.
|
|
Does an entity subsequently revise the
initial estimate of the derived service period on the basis
of updated assumptions?
|
No, unless the market condition is met
earlier than estimated.
|
No, unless the market condition is met
earlier than estimated.
|
N/A
|
N/A
|
|
Does an entity subsequently revise the
estimate of an implicit service period for updated
assumptions?
|
Yes.
|
Yes.
|
Yes.
|
Yes.
|
3.7.1 Only One Condition Must Be Met — Employee Awards
If the terms of an award contain multiple conditions but only one condition must be met for an employee to vest
in or exercise the award, the requisite service period is the shortest of the explicit, implicit, or derived service
period because the employee must only remain employed until any one of the
conditions is met. Compensation cost should be recognized over that requisite
service period.
A condition that is not expected to be met must be excluded from
the determination of the shortest of the explicit, implicit, or derived service
period. However, if an entity has a policy of recognizing forfeitures when they
occur, it would not disregard any service condition in the determination of the
requisite service period; rather, the entity would assume that a service
condition would be met unless the award is actually forfeited. If the award is
forfeited in the future (on the basis of the service condition), the service
condition can no longer be used as the basis for the requisite service
period.
If an award that is classified as equity includes a market
condition and neither that nor any other condition was ultimately met,
compensation cost should still be recorded as long as the employee provides the
requisite service under the derived service period. An entity should not
consider the probability that the market condition will be met when it
recognizes compensation cost because a market condition is not a vesting
condition. Rather, it should factor the probability of meeting the market
condition into the fair-value-based measure of the award.
ASC 718-10-55-100 through 55-105 provide an example of an award
in which only the market condition or the service condition must be met for the
award to vest.
ASC
718-10
Example 5: Employee Share-Based
Payment Award With Market and Service Conditions
and Multiple Service Periods
55-100 The following Cases
illustrate the guidance in paragraph 718-10-35-5
applicable to employee awards in circumstances in which
an award includes both a market condition and a service
condition:
- When only one condition must be met (Case A)
- When both conditions must be met (Case B).
55-101 Cases A and B share
the following assumptions.
55-102 On January 1, 20X5,
Entity T grants an executive 200,000 share options on
its stock with an exercise price of $30 per option. The
award specifies that vesting (or exercisability) will
occur upon the earlier of the following for Case A or
both are met for Case B:
- The share price reaching and maintaining at least $70 per share for 30 consecutive trading days
- The completion of eight years of service.
55-103 The award contains an
explicit service period of eight years related to the
service condition and a derived service period related
to the market condition.
Case
A: When Only One Condition Must Be Met
55-104 An entity shall make
its best estimate of the derived service period related
to the market condition (see paragraph 718-10-55-71).
The derived service period may be estimated using any
reasonable methodology, including Monte Carlo simulation
techniques. For this Case, the derived service period is
assumed to be six years. As described in paragraphs
718-10-55-72 through 55-73, if an award’s vesting (or
exercisability) is conditional upon the achievement of
either a market condition or performance or service
conditions, the requisite service period is generally
the shortest of the explicit, implicit, and derived
service periods. In this Case, the requisite service
period over which compensation cost would be attributed
is six years (shorter of eight and six years). (An
entity may grant a fully vested deep out-of-the-money
share option that would lapse shortly after termination
of service, which is the equivalent of an award with
both a market condition and a service condition. The
explicit service period associated with the explicit
service condition is zero; however, because the option
is deep out-of-the-money at the grant date, there would
be a derived service period.)
55-105 Continuing with this
Case, if the market condition is actually satisfied in
February 20X9 (based on market prices for the prior 30
consecutive trading days), Entity T would immediately
recognize any unrecognized compensation cost because no
further service is required to earn the award. If the
market condition is not satisfied as of that date but
the executive renders the six years of requisite
service, compensation cost shall not be reversed under
any circumstances.
Example 3-24
Service or Performance
Condition
On January 1,
20X1, Entity A grants employee stock options that vest
upon the earlier of (1) the end of the fifth year of
service (cliff vesting) or (2) A’s obtaining a patent
for the prescription drug it is currently developing.
Entity A believes that it is probable that the patent
will be obtained at the end of four years. The options
contain an explicit service condition (i.e., the options
vest at the end of the fifth year of service) and a
performance condition (i.e., the options vest when the
entity obtains a patent for the prescription drug it is
currently developing), with an implicit service period
of four years. Because the options vest when either
condition is met, the requisite service period is the
shorter of the two service periods: four years.
The implicit service period is simply
an estimate. Therefore, if the award becomes exercisable
because the patent is obtained before A’s original
estimate of four years, A should immediately record any
unrecognized compensation cost on the date the
performance condition is met.
Example 3-25
Service or Market
Conditions
On January 1,
20X1, when Entity A’s share price is $25 per share, A
grants employee stock options that vest on the earlier
of (1) the end of the fifth year of service (cliff
vesting) or (2) an increase in A’s share price to $50
per share. By using a lattice model valuation technique,
A estimates that its share price will reach $50 in four
years.
The options contain an
explicit service condition (i.e., the options vest at
the end of the fifth year of service) and a market
condition (i.e., the options vest if A’s share price
increases to $50 per share), with a derived service
period of four years. Because the options vest when
either condition is met, the requisite service period is
the shorter of the two service periods: four years. If
the options vest sooner because the $50 share price
target is attained before the derived service period of
four years, A should immediately record any unrecognized
compensation cost on the date the market condition is
met. Conversely, if the options never become exercisable
because the share price target is never achieved, but
the employee remains employed for at least four years,
compensation cost should still be recorded.
Example 3-26
Performance or
Market Conditions
On January 1, 20X1, when its share price
is $30 per share, Entity A grants employee stock options
that vest on the basis of continued employment through
the earlier of (1) the launch of Product X within six
years of the grant date (a performance condition) or (2)
an increase in A’s share price to $45 per share within
six years of the grant date (a market condition). By
using a lattice model valuation technique, A estimates
that its share price will reach $45 in four years and
that the grant-date fair-value-based measure of each
stock option is $5 if the market condition is included
in the calculation and $7 if the market condition is not
included.
For an award in which vesting or
exercisability is based on a market or performance
condition, an entity would determine the grant-date
fair-value-based measure separately depending on whether
the market condition is included in the calculation. The
total amount of compensation recognized over the award’s
service period would depend on whether the performance
condition is probable.
On January 1, 20X1, it is determined
that it is not probable that the performance condition
will occur. Accordingly, A concludes that the requisite
service period is the derived service period of four
years.
If it continues not to be probable that
the performance condition will occur during the
requisite four-year service period, A would recognize
compensation over such period at a grant-date
fair-value-based measure of $5 per option. If the
options vest sooner because the $45 share price target
is attained before the derived service period of four
years, A should immediately record any unrecognized
compensation cost by using the grant-date
fair-value-based measure of $5 on the date the market
condition is met.
However, if the entity determines that
it is probable that the launch of Product X will occur
before the market condition is achieved, A should
recognize compensation cost by using the grant-date
fair-value-based measure of $7 over the applicable
requisite service period.
Conversely, if (1) the options never
become exercisable because the share price target is
never achieved and Product X is not launched within six
years of the grant date and (2) the employee completes
the derived service period of four years, A should still
record compensation cost but use the grant-date
fair-value-based measure of $5.
3.7.2 Multiple Conditions Must Be Met — Employee Awards
If all of the conditions in the terms of
an award must be met for an employee to vest in or exercise the award, the
requisite service period is the longest of the explicit,
implicit, or derived service period because the employee must still be employed
when the last condition is met. Compensation cost should be recognized over that
requisite service period.
However, when one of the conditions is a service or performance
condition, recognition of compensation cost will depend on the probability that
the condition will be met. That is, if it is not probable that the service or
performance condition will be met, no compensation cost should be recognized.
On the other hand, if one of the conditions is a market condition, the entity
should not consider the probability of meeting the market condition when it
recognizes compensation cost because a market condition is not a vesting
condition. Rather, the probability of meeting the market condition should be
factored into the fair-value-based measure of the award. See Section 4.5 for a
discussion of how a market condition affects the valuation of a share-based
payment award. Even if the market condition is never met, compensation cost
should be recognized if the employee provides the requisite service and the
other vesting conditions are met.
For awards that include a performance condition and a service
condition, an entity should consider the probability that the conditions will be
met independently. For example, if it is probable that the performance condition
will be met, the entity should still consider its policy election for forfeiture
estimates with respect to the service condition when recognizing compensation
cost. Conversely, if an entity has a policy of recognizing forfeitures when they
occur, it would assume that the service condition will be met unless the award
is actually forfeited. In this case, it considers only the probability of a
performance condition and would recognize compensation cost only if it is
probable that such condition will be met.
Case B in ASC 718-10-55-106 is based on the same facts as in ASC
718-10-55-100 through 55-103 (see Section 3.7.1) and illustrates an award in
which both a market condition and a service condition must be met for the award
to vest.
ASC
718-10
Case
B: When Both the Market and Service Condition Must Be
Met
55-106 The
initial estimate of the requisite service period for an
award requiring satisfaction of both market and
performance or service conditions is generally the
longest of the explicit, implicit, and derived service
periods (see paragraphs 718-10-55-72 through 55-73). For
example, if the award described in Case A [see Section
3.7.1] required both the completion of 8
years of service and the share price reaching and
maintaining at least $70 per share for 30 consecutive
trading days, compensation cost would be recognized over
the 8-year explicit service period. If the employee were
to terminate service prior to the eight-year requisite
service period, compensation cost would be reversed even
if the market condition had been satisfied by that
time.
Example 3-27
Both a Service Condition and a
Performance Condition
On
January 1, 20X1, Entity A grants employee stock options
that vest at the end of the fourth year of service
(cliff vesting). The options can be exercised only by
employees who are still employed by the entity when it
successfully completes an IPO.
The options contain an explicit service condition
(i.e., the options vest at the end of the fourth year of
service) and a performance condition (i.e., the options
can be exercised only upon successful completion of an
IPO by employees who are still employed by A upon the
IPO’s completion). Entity A’s treatment of the
exercisability condition should be similar to its
treatment of a vesting requirement. Under ASC
718-10-55-76, if the vesting (or exercisability) of an
award is based on the satisfaction of both a service and
performance condition, the entity must initially
determine which outcomes are probable and recognize the
compensation cost over the longer of the explicit or
implicit service period. Because an IPO generally is not
considered to be probable until the IPO is effective, no
compensation cost would be recognized until the IPO
occurs. For example, if an IPO becomes effective on
December 31, 20X2, and the four years of service are
expected to be rendered upon the IPO’s becoming
effective, A would (1) recognize a cumulative-effect
adjustment to compensation cost for the service that has
already been provided (two of the four years) and (2)
record the unrecognized compensation cost ratably over
the remaining two years of service.
Example 3-28
Both a Service Condition and a
Market Condition
On
January 1, 20X1, Entity A grants employee stock options
that vest if A’s share price is at least $50 and the
employee provides service for at least one year (to
exercise the options, the employee must also be employed
when the share price is at least $50). Using a Monte
Carlo valuation technique, A estimates that its share
price will reach $50 in three years.
The options contain an explicit service
condition (i.e., the options vest at the end of one year
of service) and a market condition (i.e., the options
become exercisable if A’s share price is at least $50
per share), with a three-year derived service period.
Because the options vest when both conditions are met,
the requisite service period is the longer of the two
service periods — three years. In addition, because a
market condition is not a vesting condition, the market
condition should be factored into the fair-value-based
measure of the options. In accordance with ASC
718-10-30-14, as long as the employee provides service
for three years, compensation cost must be recognized
regardless of whether the market condition is
satisfied.
If, to vest in the award, the employee was not required
to be employed at the time the market condition is met,
the derived service period would not be relevant since
there would be no requisite service requirement tied to
achievement of the target share price.
Example 3-29
Both a Performance Condition and a
Market Condition
On
January 1, 20X1, Entity A grants employee stock options
that vest if (1) A’s share price is at least $50 and (2)
A’s cumulative net income over the next two annual
reporting periods exceeds $12 million. As of January 1,
20X1, A’s share price is $40. By using a Monte Carlo
valuation technique, A estimates that its share price
will reach $50 in three years.
The options contain a performance condition (i.e., the
options vest if A exceeds $12 million in cumulative net
income over the next two annual reporting periods) and a
market condition (i.e., the options vest if A’s share
price is at least $50 per share), with a derived service
period of three years. Since the market condition is not
a vesting condition, the market condition should be
factored into the fair-value-based measure of the
options.
The award’s vesting is
based on the satisfaction of both a market condition and
a performance condition, and if it is probable that the
performance condition will be satisfied in accordance
with ASC 718-10-55-73, the initial estimate of the
requisite service period would generally be the longest
of the explicit, implicit, or derived service period.
The performance condition provides an explicit service
period of two years. The three-year derived service
period is based on an increase in A’s share price to
$50. Since the derived service period of three years
represents the longer of the two service periods,
compensation cost would be recognized over that
three-year period.
If the market
condition is satisfied on an earlier date, any
unrecognized compensation cost would be recognized
immediately upon its satisfaction. However, this
accelerated service period cannot be shorter than the
explicit service period of two years that is associated
with the performance condition. Note that in accordance
with ASC 718-10-25-20, if meeting the performance
condition were to become improbable, all previously
recognized compensation cost would be reversed. In
addition, if the options never vest because the share
price target is never achieved, but the employee remains
employed for at least the derived service period of
three years and the performance condition is satisfied,
compensation cost still should be recorded.
If, to vest in the award, the employee was not required
to be employed at the time the market condition is met,
the derived service period would not be relevant since
there would be no requisite service requirement tied to
achievement of the target share price.
Example 3-30
Both a Performance Condition and a
Market Condition — Payoff Matrix
On January 1, 20X1, Entity A grants
to its employees 100,000 RSUs with a four-year service
period (cliff vesting). The number of RSUs that vest
will be determined at the end of the four-year service
period on the basis of the combination of an EBITDA
outcome (performance condition) and a TSR outcome
(market condition). The threshold outcomes for both
conditions must be met for the employees to vest in any
portion of the award. The number of RSUs that vest is
determined in accordance with the following payoff
matrix:
Assume that the grant-date
fair-value-based measure of each RSU is $25 (determined
by using a Monte Carlo valuation technique), which
incorporates the possible outcomes of the market
condition (i.e., the TSR). Compensation cost is
recognized by using the number of shares expected to
vest on the basis of (1) the outcome of the performance
condition and (2) the target market condition. If A
estimates that the service and performance conditions
will be achieved at the target outcome, total
compensation cost would be $2.5 million (100,000 RSUs ×
$25 grant-date fair-value-based measure × 100%).
If the outcome of the performance
condition is different from the initial estimate,
compensation cost is adjusted. However, compensation
cost is not adjusted for changes in the outcome of the
market condition, because the RSUs’ grant-date
fair-value-based measure of $25 already takes into
account the potential outcomes of the market condition.
For example, if the outcome of the performance condition
is the maximum amount, A would recognize $3.75 million
(100,000 RSUs × $25 grant-date fair-value-based measure
× 150%) of compensation cost, irrespective of the
outcome of the market condition.
Example 3-31
Both a Performance Condition and a Market Condition —
Two Awards
On January 1, 20X1, Entity A grants to its employees
100,000 RSUs. The number of RSUs earned is based on (1)
a range of A’s revenue growth objectives (performance
condition) and (2) a specified stock price objective
(market condition) over the year ending December 31,
20X1.
A revenue growth objective includes a
minimum threshold for vesting in 20 percent (20,000) of
the RSUs, a target threshold for vesting in 50 percent
(50,000) of the RSUs, and a maximum threshold for
vesting in 100 percent (100,000) of the RSUs. If the
target or maximum growth objective is met and the
stock price objective is met, the number of RSUs earned
will increase by 50 percent. Therefore, up to 150
percent of the awards can be earned if both (1) the
maximum (i.e., 100 percent) revenue growth objective and
(2) the stock price objective are met. If only the
minimum growth objective is met, the stock price
objective will have no effect on the RSUs earned.
In this example, unlike the scenario in
the previous example, 20,000 RSUs may be earned solely
on the basis of the achievement of the performance
condition (i.e., the revenue growth objective).
Therefore, the 20,000 RSUs may be accounted for
separately and the grant-date fair-value-based
measurement should not incorporate the market
condition associated with the stock price objective
because the 20,000 RSUs can be earned and remain
unaffected by whether the stock price objective is
achieved if only the minimum growth objective is
met.
The remainder of the RSUs may be
evaluated separately since they are subject to both a
performance condition and a market condition. If the
stock price objective is met, 75,000 or 150,000 RSUs may
vest depending on the outcome of the revenue growth
objective. If the stock price objective is not met,
50,000 or 100,000 RSUs may vest depending on the outcome
of the revenue growth objective. Determining the
grant-date fair-value-based measure for this portion of
the award is challenging, and companies should consult
with their valuation specialists for assistance.
3.7.2.1 Liquidity Event and Target IRR
The accounting for share-based payment awards that contain multiple
conditions is based on the type of conditions (service, performance, or
market) associated with the awards. For example, certain awards may vest
only if both:
- A target IRR to shareholders is achieved while the grantee is employed.
- The IRR is based on the payment of sufficient proceeds tendered (1) as a result of either a full or partial sale of the shareholders’ equity (e.g., because of a liquidity event) or (2) through distributions (e.g., dividends).
In such cases, we believe that attaining a specified
IRR that is based on the payment of sufficient proceeds made as a result of
either a full or partial sale of the shareholders’ equity is functionally
equivalent to achieving a specified rate of return on an entity’s stock,
which is an example of a market condition under ASC 718 (see Section 3.5).
Market conditions are treated as nonvesting conditions that
are factored into the award’s fair-value-based measure. Further, the award’s
ability to vest on the basis of (1) sufficient proceeds distributed to
shareholders (e.g., dividends) or (2) the sale of sufficient equity each
represents a performance condition under ASC 718 (see Section 3.4.2).
Therefore, this type of award vests on the basis of a performance condition
(i.e., sufficient proceeds) or a performance and market condition (i.e., the
sale of sufficient equity to achieve the IRR).
In determining the award’s requisite service period, an entity must consider
the multiple conditions associated with it (see Section 3.7). Accordingly, during the service (vesting)
period, an entity would assess the probability that any performance
conditions (i.e., the payment of sufficient proceeds either through
distributions or the sale of sufficient equity) will be met (i.e., the
probability that the employee will earn the award). However, the entity may
conclude that it is not probable that there will be sufficient proceeds
through distributions for the specified IRR to be attained and that for the
award to vest, a liquidity event would be necessary in which the payment of
sufficient proceeds could be made through a full or partial sale of the
shareholders’ equity. Therefore, although a liquidity event may not be an
explicit vesting condition, the probability that a liquidity event will
occur may govern whether the performance condition (i.e., the sale of
sufficient equity) is achieved.
An entity generally does not recognize compensation cost related to awards
that vest upon certain liquidity events such as a change in control or an
IPO until the event takes place (see Section
3.4.2.1). That is, 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. Thus, if it is not probable
that (1) the entity will declare and pay sufficient distributions to meet
the IRR target and (2) sufficient equity will be sold, the entity should not
record any compensation cost. However, if a liquidity event occurs that
results in the sale of all relevant equity and satisfaction of the requisite
service period, compensation cost should be recognized regardless of whether
the IRR target is achieved. Similarly, in circumstances in which it is
explicit that the IRR market condition must be met upon the occurrence of a
liquidity event, compensation cost would be recognized as of the date of the
liquidity event regardless of whether the IRR market condition has been met
because a market condition is factored into the fair-value-based measure of
the award.
Further, in instances in which the IRR market condition can only be met upon
the occurrence of the liquidity event, the entity does not need to calculate
a derived service period to determine the requisite service period. In that
scenario, the implicit service period is determined on the basis of the
expected date of the liquidity event, so the requisite service period would
always equal the implicit service period. However, because the occurrence of
a liquidity event is generally not considered probable until the event has
occurred, no compensation cost would be recognized until such time.
Example 3-32
Entity C was formed with two classes of legal-form
equity: Series A Units and Series B Units. The
Series A Units were issued by C in exchange for a
capital contribution from P, a private equity
investment fund.
Entity C granted 1,000 Series B
Units to its employees. The Series B Units vest on
the basis of a target MOIC and IRR on the capital
contribution from P for the Series A Units. The MOIC
and IRR on the Series A Units are based on the
payment of sufficient proceeds tendered (1) as a
result of either a full or partial sale of the
target shareholder’s equity (e.g., a liquidity
event) or (2) through distributions (e.g.,
dividends) to the Series A Unit holders. The number
of Series B Units that vest on the basis of the
target MOIC and the IRR are as follows:
- Forty percent upon a 2.00 × MOIC and 15% IRR.
- An additional 30% upon a 2.50 × MOIC and 20% IRR.
- The remaining 30% upon a 3.00 × MOIC and 25% IRR.
The requirements to achieve a target
MOIC and IRR based on the sale of equity represent
market conditions because they depend on a specified
return on the Series A Units. Market conditions are
treated as nonvesting conditions that are factored
into the fair-value-based measure of the award. The
requirements that the award vest on the basis of
sufficient proceeds through distributions or through
the sale of sufficient equity by P represent
performance conditions under ASC 718.
During the service (vesting) period,
an entity must assess the probability that any
performance condition (i.e., the payment of
sufficient proceeds either through distributions or
the sale of sufficient equity) will be met. For
example, if it is not probable that the entity will
declare and pay sufficient distributions to meet the
IRR and MOIC target or that, in the absence of a
liquidity event, sufficient equity would be sold,
the entity should not record any compensation
cost.
3.7.2.2 Multiple Performance Conditions That Affect Vesting and Nonvesting Factors
If a share-based payment award contains multiple performance
conditions that affect both vesting factors and nonvesting (e.g., exercise
price) factors, a grant-date fair-value-based measure should be calculated
for each possible nonvesting condition outcome. If the vesting condition is
not expected to be met, no compensation cost should be recorded. If the
vesting condition is expected to be met, the amount of compensation cost
should be based on the grant-date fair-value-based measure associated with
the nonvesting condition outcome whose achievement is probable. This
analysis applies to both employee and nonemployee awards. See Section 4.6 for a
discussion of the effect of performance conditions that affect factors other
than vesting or exercisability.
Example 3-33
On January 1, 20X1, Entity A grants 1,000
at-the-money employee stock options with an exercise
price of $10. The options vest in two years if its
EBITDA growth rate exceeds the industry average by
10 percent. The grant-date fair-value-based measure
of this option is $3. However, the exercise price
will be reduced to $5 if regulatory approval for
Product X is obtained within two years. The
grant-date fair-value-based measure of this option
is $6.
The EBITDA target is
expected to be achieved by December 31, 20X2, but it
is not probable that regulatory approval will be
obtained by that time. Therefore, compensation cost
of $1,500 should be recorded in 20X1 (1,000 options
× $3 grant-date fair-value-based measure × 50% for
one of two years of service provided).
On December 31, 20X2, regulatory approval is obtained and A’s EBITDA target is
met. Therefore, in 20X2, A should recognize
compensation cost of $4,500, or (1,000 options × $6
grant-date fair-value-based measure × 100% of
services provided) – $1,500 of compensation cost
previously recognized.
3.7.3 Multiple Conditions and Multiple Service Periods — Employee Awards
An award’s terms and conditions can sometimes result in multiple
service periods. In such cases, an entity must evaluate each condition to
determine whether there are multiple (1) grant dates, (2) service inception
dates, and (3) service periods. The examples below in ASC 718 illustrate
scenarios in which multiple service periods can exist.
3.7.3.1 Multiple Performance Conditions and Multiple Service Periods
ASC 718-10
Example 3: Employee
Share-Based Payment Award With a Performance
Condition and Multiple Service
Periods
55-92 The following Cases
illustrate employee share-based payment awards with
a performance condition (see paragraphs 718-10-25-20
through 25-21; 718-10-30-27; and 718-10-35-4) and
multiple service dates:
- Performance targets are set at the inception of the arrangement (Case A).
- Performance targets are established at some time in the future (Case B).
- Performance targets established up front but vesting is tied to the vesting of a preceding award (Case C).
55-93 Cases A, B, and C share
the following assumptions:
- On January 1, 20X5, Entity T enters into an arrangement with its chief executive officer relating to 40,000 share options on its stock with an exercise price of $30 per option.
- The arrangement is structured such that 10,000 share options will vest or be forfeited in each of the next 4 years (20X5 through 20X8) depending on whether annual performance targets relating to Entity T’s revenues and net income are achieved.
Case A: Performance Targets Are Set at the
Inception of the Arrangement
55-94 All of the annual
performance targets are set at the inception of the
arrangement. Because a mutual understanding of the
key terms and conditions is reached on January 1,
20X5, each tranche would have a grant date and,
therefore, a measurement date, of January 1, 20X5.
However, each tranche of 10,000 share options should
be accounted for as a separate award with its own
service inception date, grant-date fair value, and
1-year requisite service period, because the
arrangement specifies for each tranche an
independent performance condition for a stated
period of service. The chief executive officer’s
ability to retain (vest in) the award pertaining to
20X5 is not dependent on service beyond 20X5, and
the failure to satisfy the performance condition in
any one particular year has no effect on the outcome
of any preceding or subsequent period. This
arrangement is similar to an arrangement that would
have provided a $10,000 cash bonus for each year for
satisfaction of the same performance conditions. The
four separate service inception dates (one for each
tranche) are at the beginning of each
year.
Case B: Performance Targets Are Established at Some
Time in the Future
55-95 If the arrangement had
instead provided that the annual performance targets
would be established during January of each year,
the grant date (and, therefore, the measurement
date) for each tranche would be that date in January
of each year (20X5 through 20X8) because a mutual
understanding of the key terms and conditions would
not be reached until then. In that case, each
tranche of 10,000 share options has its own service
inception date, grant-date fair value, and 1-year
requisite service period. The fair value measurement
of compensation cost for each tranche would be
affected because not all of the key terms and
conditions of each award are known until the
compensation committee sets the performance targets
and, therefore, the grant dates are those
dates.
Case C: Performance Targets Established Up Front
but Vesting Is Tied to the Vesting of a Preceding
Award
55-96 If the
arrangement in Case A instead stated that the
vesting for awards in periods from 20X6 through 20X8
was dependent on satisfaction of the performance
targets related to the preceding award, the
requisite service provided in exchange for each
preceding award would not be independent of the
requisite service provided in exchange for each
successive award. In contrast to the arrangement
described in Case A, failure to achieve the annual
performance targets in 20X5 would result in
forfeiture of all awards. The requisite service
provided in exchange for each successive award is
dependent on the requisite service provided for each
preceding award. In that circumstance, all awards
have the same service inception date and the same
grant date (January 1, 20X5); however, each award
has its own explicit service period (for example,
the 20X5 grant has a one-year service period, the
20X6 grant has a two-year service period, and so on)
over which compensation cost would be recognized.
Because this award contains a performance condition,
it is not subject to the attribution guidance in
paragraph 718-10-35-8.
Case A of Example 3 in ASC 718-10-55-94 above illustrates a
scenario in which the grant date precedes the service inception date. The
example describes four tranches with four annual performance targets (i.e.,
performance conditions) and notes that “the failure to satisfy the
performance condition in any one particular year has no effect on the
outcome of any preceding or subsequent period.” In accordance with the
example, each tranche should be accounted for as a separate award with its
own service inception date. This conclusion was reached on the basis of the
following facts:
- All performance conditions are set at the inception of the arrangement.
- The performance condition for each tranche is independent of the other tranches.
- The grantee’s ability to vest in the award for each tranche is not based on the service provided beyond the vesting term of that specific tranche.
The guidance in this example should not be applied by analogy to other
scenarios.
3.7.3.2 Multiple Service Periods Related to Exercise Price
ASC 718-10
Example 4: Employee
Share-Based Payment Award With a Service Condition
and Multiple Service Periods
55-97 The following Cases
illustrate the guidance in paragraph 718-10-30-12 to
determine the service period for employee awards
with multiple service periods:
- Exercise price established at subsequent dates (Case A)
- Exercise price established at inception (Case B).
Case A: Exercise Price Established at Subsequent
Dates
55-98 The
chief executive officer of Entity T enters into a
five-year employment contract on January 1, 20X5.
The contract stipulates that the chief executive
officer will be given 10,000 fully vested share
options at the end of each year (50,000 share
options in total). The exercise price of each
tranche will be equal to the market price at the
date of issuance (December 31 of each year in the
five-year contractual term). In this Case, there are
five separate grant dates. The grant date for each
tranche is December 31 of each year because that is
the date when there is a mutual understanding of the
key terms and conditions of the agreement — that is,
the exercise price is known and the chief executive
officer begins to benefit from, or be adversely
affected by, subsequent changes in the price of the
employer’s equity shares (see paragraphs
718-10-55-80 through 55-83 for additional guidance
on determining the grant date). Because the awards’
terms do not include a substantive future requisite
service condition that exists at the grant date (the
options are fully vested when they are issued), and
the exercise price (and, therefore, the grant date)
is determined at the end of each period, the service
inception date precedes the grant date. The
requisite service provided in exchange for the first
award (pertaining to 20X5) is independent of the
requisite service provided in exchange for each
consecutive award. The terms of the share-based
compensation arrangement provide evidence that each
tranche compensates the chief executive officer for
one year of service, and each tranche shall be
accounted for as a separate award with its own
service inception date, grant date, and one-year
service period; therefore, the provisions of
paragraph 718-10-35-8 would not be applicable to
this award because of its structure.
Case B: Exercise Price Established at
Inception
55-99
If the arrangement described in Case A provided
instead that the exercise price for all 50,000 share
options would be the January 1, 20X5, market price,
then the grant date (and, therefore, the measurement
date) for each tranche would be January 1, 20X5,
because that is the date at which there is a mutual
understanding of the key terms and conditions. All
tranches would have the same service inception date
and the same grant date (January 1, 20X5). Because
of the nature of this award, Entity T would make a
policy decision pursuant to paragraph 718-10-35-8 as
to whether it considers the award as in-substance,
multiple awards each with its own requisite service
period (that is, the 20X5 grant has a one-year
service period, the 20X6 grant has a two-year
service period, and so on) or whether the entity
considers the award as a single award with a single
requisite service period based on the last
separately vesting portion of the award (that is, a
requisite service period of five years). Once
chosen, this Topic requires that accounting policy
be applied consistently to all similar
awards.
3.7.3.3 Multiple Service Periods Related to Transferability
ASC 718-20
Example 4: Share Option
Award With Other Performance
Conditions
55-47
This Example illustrates the guidance in paragraph
718-10-30-15.
55-47A
This Example (see paragraphs
718-20-55-48 through 55-50) describes employee
awards. However, the principles on how to account
for the various aspects of employee awards, except
for the compensation cost attribution and certain
inputs to valuation, are the same for nonemployee
awards. Consequently, the concepts about valuation,
expected term, and total compensation cost that
should be recognized (that is, the consideration of
whether it is probable that performance conditions
will be achieved) in paragraphs 718-20-55-48 through
55-50 are equally applicable to nonemployee awards
with the same features as the awards in this Example
(that is, awards with performance conditions that
affect inputs to an award’s fair value). Therefore,
the guidance in those paragraphs may serve as
implementation guidance for similar nonemployee
awards.
55-47B
Compensation cost attribution for awards to
nonemployees may be the same or different for
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 this Example 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.
55-48 While performance
conditions usually affect vesting conditions, they
may affect exercise price, contractual term,
quantity, or other factors that affect an award’s
fair value before, at the time of, or after vesting.
This Topic requires that all performance conditions
be accounted for similarly. A potential grant-date
fair value is estimated for each of the possible
outcomes that are reasonably determinable at the
grant date and associated with the performance
condition(s) of the award (as demonstrated in
Example 3 [see paragraph 718-20-55-41)].
Compensation cost ultimately recognized is equal to
the grant-date fair value of the award that
coincides with the actual outcome of the performance
condition(s).
55-49 To illustrate the
notion described in the preceding paragraph and
attribution of compensation cost if performance
conditions have different service periods, assume
Entity C grants 10,000 at-the-money share options on
its common stock to an employee. The options have a
10-year contractual term. The share options vest
upon successful completion of phase-two clinical
trials to satisfy regulatory testing requirements
related to a developmental drug therapy. Phase-two
clinical trials are scheduled to be completed (and
regulatory approval of that phase obtained) in
approximately 18 months; hence, the implicit service
period is approximately 18 months. Further, the
share options will become fully transferable upon
regulatory approval of the drug therapy (which is
scheduled to occur in approximately four years). The
implicit service period for that performance
condition is approximately 30 months (beginning once
phase-two clinical trials are successfully
completed). Based on the nature of the performance
conditions, the award has multiple requisite service
periods (one pertaining to each performance
condition) that affect the pattern in which
compensation cost is attributed. Paragraphs
718-10-55-67 through 55-79 and 718-10-55-86 through
55-88 provide guidance on estimating the requisite
service period of an award. The determination of
whether compensation cost should be recognized
depends on Entity C’s assessment of whether the
performance conditions are probable of achievement.
Entity C expects that all performance conditions
will be achieved. That assessment is based on the
relevant facts and circumstances, including Entity
C’s historical success rate of bringing
developmental drug therapies to market.
55-50 At the grant date,
Entity C estimates that the potential fair value of
each share option under the 2 possible outcomes is
$10 (Outcome 1, in which the share options vest and
do not become transferable) and $16 (Outcome 2, in
which the share options vest and do become
transferable). The difference in estimated fair
values of each outcome is due to the change in
estimate of the expected term of the share option.
Outcome 1 uses an expected term in estimating fair
value that is less than the expected term used for
Outcome 2, which is equal to the award’s 10-year
contractual term. If a share option is transferable,
its expected term is equal to its contractual term
(see paragraph 718-10-55-29). If Outcome 1 is
considered probable of occurring, Entity C would
recognize $100,000 (10,000 × $10) of compensation
cost ratably over the 18-month requisite service
period related to the successful completion of
phase-two clinical trials. If Outcome 2 is
considered probable of occurring, then Entity C
would recognize an additional $60,000 [10,000 × ($16
– $10)] of compensation cost ratably over the
30-month requisite service period (which begins
after phase-two clinical trials are successfully
completed) related to regulatory approval of the
drug therapy. Because Entity C believes that Outcome
2 is probable, it recognizes compensation cost in
the pattern described. However, if circumstances
change and it is determined at the end of Year 3
that the regulatory approval of the developmental
drug therapy is likely to be obtained in six years
rather than four, the requisite service period for
Outcome 2 is revised, and the remaining unrecognized
compensation cost would be recognized prospectively
through Year 6. On the other hand, if it becomes
probable that Outcome 2 will not occur, compensation
cost recognized for Outcome 2, if any, would be
reversed.
3.8 Changes in Estimate for Employee Awards
ASC 718-10
35-7 An entity shall adjust that initial best estimate in light of changes in facts and circumstances. Whether and how the initial best estimate of the requisite service period is adjusted depends on both the nature of the conditions identified in paragraph 718-10-30-26 and the manner in which they are combined, for example, whether an award vests or becomes exercisable when either a market or a performance condition is satisfied or whether both conditions must be satisfied. Paragraphs 718-10-55-69 through 55-79 provide guidance on adjusting the initial estimate of the requisite service period.
55-76 If an award vests upon the satisfaction of both a service condition and the satisfaction of one or more performance conditions, the entity also must initially determine which outcomes are probable of achievement. For example, an award contains a four-year service condition and two performance conditions, all of which need to be satisfied. If initially the four-year service condition is probable of achievement and no performance condition is probable of achievement, then no compensation cost would be recognized unless the two performance conditions and the service condition subsequently become probable of achievement. If both performance conditions become probable of achievement one year after the grant date and the entity estimates that both performance conditions will be achieved by the end of the second year, the requisite service period would be four years as that is the longest period of both the explicit service period and the implicit service periods. Because the performance conditions are now probable of achievement, compensation cost will be recognized in the period of the change in estimate (see paragraph 718-10-35-3) as the cumulative effect on current and prior periods of the change in the estimated number of awards for which the requisite service is expected to be rendered. Therefore, compensation cost for the first year will be recognized immediately at the time of the change in estimate for the awards for which the requisite service is expected to be rendered. The remaining unrecognized compensation cost for those awards would be recognized prospectively over the remaining requisite service period. An entity that has an accounting policy to account for forfeitures when they occur in accordance with paragraph 718-10-35-3 would assume that the achievement of a service condition is probable when determining the amount of compensation cost to recognize unless the award has been forfeited.
55-77 As indicated in paragraph 718-10-55-75, the initial estimate of the requisite service period based on an explicit or implicit service period shall be adjusted for changes in the expected and actual outcomes of the related service or performance conditions that affect vesting of the award. Such adjustments will occur as the entity revises its estimates of whether or when different conditions or combinations of conditions are probable of being satisfied. Compensation cost ultimately recognized is equal to the grant-date fair value of the award based on the actual outcome of the performance or service conditions (see paragraph 718-10-30-15). If an award contains a market condition and a performance or a service condition and the initial estimate of the requisite service period is based on the market condition’s derived service period, then the requisite service period shall not be revised unless either of the following criteria is met:
- The market condition is satisfied before the end of the derived service period
- Satisfying the market condition is no longer the basis for determining the requisite service period.
55-78 How a change to the initial estimate of the requisite service period is accounted for depends on whether that change would affect the grant-date fair value of the award (including the quantity of instruments) that is to be recognized as compensation. For example, if the quantity of instruments for which the requisite service is expected to be rendered changes because a vesting condition becomes probable of satisfaction or if the grant-date fair value of an instrument changes because another performance or service condition becomes probable of satisfaction (for example, a performance or service condition that affects exercise price becomes probable of satisfaction), the cumulative effect on current and prior periods of those changes in estimates shall be recognized in the period of the change. In contrast, if compensation cost is already being attributed over an initially estimated requisite service period and that initially estimated period changes solely because another market, performance, or service condition becomes the basis for the requisite service period, any unrecognized compensation cost at that date of change shall be recognized prospectively over the revised requisite service period, if any (that is, no cumulative-effect adjustment is recognized).
55-79 To summarize, changes in actual or estimated outcomes that affect either the grant-date fair value of the instrument awarded or the quantity of instruments for which the requisite service is expected to be rendered (or both) are accounted for using a cumulative effect adjustment, and changes in estimated requisite service periods for awards for which compensation cost is already being attributed are accounted for prospectively only over the revised requisite service period, if any.
The accounting for a change in estimate is based on the cause of the change. Generally, changes in the requisite service period are accounted for prospectively, while other changes in estimate are accounted for by using a cumulative-effect adjustment.
3.9 Clawback Features
ASC 718-10
30-24 A contingent feature of an award that might cause a grantee to return to the entity either equity instruments earned or realized gains from the sale of equity instruments earned for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature (see paragraph 718-10-55-8), shall not be reflected in estimating the grant-date fair value of an equity instrument.
55-8 Reload features and contingent features that require a grantee to transfer equity shares earned, or realized gains from the sale of equity instruments earned, to the issuing entity for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature, shall not be reflected in the grant-date fair value of an equity award. Those features are accounted for if and when a reload grant or contingent event occurs. A clawback feature can take various forms but often functions as a noncompete mechanism. For example, an employee that terminates the employment relationship and begins to work for a competitor is required to transfer to the issuing entity (former employer) equity shares granted and earned in a share-based payment transaction.
Contingency Features That Affect the Option Pricing Model
55-47 Contingent features that might cause a grantee to return to the entity either equity shares earned or realized gains from the sale of equity instruments earned as a result of share-based payment arrangements, such as a clawback feature (see paragraph 718-10-55-8), shall not be reflected in estimating the grant-date fair value of an equity instrument. Instead, the effect of such a contingent feature shall be accounted for if and when the contingent event occurs. For instance, a share-based payment arrangement may stipulate the return of vested equity shares to the issuing entity for no consideration if the grantee terminates the employment or vendor relationship to work for a competitor. The effect of that provision on the grant-date fair value of the equity shares shall not be considered. If the issuing entity subsequently receives those shares (or their equivalent value in cash or other assets) as a result of that provision, a credit shall be recognized in the income statement upon the receipt of the shares. That credit is limited to the lesser of the recognized compensation cost associated with the share-based payment arrangement that contains the contingent feature and the fair value of the consideration received. The event is recognized in the income statement because the resulting transaction takes place with a grantee as a result of the current (or prior) employment or vendor relationship rather than as a result of the grantee’s role as an equity owner. Example 10 (see paragraph 718-20-55-84) provides an illustration of the accounting for an employee award that contains a clawback feature, which also applies to nonemployee awards.
ASC 718-20
35-2 A contingent feature of an award that might cause a grantee to return to the entity either equity instruments earned or realized gains from the sale of equity instruments earned for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature (see paragraph 718-10-55-8), shall be accounted for if and when the contingent event occurs. Example 10 (see paragraph 718-20-55-84) provides an illustration of an employee award with a clawback feature.
Example 10: Share Award With a Clawback Feature
55-84 This Example illustrates the guidance in paragraph 718-20-35-2.
55-84A
This Example (see paragraphs 718-20-55-85 through 55-86)
describes employee awards. However, the principles on how to
account for the various aspects of employee awards, except
for the compensation cost attribution and certain inputs to
valuation, are the same for nonemployee awards.
Consequently, the accounting for a contingent feature (such
as a clawback) of an award that might cause a grantee to
return to the entity either equity instruments earned or
realized gains from the sale of the equity instruments
earned is equally applicable to nonemployee awards with the
same feature as the awards in this Example (that is, the
clawback feature). Therefore, the guidance in this Example
also serves as implementation guidance for similar
nonemployee awards.
55-84B
Compensation cost attribution for awards to nonemployees may
be the same or different for 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 this Example 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.
55-85 On January 1, 20X5, Entity T grants its chief executive officer an award of 100,000 shares of stock that vest upon the completion of 5 years of service. The market price of Entity T’s stock is $30 per share on that date. The grant-date fair value of the award is $3,000,000 (100,000 × $30). The shares become freely transferable upon vesting; however, the award provisions specify that, in the event of the employee’s termination and subsequent employment by a direct competitor (as defined by the award) within three years after vesting, the shares or their cash equivalent on the date of employment by the direct competitor must be returned to Entity T for no consideration (a clawback feature). The chief executive officer completes five years of service and vests in the award. Approximately two years after vesting in the share award, the chief executive officer terminates employment and is hired as an employee of a direct competitor. Paragraph 718-10-55-8 states that contingent features requiring an employee to transfer equity shares earned or realized gains from the sale of equity instruments earned as a result of share-based payment arrangements to the issuing entity for consideration that is less than fair value on the date of transfer (including no consideration) are not considered in estimating the fair value of an equity instrument on the date it is granted. Those features are accounted for if and when the contingent event occurs by recognizing the consideration received in the corresponding balance sheet account and a credit in the income statement equal to the lesser of the recognized compensation cost of the share-based payment arrangement that contains the contingent feature ($3,000,000) and the fair value of the consideration received. This guidance does not apply to cancellations of awards of equity instruments as discussed in paragraphs 718-20-35-7 through 35-9. The former chief executive officer returns 100,000 shares of Entity T’s common stock with a total market value of $4,500,000 as a result of the award’s provisions. The following journal entry accounts for that event.
55-86 If instead of delivering shares to Entity T, the former chief executive officer had paid cash equal to the total market value of 100,000 shares of Entity T’s common stock, the following journal entry would have been recorded.
Clawback features, as contemplated in ASC 718, are protective provisions that require or permit the recovery of value transferred to award holders who violate certain conditions. Examples include the violation of a noncompete or nonsolicitation agreement, termination of employment for cause (e.g., because of fraud or noncompliance with company policies), and material restatements of financial statements. ASC 718-20-35-2 requires that the effect of certain contingent features “such as a clawback feature . . . be accounted for if and when the contingent event occurs.” ASC 718-20-55-85 states that contingent features, such as clawback features, “are accounted for . . . by recognizing the consideration received in the corresponding balance sheet account and a credit in the income statement equal to the lesser of [1] the recognized compensation cost of the share-based payment [award] that contains the contingent feature . . . and [2] the fair value of the consideration received.” By contrast, in the absence of a clawback feature, a credit to the income statement is not recorded for vested awards (i.e., those for which the grantee has provided the required goods or services for earning the award) even if the awards are canceled or expire unexercised. Many share-based payment awards contain provisions requiring grantees to exercise vested stock option awards within a specified period after termination (i.e., the contractual term of the awards is truncated). Awards not exercised within the specified period expire.
The requirement to forfeit vested awards after a specified period because the vested awards are not exercised before their expiration is not considered a clawback feature. In accordance with ASC 718-10-35-3, entities are prohibited from accounting for these types of provisions as clawback features and from reversing the compensation cost for vested awards that are returned because they expire unexercised.
Example 3-34
On January 1, 20X1, Entity A grants to its CEO 1 million at-the-money employee stock options, each with a grant-date fair-value-based measure of $6. The options vest at the end of the fourth year of service (cliff vesting). However, the options contain a provision that requires the CEO to return vested options, including any gain realized by the CEO related to vested and previously exercised options, to the entity for no consideration if the CEO terminates employment to work for a competitor any time within six years of the grant date. The CEO completes four years of service and exercises the vested options. Entity A has recognized total compensation cost of $6 million (1 million options × $6 grant-date fair-value-based measure) over the four-year service period. Approximately one year after the options vest, the CEO terminates employment and is hired as an employee of a direct competitor. Because of the options’ provisions, the former CEO returns 1 million shares of A’s common stock with a total fair value of $3 million. Entity A records the amounts below on the date the clawback feature is enforced.
Alternatively, assume that in accordance with the options’ provisions, the former CEO returns 1 million shares of A’s common stock with a total fair value of $7.5 million. Since the fair value of the shares returned ($7.5 million) is greater than the compensation cost previously recorded ($6 million), an amount equal to the compensation cost previously recorded would be recorded as other income. The difference ($1.5 million) would be recorded as an increase to paid-in capital. See the journal entry below.
Section 3.4.3 discusses share-based payment awards that have repurchase features that function, in substance, as vesting conditions (i.e., forfeiture provisions). Similarly, some awards have repurchase features that function, in substance, as clawback features. For example, a feature is substantively a clawback feature if it gives an entity the option to repurchase a grantee’s share-based payment award for (1) cost (which often is zero or, for options, the exercise price) or (2) the lesser of the fair value of the shares on the repurchase date or the cost of the award if, for example, an employee is terminated for cause. Such a repurchase feature is a protective clause, not a forfeiture provision, because it does not create an in-substance service condition in the event, for example, the employee is terminated for cause. A repurchase feature that functions as a clawback feature does not affect the balance sheet classification for awards (i.e., liability versus equity). It is instead recognized if and when the contingent event occurs (e.g., an employee is terminated for cause).
Example 3-35
Entity A grants 1,000 stock awards to an employee that vest at the end of the second year of service (cliff vesting). However, if the employee is terminated at any time by A for cause, A has the right to call the shares at cost.
The repurchase feature (i.e., the call option) functions as an in-substance clawback feature. This type of repurchase feature is not a forfeiture provision because it does not create an in-substance service condition; rather, it is a protective clause that applies if the employee is terminated for cause. Accordingly, the requisite service period is the explicitly stated vesting period of two years.
3.9.1 SEC’s Final Rule on the Recovery of Erroneously Awarded Compensation (“Clawback Policies”)
In October 2022, the SEC issued a final
rule aimed at ensuring that executive officers do not receive
“excess compensation” if the financial results on which previous awards of
compensation were based are subsequently restated because of material noncompliance
with financial reporting requirements. Such restatements would include those
correcting an error that either (1) “is material to the previously issued financial
statements” (a “Big R” restatement) or (2) “would result in a material misstatement
if the error were corrected in or left uncorrected in the current period” (a “little
r” restatement). The final rule implements the mandate in Section 954 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank
Act”) under which the SEC is required “to adopt rules directing the national
securities exchanges . . . and the national securities associations . . . to
prohibit the listing of any security of an issuer” that has not adopted and
implemented a written policy providing for the recovery of incentive-based
compensation (IBC) under certain circumstances.
The final rule requires issuers to “claw back” excess compensation for the three
fiscal years before the determination of a restatement regardless of whether an
executive officer had any involvement in the restatement. The final rule also
requires an issuer to disclose its recovery policy in an exhibit to its annual
report and to include new checkboxes on the cover page of its annual report to
indicate whether the financial statements “reflect correction of an error to
previously issued financial statements and whether [such] corrections are
restatements that required a recovery analysis.” Additional disclosures are required
in the proxy statement or annual report when a clawback occurs. Such disclosures
include the date of the restatement, the amount of excess compensation to be clawed
back, and any amounts outstanding that have not yet been clawed back.
The concept of clawbacks is not new. Section 304 of the Sarbanes-Oxley Act of 2002
contains a recovery provision that is triggered when an accounting restatement
results from an issuer’s misconduct. The provision applies only to CEOs and CFOs,
and the amount of required recovery is limited to compensation received in the
12-month period after the first public issuance or filing of the improper financial
statements with the SEC. In addition, in the interim period before the issuance of
the final rule, many companies already had voluntarily adopted compensation recovery
policies based on investor sentiment and good governance practices. However, it is
likely that even those companies will be required to make substantial changes to
their policies in light of the following aspects of the final rule:
- The inclusion of a broader list of executive officers, including former executive officers, within the rule’s scope.
- The broader events that would trigger recovery analysis (“Big R” and “little r” restatements).
- The “no-fault” nature of the final rule.
- The longer look-back period of three completed fiscal years.
Changing Lanes
On June 9, 2023, the SEC approved amendments filed by the NYSE and Nasdaq
that revise the date by which listed companies must comply with the
requirements of the final rule. Under the approved amendments, the effective
date of the new clawback requirements is October 2, 2023, and the official
compliance date for public companies is December 1, 2023, which is the date
by which public companies must have a clawback policy that complies with the
requirements of the respective exchange.
3.9.1.1 Accounting Considerations Related to Adopting the Final Rule on Clawback Policies
Companies should consider the potential accounting consequences
of adopting the final rule.
Depending on its category, the IBC subject to recovery may have
been accounted for under ASC 718 (e.g., RSUs or stock options), ASC 710 and ASC
450 (e.g., profit-sharing arrangements), or other applicable accounting
guidance.
The final rule’s accounting implications will be based on a
company’s specific facts and circumstances. In particular, companies should
consider possible effects on the accounting for share-based payment
arrangements. Under ASC 718, an equity-classified award issued to an employee is
generally (1) measured on the basis of the fair value of the award on the grant
date and (2) recognized over the requisite service period.
The discussion below outlines various accounting considerations
related to share-based payment awards that companies may need to take into
account when applying the final rule.3
3.9.1.1.1 Establishing a Grant Date
One of the conditions for establishing a grant date is that the employer and
its employees must “reach a mutual understanding of the key terms and
conditions of a share-based payment award” (see Section 3.2 for guidance on determining the grant date). If
the key terms of an award are overly broad, subjective, or discretionary,
there may be a delay in establishing a grant date for accounting purposes,
which would, in turn, delay the establishment of a measurement date for
determining the fair-value-based measure of the award. In addition, if
certain conditions are met and the service inception date precedes the grant
date as a result (see Section 3.6.4
for discussion of the service inception date), compensation cost may need to
be recognized on the basis of the fair value of the award as of each
reporting date until a grant date is established, even if the award is
classified as equity (i.e., “mark-to-market” or “variable” accounting before
the grant date).
Connecting the Dots
We generally expect that recovery policies adopted to comply with the
provisions of the final rule will not preclude a company from
establishing a grant date because the rule would require such
policies to be well-defined and sufficiently objective. Conversely,
clawback policies that are subjective or that allow companies to
exercise discretion in determining when an IBC clawback is triggered
could preclude an issuer from establishing a grant date because the
clawback-triggering event would generally be a “key” term or
condition for which a mutual understanding must exist. Therefore, in
a company’s policies, it is especially important for the contingent
event that triggers the clawback to be well-defined and sufficiently
objective.
3.9.1.1.2 Modification Considerations
ASC 718-10-20 defines a modification as a “change in the terms or conditions
of a share-based payment award.” However, an entity is not required to apply
modification accounting if the fair-value-based measure, vesting conditions,
or classification is the same immediately before and after the modification.
Companies will need to consider whether modification accounting is required
for changes made to existing awards as a result of the final rule.
Under ASC 718-10-30-24, clawback provisions4 in share-based payment plans generally are not reflected in estimates
of the fair-value-based measure of awards. Accordingly, the addition of a
clawback provision to an award would typically not result in the application
of modification accounting because such clawbacks generally do not change
the award’s fair-value-based measure, vesting conditions, or classification.
Further, a company that is preparing to adopt the final rule may decide to
make other changes to an award, such as changing its performance or market
conditions. Companies should evaluate such changes under the modification
framework in ASC 718. See Chapter 6
for more information about modifications.
3.9.1.1.3 Accounting for a Recovery
If a company concludes that an accounting restatement is required and that
excess IBC has been received by an executive officer, there are additional
considerations associated with accounting for the recovery. The final rule
requires companies to apply their recovery policy to awards that are
“received,” which may precede the date the awards may be earned (i.e.,
vested) under ASC 718.
A company should assess its specific facts and circumstances to determine the
appropriate accounting for a recovery. Although the discussion below focuses
on two possible approaches that depend on whether the awards have been
earned, there may also be other acceptable approaches.
3.9.1.1.3.1 Recovery of Earned Awards (“Clawback”)
A company may conclude that clawback accounting, as described in ASC 718,
is appropriate for the recovery related to awards that have been earned
as of the trigger date. Contingent features, such as clawback
provisions, are not reflected in the fair-value-based measure of an
equity instrument on the grant date and do not affect the recognition of
compensation cost if they are triggered after the equity instrument is
earned. Therefore, a clawback provision has no day 1 impact on the
accounting for an award, and the clawback would be accounted for only if
and when it is triggered by a contingent event (i.e., an accounting
restatement).
The guidance in ASC 718 addresses how to account for
clawbacks of awards that have been earned (i.e., vested).5 Under that guidance, a clawback of IBC would be recognized when
(1) the material restatement triggering the clawback occurs after an
award has been earned and (2) the consideration is received or
receivable. At that time, the company would recognize (1) the
consideration returned by the individual; (2) a receivable for such
consideration; or, if the individual returns shares, (3) treasury stock
at the fair value of those shares. The company also would recognize as
other income the fair value of the consideration received to the extent
that it previously recognized compensation cost for awards that were
subject to the clawback; any excess of the fair value of the
consideration received over the previously recognized compensation cost
would be recognized as an increase to APIC.
3.9.1.1.3.2 Recovery of Unearned Awards
For an award within the scope of ASC 718, as of the trigger date, if
excess IBC is deemed received on the basis of the final rule but the
requisite service period has not been satisfied and the award has not
yet been vested under ASC 718, the company would still be required to
apply the recovery policy. Effectively, the company’s recovery policy
would reduce the number of units that could be earned.
Under ASC 718, if an award has a performance condition, accruals of
compensation cost should be based on the probable outcome of that
performance condition. That is, compensation cost is accrued only if it
is probable that the performance condition will be achieved; otherwise,
no compensation cost is accrued. Compensation cost is not recognized if
awards are forfeited because a performance condition is not satisfied.
However, if the award has a market condition, compensation cost is
recognized even if the market condition is not satisfied, as long as the
requisite service is rendered. This is because a market condition is not
a vesting condition; rather, it is reflected in the fair-value-based
measure of the award on the grant date.
ASC 718 addresses how to account for changes in estimates if an award has
not vested. For example, assume that an award is based on a performance
condition with a three-year performance period ending in the issuer’s
20X1 fiscal year but is subject to service-based vesting for two
additional years beyond the performance period. If the issuer concludes
in late 20X2 that its 20X1 fiscal year is subject to a material
restatement that triggers recovery for awards received in 20X1, that
award would be deemed “received” under the final rule in 20X1 because
the performance condition is “attained” (i.e., the performance condition
is achieved), even if the award is subject to additional vesting (i.e.,
has not been earned). In this situation, the company may conclude that
when considering the effect of the restated financial statements, it is
not probable that the award will vest (i.e., on the basis of the
restated financial statements, the performance condition will not be
achieved) and any compensation cost previously recognized would be
reversed.
If, on the other hand, there is a material restatement and it is
determined that the market condition was not achieved, compensation cost
is still recognized even if the market condition is not satisfied, as
long as the requisite service is rendered.
Footnotes
3
While this discussion focuses on share-based payment
awards that are classified as equity, some of the same considerations
could apply to awards classified as liabilities.
4
ASC 718 states that a clawback feature is an example
of a “contingent feature of an award that might cause a grantee to
return to the entity either equity instruments earned or realized
gains from the sale of equity instruments earned.” The final rule
requires companies to have a recovery policy that could extend
beyond equity instruments earned under ASC 718. Thus, a company may
adopt a recovery policy under the final rule that could extend
beyond what is described as a clawback under ASC 718.
5
If the award is not vested, see Section
3.9.1.1.3.2.
3.10 Dividend Protected Awards
ASC 718-10
55-45 In certain situations, grantees may receive the dividends paid on the underlying equity shares while the option is outstanding. Dividends or dividend equivalents paid to grantees on the portion of an award of equity shares or other equity instruments that vests shall be charged to retained earnings. If grantees are not required to return the dividends or dividend equivalents received if they forfeit their awards, dividends or dividend equivalents paid on instruments that do not vest shall be recognized as additional compensation cost. If an entity’s accounting policy is to estimate the number of awards expected to be forfeited in accordance with paragraph 718-10-35-1D or 718-10-35-3, the estimate of compensation cost for dividends or dividend equivalents paid on instruments that are not expected to vest shall be consistent with an entity’s estimates of forfeitures. Dividends and dividend equivalents shall be reclassified between retained earnings and compensation cost in a subsequent period if the entity changes its forfeiture estimates (or actual forfeitures differ from previous estimates). If an entity’s accounting policy is to account for forfeitures when they occur in accordance with paragraph 718-10-35-1D or 718-10-35-3, the entity shall reclassify to compensation cost in the period in which the forfeitures occur the amount of dividends and dividend equivalents previously charged to retained earnings relating to awards that are forfeited.
The terms of some share-based payment awards permit holders to receive a dividend during the vesting period and, in some instances, to retain the dividend even if the award fails to vest. Such awards are commonly referred to as “dividend-protected awards.”
The accounting for dividends paid on dividend-protected equity-classified awards
is based on the manner in which the entity has elected to account for
forfeitures.6 If the entity elects, as an accounting policy, to estimate the number of
awards expected to be forfeited, the entity should, in a manner consistent with the
forfeiture estimate it uses to recognize compensation cost of an award, charge to
retained earnings the dividend payment for dividend-protected awards to the extent
that the award is expected to vest. Such dividends are recognized in retained
earnings to prevent their being double-counted as compensation cost since dividends
are already factored into the grant-date fair-value-based measure of the awards. If
a grantee is entitled to retain dividends paid on shares that fail to vest, the
dividend payment for dividend-protected awards that are not expected to vest should
be charged to compensation cost and then periodically adjusted on the basis of any
revisions to the forfeiture estimate, with a final true-up based on actual
forfeitures.
However, if an entity elects as an accounting policy to account for forfeitures as they occur, all dividends paid on dividend-protected equity-classified awards (i.e., both forfeitable and nonforfeitable dividends) are initially charged to retained earnings and, if nonforfeitable, reclassified to compensation cost if and when forfeitures of the underlying awards occur.
While ASC 718 does not specifically address the appropriate treatment of dividend-protected liability-classified awards, we believe that by analogy to ASC 480-10-55-14 and ASC 480-10-55-28, such dividends should be recognized as compensation cost.
ASC 718-740-45-8 indicates that if an entity receives a tax deduction for dividends paid, any income tax expense or benefit related to dividend or dividend equivalents paid to grantees must be recognized in the income statement, even if charged to retained earnings.
An entity that uses an option-pricing model to estimate the fair-value-based measure of a stock option usually takes expected dividends into account because dividends paid on the underlying shares are part of the fair value of those shares, and option holders generally are not entitled to receive those dividends. However, for dividend-protected awards, the entity should appropriately reflect that dividend protection in estimating the fair-value-based measure of a stock option. For example, an entity could appropriately reflect the effect of the dividend protection by using an expected dividend yield input of zero if all dividends paid to shareholders are applied to reduce the exercise price of the options being valued.
Note that if any dividends are nonforfeitable, the awards would be considered
“participating securities” in the EPS calculation. See Section 12.4.3 for a discussion of the effect
of dividend-paying share-based payment awards on the computation of EPS. Further
note that irrespective of whether an award is dividend-protected, the accounting for
a large, nonrecurring cash dividend for an equity-classified award in connection
with an equity restructuring differs from the accounting discussed above and may
result in both a partial settlement of vested awards and a partial modification from
equity to liability classification of unvested awards, as illustrated in Example 6-34 in Section 6.10.2.
Example 3-36
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 $100. The options vest at the end of one year of service (cliff vesting). The option holders will receive a cash amount per option that is equal to the dividends paid per share to common shareholders during the vesting period. Employees are not required to return the dividends received if they forfeit their options. On July 1, 20X1, A declares a dividend of $1 per share. Entity A has elected as an accounting policy to estimate the number of awards expected to be forfeited, and it has estimated a forfeiture rate of 10 percent. See the journal entries below.
In the fourth quarter, A experiences lower turnover than expected. On December 31, 20X1, 980 of the 1,000 options that were granted become vested. On that date, A would record the journal entries below.
In the journal entries below, assume the same facts as those above except that
Entity A has elected as an accounting policy to account for
forfeitures as they occur.
In the fourth quarter, 20 options were forfeited, and on December 31, 20X1, the remaining 980 of the 1,000 options that were granted become vested. On that date, A would record the journal entries below.
Footnotes
6
As discussed in Section 3.4.1, an entity can make a
different accounting policy election between employee and nonemployee awards
to either estimate forfeitures or account for forfeitures when they occur.
3.11 Nonrecourse and Recourse Notes
ASC 718-10
25-3 The accounting for all share-based payment transactions shall reflect the rights conveyed to the holder of the instruments and the obligations imposed on the issuer of the instruments, regardless of how those transactions are structured. For example, the rights and obligations embodied in a transfer of equity shares for a note that provides no recourse to other assets of the grantee (that is, other than the shares) are substantially the same as those embodied in a grant of equity share options. Thus, that transaction shall be accounted for as a substantive grant of equity share options.
An entity may offer financing in the form of a recourse note or a nonrecourse
note in connection with a grantee’s purchase of
its shares or the exercise of stock options. A
nonrecourse note is a loan that limits the
liability of the holder of the stock being
purchased if for any reason the holder defaults on
the note. If, however, the loan was collateralized
by more than the stock purchased (e.g., the entity
would seek recovery of the money by claiming
personal assets of the grantee), the loan would be
considered a recourse note. The measurement and
recognition of an award is based on whether the
financing is a recourse note or a nonrecourse
note.
3.11.1 Recourse Notes
If the consideration received from the grantee consists of a recourse note, the
transfer of shares is a substantive purchase of stock or an exercise of an
option. If the stated interest rate is less than a market rate of interest, the
exercise or purchase price is equal to the fair value of the note (i.e., the
present value of the principal and interest payments when a discount rate
equivalent to a market rate of interest is used). The impact of a below-market
rate of interest would be reflected as a reduction of the exercise or purchase
price and an increase in compensation cost recognized (see the example below).
If the stated interest rate is equal to a market rate of interest, the exercise
or purchase price is equal to the principal of the note. That is, the impact of
an at-market rate of interest would have no effect on the exercise or purchase
price and therefore would not result in an increase in compensation cost
recognized.
Example 3-37
An entity indirectly reduces the price of an award when it provides an employee with a non-interest-bearing, full-recourse note to cover the purchase price of shares. If an employee purchased shares with a fair value of $20,000 but the entity provided a five-year, non-interest-bearing note (when the market rate of interest was 10 percent), the fair value of the consideration (i.e., the purchase price) is now only $12,418 (the present value of $20,000 in five years, discounted at 10 percent). A reduction in the purchase price results in an increase in the grant-date fair-value-based measure of the award and an increase in the amount of compensation cost recognized. The entity would therefore record compensation cost of $7,582, equal to the $20,000 fair value of the shares less the $12,418 fair value of the consideration received.
3.11.2 Nonrecourse Notes
If the consideration received from the grantee consists of a nonrecourse note,
the award is, or continues to be, accounted for as
an option until the note is repaid. That is, if an
entity provides a loan to its employees to
purchase shares or exercise options and that loan
is collateralized only by the stock issued, the
issued stock and the loan collateralizing it are
accounted for as an option. This is because even
after the original options are exercised or the
shares are purchased, a grantee could decide not
to repay the loan if the value of the shares
declines below the outstanding loan amount and
could instead choose to return the shares in
satisfaction of the loan. The result would be
similar to a grantee’s electing not to exercise an
option whose exercise price exceeds the current
share price.
The same result would occur if the nonrecourse
note was not for the entire award. For example, a
grantee could exercise 1,000 stock options in
exchange for (1) cash equating to the exercise
price for 720 of the options and (2) a nonrecourse
note for 280 of the options solely to cover the
required tax withholdings. However, only the 280
options exercised in exchange for the nonrecourse
note would continue to be accounted for as options
until the note is repaid.
When shares are exchanged for a nonrecourse note, the principal and interest are
viewed as part of the exercise price of the
“option” (therefore, no interest income is
recognized). If the note bears interest, the
exercise price increases over time by the amount
of interest accrued and, accordingly, the option
valuation model must incorporate an increasing
exercise price. Further, because the shares sold
on a nonrecourse basis are accounted for as
options, the note and the shares are not recorded.
Rather, compensation cost is recognized over the
requisite service period or nonemployee’s vesting
period, with an offsetting credit to APIC.
Periodic principal and interest payments, if any,
are treated as deposits. Refundable deposits are
recorded as a liability until the note is paid
off, at which time the deposit balance is
transferred to APIC. Nonrefundable deposits are
immediately recorded as a credit to APIC as
payments are received. In addition, the shares
would be excluded from basic EPS and included in
diluted EPS in accordance with the treasury stock
method until the note is repaid.
3.11.3 Cash Loans Through Nonrecourse Notes
An entity may pay cash to an
employee for personal use in exchange for a
nonrecourse loan that is collateralized by the
entity’s stock that is already owned by the
employee. Although the loan is not issued in
connection with the purchase of shares or the
exercise of options, the employee obtains a right
similar to that of a stock option (i.e., the
employee will make a decision to either repay the
loan and retain the shares or not repay the loan
and forfeit the shares). In this scenario, the
entity has effectively repurchased the employee’s
shares in exchange for cash proceeds from the
nonrecourse loan and the grant of an option.
Accordingly, the entity would recognize as
compensation cost any excess of the repurchase
amount (i.e., the cash proceeds and the
fair-value-based measure of the option) over the
fair value of the shares pledged.
Example 3-38
Entity K provides a
three-year, 5 percent interest-bearing note of
$200,000 to its CTO. The note is a nonrecourse
loan that is collateralized by 15,000 of K’s
common shares that the CTO had previously
acquired. The fair value of the common shares on
the loan inception date is $300,000.
Although the obligation to repay the loan and
the associated collateral are not in the legal
form of an option, the CTO has obtained a right
similar to a stock option. Entity K has
effectively repurchased the CTO’s 15,000 common
shares in exchange for $200,000 cash and an
option. It has also determined that the
fair-value-based measure of the instrument (the
“option”) granted to the CTO is $120,000. The
entity would recognize compensation cost equal to
the difference between the repurchase amount (cash
proceeds of $200,000 and the fair-value-based
measure of the option of approximately $120,000)
and the fair value of the shares pledged at
$300,000. Therefore, K would recognize $20,000 of
compensation costs over the requisite service
period of the option, if any.
3.11.4 Changes Made to the Notes
If (1) a grantee is allowed to exercise an option with a note that was not provided for in the terms of the options when the options were granted, (2) the terms of a note (e.g., interest rate) are changed, or (3) the note is forgiven, these changes constitute modifications that should be accounted for in accordance with ASC 718-20-35-2A through 35-3A. See Chapter 6 for a discussion and examples of the accounting for the modification of a share-based payment award. In addition, a change in the terms, or forgiveness of, an outstanding recourse note would constitute a modification even if the issued shares are no longer subject to ASC 718, unless the modification made to the outstanding recourse note applies equally to all shares of the same class.
Further, an entity should
reevaluate whether it intends to forgive other
outstanding recourse notes and determine whether
such notes should instead be considered
in-substance nonrecourse notes. If, as a result of
a change in its terms, a note becomes a
nonrecourse note, an entity should account for the
modification as a repurchase of shares by using
the treasury stock method. If the repurchase
amount exceeds the fair value of the repurchased
shares, the difference would be recognized as
compensation cost. This would be calculated as the
sum of the outstanding principal and interest on
the note and the fair value of the nonrecourse
note, less the fair value of the repurchased
shares. See Section
6.10 for more information about
repurchases and settlements of shares.
3.11.5 In-Substance Nonrecourse Notes
A recourse note issued to a grantee may be an in-substance nonrecourse note. In determining whether a recourse note is, in substance, a nonrecourse note, entities should consider Issue 34 of EITF Issue 00-23. Although it was nullified, EITF Issue 00-23 contains guidance that remains relevant on determining whether a recourse note is substantively a nonrecourse note. It indicates that a recourse note should be considered nonrecourse if any of the following factors are present:
- The entity has legal recourse to the grantee’s other assets but does not intend to seek repayment beyond the shares issued.
- The entity has a history of not demanding repayment of loan amounts in excess of the fair value of the shares
- The grantee does not have sufficient assets or other means (beyond the shares) of justifying the recourse nature of the loan.
- The entity has accepted a recourse note upon exercise and subsequently converts the recourse note to a nonrecourse note.
At an EITF meeting to discuss Issue 00-23, an SEC observer stated that all other relevant facts and circumstances should be evaluated and that if the note is ultimately forgiven, the SEC will most likely challenge the appropriateness of a conclusion that the note was a recourse note.
3.11.6 Combination Recourse and Nonrecourse Loans
For tax purposes, a grantee may exercise options by using a nonrecourse note for
a portion of the total exercise price and a
recourse note for the remainder. If the respective
notes are not distinctly aligned with a
corresponding percentage of the underlying shares
(i.e., in a non-pro-rata structure), both notes
should be accounted for together as nonrecourse. A
non-pro-rata structure is one in which the share
purchase price or exercise price for each share of
stock is represented by both the nonrecourse note
and the recourse note on the basis of their
respective percentages of the total exercise price
(e.g., 40 percent of the exercise price is
nonrecourse and 60 percent of the exercise price
is recourse). However, if the nonrecourse and
recourse notes are related to a pro rata portion
of the shares (e.g., 40 percent of the shares
correspond to a nonrecourse note, and 60 percent
of the shares correspond to a recourse note), an
entity would account for (1) the shares associated
with the recourse note as a substantive exercise
of the option and (2) the shares associated with
the nonrecourse note as an outstanding option.
3.12 Employee Payroll Taxes
ASC 718-10
Payroll Taxes
25-22 A liability for employee payroll taxes on employee stock compensation shall be recognized on the date of the event triggering the measurement and payment of the tax to the taxing authority (for a nonqualified option in the United States, generally the exercise date).
3.13 Capitalization of Compensation Cost
SEC Staff Accounting Bulletins
SAB Topic 14.I, Capitalization of
Compensation Cost Related to Share-Based Payment
Arrangements
Facts: Company K is
a manufacturing company that grants share options to its
production employees. Company K has determined that the cost
of the production employees’ service is an inventoriable
cost. As such, Company K is required to initially capitalize
the cost of the share option grants to these production
employees as inventory and later recognize the cost in the
income statement when the inventory is
consumed.85
Question: If Company
K elects to adjust its period end inventory balance for the
allocable amount of share-option cost through a period end
adjustment to its financial statements, instead of
incorporating the share-option cost through its inventory
costing system, would this be considered a deficiency in
internal controls?
Interpretive
Response: No. FASB ASC Topic 718, Compensation —
Stock Compensation, does not prescribe the mechanism a
company should use to incorporate a portion of share-option
costs in an inventory-costing system. The staff believes
Company K may accomplish this through a period end
adjustment to its financial statements. Company K should
establish appropriate controls surrounding the calculation
and recording of this period end adjustment, as it would any
other period end adjustment. The fact that the entry is
recorded as a period end adjustment, by itself, should not
impact management’s ability to determine that the internal
control over financial reporting, as defined by the SEC’s
rules implementing Section 404 of the Sarbanes-Oxley Act of
2002,86 is effective.
__________________________________
85 FASB ASC paragraph
718-10-25-2A.
86 Release No. 34-47986, June 5,
2003, Management’s Report on Internal Control Over Financial
Reporting and Certification of Disclosure in Exchange Act
Period Reports.
While ASC 718 provides guidance on the measurement and recognition of share-based
compensation cost, it does not specify that all share-based compensation cost should
immediately be expensed. In certain cases, share-based compensation cost could be
capitalized on the basis of U.S. GAAP guidance such as the following:
- Inventory (ASC 330).
- Incremental costs of obtaining a contract with a customer and costs incurred in fulfilling a contract with a customer (ASC 340-40).
- Capitalized software costs (ASC 350-40 and ASC 985-20).
- Property, plant, and equipment (ASC 360).
If share-based compensation cost meets the criteria to be capitalized, the
capitalized amounts are subsequently accounted for in accordance with other
applicable GAAP. For example, share-based compensation cost may be capitalized as
internal-use software, which then would be subject to amortization requirements
under ASC 350-40 and impairment considerations under ASC 360.