6.8 Modifications That Result in a Change in Classification

A modification can result in a change in an award’s classification from equity to liability or vice versa. The accounting for the modification will depend on the classification of the award before and after the modification.

6.8.1 Modification From an Equity Award to a Liability Award

To account for the modification of an award that results in reclassification from equity to liability, an entity would, on the modification date, recognize a share-based liability for the portion of the award for which the goods or services have already been provided and multiply that amount by the modified award’s fair-value-based measure. If the fair-value-based measure of the modified award is less than or equal to the fair-value-based measure of the original award, the offsetting amount would be recorded in APIC. If, on the other hand, the fair-value-based measure of the modified award is greater than the fair-value-based measure of the original award, the excess value would be recognized as additional compensation cost either immediately (for vested awards) or over the remaining employee requisite service period or nonemployee’s vesting period (for unvested awards). Because the award has been reclassified as a liability, it is remeasured at a fair-value-based amount in each reporting period until settlement. However, total compensation cost cannot be less than the grant-date fair-value-based measure of the original award if the original award was expected to vest.

The accounting for such a modification differs from that of a settlement of an award. For example, if an entity cash settles a fully vested equity award rather than modifying its terms to reclassify it as a liability, the entity does not apply modification accounting. As long as the cash settlement amount is less than or equal to the award’s then-current fair-value-based measure, no additional compensation cost results under ASC 718-20-35-7 and the settlement is accounted for as a treasury stock transaction. See Section 6.10.1 for a discussion of a cash settlement that is different from the current fair-value-based measure, and see Section 6.10.2 for a discussion of how to differentiate between a modification and a settlement.

Example 16 in ASC 718-20-55-123 below describes employee awards; however, the FASB indicates that the same principles apply to nonemployee awards with similar features as the awards described in Cases A through E in the determination of total compensation cost to be recognized as a result of a modification. The cost associated with nonemployee awards should be recognized in the same period(s) and in the same manner as though the grantor had paid cash.

ASC 718-20

Example 16: Modifications That Change an Award’s Classification

Case A: Equity to Liability Modification (Share-Settled Share Options to Cash-Settled Share Options)

55-123 Entity T grants the same share options described in Example 1, Case A (see paragraph 718-20-55-10). As in Example 1, Case A, Entity T has an accounting policy to estimate the number of forfeitures expected to occur in accordance with paragraph 718-10-35-3. The number of options for which the requisite service is expected to be rendered is estimated at the grant date to be 821,406 (900,000 × .973). For simplicity, this Case assumes that estimated forfeitures equal actual forfeitures. Thus, as shown in the table in paragraph 718-20-55-130, the fair value of the award 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 for 20X5 are the same as those in paragraph 718-20-55-12.

55-124 On January 1, 20X6, Entity T modifies the share options granted to allow the employee the choice of share settlement or net cash settlement; the options no longer qualify as equity because the holder can require Entity T to settle the options by delivering cash. Because the modification affects no other terms or conditions of the options, the fair value (assumed to be $7 per share option) of the modified award equals the fair value of the original award immediately before its terms are modified on the date of modification; the modification also does not change the number of share options for which the requisite service is expected to be rendered. On the modification date, Entity T recognizes a liability equal to the portion of the award attributed to past service multiplied by the modified award’s fair value. To the extent that the liability equals or is less than the amount recognized in equity for the original award, the offsetting debit is a charge to equity. To the extent that the liability exceeds the amount recognized in equity for the original award, the excess is recognized as compensation cost. In this Case, at the modification date, one-third of the award is attributed to past service (one year of service rendered/three-year requisite service period). The modified award’s fair value is $5,749,842 (821,406 × $7), and the liability to be recognized at the modification date is $1,916,614 ($5,749,842 ÷ 3). The related journal entry follows.

55-125 No entry would be made to the deferred tax accounts at the modification date. The amount of remaining additional paid-in capital attributable to compensation cost recognized in 20X5 is $2,105,537 ($4,022,151 – $1,916,614).

55-126 Paragraph 718-20-35-3(b) specifies that total recognized compensation cost for an equity award shall at least equal the fair value of the award at the grant date unless at the date of the modification the service or performance conditions of the original award are not expected to be satisfied. In accordance with that principle, Entity T would ultimately recognize cumulative compensation cost equal to the greater of the following:

The grant-date fair value of the original equity award
The fair value of the modified liability award when it is settled.

55-127 To the extent that the recognized fair value of the modified liability award is less than the recognized compensation cost associated with the grant-date fair value of the original equity award, changes in that liability award’s fair value through its settlement do not affect the amount of compensation cost recognized. To the extent that the fair value of the modified liability award exceeds the recognized compensation cost associated with the grant-date fair value of the original equity award, changes in the liability award’s fair value are recognized as compensation cost.

55-128 At December 31, 20X6, the fair value of the modified award is assumed to be $25 per share option; hence, the modified award’s fair value is $20,535,150 (821,406 × $25), and the corresponding liability at that date is $13,690,100 ($20,535,150 × 2/3) because two-thirds of the requisite service period has been rendered. The increase in the fair value of the liability award is $11,773,486 ($13,690,100 – $1,916,614). Before any adjustments for 20X6, the amount of remaining additional paid-in capital attributable to compensation cost recognized in 20X5 is $2,105,537 ($4,022,151 – $1,916,614). The cumulative compensation cost at December 31, 20X6, associated with the grant-date fair value of the original equity award is $8,044,302 ($4,022,151 × 2). Entity T would record the following journal entries for 20X6.

55-129 At December 31, 20X7, the fair value is assumed to be $10 per share option; hence, the modified award’s fair value is $8,214,060 (821,406 × $10), and the corresponding liability for the fully vested award at that date is $8,214,060. The decrease in the fair value of the liability award is $5,476,040 ($8,214,060 – $13,690,100). The cumulative compensation cost as of December 31, 20X7, associated with the grant-date fair value of the original equity award is $12,066,454 (see paragraph 718-20-55-123). Entity T would record the following journal entries for 20X7.

55-130 The modified liability award is as follows.

55-131 For simplicity, this Case assumes that all share option holders elected to be paid in cash on the same day, that the liability award’s fair value is $10 per option, and that Entity T has already recognized its income tax expense for the year without regard to the effects of the settlement of the award. In other words, current tax expense and current taxes payable were recognized based on income and deductions before consideration of additional deductions from settlement of the award.

55-132 The $8,214,060 in cash paid to the employees on the date of settlement is deductible for tax purposes. In the period of settlement, tax return deductions that are less than compensation cost recognized result in a charge to income tax expense. The tax benefit is $2,874,921 ($8,214,060 × .35). Because tax return deductions are less than compensation cost recognized, the entity must write off the deferred tax assets recognized in excess of the tax benefit from the exercise of employee stock options to income tax expense in the income statement. The journal entries to reflect settlement of the share options are as follows.

55-133 If instead of requesting cash, employees had held their share options and those options had expired worthless, the share-based compensation liability account would have been eliminated over time with a corresponding increase to additional paid-in capital. Previously recognized compensation cost would not be reversed. Similar to the adjustment for the actual tax deduction described in paragraph 718-20-55-132, all of the deferred tax asset of $4,223,259 would be charged to income tax expense when the share options expire.

Case E: Equity to Liability Modification (Share Options to Fixed Cash Payment)

55-144 Entity T grants the same share options described in Example 1, Case A (see paragraph 718-20-55-10) and records similar journal entries for 20X5 (see paragraphs 718-20-55-12 through 55-16). By January 1, 20X6, Entity T’s share price has fallen, and the fair value per share option is assumed to be $2 at that date. Entity T provides its employees with an election to convert each share option into an award of a fixed amount of cash equal to the fair value of each share option on the election date ($2) accrued over the remaining requisite service period, payable upon vesting. The election does not affect vesting; that is, employees must satisfy the original service condition to vest in the award for a fixed amount of cash. Entity T considers the guidance in paragraph 718-20-35-2A. Because the change in the terms or conditions of the award changes the classification of the award from equity to liability, Entity T applies modification accounting. This transaction is considered a modification instead of a settlement because Entity T continues to have an obligation to its employees that is conditional upon the receipt of future employee services. There is no incremental compensation cost because the fair value of the modified award is the same as that of the original award. At the date of the modification, a liability of $547,604 [(821,406 × $2) × (1 year of requisite service rendered ÷ 3-year requisite service period)], which is equal to the portion of the award attributed to past service multiplied by the modified award’s fair value, is recognized by reclassifying that amount from additional paid-in capital. The total liability of $1,642,812 (821,406 × $2) should be fully accrued by the end of the requisite service period. Because the possible tax deduction of the modified award is capped at $1,642,812, Entity T also must adjust its deferred tax asset at the date of the modification to the amount that corresponds to the recognized liability of $547,604. That amount is $191,661 ($547,604 × .35), and the write-off of the deferred tax asset is $1,216,092 ($1,407,753 – $191,661). That write-off would be recognized as income tax expense in the income statement. Compensation cost of $4,022,151 would be recognized in each of 20X6 and 20X7 for a cumulative total of $12,066,454 (as calculated in Case A); of this, $547,604 would be recognized as an increase to the liability balance, with the remaining $3,474,547 recognized as an increase in additional paid-in capital. A deferred tax benefit would be recognized in the income statement, and a corresponding increase to the deferred tax asset would be recognized for the tax effect of the increased liability of $191,661 ($547,604 × .35). The compensation cost recognized in additional paid-in capital in this situation has no associated income tax effect (additional deferred tax assets are recognized based only on subsequent increases in the amount of the liability).

Example 6-26

On January 1, 20X1, Entity A grants 1,000 equity-classified at-the-money share-settled SARs, each with a grant-date fair-value-based measure of $3. The SARs vest at the end of the fourth year of service (cliff vesting). On December 31, 20X2, A modifies the awards from share-settled SARs to cash-settled SARs. The fair-value-based measure of the SARs on December 31, 20X2, and December 31, 20X3, is $4 and $5, respectively.

Because the modification only affects the SARs’ settlement feature (i.e., cash settlement vs. share settlement), the fair-value-based measure of the modified SARs presumably equals the fair-value-based measure of the original SARs immediately before modification. Accordingly, there is no incremental value conveyed to the holder of the SARs.

However, because the modification-date fair-value-based measure is greater than the grant-date fair-value-based measure, A (1) reclassifies the amount currently residing in APIC, $1,500 (1,000 SARs × $3 grant-date fair-value-based measure × 50% for two of four years of services rendered), as a share-based liability and (2) records the excess $500 — ($4 modification-date fair-value-based measure – $3 grant-date fair-value-based measure) × 1,000 SARs × 50% for two of four years of services rendered — as additional compensation cost to record the new liability award at its fair-value-based measure, with a corresponding adjustment to share-based liability in the period of modification. See the journal entries below.

Now that the SARs are classified as a liability, A must remeasure them at their fair-value-based amount in each reporting period until settlement in accordance with ASC 718-30-35-2. (Chapter 7 discusses the differences between the accounting treatment of equity and liability awards.) See the journal entry below.

Example 6-27

Assume all the same facts as in the example above, except that the fair-value-based measure of the SARs on the date of modification (December 31, 20X2) and December 31, 20X3, is $2.50 and $2, respectively. Entity A reclassifies the portion of the SARs’ modification-date fair-value-based measure of $1,250 (1,000 SARs × $2.50 fair-value-based measure × 50% for two of four years of services rendered) currently residing in APIC as a share-based liability. See the journal entries below.

Now that the SARs are classified as a liability, in accordance with ASC 718-30-35-2, A must remeasure them at their fair-value-based amount in each reporting period until settlement. If the value of the liability award at settlement is less than its grant-date fair-value-based measure, then total compensation cost will equal the grant-date fair-value-based measure, and a portion of that value will remain in equity. On the other hand, if at settlement the value of the liability award is greater than its grant-date fair-value-based measure, total compensation cost will equal the liability award’s value at settlement. This conclusion is consistent with the requirement in ASC 718 that compensation cost for an equity award (i.e., the original award’s treatment before modification) should generally be recorded at least at its grant-date fair-value-based measure if the original award was expected to vest. See the journal entries below.

6.8.2 Modification From a Liability Award to an Equity Award

The treatment of a modification that changes an award’s classification from liability to equity is different from the treatment of other modifications, for which total recognized compensation cost attributable to an award that has been modified is, at least, the grant-date fair-value-based measure of the original award unless the original award was not expected to vest. For liability to equity modifications, the aggregate amount of compensation cost recognized is generally the fair-value-based measure of the award on the modification date. To account for the modification, an entity would, on the modification date, record the amounts previously recorded as a share-based compensation liability as a component of equity in the form of a credit to APIC. Because the award is no longer classified as a liability, it no longer has to be remeasured at a fair-value-based amount in each reporting period until settlement.

ASC 718-30

Example 1: Cash-Settled Stock Appreciation Right

55-1 This Example illustrates the guidance in paragraphs 718-30-35-2 through 35-4 and 718-740-25-2 through 25-4.

55-1A This Example (see paragraphs 718-30-55-2 through 55-11) 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 and forfeiture estimation and remeasurement of awards, exercise, and expiration in paragraphs 718-30-55-2 through 55-11 are equally applicable to nonemployee awards with the same features as the awards in this Example (that is, awards with a specified period of time for vesting classified as liabilities). Therefore, the guidance in those paragraphs may serve as implementation guidance for similar nonemployee awards.

55-1B 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.

55-2 Entity T, a public entity, grants share appreciation rights with the same terms and conditions as those described in Example 1 (see paragraph 718-20-55-4). As in Example 1, Case A, Entity T makes an accounting policy election in accordance with paragraph 718-10-35-3 to estimate the number of forfeitures expected to occur and includes that estimate in its initial accrual of compensation costs. Each stock appreciation right entitles the holder to receive an amount in cash equal to the increase in value of 1 share of Entity T stock over $30. Entity T determines the grant-date fair value of each stock appreciation right in the same manner as a share option and uses the same assumptions and option-pricing model used to estimate the fair value of the share options in that Example; consequently, the grant-date fair value of each stock appreciation right is $14.69 (see paragraphs 718-20-55-7 through 55-9). The awards cliff-vest at the end of three years of service (an explicit and requisite service period of three years). The number of stock appreciation rights for which the requisite service is expected to be rendered is estimated at the grant date to be 821,406 (900,000 × .973). Thus, the fair value of the award as of January 1, 20X5, is $12,066,454 (821,406 × $14.69). For simplicity, this Example assumes that estimated forfeitures equal actual forfeitures.

ASC 718-20

Example 16: Modifications That Change an Award’s Classification

Case C: Liability to Equity Modification (Cash-Settled to Share-Settled Stock Appreciation Rights)

55-135 This Case is based on the facts given in Example 1 (see paragraph 718-30-55-1). Entity T grants cash-settled stock appreciation rights to its employees. The fair value of the award on January 1, 20X5, is $12,066,454 (821,406 × $14.69) (see paragraph 718-30-55-2).

55-136 On December 31, 20X5, the assumed fair value is $10 per stock appreciation right; hence, the fair value of the award at that date is $8,214,060 (821,406 × $10). The share-based compensation liability at December 31, 20X5, is $2,738,020 ($8,214,060 ÷ 3), which reflects the portion of the award related to the requisite service provided in 20X5 (1 year of the 3-year requisite service period). For convenience, this Case assumes that journal entries to account for the award are performed at year-end. The journal entries for 20X5 are as follows.

55-137 On January 1, 20X6, Entity T modifies the stock appreciation rights by replacing the cash-settlement feature with a net share settlement feature, which converts the award from a liability award to an equity award because Entity T no longer has an obligation to transfer cash to settle the arrangement. Entity T would compare the fair value of the instrument immediately before the modification to the fair value of the modified award and recognize any incremental compensation cost. Because the modification affects no other terms or conditions, the fair value, assumed to be $10 per stock appreciation right, is unchanged by the modification and, therefore, no incremental compensation cost is recognized. The modified award’s total fair value is $8,214,060. The modified award would be accounted for as an equity award from the date of modification with a fair value of $10 per share. Therefore, at the modification date, the entity would reclassify the liability of $2,738,020 recognized on December 31, 20X5, as additional paid-in capital. The related journal entry is as follows.

55-138 Entity T will account for the modified awards as equity going forward following the pattern given in Example 1, Case A (see paragraph 718-20-55-1), recognizing $2,738,020 of compensation cost in each of 20X6 and 20X7, for a cumulative total of $8,214,060.

Example 6-28

On January 1, 20X1, Entity A grants 1,000 at-the-money cash-settled SARs, each with a grant-date fair-value-based measure of $3. The SARs vest at the end of the fourth year of service (cliff vesting). On December 31, 20X1, the SARs’ fair-value-based measure is still $3. On December 31, 20X2, A modifies the awards, changing them from cash-settled SARs to share-settled restricted stock awards. The fair-value-based measure of the restricted stock awards on December 31, 20X2, is $7, and the fair-value-based measure of the original SARs immediately before modification is $5.

The modification to replace the original SARs awards with restricted stock awards and to change the settlement feature of the awards (i.e., share settlement versus cash settlement) increases the fair-value-based measure of the modified restricted stock awards relative to the fair-value-based measure of the original SARs immediately before modification. Accordingly, since there is incremental value conveyed to the holder of the restricted stock awards in connection with the modification from liability to equity, A will record incremental compensation cost of $2,000, or ($7 – $5) × 1,000 restricted stock awards, over the remaining two years of service required.

On December 31, 20X2, the modified restricted stock awards are accounted for as an equity award from the date of modification, with compensation cost fixed at $7 (which is the fair-value-based measure on the modification date). As a result, A reclassifies as APIC the amount previously recorded as a share-based liability ($2,500 = 1,000 SARs × $5 modification-date fair-value-based measure × 50% for two of four years of services rendered). In addition, A records the remaining $4,500 of compensation cost (1,000 restricted stock awards × $7 modification-date fair-value-based measure – $2,500 previously recognized compensation cost) over the remaining service period (two years). See the journal entries below.

When a reduction in an award’s fair-value-based measure occurs in conjunction with a change in its classification from liability to equity, an entity should record the reduction in the fair-value-based measure in equity (as APIC), not in the income statement. Grantees ordinarily would not exchange one award for another that is less valuable. Therefore, their acceptance of the new award is analogous to debt forgiveness by a related party and should be treated as a contribution of capital (see ASC 470-50-40-2).

This situation is also analogous to the example described in paragraph 5 of FASB Interpretation 28, in which employees are granted a combination award (i.e., SARs that are exercisable for the same period as companion stock options, and the exercise of either cancels the other). If circumstances change and the employee will exercise the stock option rather than the SAR, accrued compensation related to the appreciation right is not adjusted. Although Interpretation 28 has been nullified by FASB Statement 123(R), the guidance in paragraph 5 remains applicable by analogy.

Example 6-29

On January 1, 20X1, Entity A grants 100 cash-settled performance units to each of its 100 employees. The units vest at the end of the third year of service (cliff vesting). On January 1, 20X2, A modifies the units (after obtaining approval from each of the unit holders) to require settlement in shares and further restricts the employees from selling the shares for one year after they become vested. The fair-value-based measure of the units immediately before modification is $12, and the fair-value-based measure of the modified award is $11. The decrease in value is attributable to the addition of the restriction on the ability to sell the vested shares.

On December 31, 20X1, A records the 20X1 compensation cost and a corresponding share-based liability on the basis of the current fair-value-based measure of the units ($12), the number of units to be issued (10,000), and the percent of services rendered (33 percent for one of three years of services rendered). See the journal entry below.

On January 1, 20X2, A accounts for the modification by first reclassifying the accumulated value of the equity award (on the basis of the new fair-value-based measure) as APIC (10,000 units × $11 fair-value-based measure × 33% for one of three years of services rendered = $36,667). Next, A reclassifies the remaining share-based liability (representing the employees’ capital contributions) as equity ($40,000 – $36,667 = $3,333). See the journal entry below.

Using the new fair-value-based measure of the award, A records the entry below to recognize the compensation cost of $36,667 (10,000 units × $11 fair-value-based measure × 33% for one of three years of services rendered) for both 20X2 and 20X3.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.