5.6 Substantive Terms
ASC 718-10
25-15 The accounting for an award of share-based payment shall reflect the substantive terms of the award and any related arrangement. Generally, the written terms provide the best evidence of the substantive terms of an award. However, an entity’s past practice may indicate that the substantive terms of an award differ from its written terms. For example, an entity that grants a tandem award under which a grantee receives either a stock option or a cash-settled stock appreciation right is obligated to pay cash on demand if the choice is the grantee’s, and the entity thus incurs a liability to the grantee. In contrast, if the choice is the entity’s, it can avoid transferring its assets by choosing to settle in stock, and the award qualifies as an equity instrument. However, if an entity that nominally has the choice of settling awards by issuing stock predominantly settles in cash or if the entity usually settles in cash whenever a grantee asks for cash settlement, the entity is settling a substantive liability rather than repurchasing an equity instrument. In determining whether an entity that has the choice of settling an award by issuing equity shares has a substantive liability, the entity also shall consider whether:
- It has the ability to deliver the shares. (Requirements to deliver registered shares do not, by themselves, imply that an entity does not have the ability to deliver shares and thus do not require an award that otherwise qualifies as equity to be classified as a liability.)
- It is required to pay cash if a contingent event occurs (see paragraphs 718-10-25-11 through 25-12).
An entity with the ability to choose the method of settlement (i.e., cash or share settlement) must consider its intent and ability to settle the awards in cash or shares in determining whether to classify the awards as equity or as a liability. The entity’s past practices related to the following may indicate that some or all of the awards must be classified as a liability:
- Repurchasing awards for cash generally or whenever requested by a grantee.
- Net cash settling options.
The entity’s ability to deliver shares upon the vesting of stock awards or upon
the exercise of stock option awards must also be considered. The grantor must have
enough unissued and authorized shares to settle the awards. A requirement to provide
registered shares does not, by itself, imply that the entity does not have the
ability to deliver shares. However, if (1) the entity does not have enough unissued
and authorized shares to settle the awards in shares and (2) obtaining authorization
for such shares is not perfunctory, liability classification of the awards may be
required. An entity should continue to evaluate the substantive terms while the
award is within the scope of ASC 718. If a reclassification is required, this should
be accounted for as a modification as discussed in Section 6.8.
If the entity can choose the method of settlement (i.e., cash or share settlement), ASC 480-10-S99-3A does not need to be considered since that guidance only applies to awards with redemption features that are not solely within the control of the issuer. An award with terms that allow the entity to choose the method of settlement will never be classified as temporary equity unless there are other redemption features that are not solely within the entity’s control.
Example 5-18
Intent and Ability to Deliver Shares
On February 5, 20X3, Entity A granted a 1,000,000 award of
stock options that vest at the end of the first year of
service (cliff vesting). The award may be settled in either
cash or shares, at A’s election.
Entity A currently has 750,000 shares authorized and unissued
for its stock option plan. To authorize additional shares, A
must obtain shareholder approval, which is considered a
substantive contingency that is not perfunctory.
Because A does not currently have the
ability to satisfy the exercise of 250,000 of the options,
those options would be classified as a liability at the time
of the grant. However, if an additional 250,000 shares are
subsequently authorized for A’s stock option plan and A has
the intent to settle the award in shares (and liability
classification is not required because of other features),
the 250,000 options would be reclassified from a liability
to equity and accounted for as a modification of an award
that changes the award’s classification.