Deloitte's Roadmap: Share-Based Payment Awards
Preface
Preface
We are pleased to present the 2023 edition of Share-Based Payment
Awards. This Roadmap provides Deloitte’s insights into and interpretations
of the guidance on share-based payment arrangements in ASC 7181 related to employee and nonemployee awards and in other literature (e.g., ASC
260 and ASC 805).
Note that in this edition, it is assumed that an entity has already adopted:
- ASU 2020-06, which simplifies the accounting for convertible instruments and equity-linked financial instruments.
- ASU 2021-07, which allows nonpublic entities to use, as a practical expedient, “the reasonable application of a reasonable valuation method” to determine the current price input of equity-classified share-based payment awards issued to both employees and nonemployees. (However, this ASU does not significantly affect the guidance in this publication.)
For a list of significant changes made since the issuance of the
2022 edition of the Roadmap, see Appendix E.
This publication is not a substitute for the exercise of professional judgment, which
is often essential to applying the accounting requirements for share-based payment
awards. It is also not a substitute for consulting with Deloitte professionals on
complex accounting questions and transactions.
Be sure to check out On the
Radar (also available as a stand-alone
publication), which briefly summarizes
emerging issues and trends related to the accounting and
financial reporting topics addressed in the Roadmap.
We hope that you find this publication a valuable resource when
considering the accounting guidance on share-based payment arrangements.
Footnotes
1
For the full titles of standards, topics, regulations, and
abbreviations used in this publication, see Appendixes C and D. Note that this
Roadmap does not cover the guidance on employee stock ownership plans
(ESOPs) in ASC 718-40.
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Profits Interests
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Modifications
On the Radar
On the Radar
To incentivize employee performance and align the interests of
employees and shareholders, entities often grant share-based payment awards —
including stock options, restricted stock, restricted stock units (RSUs), stock
appreciation rights (SARs), and other equity-based instruments — in exchange for
services. To a lesser extent, entities also grant such awards to compensate vendors
for goods and services or as sales incentives to customers.
ASC 718 provides the accounting guidance on
share-based payment awards, which requires entities to use a
fair-value-based measure when recognizing the cost
associated with these awards in the financial statements.
Some of the more challenging aspects of applying this
guidance are highlighted below.
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Scope
An entity must first determine whether an award is within the
scope of ASC 718 or is, in substance, a bonus or profit-sharing arrangement. ASC
718 applies to awards that require or may require settlement in the equity of
the entity or whose settlement is based, at least in part, on the price of the
entity’s equity. An entity’s conclusion related to whether an award is within
the scope of ASC 718 can significantly affect the amount of compensation cost
recognized and when such cost is recognized in the financial statements.
Nonpublic limited partnerships, limited liability companies, and
other pass-through entities often establish special classes of equity, referred
to as profits interests. These special equity classes often have distribution
thresholds or hurdles related to amounts that must be paid to other classes of
equity before the grantee of the profits interest can receive distributions. On
the grant date, an award may have zero liquidation value for tax purposes but a
fair value for financial reporting purposes.
While the features of a profits interest award can vary, such an award should be
accounted for on the basis of its substance. If the award has the
characteristics of an equity interest, it represents a “substantive class of
equity” and should be accounted for under ASC 718. However, an award that is, in
substance, a performance bonus or a profit-sharing arrangement would be
accounted for as such in accordance with other U.S. GAAP (e.g., typically ASC
710 for employee arrangements).
There are several characteristics to consider when determining whether an
instrument is within the scope of ASC 718. To be a substantive class of equity,
the profits interest must be legal form equity. An entity would also consider
whether the instrument’s holder can retain a vested interest in an award if the
holder stops providing goods or services to the company. In determining whether
a repurchase feature allows the grantee to retain a vested interest, an entity
would assess whether the repurchase price of that repurchase feature is
consistent with the fair value of the award. Other characteristics of the award
(e.g., claim to residual assets of the entity upon liquidation, substantive net
assets underlying the interest, and distribution rights after vesting) could
also be relevant to the entity’s conclusion.
On May 11, 2023, the
FASB issued a proposed ASU that would clarify
U.S. GAAP by adding an illustrative example to help
entities determine whether a profits interest or
similar award should be accounted for under ASC 718.
Comments on the proposed ASU were due July 10, 2023.
Stakeholders should monitor the FASB’s deliberations
for developments related to the proposal.
Classification
If an entity concludes that an award is within the scope of ASC
718, it must then determine whether that award will be recognized within equity
or as a liability. Equity-classified awards are generally measured as of the
grant date and, in the absence of any modifications, the total amount of
compensation cost to be recognized is fixed at the grant-date measurement
amount. By contrast, liability-classified awards must be remeasured to fair
value as of every reporting period until settled. Accordingly, if the value of
an entity’s shares increases before the liability is settled, the total
recognized compensation cost of a liability-classified award will also
increase.
Determining the classification
of a share-based payment award can be challenging. While classifying a
cash-settled award as a liability may seem straightforward, other awards may
contain features and conditions that entities must analyze further. Examples of
questions to consider in the determination of the classification of an award
include the following:
Some of these questions typically only pertain to nonpublic entities. For
example, nonpublic entities often include repurchase features to remain closely
held or may choose to settle the award in cash to provide liquidity to the
grantee for shares that are not actively traded.
Secondary Transactions
When a nonpublic entity repurchases common shares from its
employees at an amount greater than the estimated fair value of the shares at
the time of the transaction, the excess of the purchase price over the fair
value of the common shares generally represents employee compensation. In
addition, investors (e.g., private equity or venture capital investors) may
purchase shares held by current or former employees of an entity because such
investors want to acquire or increase their stake in that entity or provide
liquidity to the entity’s employees. Any consideration paid in excess of the
fair value of the shares is presumed to be compensation cost and an in-substance
equity contribution that must be recognized by the reporting entity.
A nonpublic company should carefully evaluate secondary
transactions when determining the fair value of its common shares. Often, an
entity may conclude that a secondary transaction includes a compensatory element
that must be recognized even when there are also indicators that the secondary
transaction was conducted at fair value. In such situations, an entity should
consider whether to give some weight to that transaction when determining the
fair value of the common shares.
Clawbacks
On October 26, 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 “is material to the previously
issued financial statements” (a “Big R” restatement) or “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 requires issuers to “claw back” excess compensation for the three
fiscal years before the determination of a restatement regardless of whether an
executive officer1 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.
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
final rule’s requirements. 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.
Cheap Stock
Since private companies often heavily rely on equity grants to
compensate their employees, it is critical for such entities to proactively
address potential issues that may emerge during the IPO process related to their
equity plan. As an entity prepares for an IPO, the SEC staff often focuses on
“cheap stock”2 issues. The staff is interested in the rationale for any difference
between the fair value measurements of the underlying common stock of
share-based payment awards issued within the past year and the anticipated IPO
price. In addition, the staff will challenge valuations that are significantly
lower than prices paid by investors in recent acquisitions of similar stock. If
the differences cannot be reconciled, a nonpublic entity may be required to
record a cheap-stock charge. Such a charge could be material and, in some cases,
lead to a restatement of the financial statements.
Waiting to consider cheap stock issues until after the
SEC raises related questions may delay a declaration
that an IPO registration statement is
effective.
When the estimated fair value of an entity’s stock is
significantly below the anticipated IPO price, the entity should be able to
reconcile the change in the estimated fair value of the underlying equity
between the award grant date and the IPO. To perform this reconciliation, the
entity would take into account, among other things, intervening events and
changes in assumptions that justify the change in fair value. The SEC staff has
frequently inquired about a registrant’s pre-IPO valuations. Specifically,
during the registration statement process, the SEC staff may ask an entity to
(1) reconcile its recent fair value measurements with the anticipated IPO price
(including significant intervening events); (2) describe its valuation methods;
(3) justify its significant valuation assumptions, including the weight given to
operating the business both under and in the absence of an IPO; and (4) discuss
the weight it gives to secondary transactions.
Footnotes
1
Compared with the recovery provisions of Section 304 of the
Sarbanes-Oxley Act of 2002 that (1) are triggered when an accounting
restatement results from an issuer’s misconduct and (2) only apply to
CEOs and CFOs, the final rule’s scope includes a broader list of
executive officers, including former executive officers.
2
Cheap stock refers to issuances of equity securities
before an IPO in which the value of the shares is below the IPO
price.
Contacts
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For information about Deloitte’s service offerings related to
share-based payment arrangements, please contact:
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Chapter 1 — Overview
Chapter 1 — Overview
1.1 Objective
ASC 718-10
10-1 The objective of
accounting for transactions under share-based payment
arrangements is to recognize in the financial statements the
goods or services received in exchange for equity
instruments granted or liabilities incurred and the related
cost to the entity as those goods or services are received.
This Topic uses the terms compensation and
payment in their broadest senses to refer to the
consideration paid for goods or services or the
consideration paid to a customer.
10-2 This Topic requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Topic establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions except for equity instruments held by employee stock ownership plans.
To incentivize employee and nonemployee performance and align the interests of
grantees and shareholders, entities often grant share-based payment awards such as
stock options, restricted stock,1 RSUs, SARs, and other equity-based instruments in exchange for goods or
services or consideration paid to a customer. Such awards are a form of
compensation. One of ASC 718’s objectives is for entities to recognize the cost of
that compensation in their financial statements as the goods or services associated
with the awards are provided. The amount of cost to recognize is generally based on
the fair value of the share-based payment arrangement, and ASC 718 requires entities
to apply a “fair-value-based measurement method” when accounting for such
arrangements.2
Footnotes
1
ASC 718 refers to restricted stock (and RSUs) as nonvested
shares (and nonvested share units). See Sections 3.3, 4.7, and 4.8 for a discussion of the differences
between a nonvested share and a restricted share.
2
See Sections
1.7 and 4.13 for a discussion of exceptions for nonpublic entities
to the fair-value-based measurement requirement.
1.2 Substantive Terms
ASC 718-10 — Glossary
Terms of a Share-Based Payment Award
The contractual provisions that determine the nature and scope of a share-based payment award. For example, the exercise price of share options is one of the terms of an award of share options. As indicated in paragraph 718-10-25-15, the written terms of a share-based payment award and its related arrangement, if any, usually provide the best evidence of its terms. However, an entity’s past practice or other factors may indicate that some aspects of the substantive terms differ from the written terms. The substantive terms of a share-based payment award, as those terms are mutually understood by the entity and a party (either an employee or a nonemployee) who receives the 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. See paragraph 718-10-30-5.
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.
25-4 Assessment of both the rights and obligations in a share-based payment award and any related arrangement and how those rights and obligations affect the fair value of an award requires the exercise of judgment in considering the relevant facts and circumstances.
It is important for an entity to consider all of an award’s terms when evaluating a share-based payment arrangement. While the written plan and agreement are generally the best evidence of the award’s terms, an entity’s past practice or other factors may indicate that the substantive terms differ from the written ones. For example, if an entity’s award agreement indicates that the award will be settled in shares of the entity’s stock, but the entity has made an oral promise to settle the award in cash or has a past practice of settling awards in cash, the substantive terms of the award would indicate that there is a cash settlement feature. The substantive terms that are mutually understood by the entity and the grantee provide the basis for determining the accounting irrespective of how the award and related agreements may be drafted or structured. This concept is illustrated in ASC 718-10-25-3, which indicates that a nonrecourse note received by an entity as consideration for the issuance of stock is, in substance, the same as the grant of stock options and therefore should be accounted for as a substantive grant of stock options. Another example of this concept is a feature that allows an entity to repurchase “vested” shares awarded in a share-based payment arrangement for no consideration if the grantee ceases providing goods or services before four years after the grant date of the awards. In this scenario, the repurchase feature functions, in substance, as a vesting condition.
1.3 Scope
ASC 718 generally applies to share-based payments granted to (1) employees or
nonemployees in exchange for goods or services to be used or consumed in the
grantor’s own operations or (2) customers of the entity.3 Further, such payments must be either (1) settled by issuing the entity’s
equity shares or other equity instruments or (2) indexed, at least in part, to the
value of the entity’s equity shares or other equity instruments. See Chapter 2 for a more detailed
discussion of the scope of ASC 718.
In addition, an entity should evaluate transactions between (1) grantees that
provide goods and services or grantees that are customers and (2) related parties or
other economic interest holders of the entity. If a transaction is deemed to be
compensation for goods or services or if the transaction provides consideration to a
customer that is not in exchange for a good or service, it is accounted for as a
capital contribution to the entity and as a share-based payment arrangement between
the entity and the grantee. See Section 2.5
for additional guidance.
Footnotes
3
Share-based payments granted to employees or nonemployees in
exchange for goods or services are discussed throughout this Roadmap.
Share-based payments issued as consideration payable to a customer are
discussed in Chapter
14.
1.4 Recognition
ASC 718 requires compensation cost to be recognized over the employee’s
requisite service period or the nonemployee’s vesting period. The requisite service
period is the period during which the employee is required to provide services to
earn the share-based payment award. The nonemployee’s vesting period is the period
over which the cost of a nonemployee share-based payment award is recognized (i.e.,
the period the goods or services are provided). The service inception date, which is
generally the grant date, is the beginning of the requisite service period or the
nonemployee’s vesting period. Therefore, the service inception date is the date on
which an entity begins to recognize compensation cost related to the share-based
payments. For awards with only a service condition, the vesting period is generally
the requisite service period or the nonemployee’s vesting period unless there are
other substantive terms to the contrary. For nonemployee share-based payment awards,
an entity should recognize compensation cost “when it obtains the goods or as
services are received” and “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.” This is referred to within ASC 718 and this Roadmap as
the “nonemployee’s vesting period.”
An employee’s requisite service period4 can be explicit, implicit, or derived, depending on the award’s terms and
conditions:
-
An explicit service period is stated in the terms of an award. For example, if the award vests after four years of continuous service, the explicit service period is four years.
-
An implicit service period is not explicitly stated in the terms of the award but may be inferred from an analysis of those terms and other facts and circumstances that are typically associated with a performance condition. For example, if an award vests only upon the completion of a new product design and the design is expected to be completed two years from the grant date, the implicit service period is two years.
-
A derived service period is inferred from the application of certain techniques used to value an award with a market condition. For example, if an award becomes exercisable when the market price of the entity’s stock reaches a specified level, and that specified level is expected to be achieved in three years (as inferred from the valuation technique), the derived service period is three years.
An award may contain more than one explicit, implicit, or derived service period (i.e., multiple conditions). However, it can have only one requisite service period, with the exception of a graded vesting award that is accounted for, in substance, as multiple awards; see Section 3.6.5. If an award contains multiple conditions, an entity may need to take into account the interrelationship of those conditions. Further, the entity must make an initial best estimate of the requisite service period as of the grant date, and it should revise that estimate as facts and circumstances change. Section 3.8 discusses how to account for a change in the estimated requisite service period.
Compensation cost is based on the number of awards that vest, which generally
depends on satisfaction of the awards’ service conditions, performance
conditions,5 or both. For service conditions, an entity can, separately for employee awards
and nonemployee awards, make an entity-wide accounting policy election to either (1)
estimate the total number of awards for which the good will not be delivered or the
service will not be rendered (i.e., estimate the forfeitures expected to occur) or
(2) account for forfeitures when they occur. If the entity elects the first option,
it will estimate the likelihood that employees will terminate employment or
nonemployees will cease providing goods or services before satisfying the service
condition and factor this forfeiture estimate into the amount of compensation cost
accrued (i.e., decrease the quantity of awards). It will then adjust the estimated
quantity if facts and circumstances change so that the total amount of compensation
cost recognized at the end of the employee’s requisite service period or the
nonemployee’s vesting period is based on the number of awards for which the
employee’s requisite service is rendered or the nonemployee’s goods or services are
provided. If the entity elects the second option, it will reverse previously
recognized compensation cost when a grantee forfeits the award by terminating
employment (for employee awards) or ceasing to provide goods or services (for
nonemployee awards) before the grantee has satisfied the service condition.
For awards that vest upon the achievement of a performance condition, an entity
will need to assess the probability of such achievement and will only recognize
compensation cost if it is probable that the performance condition will be met. The
total compensation cost recognized will ultimately be based on the outcome of the
performance condition.
If a grantee forfeits an award that contains a market condition because of failure to meet the market condition but delivers the promised good or renders the requisite service, compensation cost previously recognized is not reversed. Compensation cost is only reversed if the grantee does not deliver the promised good or render the requisite service, because a market condition is not considered a vesting condition. In determining the fair-value-based measurement of the award, an entity takes into account the likelihood that it will meet the market condition.
See Sections 3.4 and 3.5 for additional information about service, performance, and market conditions, and see Chapter 3 for detailed guidance on the recognition of compensation cost.
Footnotes
4
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 such guidance is relevant to the
accounting for the nonemployee award. For additional discussion of a
nonemployee’s vesting period, see Section 9.3.2.
5
There may be certain situations in which a service or
performance condition does not affect the number of awards that vest and
instead affects factors other than vesting, such as the exercise price or
conversion ratio.
1.5 Measurement
Share-based payment transactions are measured on the basis of the fair value (or
in certain situations, the calculated value or
intrinsic value) of the equity instrument issued.
As noted in Section 1.1, ASC
718 refers to a “fair-value-based” method for
measuring the value of the share-based payment.
Conceptually, the fair value determined under this
method is not fair value as defined in ASC 820,
which explicitly excludes share-based payments
from its scope. Although fair value measurement
techniques are used in the fair-value-based
measurement method, it specifically excludes the
effects of vesting conditions and other types of
features (e.g., clawback provisions) that would be
included in a fair value measurement that is based
on ASC 820. Therefore, when the term “fair value”
is used in ASC 718 and in this Roadmap, it refers
to a fair-value-based measurement determined in
accordance with the requirements of ASC 718.
For equity-classified awards, compensation cost is recognized over the
employee’s requisite service period or the
nonemployee’s vesting period on the basis of the
fair-value-based measure of the awards on the
grant date. The measurement of such awards is
generally fixed on the grant date. By contrast,
liability-classified awards are remeasured at
their fair-value-based measurement as of each
reporting date until settlement. That is, changes
in the fair-value-based measure of the liability
at the end of each reporting period are recognized
as compensation cost, either (1) immediately or
(2) over the employee’s requisite service period
or the nonemployee’s vesting period. The total
compensation cost ultimately recognized for
liability-classified awards on the settlement date
will generally equal the settlement amount (e.g.,
the amount of cash paid to settle the award).
Nonpublic entities can use certain practical expedients as a substitute for a fair-value-based measurement. See further discussion in Section 1.7. See Chapter 4 for additional guidance on the measurement of share-based payment awards.
1.6 Classification
As described above, an entity’s measurement of compensation cost differs depending on whether the entity has determined that share-based payment awards are classified as equity or liabilities. An overarching principle in ASC 718 is that a share-based payment arrangement cannot be classified as equity unless the grantee is subject to the risks and rewards associated with equity share ownership for a reasonable period. Any terms and conditions that could result in cash settlement, settlement in other assets, or settlement in a variable number of shares should be carefully evaluated. In addition, indexation of share-based payments to a factor other than a service, performance, or market condition could result in liability classification. Further, all of an award’s substantive terms and conditions, as well as an entity’s past practices, should be assessed in the determination of whether the entity has the intent and ability to settle in shares. See Chapter 5 for a more detailed discussion of the classification of awards as either liabilities or equity.
1.7 Nonpublic Entities
ASC 718-10 — Glossary
Nonpublic Entity
Any entity other than one that meets any of the following criteria:
- Has equity securities that trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
- Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
- Is controlled by an entity covered by the preceding criteria.
An entity that has only debt securities trading in a public market (or that has made a filing with a regulatory agency in preparation to trade only debt securities) is a nonpublic entity.
Public Business Entity
A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.
- It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
- It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
- It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
- It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
- It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity’s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC.
Public Entity
An entity that meets any of the following
criteria:
-
Has equity securities that trade in a public market, either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
-
Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
-
Is controlled by an entity covered by the preceding criteria. That is, a subsidiary of a public entity is itself a public entity.
An entity that has only debt securities
trading in a public market (or that has made a filing with a
regulatory agency in preparation to trade only debt
securities) is not a public entity.
Several practical expedients are available only to entities that meet the definition of a nonpublic entity in ASC 718. In determining whether it qualifies as a nonpublic entity and can therefore apply the practical expedients, an entity should note that the definition of a public entity is not the same as that of a public business entity, which is separately defined in ASC 718. While an entity uses the definitions of a public entity and a nonpublic entity to apply most of the guidance in ASC 718, it may also need to determine whether it meets the definition of a public business entity when adopting a new standard’s requirements.
1.7.1 Calculated Value
If a nonpublic entity cannot reasonably estimate the fair-value-based measure of its options and similar instruments because estimating the expected volatility of its stock price is not practicable, it should use the historical volatility of an appropriate industry sector index to calculate the value of the awards. The resulting value is referred to as calculated value. See Section 4.13.2.
1.7.2 Intrinsic Value
For liability-classified awards, a nonpublic entity can elect as an accounting policy to measure all of its liability-classified awards at either their intrinsic value or their fair-value-based measure. See Section 4.13.3 for additional information.
1.7.3 Expected Term
A nonpublic entity can elect, as an entity-wide accounting policy, to use a practical expedient in estimating the expected term of certain options and similar instruments. That practical expedient can only be used for awards that meet certain conditions. See Sections 4.9.2.2.3 and 4.13.1.2 for additional information.
1.7.4 Transition to Public Entity
A nonpublic entity that becomes a public entity can no longer use the practical
expedients that are available to nonpublic entities, including calculated value
and intrinsic value since public entities must use a fair-value-based
measurement. In addition, the practical expedient used by nonpublic entities to
determine the expected term of certain options and similar instruments is
different from that used by public entities. SAB Topic 14.B provides transition
guidance on the use of the calculated value or intrinsic value practical
expedient for nonpublic entities that are becoming public entities. See
Section 4.13.4
for more information.
In October 2021, the FASB issued ASU 2021-07, which allows nonpublic entities to use, as a
practical expedient, “the reasonable application of a reasonable valuation
method” to determine the current price input of equity-classified share-based
payment awards issued in exchange for goods or services. There is no transition
guidance on the election of this practical expedient for nonpublic entities that
are becoming public entities. Therefore, an entity that no longer meets the
criteria to be a nonpublic entity would have to reverse the practical
expedient’s effect in its historical financial statements. See Section 4.13.1.3 for
more information.
1.8 Comparison With IFRS® Accounting Standards
ASC 718 is the primary source of guidance in U.S. GAAP on the accounting for
employee and nonemployee share-based payment awards. IFRS 2 is the primary source of
guidance on such awards under IFRS Accounting Standards. Although much of the U.S.
GAAP guidance is converged with that in IFRS 2, there are some notable differences.
See Appendix A for a
discussion of those differences.
Chapter 2 — Scope
Chapter 2 — Scope
2.1 General
ASC 718-10
Overall Guidance
15-1 The Scope Section of the Overall Subtopic establishes the pervasive scope for all Subtopics of the Compensation — Stock Compensation Topic. Unless explicitly addressed within specific Subtopics, the following scope guidance applies to all Subtopics of the Compensation — Stock Compensation Topic, with the exception of Subtopic 718-50, which has its own discrete scope.
Entities
15-2 The guidance in the Compensation — Stock Compensation Topic applies to all entities that enter into share-based payment transactions.
15-3 The guidance in the
Compensation — Stock Compensation Topic applies to all
share-based payment transactions in which a grantor acquires
goods or services to be used or consumed in the grantor’s
own operations or provides consideration payable to a
customer by issuing (or offering to issue) its shares, share
options, or other equity instruments or by incurring
liabilities to an employee or a nonemployee that meet either
of the following conditions:
-
The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award of share-based compensation may be indexed to both the price of an entity’s shares and something else that is neither the price of the entity’s shares nor a market, performance, or service condition.)
-
The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.
15-3A
Paragraphs 323-10-25-3 through 25-5 provide guidance on
accounting for share-based compensation granted by an
investor to employees or nonemployees of an equity method
investee that provide goods or services to the investee that
are used or consumed in the investee’s operations.
15-5 The guidance in this Topic
does not apply to transactions involving share-based payment
awards granted to a lender or an investor that provides
financing to the issuer. However, see paragraphs
815-40-35-14 through 35-15, 815-40-35-18, 815-40-55-49, and
815-40-55-52 for guidance on an issuer’s accounting for
modifications or exchanges of written call options to
compensate grantees.
- Subparagraph superseded by Accounting Standards Update No. 2018-07.
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
15-5A Share-based payment
awards granted to a customer shall be measured and
classified in accordance with the guidance in this Topic
(see paragraph 606-10-32-25A) and reflected as a reduction
of the transaction price and, therefore, of revenue in
accordance with paragraph 606-10-32-25 unless the
consideration is in exchange for a distinct good or service.
If share-based payment awards are granted to a customer as
payment for a distinct good or service from the customer,
then an entity shall apply the guidance in paragraph
606-10-32-26.
15-6 Paragraphs 805-30-30-9 through 30-13 provide guidance on determining whether share-based payment awards issued in a business combination are part of the consideration transferred in exchange for the acquiree, and therefore in the scope of Topic 805, or are for continued service to be recognized in the postcombination period in accordance with this Topic.
15-7 The guidance in the Overall Subtopic does not apply to equity instruments held by an employee stock ownership plan.
ASC 718 applies to all transactions in which an entity receives goods or
services to be used or consumed in the entity’s own operations in exchange for
share-based instruments. In such transactions, an entity effectively “pays” grantees
in the form of share-based instruments for goods or services. Common examples of
share-based payment awards include stock options, SARs, restricted stock,1 and RSUs.
In addition, entities must apply ASC 718 to measure and classify
share-based payments that are issued as consideration payable to a customer and are
not in exchange for distinct goods or services (i.e., share-based sales incentives).
Because entities are also required to recognize share-based sales incentives in
accordance with ASC 606, the accounting for such awards is unique. See Chapter 14 for additional
information.
ASC 718 does not apply to share-based instruments issued
in exchange for cash or other assets (i.e., detachable warrants or similar
instruments issued in a financing transaction) because such instruments are not
issued in exchange for goods or services. Other share-based transactions, or aspects
of these transactions, that are not within the scope of ASC 7182 include:
-
Equity instruments issued as consideration in a business combination — ASC 718 does not address the accounting for equity instruments issued as consideration in a business combination. The measurement date for such equity instruments is described in ASC 805-30-30-7.ASC 805 also provides guidance on determining what portion of share-based payment awards exchanged in a business combination is (1) part of the consideration transferred in a business combination or (2) related to service to be recognized in the postcombination period and therefore is within the scope of ASC 718. ASC 805-20-30-21, ASC 805-30-30-9 through 30-13, ASC 805-30-55-6 through 55-13, ASC 805-30-55-17 through 55-35, ASC 805-740-25-10 and 25-11, and ASC 805-740-45-5 and 45-6 provide guidance on share-based payment awards exchanged in connection with a business combination. See Chapter 10 for additional information.
-
Options or warrants issued for cash or other than for goods or services — Financial instruments issued for cash or other financial instruments (i.e., other than for goods or services) are accounted for in accordance with the relevant literature on accounting for and reporting the issuance of financial instruments, such as ASC 815 and ASC 480.
-
Detachable options or warrants issued in a financing transaction — ASC 470-20 describes how an entity should account for detachable warrants, or similar instruments, issued in a financing transaction.
-
Share-based awards that are granted to employees or nonemployees and settled in shares of an unrelated entity — ASC 815-10-45-10 and ASC 815-10-55-46 through 55-48 describe the accounting for stock options that are issued to grantees and indexed to and settled in publicly traded shares of an unrelated entity. See Section 2.11 for more information about the accounting for awards that are issued to grantees and indexed to and settled in shares of an unrelated entity.
Only share-based payment awards that are issued in exchange for goods or
services or issued as share-based sales incentives are within the scope of ASC 718.
Further, such awards must be settled (or may require settlement) by issuing the
entity’s equity shares or other equity instruments or they must be indexed, at least
in part, to the value of the entity’s equity shares or other equity instruments. In
this context, the word “indexed” indicates that the value the grantee receives upon
settlement of the award is, at least in part, determined on the basis of the value
of the entity’s equity. For instance, an entity may award a cash-settled SAR that
can only be settled in cash. In such circumstances, the amount of cash the grantee
receives upon settlement of the award is based on the relationship of the market
price of the entity’s equity shares to the exercise price of the award; therefore,
the award is considered indexed to the entity’s equity and is within the scope of
ASC 718.
Example 2-1
Entity A, a public entity, offers a long-term incentive plan (LTIP) to certain of its employees. At the beginning of each year, a target cash bonus based on a specific dollar amount is established for each employee. Each employee in the LTIP will receive a predetermined percentage of his or her target bonus at the end of three years on the basis of the total return on A’s stock price relative to that of its competitors over the three-year performance period. The return on A’s stock price is ranked with that of its competitors from the highest to the lowest performer. On the basis of A’s ranking, each employee will receive a percentage of his or her target bonus that increases or decreases as A’s ranking increases or decreases.
For example, at the beginning of the three-year performance period, A sets a target cash bonus of $100,000 for an employee. Entity A includes nine of its competitors in its peer group to establish a ranking. Depending on the ranking, the employee will receive a percentage that ranges from 0 percent to 200 percent of the target bonus. For instance, if A ranks first in stock price return, the employee will receive 200 percent of $100,000, or $200,000; if A ranks fifth, the employee will receive 100 percent of $100,000, or $100,000; and if A ranks tenth or last, the employee will not receive a bonus.
Because the bonus is settled only in cash, A’s obligation under the LTIP is classified as a share-based liability. The liability is based, in part, on the price of A’s shares. That is, the share-based liability is based on the return on A’s stock price relative to the returns on the stock prices of A’s competitors. While the bonuses to be paid are not linearly correlated to the return on A’s stock price, the amount of the bonus does depend on the return on A’s stock price relative to that of its competitors. Accordingly, the LTIP is within the scope of, and therefore is accounted for in accordance with, ASC 718. Under ASC 718-30-35-3, A “shall measure a liability award under a share-based payment arrangement based on the award’s fair value remeasured at each reporting date until the date of settlement.”
Informal discussions with the FASB staff support the conclusion that LTIPs can be within the scope of ASC 718.
If an award offers a grantee a fixed monetary amount that is settled in a variable number of an entity’s shares, the amount the grantee receives upon settlement of the award is not based on the value of the entity’s equity and therefore is not considered indexed to the entity’s own equity. However, the fixed monetary amount will be settled by issuing a variable number of the entity’s shares. Because the award is settled by issuing the entity’s own equity, the award is within the scope of ASC 718.
Example 2-2
An entity sets a bonus of $100,000 for its chief executive if the executive remains employed for a two-year period. The bonus will be settled by issuing enough equity shares whose value equals $100,000. Therefore, if the entity’s share price is $50 at the end of the second year, the entity will settle the bonus by issuing 2,000 ($100,000 bonus ÷ $50 share price) of the entity’s equity shares. This bonus award is within the scope of ASC 718 because it is settled by issuing the entity’s own equity.
Share-based payment awards that are indexed to or settled in something other than an entity’s shares may be within the scope of ASC 718. ASC 718-10-20 defines share-based payment arrangements, in part, as follows:
The term shares [in ASC 718-10-15-3] includes various forms of ownership interest that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. Equity shares refers only to shares that are accounted for as equity.
That is, the legal form of the entity’s award does not preclude it from being within the scope of ASC 718. In this context, the term “shares” broadly represents instruments that entitle the holder to share in the risks and rewards of the entity as an owner.
Example 2-3
Trust Unit Rights
An entity may grant its employees trust unit rights to purchase a unit in a unit
investment trust at a reduced exercise price. Upon exercise
of the unit right, the holder receives publicly traded trust
units, which are equal to fractional undivided interests in
the trust. The trust units are the only voting,
participating equity securities of the trust. The trust
structure is created to purchase and hold a fixed portfolio
of securities or other assets, which represent the “trust
portfolio.” The trust then distributes the income generated
from the portfolio to the holders of the trust units.
Therefore, owning a trust unit allows the holder to share in
the appreciation of the trust portfolio. Common examples of
this type of investment trust structure include mutual funds
and real estate investment trusts.
While the entity is offering to issue unit rights, which are not legal securities themselves, the rights entitle the holder to trust units. Although these trust units are not “shares” in the strictest sense, they provide the holder with the risks and rewards of the entity as an owner (e.g., voting rights). Accordingly, this arrangement is within the scope of ASC 718.
Example 2-4
Phantom Stock Plans
Under a typical phantom stock plan, an employee is granted a theoretical number of units that are exercisable into common stock of the entity. These units are not legal securities themselves and usually are issued only on a memorandum basis. The units do not have voting rights with the common stockholders. The value of each phantom unit is based on the value of the entity’s stock and, therefore, appreciates and depreciates on the basis of fluctuations in the value of the entity’s stock.
The phantom stock unit holders do not have the same rights as a common stockholder (i.e., voting rights). However, because the phantom units are indexed to and settled in the entity’s equity, this arrangement is within the scope of ASC 718.
Footnotes
1
ASC 718 refers to restricted stock (and RSUs) as nonvested
shares (and nonvested share units).
2
ESOPs are within the scope of ASC 718-40 and are not covered
in this Roadmap. ASC 718-10-20 defines an ESOP as “an employee benefit plan
that is described by the Employee Retirement Income Security Act of 1974 and
the Internal Revenue Code of 1986 as a stock bonus plan, or combination
stock bonus and money purchase pension plan, designed to invest primarily in
employer stock. Also called an employee share ownership plan.” Entities
should continue to account for ESOPs in accordance with ASC 718-40 or SOP
76-3. Although SOP 76-3 was not included in the Codification, entities may
continue to apply it to shares acquired by ESOPs on or before December 31,
1992.
2.2 Definition of Employee
ASC 718-10 — Glossary
Employee
An individual over whom the grantor of a share-based compensation award exercises or has the right to exercise sufficient control to establish an employer-employee relationship based on common law as illustrated in case law and currently under U.S. Internal Revenue Service (IRS) Revenue Ruling 87-41. A reporting entity based in a foreign jurisdiction would determine whether an employee-employer relationship exists based on the pertinent laws of that jurisdiction. Accordingly, a grantee meets the definition of an employee if the grantor consistently represents that individual to be an employee under common law. The definition of an employee for payroll tax purposes under the U.S. Internal Revenue Code includes common law employees. Accordingly, a grantor that classifies a grantee potentially subject to U.S. payroll taxes as an employee also must represent that individual as an employee for payroll tax purposes (unless the grantee is a leased employee as described below). A grantee does not meet the definition of an employee solely because the grantor represents that individual as an employee for some, but not all, purposes. For example, a requirement or decision to classify a grantee as an employee for U.S. payroll tax purposes does not, by itself, indicate that the grantee is an employee because the grantee also must be an employee of the grantor under common law.
A leased individual is deemed to be an employee of the lessee if all of the following requirements are met:
- The leased individual qualifies as a common law employee of the lessee, and the lessor is contractually required to remit payroll taxes on the compensation paid to the leased individual for the services provided to the lessee.
- The lessor and lessee agree in writing to all of the following conditions related to the leased individual:
- The lessee has the exclusive right to grant stock compensation to the individual for the employee service to the lessee.
- The lessee has a right to hire, fire, and control the activities of the individual. (The lessor also may have that right.)
- The lessee has the exclusive right to determine the economic value of the services performed by the individual (including wages and the number of units and value of stock compensation granted).
- The individual has the ability to participate in the lessee’s employee benefit plans, if any, on the same basis as other comparable employees of the lessee.
- The lessee agrees to and remits to the lessor funds sufficient to cover the complete compensation, including all payroll taxes, of the individual on or before a contractually agreed upon date or dates.
A nonemployee director does not satisfy this definition of employee. Nevertheless, nonemployee directors acting in their role as members of a board of directors are treated as employees if those directors were elected by the employer’s shareholders or appointed to a board position that will be filled by shareholder election when the existing term expires. However, that requirement applies only to awards granted to nonemployee directors for their services as directors. Awards granted to those individuals for other services shall be accounted for as awards to nonemployees.
ASC 718-10
Identifying an Employee of a Physician Practice Management Entity
55-85A A physician practice management entity shall determine whether an employee of the physician practice is considered an employee of the physician practice management entity for purposes of determining the method of accounting for that person’s share-based compensation as follows:
- An employee of a physician practice that is consolidated by the physician practice management entity shall be considered an employee of the physician practice management entity and its subsidiaries.
- An employee of a physician practice that is not consolidated by the physician practice management entity shall not be considered an employee of the physician practice management entity and its subsidiaries.
Determining whether a grantee meets the definition of an employee under ASC 718
is important for certain aspects of the accounting for a share-based payment award.
On the basis of an examination of cases and rules, the IRS issued Revenue Ruling
87-41, which establishes 20 criteria for determining whether an individual is an
employee under common law. The degree of importance of each criterion varies
depending on the context in which the services of an individual are performed. In
addition, the criteria are designed as guides to help an entity determine whether an
individual is an employee. An entity should ensure that the substance of an
arrangement is not obscured by attempts to achieve a particular employment status.
The criteria include the following:
-
Instructions — “A worker who is required to comply with other persons’ instructions about when, where, and how he or she is to work is ordinarily an employee. This control factor is present if the person or persons for whom the services are performed have the right to require compliance with instructions.”
-
Continuing relationship — “A continuing relationship between the worker and the person or persons for whom the services are performed indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals.”
-
Set hours of work — “The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control.”
-
Hiring, supervising, and paying assistants — “If the person or persons for whom the services are performed hire, supervise, and pay assistants, that factor generally shows control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract under which the worker agrees to provide materials and labor and under which the worker is responsible only for the attainment of a result, this factor indicates an independent contractor status.”
-
Working on the employer’s premises — “If the work is performed on the premises of the person or persons for whom the services are performed, that factor suggests control over the worker, especially if the work could be done elsewhere. . . . Work done off the premises of the person or persons receiving the services, such as at the office of the worker, indicates some freedom from control. However, this fact by itself does not mean that the worker is not an employee. The importance of this factor depends on the nature of the service involved and the extent to which an employer generally would require that employees perform such services on the employer’s premises. Control over the place of work is indicated when the person or persons for whom the services are performed have the right to compel the worker to travel a designated route, to canvass a territory within a certain time, or to work at specific places as required.”
-
Full-time employment requirement — “If the worker must devote substantially full time to the business of the person or persons for whom the services are performed, such person or persons have control over the amount of time the worker spends working and impliedly restrict the worker from doing other gainful work. An independent contractor on the other hand, is free to work when and for whom he or she chooses.”
-
Payment — “Payment by the hour, week, or month generally points to an employer-employee relationship, provided that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on a straight commission generally indicates that the worker is an independent contractor.”
See IRS Revenue Ruling 87-41 for additional information about assessing whether an individual is an employee under common law.
2.2.1 Employees of Pass-Through Entities
The ASC master glossary defines share-based payment
arrangements, in part, as follows:
The term shares includes various forms of ownership
interest that may not take the legal form of securities (for example,
partnership interests), as well as other interests, including those that
are liabilities in substance but not in form. Equity shares refers only
to shares that are accounted for as equity.
Since the definition includes awards of pass-through entities
(e.g., partnerships, limited liabilities corporations or limited liability
partnerships), an individual is considered an employee of a pass-through entity
if the individual qualifies as an employee of the entity under common law. The
fact that a pass-through entity does not classify the grantee as an employee for
U.S. payroll tax purposes does not, by itself, indicate that the grantee is not
an employee for accounting purposes.
2.3 Nonemployee Directors
ASC 718-10
Example 2: Definition of Employee
55-89 This Example illustrates the evaluation as to whether an individual meets conditions to be considered an employee under the definition of that term used in this Topic.
55-90 This Topic defines employee as an individual over whom the grantor of a share-based compensation award exercises or has the right to exercise sufficient control to establish an employer-employee relationship based on common law as illustrated in case law and currently under U.S. Internal Revenue Service (IRS) Revenue Ruling 87-41. An example of whether that condition exists follows. Entity A issues options to members of its Advisory Board, which is separate and distinct from Entity A’s board of directors. Members of the Advisory Board are knowledgeable about Entity A’s industry and advise Entity A on matters such as policy development, strategic planning, and product development. The Advisory Board members are appointed for two-year terms and meet four times a year for one day, receiving a fixed number of options for services rendered at each meeting. Based on an evaluation of the relationship between Entity A and the Advisory Board members, Entity A concludes that the Advisory Board members do not meet the common law definition of employee. Accordingly, the awards to the Advisory Board members are accounted for as awards to nonemployees under the provisions of this Topic.
55-91 Nonemployee directors acting in their role as members of an entity’s board of directors shall be treated as employees if those directors were elected by the entity’s shareholders or appointed to a board position that will be filled by shareholder election when the existing term expires. However, that requirement applies only to awards granted to them for their services as directors. Awards granted to those individuals for other services shall be accounted for as awards to nonemployees in accordance with Section 505-50-25. Additionally, consolidated groups may have multiple boards of directors; this guidance applies only to either of the following:
- The nonemployee directors acting in their role as members of a parent entity’s board of directors
- Nonemployee members of a consolidated subsidiary’s board of directors to the extent that those members are elected by shareholders that are not controlled directly or indirectly by the parent or another member of the consolidated group.
Under an exception in ASC 718, a member of an entity’s board of directors who may not meet the common law definition of an employee may be treated as an employee if certain conditions are met.
2.3.1 Parent-Entity Directors
A nonemployee member of a parent entity’s board of directors is treated as an
employee if (1) the director was elected by the entity’s shareholders or (2) the
board position will be subject to shareholder election upon expiration of the
director’s term. (However, see ASC 718-10-55-90 for guidance on awards issued to
members of an advisory board.)
2.3.2 Subsidiary Directors
A nonemployee member of a subsidiary’s board of directors who is granted awards
is treated as an employee in the parent’s
consolidated financial statements if the
individual is granted awards for services as a
member of the parent company’s board of directors
(and meets one of the conditions described in ASC
718-10-55-91 [see the previous section]).
Further, nonemployee members of a consolidated subsidiary’s board of directors
that are granted awards for their director
services to the subsidiary are considered
employees under ASC 718 if they were elected by
minority shareholders who are not directly or
indirectly controlled by the parent or another
member of the consolidated group. Such awards are
accounted for under ASC 718 in the parent
company’s consolidated financial statements and in
the separate financial statements of the
subsidiary. If the directors were not elected by
minority shareholders of the subsidiary (i.e.,
they were elected by the controlling shareholders
or another member of the consolidated group), the
awards should be accounted for as nonemployee
awards under ASC 718 in the parent company’s
consolidated financial statements. However, if
they were elected by the subsidiary’s
shareholders, including controlling shareholders
of the consolidated group, the awards granted for
director services should be accounted for as
awards granted to employees under ASC 718 in the
separate financial statements of the
subsidiary.
2.4 Nonemployee Awards
While most of the guidance on share-based payments granted to nonemployees is
aligned with the requirements for share-based payments granted to employees, there
remain some differences, notably those related to the attribution of compensation
cost and an entity’s election to measure a nonemployee stock option award by using
the contractual term instead of the expected term. See Chapter 9 for additional information about
accounting for nonemployee awards.
Connecting the Dots
If a grantee’s employment status changes from employee to nonemployee, an
entity must consider whether the share-based payment award was modified as a
result of that change. For example, an employee may be granted an
equity-classified share-based payment award under which continued vesting in
the award is permitted notwithstanding a change in employment status (e.g.,
the award will vest as long as the grantee continues to provide services to
the entity, whether as an employee or as an independent contractor). Such an
award would not be modified in connection with the change in employment
status provided that the grantee continues to provide substantive services
to earn the award. The entity would continue to recognize the original
grant-date fair-value-based measure of the award and would recognize the
remaining cost in accordance with the nonemployee recognition guidance (see
Section 9.3.1).
However, an entity may grant an award whose original terms
prohibit the grantee from continuing to vest in the award after a change in
employment status. If the entity modifies such an award concurrently with a
change in employment status to permit continued vesting, that change to the
terms of the award represents a modification. Generally, this would result
in a Type III improbable-to-probable modification (see Section 6.3.3)
because the employee would not have otherwise provided the required service
under the original terms of the award. Accordingly, the modification-date
fair-value-based measure of the award would be recognized in accordance with
the nonemployee recognition guidance (see Section
9.3.1).
2.5 Economic Interest Holders
ASC 718-10
15-4 Share-based payments awarded to a grantee by a related party or other holder of an economic interest in the entity as compensation for goods or services provided to the reporting entity are share-based payment transactions to be accounted for under this Topic unless the transfer is clearly for a purpose other than compensation for goods or services to the reporting entity. The substance of such a transaction is that the economic interest holder makes a capital contribution to the reporting entity, and that entity makes a share-based payment to the grantee in exchange for services rendered or goods received. An example of a situation in which such a transfer is not compensation is a transfer to settle an obligation of the economic interest holder to the grantee that is unrelated to goods or services to be used or consumed in a grantor’s own operations.
ASC 718-10 — Glossary
Economic Interest in an Entity
Any type or form of pecuniary interest or arrangement that an entity could issue or be a party to, including equity securities; financial instruments with characteristics of equity, liabilities, or both; long-term debt and other debt-financing arrangements; leases; and contractual arrangements such as management contracts, service contracts, or intellectual property licenses.
An economic interest holder of a reporting entity may issue share-based payment awards in the reporting entity’s equity for goods or services provided to the reporting entity. If so, the reporting entity typically records the transaction as if it had issued the awards (with a corresponding capital contribution from the economic interest holder) since the entity benefits from the compensation paid to the grantees.
2.5.1 Investor Purchases of Shares From Grantees
On occasion, investors intending to acquire or increase their stake in a
nonpublic entity may purchase shares from the founders of the nonpublic entity
or other individuals who are also considered grantees. The presumption in such
transactions is that any consideration in excess of the fair value of the shares
is compensation paid to grantees. See Section 4.12.3.2 for more information.
2.5.2 Share-Based Payments in an Economic Interest Holder’s Equity
An economic interest holder may issue awards of its own equity to grantees that provide goods or services to a reporting entity (these can be employees of a reporting entity or nonemployees providing goods or services to a reporting entity). An economic interest holder could be, for example, a parent entity, another subsidiary of the parent (e.g., a sister subsidiary), an equity method investor, an unrelated investor, or a third party. If there are various ownership and legal entity structures (particularly partnerships and limited liability companies), it may be difficult for a reporting entity to determine whether the awards are subject to ASC 718 or other U.S. GAAP (e.g., ASC 323 or ASC 815). The determination of which guidance to apply could affect the awards’ classification, measurement, and recognition in the reporting entity’s financial statements as well as the required disclosures. Accordingly, the reporting entity should evaluate the following:
- Which legal entity is issuing the awards and whether the awards are indexed to or settled in that entity’s equity — For example, if awards are settled in the equity of an unrelated investor, they may not be share-based payments of the reporting entity that are accounted for under ASC 718.
- The economic substance of the legal entity issuing the awards — The evaluation should include whether the entity has other substantive (1) investments or operations (outside of its ownership in the reporting entity) and (2) investors. For example, if a legal entity that is an investor in the reporting entity grants awards to employees of the reporting entity but is created solely as a holding company (with no operations) by the reporting entity to issue awards to the reporting entity’s employees, the legal entity’s purpose may be to issue awards to employees that are effectively indexed to the reporting entity’s equity. In this circumstance, issuance of the awards may not be substantively different from the reporting entity’s issuance of equity to its employees. Accordingly, it may be appropriate to account for those awards under ASC 718. See Example 2-5.
- The legal entity’s relationship with the reporting entity — If the legal entity whose equity is the basis for the awards has economic substance other than to issue awards to the reporting entity’s employees or nonemployees, the accounting will depend on that entity’s relationship with the reporting entity. For a discussion of awards issued by an entity to providers of goods or services of another entity within a consolidated group, see Sections 2.8 and 2.9. For a discussion of awards issued by an equity method investor to providers of goods or services of its equity method investee, see Section 2.10.
- Whether the grantees are common law employees of the reporting entity — For example, if a parent entity grants awards of its equity to employees of an entity that is (1) unrelated to the subsidiary reporting entity (e.g., an unrelated management or advisory company) and (2) providing nonemployee services to the reporting entity, the awards may be subject to ASC 718. However, the accounting for nonemployee awards could be different under ASC 718 from that for employee awards (see Chapter 9).
- Whether the reporting entity has an obligation to settle the awards issued — For example, if the reporting entity has an obligation to settle awards granted to its employees or nonemployees in the equity of another entity that is not the reporting entity’s parent, the awards may not be subject to ASC 718. For a discussion of awards issued by a reporting entity that are settled in the equity of an unrelated entity, see Section 2.11.
Example 2-5
Entity C, the reporting entity, is a privately held limited liability company that is wholly owned by Entity B, a limited partnership and holding company with no operations or assets other than its investment in C. Entity B is controlled and consolidated by Entity A, a management company and the general partner, but B is also owned by other investors. The ownership interests are as follows:
- Entity A — 15%
- Other investors — 82%
- Entity D — 3%
Entity D was created by A as a holding company with no operations or assets
other than its investment in B (which also has no
operations or assets other than its investment in C).
Under this structure, recipients of the awards invest
through D (an upper-tier LLC) and remain employees at C
(the lower-tier LLC). Entity D obtained the 3 percent
ownership interest in B solely to grant equity awards
equivalent to its ownership interest in B to certain
employees of C for services provided to C. The
share-based payment awards will be settled in D’s
equity, which is a substantive class of equity that
derives its value entirely from the value of C.
Entity C determines that the equity issued by D is substantively equivalent to its own equity. That is, D’s equity derives its value exclusively from C as a result of D’s 3 percent ownership in B. Entity B’s equity, in turn, derives its value exclusively from B’s 100 percent ownership of C (B and D hold no other assets). Therefore, it is reasonable to conclude that the share-based payment awards issued by D to the employees of C should be accounted for in C’s financial statements under ASC 718 as C’s share-based payment awards since C’s employees effectively received share-based payment awards in C’s equity. That is, in substance and in accordance with ASC 718-10-15-4, D (the economic interest holder) made a capital contribution to C (the reporting entity), and C then made a share-based payment to its employees in exchange for services rendered.
2.6 Profits Interests and Other Awards Issued by Pass-Through Entities
Nonpublic entities such as limited
partnerships, limited liability companies, or similar
pass-through entities may grant special classes of equity,
frequently in the form of “profits interests.” In many
cases, a waterfall calculation is used to determine the
payout to the different classes of shares or units. While
arrangements vary, the waterfall calculation often is
performed to allocate distributions and proceeds to the
profits interests only after specified amounts (e.g.,
multiple of invested capital [MOIC]) or specified returns
(e.g., internal rate of return [IRR] on invested capital)
are first allocated to the other classes of equity. In
addition, future profitability threshold amounts or
“hurdles” must be cleared before the grantee receives
distributions so that, for tax purposes on the grant date,
the award has zero liquidation value. However, the award
would have a fair value in accordance with ASC 718. In
certain cases, distributions on and realization of value
from profits interests are expected only from the proceeds
from a liquidity event such as a sale or IPO of the entity,
provided that the sale or IPO exceeds a target hurdle
rate.
|
While the legal and economic form of these awards can vary, they should be accounted for on the basis of their substance. If an award has the characteristics of an equity interest, it represents a substantive class of equity and should be accounted for under ASC 718; however, an award that is, in substance, a performance bonus or a profit-sharing arrangement would be accounted for as such in accordance with other U.S. GAAP (e.g., typically ASC 710 and ASC 450 for employee arrangements).
In a speech at the December 2006 AICPA Conference on Current SEC and PCAOB Developments, Joseph Ucuzoglu, then a professional accounting fellow in the SEC’s Office of the Chief Accountant, discussed observations of the SEC staff related to special classes of equity and associated financial reporting considerations. Specifically, he stated:
Public companies often create special classes of stock to more closely align the compensation of an employee with the operating performance of a portion of the business with which he or she has oversight responsibility. That is, rather than granting an equity interest in the parent company, employees are granted instruments whose value is based predominantly on the operations of a particular subset of the parent’s operations. The staff has observed the use of these arrangements in diverse industries, ranging from the grant of an interest in a group of restaurants that an employee oversees, to the grant of an interest in a particular investment fund that an employee manages.
Similarly, pre-IPO companies often create special classes of stock to provide employees with an opportunity to participate in any appreciation realized through a future initial public offering or sale of the company, with limited opportunity for gain if no liquidity event occurs. In order to accomplish this objective, the special class is often subordinate in both dividend rights and liquidation preference to the company’s main class of stock, and may have little or no claim to the underlying net assets of the company. In many cases, the terms of these instruments mandate conversion into the entity’s main class of common stock upon the completion of an IPO.
Several accounting issues arise when a special class of stock is granted to employees. First and foremost, one must look through the legal form of the instrument to determine whether the instrument is in fact a substantive class of equity for accounting purposes, or is instead similar to a performance bonus or profit sharing arrangement. When making this determination, all relevant features of the special class must be considered. There are no bright lines or litmus tests. When few if any assets underlie the special class, or the holder’s claim to those assets is heavily subordinated, the arrangement often has characteristics of a performance bonus or profit-sharing arrangement. Instruments that provide the holder with substantive voting rights and pari passu dividend rights are at times indicative of an equity interest. Consideration should also be given to any investment required, and any put and call rights that may limit the employee’s downside risk or provide for cash settlement. Many of these factors were contained in Issues 28 and 40 of EITF Issue 00-23, which provided guidance on the accounting under APB Opinion No. 25 for certain of these arrangements.
When the substance of the instrument is that of a performance bonus or profit sharing arrangement, it should be accounted for as such. In those circumstances, any returns to the employee should be reflected as compensation expense, not as equity distributions or minority interest expense. Further, if the employee remitted consideration at the outset of the arrangement in exchange for the instrument, such consideration should generally be reflected in the balance sheet as a deposit liability.
On the other hand, when the substance of the arrangement is in fact that of a substantive class of equity, questions often arise as to the appropriate valuation of the instrument for the purpose of recording compensation expense pursuant to FASB Statement No. 123R. These instruments, by design, often derive all or substantially all of their value from the right to participate in future share price appreciation or profits. Accordingly, the staff has rejected the use of valuation methodologies that focus predominantly on the amount that would be realized by the holder in a current liquidation, as such an approach fails to capture the substantial upside potential of the security. [Footnotes omitted]
Although Issues 28 and 40 of EITF Issue 00-23 (referred to in the speech above) were superseded and nullified by FASB Statement 123(R) (codified in ASC 718), the
indicators provided in them are useful in the determination of whether profits
interests represent a substantive class of equity. Those indicators, as well as
others, include:
- The legal form of the instrument (a profits interest can only be a substantive class of equity if it is legal form equity).
- Distribution rights, particularly after vesting.
- Claims to the residual assets of the entity upon liquidation.
- Substantive net assets underlying the interest.
- Retention of vested interests upon termination.
- Any investment required to purchase the shares or units.
- Transferability after vesting.
- Voting rights commensurate with those of other substantive equity holders.
- An entity’s intent in issuing the interest (i.e., whether the entity is attempting to align the holder’s interests with those of other substantive equity holders).
- Provisions for realization of value.
- Repurchase features that may affect exposure to risks and rewards.
A key focus in the determination of whether profits interests represent a substantive class of equity is the ability to retain residual interests upon vesting, including after termination. This includes the ability to realize value that is tied to the underlying value of the entity’s net assets, through distributions that are based on an entity’s profitability and operations as well as on any liquidity event (even if through a lower level of waterfall distributions). By contrast, in a profit-sharing arrangement, a grantee typically is only able to participate in the entity’s profits while providing goods or services to the entity, and a residual interest is not retained upon termination. A profit-sharing arrangement may also contain provisions (e.g., repurchase features) that limit the grantee’s risks and rewards (e.g., a repurchase feature that, upon termination of employment, is at cost or a nominal amount).
In addition, not all the indicators described above are given equal weight. While voting rights and transferability may be indicative of an equity interest, the absence of such features would not preclude the interest from being considered a substantive class of equity. Nonpublic entities frequently issue equity interests that lack voting rights (particularly to noncontrolling interest holders) and have transferability restrictions. Further, if a grantee does not make an initial investment to purchase an equity interest, the equity interest may still be a substantive class of equity. In that circumstance, consideration for the shares or units is in the form of goods or services.
In determining whether a vested residual interest is retained after termination,
an entity typically focuses on what happens to the interest if the grantee is an
employee who voluntarily terminates employment without good reason3 or if the grantee is a nonemployee who ceases to provide goods or services.
For example, if an employee award is legally vested but is substantively forfeited
upon voluntary termination without good reason (e.g., the entity can repurchase the
legally vested award at the lower of cost or fair value upon such termination
event), the award will most likely be a profit-sharing arrangement (see Section 3.4.3 for a
discussion of repurchase features that function as vesting conditions). By contrast,
if an employee award is legally vested but substantively forfeited only upon
termination for cause (e.g., the entity can repurchase the legally vested award at
the lower of cost or fair value upon such termination event), that feature would not
affect the analysis since it functions as a clawback provision (see Section 3.9 for a discussion
of repurchase features that function as clawback provisions).
An entity should consider the substance of an award rather than its form. For example, an award may legally vest immediately under an agreement; however, the vesting may not be substantive if the award cannot be transferred or otherwise monetized until an IPO occurs and the entity can repurchase the award for no consideration if the grantee terminates employment or ceases to provide goods or services before the IPO. We would most likely conclude that such an award has a substantive performance condition that affects vesting (i.e., an IPO is a vesting condition) even though the award was deemed “immediately vested” according to the agreement.
Changing Lanes
On May 11, 2023, the FASB issued a proposed ASU that would clarify how an
entity determines whether it is required to account for profits interest
awards (and similar awards) in accordance with ASC 718 or other guidance.
The proposed ASU would add to U.S. GAAP an example illustrating four
scenarios in which an entity applies the scope criteria in ASC 718-10-15-3
to determine whether to account for a profits interest award in accordance
with ASC 718. The illustrative example is intended to reduce (1) complexity
in the determination of whether a profits interest award is subject to the
guidance in ASC 718 and (2) diversity in practice. For further details on
this project, see Deloitte’s May 12, 2023, Heads Up.
From a valuation standpoint, nonpublic entities might consider whether the profits interests that represent a substantive class of equity have no value on the grant date. For example, if the entity were liquidated on the grant date, the waterfall calculation would result in no payment to the special class. However, in a manner consistent with the SEC staff’s speech above, the profits interests generally have a fair value because of the upside potential of the equity.
Connecting the Dots
Once a nonpublic entity concludes that the profits interests
are subject to the guidance in ASC 718 because they represent a substantive
class of equity, the entity would next need to assess the conditions in ASC
718-10-25-6 through 25-19A to determine whether the award should be equity-
or liability-classified. See Chapter 5 for a detailed discussion of
how to determine the classification of awards.
Footnotes
3
A significant demotion, a significant reduction in
compensation, or a significant relocation are commonly considered “good
reasons” for termination.
2.7 Rabbi Trusts
Many entities have arrangements that allow their employees to defer some or all
of their earned compensation (i.e., salary or bonus). Sometimes the employer uses a
“rabbi trust”4 to hold assets from which nonqualified deferred compensation payments will be
made. ASC 710 provides guidance on deferred compensation arrangements in which
assets equal to compensation amounts earned by employees are placed in a rabbi
trust. Such arrangements often permit employees to diversify their accounts by
investing in cash, the employer’s stock, nonemployer securities, or a combination of
these options. In all cases, the employer consolidates the rabbi trust in the
employer’s financial statements.
The guidance in ASC 710 refers to
four types of deferred compensation arrangements involving rabbi trusts. These four
arrangement types, known as plans A, B, C, and D, differ on the basis of whether the
plan permits diversification, whether the employee has elected to diversify, and the
allowable forms of settlement:
Plan
|
Diversification
|
Settlement Options Permitted Under Plan
|
---|---|---|
A
|
Not permitted
|
Delivery of a fixed number of shares of employer stock
|
B
|
Not permitted
|
Delivery of cash or shares of employer stock
|
C
|
Permitted, but employee has not diversified
|
Delivery of cash, shares of employer stock, or diversified
assets
|
D
|
Permitted, and employee has diversified
|
Delivery of cash, shares of employer stock, or diversified
assets
|
Deferred compensation arrangements in which the amounts earned are indexed to,
or can be settled in, an entity’s own stock before being placed into a rabbi trust
are within the scope of ASC 718. When the amounts earned in a deferred compensation
arrangement (1) are within the scope of ASC 718 before being placed into a rabbi
trust and (2) can be settled only in the employer’s stock (i.e., Plan A), the
arrangement would be accounted for as an equity award under ASC 718 before the
amounts earned are placed into the trust (provided that all other criteria for
equity classification have been met). In addition, the deferred compensation
arrangement would remain classified in equity and would therefore not need to be
remeasured under ASC 710 after the amounts earned are placed into the rabbi
trust.
Similarly, when the amounts earned in a deferred compensation
arrangement (1) are within the scope of ASC 718 before being placed into a rabbi
trust and (2) can be settled only in the employer’s stock or cash at the election of
the employee (i.e., Plan B), the arrangement may be accounted for as a liability or
equity award under ASC 718 before the amounts earned are placed into the trust. The
deferred compensation arrangement would be classified as a liability after the
amounts earned are placed into the rabbi trust.
For all other deferred compensation arrangements in which amounts earned are placed into a rabbi trust, the accounting depends on the terms of the arrangement and on whether the arrangement is viewed either as one plan or as substantively consisting of two plans.
Connecting the Dots
For all plans except Plan A, SEC registrants (or entities electing to apply
SEC requirements) should consider ASR 268 and ASC 480-10-S99-3A, as
discussed in SAB Topic 14.E, under which presentation must occur outside of
permanent equity (i.e., as temporary or mezzanine equity) when redemption is
outside the control of the entity. See Section
5.10 for discussion on the SEC guidance on temporary
equity.
2.7.1 Accounting for a Deferred Compensation Arrangement as Two Plans (Plans C and D)
For an arrangement to be viewed as substantively consisting of two plans, the
following two criteria must be met:
-
There must be a reasonable period within which the employee is required to be subjected to the risks and rewards of ownership (i.e., to all the stock price movements of the employer’s stock). ASC 718-10-25-9 defines this period as six months or more. Accordingly, once the share-based payment award is vested, it would need to remain indexed to the employer’s stock for at least six months. After six months, the employee could liquidate the employer’s stock into a diversified account (i.e., a rabbi trust), which would be the beginning of the deferred compensation arrangement.
-
The option to defer the amounts earned under the share-based payment award must be entirely elective. If the employee is forced into a diversified account (i.e., a rabbi trust), the award would most likely be considered mandatorily redeemable under ASC 480. That is, the deferred compensation arrangement would have to be classified as a liability. Therefore, if the employee is “forced” to accept a liability in satisfaction of the share-based payment award, redemption is deemed mandatory. Accordingly, the entire arrangement would be accounted for as a liability from the grant date of the share-based payment award and not just from the beginning of the deferred compensation arrangement.
If the above two criteria are met, the deferred compensation
arrangement is viewed as a share-based payment arrangement that is subsequently
“converted” into a diversified deferred compensation arrangement (i.e., two
plans). Accordingly, an entity applies the guidance in ASC 718 until the amounts
earned are placed into the rabbi trust (“the share-based payment award”) and
then applies the guidance in ASC 710 until the deferred amounts are received by
the employee (“the deferred compensation arrangement”).
However, if the above two criteria are met and equity classification is achieved from the grant date of the share-based payment award until the amounts earned are placed into the rabbi trust, a public entity also must consider the guidance in ASR 268 (FRR Section 211) and ASC 480-10-S99-3A. ASC 480-10-S99-3A addresses share-based payment arrangements with employees whose terms may permit redemption of the employer’s shares for cash or other assets. Since the distribution of the amounts earned under the share-based payment award into a diversified account is viewed as settlement in cash or other assets (i.e., because the deferred compensation obligation must be classified as a liability pursuant to ASC 710 once the amounts are placed into the rabbi trust), the share-based payment award would be subject to the guidance in ASC 480-10-S99-3A. The guidance in ASC 480-10-S99-3A requires classification in temporary (mezzanine) equity from the grant date of the share-based payment award until the beginning of the deferred compensation arrangement. At the beginning of the deferred compensation arrangement, the amounts placed into the rabbi trust would be classified as a liability under ASC 710.
2.7.2 Accounting for a Deferred Compensation Arrangement as One Plan (Plans C and D)
If the two criteria in the previous section are not met, the deferred
compensation arrangement is viewed as one plan. When an arrangement is viewed as
one plan, the diversification option would result in liability classification
under ASC 718 for the share-based payment award from the grant date to the date
the amounts earned are placed into the rabbi trust. Under ASC 718, an award that
allows an employee to diversify outside of the employer’s stock would be indexed
to something other than a market, performance, or service condition (i.e., the
ultimate value received by the employee also is indexed to the performance of
the assets into which they diversified). In accordance with ASC 718-10-25-13, an
arrangement that is indexed to an “other” condition is classified as a
share-based liability irrespective of whether the employee ultimately receives
cash, other assets, or the employer’s stock. (See Chapter 7 for more detailed guidance on
the accounting treatment of liability awards.) Accordingly, the deferred
compensation arrangement would be classified as a share-based liability from the
grant date until the amounts earned are placed into the rabbi trust. Once placed
into the rabbi trust, the amounts earned would be classified as a liability
pursuant to ASC 710 until the deferred amounts are received by the employee.
Footnotes
4
Rabbi trusts are generally used as funding vehicles to
provide for the deferral of taxation to the employee receiving the
compensation. That is, in a nonqualified deferred compensation plan,
employees defer the receipt of compensation amounts earned by placing the
amounts earned in a rabbi trust. By deferring receipt of the amounts earned,
the employees are also deferring the taxability of those amounts. The
employees will be subsequently taxed upon receiving the amounts that have
been placed in the rabbi trust.
2.8 Consolidated Financial Statements
Share-based payment awards issued to grantees of entities within a consolidated group include, for example, awards that a parent grants to its subsidiary’s employees or nonemployees and that are indexed to or settled in the parent’s equity instruments. A consolidated subsidiary may also grant share-based payment awards to employees or nonemployees of the parent or another subsidiary that are indexed to or settled in the equity of the consolidated subsidiary. In the consolidated financial statements, because the share-based payment awards are issued to employees or nonemployees of the consolidated group and indexed to or settled in the equity of an entity within the consolidated group, the awards are within the scope of ASC 718.
While FASB Statement 123(R) (codified in ASC 718) nullified FASB Interpretation 44, paragraph 11 of Interpretation 44 remains applicable by analogy. It stated, in part:
In consolidated financial statements, the evaluation of whether a grantee is an employee under Opinion 25 is made at the consolidated group level and stock compensation based on the stock of a subsidiary is deemed to be stock compensation based on the stock of the consolidated group (the employer). Therefore, in the consolidated financial statements, stock compensation granted based on the stock of any consolidated group member shall be accounted for under Opinion 25 if the grantee meets the definition of an employee for any entity in the consolidated group. For example, Opinion 25 applies to the accounting in the consolidated financial statements for awards based on parent stock granted to employees of a (consolidated) subsidiary and to awards in stock of a (consolidated) subsidiary granted to employees of the parent. Also, Opinion 25 applies to the accounting in the consolidated financial statements for awards based on a subsidiary’s stock granted to the employees of another subsidiary. This guidance applies only to consolidated financial statements. [Emphasis added]
Accordingly, the parent entity accounts for the awards under ASC 718 when preparing its consolidated financial statements.
2.9 Separate Financial Statements
The accounting for share-based payment transactions in the separate financial
statements of each entity within a consolidated group is somewhat complicated.
Before FASB Statement 123(R) (codified in ASC 718), entities applied the guidance in
Question 4 of FASB Interpretation 44 and Issues 21 and 22 of EITF Issue 00-23 when
accounting for such transactions. Although FASB Statement 123(R) (codified in ASC
718) subsequently superseded and nullified Interpretation 44 and Issue 00-23,
entities should continue to analogize to this guidance when accounting for
consolidated-group share-based payment transactions.
The share-based payment awards of a consolidated subsidiary that are issued to employees of that subsidiary and are indexed to and settled in equity of the subsidiary’s parent are within the scope of ASC 718. Although ASC 718 does not specifically address such awards, they would be within the scope of ASC 718 by analogy to paragraph 14 of Interpretation 44. Paragraph 14 states, in part:
[A]n exception is made to require the application of Opinion 25 to stock compensation based on stock of the parent company granted to employees of a consolidated subsidiary for purposes of reporting in the separate financial statements of that subsidiary. The exception applies only to stock compensation based on stock of the parent company (accounted for under Opinion 25 in the consolidated financial statements) granted to employees of an entity that is part of the consolidated group. [Emphasis added]
Under the exception in Interpretation 44, an entity treated the stock of the parent entity as though it were the stock of the consolidated subsidiary when reporting in the separate financial statements of the subsidiary. We believe that the same analogy can be applied to awards granted to the subsidiary’s nonemployee providers of goods or services. The exception did not, however, extend to share-based payment awards “granted (a) to the subsidiary’s employees based on the stock of another subsidiary in the consolidated group or (b) by the subsidiary to employees of the parent or another subsidiary.” Therefore, the share-based payment awards of a consolidated subsidiary that reports separate financial statements and grants such awards to employees or nonemployees of the parent or another subsidiary, and that are indexed to and settled in the equity of the consolidated subsidiary, are not within the scope of ASC 718.
Neither Interpretation 44 nor ASC 718 specifically addresses the accounting for these awards. Such guidance is contained in Issue 21 of EITF Issue 00-23. The conclusion in Issue 21 of EITF Issue 00-23 states that the parent (controlling entity) can always direct subsidiaries (controlled entities) within the consolidated group to grant share-based payment awards to the parent’s employees and to the employees of other subsidiaries in the consolidated group. Therefore, in its separate financial statements, the subsidiary granting the awards measures the awards at their fair-value-based measure as of the grant date. That amount is recognized as a dividend from the subsidiary to the parent; a corresponding amount is recognized as equity. The EITF’s reasoning is as follows:
Because the controlling entity has the discretion to require entities it controls to enter into a variety of transactions, recognizing the transaction as a dividend more closely mirrors the economics of the arrangement because it will not be clear that the entity granting the stock compensation has received goods or services in return for that grant, and if so, whether the fair value of those goods or services approximates the value of the equity awards.
Likewise, share-based payment awards that are issued to employees or nonemployees of a subsidiary and indexed to and settled in another subsidiary’s equity are also not within the scope of ASC 718. In its separate financial statements, the subsidiary issuing the awards would apply the guidance in Issue 21 of EITF Issue 00-23 because the parent (controlling entity) can always direct subsidiaries (controlled entities) within the consolidated group to grant share-based payment awards to its employees or nonemployees and to the employees or nonemployees of other subsidiaries in the consolidated group. In theory, the subsidiary granting the share-based payment award is accounting for the grant as if the awards were issued to the parent and as if, after receiving the awards, the parent issues the same awards to another subsidiary within the consolidated group. Therefore, in its separate financial statements, the subsidiary issuing the awards measures the awards at their fair-value-based measure as of the grant date. That amount is recognized as a dividend from the subsidiary to the parent; a corresponding amount is recognized as equity.
In addition, in its separate financial statements, the subsidiary whose employees or nonemployees are receiving the awards would apply the guidance in Issue 22 of EITF Issue 00-23, which specifies that the awards are accounted for as compensation cost on the basis of their fair value. We believe that in a manner similar to the entity issuing the awards, if the subsidiary whose employees or nonemployees are receiving the awards has no obligation to settle those awards, it is acceptable to measure the awards at their fair-value-based measure as of the grant date. The subsidiary would also account for the offsetting entry to compensation cost as a credit to equity (i.e., a capital contribution from or on behalf of the parent). By contrast, if the subsidiary whose employees or nonemployees are receiving the awards has an obligation to settle those awards, the awards generally would be accounted for under ASC 815 (see Section 2.11).
The table below summarizes the accounting for awards in a parent’s consolidated financial statements and the separate financial statements of its wholly owned subsidiaries, A and B, in three scenarios.
Awards
|
Parent’s Consolidated Financial
Statements
|
Subsidiary A’s Separate Financial
Statements
|
Subsidiary B’s Separate Financial
Statements
|
---|---|---|---|
Share-based payment awards issued to
employees/nonemployees of A and indexed to and settled in
the parent’s equity
|
The awards are accounted for as share-based
payment awards within the scope of ASC 718.
|
The awards are within the scope of ASC 718.
Compensation cost for the awards is recognized at their
fair-value-based measure as of the grant date.
If A does not reimburse the parent for the
awards, it makes an offsetting entry to equity to represent
a capital contribution by the parent.
|
N/A
|
Share-based payment awards issued to the
parent’s employees/nonemployees and indexed to and settled
in A’s equity
|
The awards are accounted for as share-based
payment awards within the scope of ASC 718.
|
The awards are not within the scope of ASC
718. Subsidiary A measures the awards at their
fair-value-based measure as of the grant date and recognizes
that amount as a dividend from itself to the parent; it
recognizes a corresponding amount as equity.
|
N/A
|
Share-based payment awards issued to
employees/nonemployees of B and indexed to and settled in
A’s equity
|
The awards are accounted for as share-based
payment awards within the scope of ASC 718.
|
The awards are not within the scope of ASC
718. Subsidiary A accounts for them as if (1) they were
issued to the parent and (2) the parent then issued them to
B. Subsidiary A measures the awards at their
fair-value-based measure as of the grant date and recognizes
that amount as a dividend from itself to the parent; it
recognizes a corresponding amount as equity.
|
Subsidiary B recognizes compensation cost
for the awards at their fair-value-based measure as of the
grant date if it does not have an obligation to settle the
awards. It accounts for the offsetting entry to compensation
cost as a credit to equity (i.e., a capital contribution
from or on behalf of the parent). If it has an obligation to
settle the awards, it would generally apply ASC 815.
|
2.10 Equity Method Investments
ASC 505-10
25-3 Paragraphs 323-10-25-3 through 25-5 provide guidance on accounting for share-based compensation granted by an investor to employees or nonemployees of an equity method investee that provide goods or services to the investee that are used or consumed in the investee’s operations. An investee shall recognize the costs of the share-based payment incurred by the investor on its behalf, and a corresponding capital contribution, as the costs are incurred on its behalf (that is, in the same period(s) as if the investor had paid cash to employees and nonemployees of the investee following the guidance in Topic 718 on stock compensation.
ASC 323-10
Stock-Based Compensation Granted to Employees and Nonemployees of an Equity Method Investee
25-3 Paragraphs 323-10-25-4
through 25-6 provide guidance on accounting for
share-based payment awards granted by an investor
to employees or nonemployees of an equity method
investee that provide goods or services to the
investee that are used or consumed in the
investee’s operations when no proportionate
funding by the other investors occurs and the
investor does not receive any increase in the
investor’s relative ownership percentage of the
investee. That guidance assumes that the
investor’s grant of share-based payment awards to
employees or nonemployees of the equity method
investee was not agreed to in connection with the
investor’s acquisition of an interest in the
investee. That guidance applies to share-based
payment awards granted to employees or
nonemployees of an investee by an investor based
on that investor’s stock (that is, stock of the
investor or other equity instruments indexed to,
and potentially settled in, stock of the
investor).
25-4 In the circumstances
described in paragraph 323-10-25-3, a contributing
investor shall expense the cost of share-based
payment awards granted to employees and
nonemployees of an equity method investee as
incurred (that is, in the same period the costs
are recognized by the investee) to the extent that
the investor’s claim on the investee’s book value
has not been increased.
25-5 In the circumstances described in paragraph 323-10-25-3, other equity method investors in an investee (that is, noncontributing investors) shall recognize income equal to the amount that their interest in the investee's net book value has increased (that is, their percentage share of the contributed capital recognized by the investee) as a result of the disproportionate funding of the compensation costs. Further, those other equity method investors shall recognize their percentage share of earnings or losses in the investee (inclusive of any expense recognized by the investee for the share-based compensation funded on its behalf).
25-6 Example 2 (see paragraph 323-10-55-19) illustrates the application of this guidance for share-based compensation granted to employees of an equity method investee.
Share-Based Compensation Granted to Employees and Nonemployees of an Equity Method Investee
30-3 Share-based compensation cost recognized in accordance with paragraph 323-10-25-4 shall be measured initially at fair value in accordance with Topic 718. Example 2 (see paragraph 323-10-55-19) illustrates the application of this guidance.
Example 2: Share-Based Compensation Granted to Employees of an Equity Method Investee
55-19 This Example illustrates the guidance in paragraphs 323-10-25-3 and 323-10-30-3 for share-based compensation by an investor granted to employees of an equity method investee. This Example is equally applicable to share-based awards granted by an investor to nonemployees that provide goods or services to an equity method investee that are used or consumed in the investee’s operations.
55-20 Entity A owns a 40 percent interest in Entity B and accounts for its investment under the equity method. On January 1, 20X1, Entity A grants 10,000 stock options (in the stock of Entity A) to employees of Entity B. The stock options cliff-vest in three years. If an employee of Entity B fails to vest in a stock option, the option is returned to Entity A (that is, Entity B does not retain the underlying stock). The owners of the remaining 60 percent interest in Entity B have not shared in the funding of the stock options granted to employees of Entity B on any basis and Entity A was not obligated to grant the stock options under any preexisting agreement with Entity B or the other investors. Entity B will capitalize the share-based compensation costs recognized over the first year of the three-year vesting period as part of the cost of an internally constructed fixed asset (the internally constructed fixed asset will be completed on December 31, 20X1).
55-21 Before granting the
stock options, Entity A’s investment balance is
$800,000, and the book value of Entity B’s net
assets equals $2,000,000. Entity B will not begin
depreciating the internally constructed fixed
asset until it is complete and ready for its
intended use and, therefore, no related
depreciation expense (or compensation expense
relating to the stock options) will be recognized
between January 1, 20X1, and December 31, 20X1.
For the years ending December 31, 20X2, and
December 31, 20X3, Entity B will recognize
depreciation expense (on the internally
constructed fixed asset) and compensation expense
(for the cost of the stock options relating to
Years 2 and 3 of the vesting period). After
recognizing those expenses, Entity B has net
income of $200,000 for the fiscal years ending
December 31, 20X1, December 31, 20X2, and December
31, 20X3.
55-22 Entity C also owns a 40
percent interest in Entity B. On January 1, 20X1,
before granting the stock options, Entity C’s
investment balance is $800,000.
55-23 Assume that the fair value of the stock options granted by Entity A to employees of Entity B is $120,000 on January 1, 20X1. Under Topic 718, the fair value of share-based compensation should be measured at the grant date. This Example assumes that the stock options issued are classified as equity and ignores the effect of forfeitures.
55-24 Entity A would make the following journal entries.
55-25 A rollforward of Entity B’s net assets and a reconciliation to Entity A’s and Entity C’s ending investment accounts follows.
55-26 A summary of the
calculation of share-based compensation cost by year
follows.
Share-based payment awards may be (1) issued by an equity method investor to
employees or nonemployees of an equity method investee and (2) indexed to, or
settled in, the equity of the investor. ASC 323-10-25-3 through 25-5 and ASC
505-10-25-3 address the accounting related to the financial statements of the equity
method investor, the equity method investee, and the noncontributing investor(s).
This guidance does not apply to share-based payment awards issued to grantees for
goods or services provided to the investor that are indexed to, or settled in, the
equity of the investee (as opposed to the equity of the investor). See Section 2.11 for further guidance on the accounting
for awards that are issued to grantees and indexed to and settled in shares of an
unrelated entity.
Note that the guidance in U.S. GAAP does not address an investee’s reimbursements to the contributing investor. Sections 2.10.4 through 2.10.6 discuss this scenario; however, there may be other acceptable views on the contributing investor’s, investee’s, and noncontributing investor’s accounting for such reimbursements.
2.10.1 Accounting in the Financial Statements of the Contributing Investor Issuing the Awards
ASC 323-10-25-3 and 25-4 indicate that an investor should recognize (1) the
entire cost (not just the portion of the cost associated with the investor’s
ownership interest) of share-based payment awards granted to employees or
nonemployees of an investee as an expense and (2) a corresponding amount in the
investor’s equity. However, the cost associated with the investor’s ownership
interest will be recognized as an expense when it records its share of the
investee’s earnings (because its share of the investee’s earnings includes the
awards’ expense). In addition, the entire cost (and corresponding equity) should
be recorded as incurred (i.e., in the same period(s) as if the investor had paid
cash to the investee’s employees or nonemployees). The cost of the share-based
payment awards is a fair-value-based amount that is consistent with the guidance
in ASC 718. As noted in ASC 323-10-S99-4, “[i]nvestors that are SEC registrants
should classify any income or expense resulting from application of this
guidance in the same income statement caption as the equity in earnings (or
losses) of the investee.” Although ASC 323-10-S99-4 refers to SEC registrants,
reporting entities that are not SEC registrants should consider applying the
same guidance.
2.10.2 Accounting in the Financial Statements of the Investee Receiving the Awards
ASC 505-10-25-3 indicates that an investee should recognize (1) the entire cost
of share-based payment awards incurred by the investor on the investee’s behalf
as compensation cost and (2) a corresponding amount as a capital contribution.
The cost of the share-based payment awards is a fair-value-based amount that is
consistent with the guidance in ASC 718. In addition, the compensation cost (and
corresponding capital contribution) should be recorded as incurred (i.e., in the
same period(s) as if the investor had paid cash to the investee’s employees or
nonemployees).
2.10.3 Accounting in the Financial Statements of the Noncontributing Investors
ASC 323-10-25-5 states that noncontributing investors “shall recognize income equal to the amount that their interest in the investee’s net book value has increased (that is, their percentage share of the contributed capital recognized by the investee)” as a result of the capital contribution by the investor issuing the awards. In addition, the noncontributing investors “shall recognize their percentage share of earnings or losses in the investee (inclusive of any expense recognized by the investee for the share-based compensation funded on its behalf).” That is, the noncontributing investors should recognize their share of the earnings or losses of the investee (including the compensation cost recognized for the share-based payment awards issued by the equity method investor) in accordance with ASC 323-10. As noted in ASC 323-10-S99-4, “[i]nvestors that are SEC registrants should classify any income or expense resulting from application of this guidance in the same income statement caption as the equity in earnings (or losses) of the investee.” Although ASC 323-10-S99-4 refers to SEC registrants, reporting entities that are not SEC registrants should consider applying the same guidance.
2.10.4 Accounting in the Financial Statements of the Contributing Investor Receiving the Reimbursement
If an investee reimburses a contributing investor for share-based payment awards, the contributing investor generally records income, with a corresponding amount recorded in equity, in the same periods as the cost that is recognized for issuing the awards. Therefore, the issuance of the awards by the contributing investor and the subsequent reimbursement by the investee may not affect the net income (loss) of the contributing investor. That is, if the reimbursement received by the investor equals the compensation cost recognized for the awards granted, the cost of issuing the awards and the income for the reimbursement of the awards will be equal and offsetting and will be recorded in the same reporting periods in the contributing investor’s income statement.
2.10.5 Accounting in the Financial Statements of the Investee Receiving the Awards and Making the Reimbursement
If an investee reimburses a contributing investor for share-based payment awards, the investee generally accrues a dividend to the contributing investor for the amount of the reimbursement in the same periods as the capital contribution from the contributing investor. The recognition of a dividend is generally appropriate given that the issuance of the awards resulted in a capital contribution from the contributing investor.
2.10.6 Accounting in the Financial Statements of the Noncontributing Investors (When the Investee Reimburses the Contributing Investor)
If an investee reimburses a contributing investor for share-based payment awards, the noncontributing investor or investors generally recognize a loss equal to the amount that their interest in the investee’s net book value has decreased (i.e., their percentage share of the distributed capital recognized by the investee) as a result of the reimbursement to the contributing investor. The recognition of a loss by the noncontributing investors is appropriate given that their interest in the investee’s net book value has decreased as a result of the reimbursement provided to the investor issuing the awards.
2.11 Unrelated Entity Awards
ASC 815-10
Options Granted to Employees and Nonemployees
45-10 Subsequent changes in the fair value of an option that was granted to a grantee and is subject to or became subject to this Subtopic shall be included in the determination of net income. (See paragraphs 815-10-55-46 through 55-48A and 815-10-55-54 through 55-55 for discussion of such an option.) Changes in fair value of the option award before vesting shall be characterized as compensation cost in the grantor’s income statement. Changes in fair value of the option award after vesting may be reflected elsewhere in the grantor’s income statement.
Equity Options Issued to Employees and Nonemployees
55-46 Some entities issue stock options to grantees in which the underlying shares are stock of an unrelated entity. Consider the following example:
- Entity A awards an option to a grantee.
- The terms of the option award provide that, if the grantee continues to provide services to Entity A for 3 years, the grantee may exercise the option and purchase 1 share of common stock of Entity B, a publicly traded entity, for $10 from Entity A.
- Entity B is unrelated to Entity A and, therefore, is not a subsidiary or accounted for by the equity method.
55-47 The option award in this example is not within the scope of Topic 718 because the underlying stock is not an equity instrument of the grantor.
55-48 The option award is not subject to Topic 718. Rather, the option award in the example in paragraph 815-10-55-46 meets the definition of a derivative instrument in this Subtopic and, therefore, should be accounted for by the grantor as a derivative instrument under this Subtopic. After vesting, the option award would continue to be accounted for as a derivative instrument under this Subtopic.
Stock options that are indexed to and settled in shares of an unrelated,
publicly traded entity are outside the scope of ASC 718. Such options are recorded
at fair value5 as liabilities at inception, with changes in fair value recorded in earnings.
If the options are indexed to and settled in shares of an unrelated,
non-publicly-traded entity, the same accounting applies by analogy6 to ASC 815-10-45-10 and ASC 815-10-55-46 through 55-48. In addition, EITF
Issue 08-8 states, in part:
The SEC Observer reiterated the SEC
staff’s longstanding position that written options that do not qualify for
equity classification should be reported at fair value and subsequently marked
to fair value through earnings.
ASC 815-10-45-10 requires that the entire change in fair value of the stock options before vesting be immediately characterized as compensation cost; however, changes in fair value after vesting may be reflected elsewhere in the entity’s income statement. ASC 815-10-45-10 and ASC 815-10-55-46 through 55-48 do not provide guidance on accounting for the corresponding debit associated with recognition of the entire derivative liability that will be recorded as of the issuance date of the stock options. However, ASC 815-10-45-10 and ASC 815-10-55-46 through 55-48 imply that these stock options are considered compensation to grantees; therefore, the initial debit upon recording the stock options at fair value is a prepaid compensation asset, with attribution of the issuance-date fair value recognized over the requisite service period. The prepaid compensation asset is not adjusted for subsequent changes in the fair value of the stock options. That is, any changes made to the fair value after the initial measurement of the prepaid compensation asset will not be reflected as additional prepaid compensation but will instead be recognized immediately as an expense (either compensation cost for changes in the fair value of the award before vesting or classification as something other than compensation cost for changes in the fair value of the award after vesting), with a corresponding debit or credit to the derivative liability.
The guidance above also applies to restricted stock that is indexed to and settled in shares of an unrelated entity.
Example 2-6
On January 1, 20X1, Entity A issues restricted stock to an employee. The terms of the award indicate that if the employee remains employed by A for three years, the employee will receive 20 shares of common stock of Entity B, an unrelated publicly traded entity, from A. The fair value of the award on January 1, 20X1, and December 31, 20X1, was $300 and $325, respectively. The following journal entries reflect the accounting for the award:
Because instruments that are indexed to and settled in shares of an unrelated
entity and that are issued to grantees for goods or services are not within the
scope of ASC 718, entities are not permitted to account for forfeitures of these
instruments in accordance with the guidance on share-based payment awards in ASC
718. The likelihood that the grantees will forfeit the awards is factored into the
fair value measurement7 of such instruments at the end of each reporting period.
Example 2-7
On January 1, 20X1, Entity A issues restricted stock to an employee. The terms of the award indicate that if the employee remains employed by A for three years, the employee will receive 20 shares of common stock of Entity B, an unrelated publicly traded entity, from A. The fair value of the award on January 1, 20X1, and December 31, 20X1, was $300 and $325, respectively. On January 1, 20X2, the employee resigns and forfeits the award. The following journal entries reflect the accounting for the award:
Footnotes
5
Because the stock options are not within the scope of ASC
718, “fair value” in this context refers to fair value as determined in
accordance with ASC 820, not to fair-value-based measurement under ASC
718.
6
In this scenario, an entity should apply ASC 815-10-45-10
and ASC 815-10-55-46 through 55-48 to the stock options by analogy rather
than directly because the stock options involve an underlying that is a
non-publicly-traded share of an unrelated entity, while the stock options in
ASC 815-10-45-10 and ASC 815-10-55-46 through 55-48 involve an underlying
that is a publicly traded share of an unrelated entity (and that therefore
meets the definition of a derivative, since it can be net settled in
accordance with ASC 815-10-15-83). Often, option awards on
non-publicly-traded shares of an unrelated entity will not meet the net
settlement criteria of ASC 815-10-15-83 because of the lack of (1) explicit
net settlement, (2) a market mechanism to net settle the options, and (3)
delivery of shares that are readily convertible to cash (since the shares
are not publicly traded). However, because there is no specific guidance in
the accounting literature on accounting for stock options that are indexed
to and settled in shares of an unrelated non-publicly-traded entity, the
fair value accounting in ASC 815-10-45-10 and ASC 815-10-55-46 through 55-48
is appropriate by analogy (since the stock options are outside the scope of
ASC 718, as discussed above), even though they do not meet the definition of
a derivative in ASC 815.
7
Because the instruments are not within the scope of ASC 718,
“fair value” in this context refers to fair value as determined in
accordance with ASC 820, not to fair-value-based measurement under ASC
718.
2.12 Escrowed Share Arrangements
ASC 718-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Escrowed Share Arrangements and the Presumption of Compensation
S99-2
This SEC staff announcement provides the SEC staff’s views
regarding Escrowed Share Arrangements and the Presumption of
Compensation.
The SEC Observer made the following announcement of the SEC
staff’s position on escrowed share arrangements. The SEC
Observer has been asked to clarify SEC staff views on
overcoming the presumption that for certain shareholders
these arrangements represent compensation.
Historically, the SEC staff has expressed the view that an
escrowed share arrangement involving the release of shares
to certain shareholders based on performance-related
criteria is presumed to be compensatory, equivalent to a
reverse stock split followed by the grant of a restricted
stock award under a performance-based
plan.FN1
When evaluating whether the presumption of compensation has
been overcome, registrants should consider the substance of
the arrangement, including whether the arrangement was
entered into for purposes unrelated to, and not contingent
upon, continued employment. For example, as a condition of a
financing transaction, investors may request that specific
significant shareholders, who also may be officers or
directors, participate in an escrowed share arrangement. If
the escrowed shares will be released or canceled without
regard to continued employment, specific facts and
circumstances may indicate that the arrangement is in
substance an inducement made to facilitate the transaction
on behalf of the company, rather than as compensatory. In
such cases, the SEC staff generally believes that the
arrangement should be recognized and measured according to
its nature and reflected as a reduction of the proceeds
allocated to the newly-issued securities.FN2,
3
The SEC staff believes that an escrowed share arrangement
in which the shares are automatically forfeited if
employment terminates is compensation, consistent with the
principle articulated in paragraph 805-10-55-25(a).
__________________________________
FN1 Under these arrangements, which can be between shareholders and a company or directly between the shareholders and new investors, shareholders agree to place a portion of their shares in escrow in connection with an initial public offering or other capital-raising transaction. Shares placed in escrow are released back to the shareholders only if specified performance-related criteria are met.
FN2 The SEC staff notes that discounts on debt instruments are amortized using the effective interest method as discussed in Section 835-30-35, while discounts on common equity are not generally amortized.
FN3 Consistent with the views in paragraph 220-10-S99-4, SAB Topic 5.T., Accounting for Expenses or Liabilities Paid by Principal Stockholder(s), and paragraph 220-10-S99-3, SAB Topic 1.B., Allocation of Expenses and Related Disclosure in Financial Statements of Subsidiaries, Divisions or Lesser Business Components of Another Entity, the SEC staff believes that the benefit created by the shareholder’s escrow arrangement should be reflected in the company’s financial statements even when the company is not party to the arrangement.
As part of completing an IPO or other financing, certain shareholders who are also key employees of an entity may agree to place in escrow a portion of their shares, which would be released to them upon the satisfaction of a specified condition. In many of these arrangements, the shares are released only if the employee shareholders remain employed for a certain period or the entity achieves a specified performance target, and services from the employee shareholders may be explicitly stated in the arrangement or implicitly required in accordance with a performance target.
As indicated in ASC 718-10-S99-2, the SEC staff has historically expressed the view that escrowed share arrangements such as these are presumed to be compensatory and equivalent to reverse stock splits followed by the grant of restricted stock, subject to certain conditions (e.g., service, performance, or market conditions). If the release of shares is tied to continued employment, the presumption cannot be overcome. In addition, even if the entity is not directly a party to the arrangement (e.g., when the arrangement is only between shareholders and new investors), the arrangement should be reflected in the entity’s financial statements.
However, the SEC staff has stated that in certain circumstances, the presumption
can be overcome that an arrangement is compensation. To identify those
circumstances, an entity should assess the substance of the escrowed share
arrangement to determine whether it was “entered into for purposes unrelated to, and
not contingent upon, continued employment.” For example, as a result of concerns
related to the entity’s value, investors may require certain shareholders to
participate in an escrowed share arrangement before the entity can raise financing.
Further, investors may require the entity to achieve certain performance targets
(e.g., an EBITDA target over a specified period) before the shares can be released.
If the arrangement also requires continued employment, the arrangement is considered
compensatory. However, if continued employment is not required (either explicitly or
implicitly), the entity should consider all relevant facts and circumstances to
determine whether the substance of the arrangement is unrelated to employee
compensation.
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.
Chapter 4 — Measurement
Chapter 4 — Measurement
4.1 Fair-Value-Based Measurement
ASC 718-10 — Glossary
Fair Value
The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.
ASC 718-10
General
30-1 While some of the material in this Section was written in terms of awards classified as equity, it applies equally to awards classified as liabilities.
Fair-Value-Based
30-2 A share-based payment
transaction shall be measured based on the fair value (or in
certain situations specified in this Topic, a calculated
value or intrinsic value) of the equity instruments
issued.
30-3 An entity shall account
for the compensation cost from share-based payment
transactions in accordance with the fair-value-based method
set forth in this Topic. That is, the cost of goods obtained
or services received in exchange for awards of share-based
compensation generally shall be measured based on the
grant-date fair value of the equity instruments issued or on
the fair value of the liabilities incurred. The cost of
goods obtained or services received by an entity as
consideration for equity instruments issued or liabilities
incurred in share-based compensation transactions shall be
measured based on the fair value of the equity instruments
issued or the liabilities settled. The portion of the fair
value of an instrument attributed to goods obtained or
services received is net of any amount that a grantee pays
(or becomes obligated to pay) for that instrument when it is
granted. For example, if a grantee pays $5 at the grant date
for an option with a grant-date fair value of $50, the
amount attributed to goods or services provided by the
grantee is $45. An entity shall apply the guidance in
paragraph 606-10-32-26 when determining the portion of the
fair value of an equity instrument attributed to goods
obtained or services received from a customer.
30-4 However, this Topic provides certain exceptions (see paragraph 718-10-30-21) to that measurement method if it is not possible to reasonably estimate the fair value of an award at the grant date. A nonpublic entity also may choose to measure its liabilities under share-based payment arrangements at intrinsic value (see paragraphs 718-10-30-20 and 718-30-30-2).
Terms of the Award Affect Fair Value
30-5 The terms of a share-based
payment award and any related arrangement affect its value
and, except for certain explicitly excluded features, such
as a reload feature, shall be reflected in determining the
fair value of the equity or liability instruments granted.
For example, the fair value of a substantive option
structured as the exchange of equity shares for a
nonrecourse note will differ depending on whether the
grantee is required to pay nonrefundable interest on the
note.
ASC 718 requires entities to measure compensation cost for share-based payments
awarded to grantees on the basis of the fair value of the equity instruments
exchanged or the liabilities incurred. Such measurement is referred to as a
fair-value-based measurement because the entity does not consider the effects of
certain features that it would take into account in a true fair value measurement in
determining the fair value of the share-based payment award. Although ASC 820
excludes from its scope the valuation of share-based payments that are subject to
ASC 718, the concepts in ASC 820 and ASC 718 are closely aligned. When accounting
for share-based payment transactions, entities should apply the measurement guidance
in ASC 820 unless it is inconsistent with the requirements in ASC 718. The most
significant difference between the terms “fair value” as defined in ASC 820 and
“fair-value-based” as used in ASC 718 is that the latter term excludes the effects
of (1) service and performance conditions that apply only to vesting or
exercisability, (2) reload features, and (3) certain contingent features.
For the rare situations in which fair value is not reasonably estimated (e.g.,
the terms of an award are highly complex), ASC 718 provides an exception to
fair-value-based measurement under which entities measure an award at its intrinsic
value and remeasure it in each reporting period until settlement. See Section 4.11 for additional
information. Entities may also use a simplified method for determining an expected
term for their options and similar instruments if certain conditions are met. The
discussion in Section
4.9.2.2.2 applies to public entities, and the discussion in Section 4.9.2.2.3 applies to
nonpublic entities.
Further, two other exceptions to fair-value-based measurement are available to nonpublic entities.
Under the first exception, nonpublic entities that cannot reasonably estimate the expected volatility
of their share price for options or similar instruments are required to substitute the historical volatility
of an appropriate industry sector index for their expected volatility. This measure is referred to as a
calculated value rather than as a fair-value-based measure. Under the second exception, nonpublic
entities are permitted to make an accounting policy election to measure all liability-classified awards at
their intrinsic value (instead of at their fair-value-based measure or calculated value) as of the end of
each reporting period until the awards are settled. See Section 4.13 for additional discussion of each
measurement exception.
4.1.1 Vesting Conditions
ASC 718-10
Forfeitability
30-11 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
estimating the fair value of the related instruments at
the grant date. Instead, those restrictions are taken
into account by recognizing compensation cost only for
awards for which grantees deliver the good or render the
service.
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.
30-13 The fair-value-based
method described in paragraphs 718-10-30-6 and
718-10-30-10 through 30-14 uses fair value measurement
techniques, and the grant-date share price and other
pertinent factors are used in applying those techniques.
However, the effects on the grant-date fair value of
service and performance conditions that apply only
during the employee’s requisite service period or a
nonemployee’s vesting period are reflected based on the
outcomes of those conditions. This Topic refers to the
required measure as fair value.
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.
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.
SEC Staff Accounting Bulletins
SAB Topic 14.D.2, Certain Assumptions
Used in Valuation Methods: Expected Term [Excerpt]
Question 2:
Should forfeitures or terms that stem from
forfeitability be factored into the determination of
expected term?
Interpretive
Response: No. FASB ASC Topic 718 indicates that
the expected term that is utilized as an assumption in a
closed-form option-pricing model or a resulting output
of a lattice option pricing model when determining the
fair value of the share options should not incorporate
restrictions or other terms that stem from the
pre-vesting forfeitability of the instruments. Under
FASB ASC Topic 718, these pre-vesting restrictions or
other terms are taken into account by ultimately
recognizing compensation cost only for awards for which
grantees deliver the good or render the
service.62
______________________________
62 FASB ASC paragraph
718-10-30-11.
An entity should consider all relevant terms and conditions of a share-based
payment award in determining an appropriate fair-value-based measure. Each of
these terms and conditions may have a direct or indirect effect on the
fair-value-based measure of the award. A service or performance condition that
affects either the vesting or the exercisability of an award is considered a
vesting condition. Vesting conditions are not directly incorporated into an
award’s fair-value-based measure. Rather, they govern whether the award has been
earned and therefore whether an entity records compensation cost for it.
However, a vesting condition can indirectly affect the fair-value-based measure.
Since the expected term of an option award cannot be shorter than the vesting
period (because the expected term should not incorporate prevesting
forfeitures), a longer vesting period would typically result in an increase in
the expected term of an award. See Sections 3.4.1 and 3.4.2 for a discussion of
how service and performance conditions affect the recognition of compensation
cost.
By contrast, a service or performance condition that affects a factor (e.g., exercise price, contractual
term, quantity, conversion ratio) other than vesting or exercisability of an award will be directly factored
into the award’s fair-value-based measure. See Section 4.6 for a discussion of how service and
performance conditions that affect factors other than vesting or exercisability of an award affect the
award’s fair-value-based measure.
A market condition is not considered a vesting condition under ASC 718-10-30-27.
Accordingly, it will be directly factored into the fair-value-based measure of
an award and will not be used to determine (other than indirectly if a derived
service period is required to be determined) whether compensation cost will be
recorded. ASC 718-10-30-14 states, in part, that the “effect of a market
condition is reflected in the grant-date fair value of an award.” See Section 3.5 for a
discussion of how a market condition affects the recognition of compensation
cost and Section
4.5 for a discussion of how a market condition affects an award’s
fair-value-based measure.
If an award is indexed to a factor other than a market, performance, or service
condition, it contains an “other” condition. Other conditions are factored into
the fair-value-based measure of an award and result in its classification as a
liability. See Section 4.6.2 for
discussion of other conditions.
4.1.2 Reload and Contingent Features
ASC 718-10 — Glossary
Reload Feature and Reload Option
A reload feature provides for automatic grants of additional options whenever a
grantee exercises previously granted options using the
entity’s shares, rather than cash, to satisfy the
exercise price. At the time of exercise using shares,
the grantee is automatically granted a new option,
called a reload option, for the shares used to exercise
the previous option.
ASC 718-10
Reload and Contingent Features
30-23 The fair value of each award of equity instruments, including an award of options with a reload feature
(reload options), shall be measured separately based on its terms and the share price and other pertinent
factors at the grant date. The effect of a reload feature in the terms of an award shall not be included in
estimating the grant-date fair value of the award. Rather, a subsequent grant of reload options pursuant to that
provision shall be accounted for as a separate award when the reload options are granted.
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.
Fair Value Measurement Objectives and Application
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.
Some stock options include a “reload feature.” This feature entitles a grantee
to automatic grants of additional stock options whenever the grantee exercises
previously granted stock options and pays the exercise price in the entity’s
shares rather than in cash. Typically, the grantee is granted a new stock
option, called a reload option, for each share surrendered to satisfy the
exercise price of the previously granted stock option. The exercise price of the
reload option is usually set at the market price of the shares on the date the
reload option is granted. For stock options that include a reload feature, the
reload feature is not incorporated into the grant-date fair-value-based measure
of the stock option but is accounted for instead as a new award and calculated
on the basis of its grant-date fair-value-based measure.
Some awards also include contingent features that may require a grantee to
return earned equity instruments or gains realized from the sale of equity
instruments in certain situations (either for no consideration or for
consideration that is less than the fair value of the equity instrument on the
date of transfer). Such contingent features are not reflected in the
fair-value-based measurement of an equity instrument, and they do not affect the
recognition of compensation cost if they are triggered after the equity
instrument is earned. Therefore, a contingent feature has no day-one impact on
the accounting for an award; it is accounted for if and when the contingent
event occurs. Examples of contingent features, also referred to as clawback
features, include provisions triggered upon terminations for cause, noncompete
and nonsolicitation violations, and material misstatements. Clawback provisions
are discussed further in Section 3.9.
4.2 Measurement Objective
ASC 718-10
Measurement Objective — Fair Value at Grant Date
30-6 The measurement objective
for equity instruments awarded to grantees is to estimate
the fair value at the grant date of the equity instruments
that the entity is obligated to issue when grantees have
delivered the good or rendered the service and satisfied any
other conditions necessary to earn the right to benefit from
the instruments (for example, to exercise share options).
That estimate is based on the share price and other
pertinent factors, such as expected volatility, at the grant
date.
Fair Value Measurement Objectives and Application
55-4 The measurement objective
for equity instruments granted in share-based payment
transactions is to estimate the grant-date fair value of the
equity instruments that the entity is obligated to issue
when grantees have delivered the good or have rendered the
service and satisfied any other conditions necessary to earn
the right to benefit from the instruments. That estimate is
based on the share price and other pertinent factors
(including those enumerated in paragraphs 718-10-55-21
through 55-22, if applicable) at the grant date and is not
remeasured in subsequent periods under the fair-value-based
method.
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.
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).
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.
55-9 The fair value measurement
objective for liabilities incurred in a share-based payment
transaction is the same as for equity instruments. However,
awards classified as liabilities are subsequently remeasured
to their fair values (or a portion thereof until the
promised good has been delivered or the service has been
rendered) at the end of each reporting period until the
liability is settled.
Fair-Value-Based Instruments in a Share-Based Transaction
55-10 The definition of fair
value refers explicitly only to assets and liabilities, but
the concept of value in a current exchange embodied in it
applies equally to the equity instruments subject to this
Topic. Observable market prices of identical or similar
equity or liability instruments in active markets are the
best evidence of fair value and, if available, shall be used
as the basis for the measurement of equity and liability
instruments awarded in a share-based payment transaction.
Determining whether an equity or liability instrument is
similar is a matter of judgment, based on an analysis of the
terms of the instrument and other relevant facts and
circumstances. For example, awards to grantees of a public
entity of shares of its common stock, subject only to a
service or performance condition for vesting (nonvested
shares), shall be measured based on the market price of
otherwise identical (that is, identical except for the
vesting condition) common stock at the grant date.
55-11 If observable market
prices of identical or similar equity or liability
instruments of the entity are not available, the fair value
of equity and liability instruments awarded to grantees
shall be estimated by using a valuation technique that meets
all of the following criteria:
-
It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic.
-
It is based on established principles of financial economic theory and generally applied in that field (see paragraph 718-10-55-16). Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).
-
It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic, such as vesting conditions and reload features).
That is, the fair values of equity and liability instruments granted in a
share-based payment transaction shall be estimated by
applying a valuation technique that would be used in
determining an amount at which instruments with the same
characteristics (except for those explicitly excluded by
this Topic) would be exchanged.
55-12 An estimate of the amount
at which instruments similar to share options and other
instruments granted in share-based payment transactions
would be exchanged would factor in expectations of the
probability that the good would be delivered or the service
would be rendered and the instruments would vest (that is,
that the performance or service conditions would be
satisfied). However, as noted in paragraph 718-10-55-4, the
measurement objective in this Topic is to estimate the fair
value at the grant date of the equity instruments that the
entity is obligated to issue when grantees have delivered
the good or rendered the service and satisfied any other
conditions necessary to earn the right to benefit from the
instruments. Therefore, the estimated fair value of the
instruments at grant date does not take into account the
effect on fair value of vesting conditions and other
restrictions that apply only during the employee’s requisite
service period or the nonemployee’s vesting period. Under
the fair-value-based method required by this Topic, the
effect of vesting conditions and other restrictions that
apply only during the employee’s requisite service period or
the nonemployee’s vesting period is reflected by recognizing
compensation cost only for instruments for which the good is
delivered or the service is rendered.
Valuation Techniques
55-13 In applying a valuation technique, the assumptions used shall be consistent with the fair value
measurement objective. That is, assumptions shall reflect information that is (or would be) available to form the
basis for an amount at which the instruments being valued would be exchanged. In estimating fair value, the
assumptions used shall not represent the biases of a particular party. Some of those assumptions will be based
on or determined from external data. Other assumptions, such as the employees’ expected exercise behavior,
may be derived from the entity’s own historical experience with share-based payment arrangements.
55-14 The fair value of any equity or liability instrument depends on its substantive characteristics. Paragraphs
718-10-55-21 through 55-22 list the minimum set of substantive characteristics of instruments with option
(or option-like) features that shall be considered in estimating those instruments’ fair value. However, a
share-based payment award could contain other characteristics, such as a market condition, that should be
included in a fair value estimate. Judgment is required to identify an award’s substantive characteristics and, as
described in paragraphs 718-10-55-15 through 55-20, to select a valuation technique that incorporates those
characteristics.
As indicated above, ASC 718-10-30-6 specifies that the measurement objective for
share-based payment arrangements is to estimate the fair-value-based measure, on the
measurement date, “of the equity [and liability] instruments that the entity is
obligated to issue when grantees have delivered the good or rendered the service and
satisfied any other conditions necessary to earn the right to benefit from the
instruments.” This estimate is based on the share price and other measurement
assumptions (e.g., the option pricing model inputs as described in ASC 718-10-55-21
in estimating the fair-value-based measure of stock options) on the measurement
date.
In SAB Topic 14, the SEC provides the following general guidance on estimating
the fair-value-based measure of share-based payment arrangements:
SEC Staff Accounting Bulletins
SAB Topic 14, Share-Based Payment
[Excerpt]
The staff recognizes that there is a range
of conduct that a reasonable issuer might use to make
estimates and valuations and otherwise apply FASB ASC Topic
718, and the interpretive guidance provided by this SAB.
Thus, throughout this SAB the use of the terms ”reasonable”
and ”reasonably” is not meant to imply a single conclusion
or methodology, but to encompass the full range of potential
conduct, conclusions or methodologies upon which an issuer
may reasonably base its valuation decisions. Different
conduct, conclusions or methodologies by different issuers
in a given situation does not of itself raise an inference
that any of those issuers is acting unreasonably. While the
zone of reasonable conduct is not unlimited, the staff
expects that it will be rare, except when observable market
prices of identical or similar equity or liability
instruments in active markets are available, when there is
only one acceptable choice in estimating the fair value of
share-based payment arrangements under the provisions of
FASB ASC Topic 718 and the interpretive guidance provided by
this SAB in any given situation. In addition, as discussed
in the Interpretive Response to Question 1 of Section C,
Valuation Methods, estimates of fair value are not intended
to predict actual future events, and subsequent events are
not indicative of the reasonableness of the original
estimates of fair value made under FASB ASC Topic 718.
SAB Topic 14.C, Valuation Methods
[Excerpt]
FASB ASC paragraph 718-10-30-6 (Compensation
— Stock Compensation Topic) indicates that the measurement
objective for equity instruments awarded to grantees is to
estimate at the grant date the fair value of the equity
instruments the entity is obligated to issue when grantees
have delivered the good or rendered the service and
satisfied any other conditions necessary to earn the right
to benefit from the instruments.15 The Topic also
states that observable market prices of identical or similar
equity or liability instruments in active markets are the
best evidence of fair value and, if available, should be
used as the basis for the measurement for equity and
liability instruments awarded in a share-based payment
transaction.16 However, if observable market
prices of identical or similar equity or liability
instruments are not available, the fair value shall be
estimated by using a valuation technique or model that
complies with the measurement objective, as described in
FASB ASC Topic 718.17
Question 1: If a
valuation technique or model is used to estimate fair value,
to what extent will the staff consider a company’s estimates
of fair value to be materially misleading because the
estimates of fair value do not correspond to the value
ultimately realized by the grantees who received the share
options?
Interpretive
Response: The staff understands that estimates of
fair value of share options, while derived from expected
value calculations, cannot predict actual future
events.18 The estimate of fair value
represents the measurement of the cost of the grantee's
goods or services to the company. The estimate of fair value
should reflect the assumptions marketplace participants
would use in determining how much to pay for an instrument
on the fair value measurement date.19 For
example, valuation techniques used in estimating the fair
value of share options may consider information about a
large number of possible share price paths, while, of
course, only one share price path will ultimately emerge. If
a company makes a good faith fair value estimate in
accordance with the provisions of FASB ASC Topic 718 in a
way that is designed to take into account the assumptions
that underlie the instrument's value that marketplace
participants would reasonably make, then subsequent future
events that affect the instrument's value do not provide
meaningful information about the quality of the original
fair value estimate. As long as the share options were
originally so measured, changes in a share option's value,
no matter how significant, subsequent to its grant date do
not call into question the reasonableness of the grant date
fair value estimate.
Question 2: In order
to meet the fair value measurement objective in FASB ASC
Topic 718, are certain valuation techniques preferred over
others?
Interpretive
Response: FASB ASC paragraph 718-10-55-17 clarifies
that the Topic does not specify a preference for a
particular valuation technique or model. As stated in FASB
ASC paragraph 718-10-55-11 in order to meet the fair value
measurement objective, a company should select a valuation
technique or model that (a) is applied in a manner
consistent with the fair value measurement objective and
other requirements of FASB ASC Topic 718, (b) is based on
established principles of financial economic theory and
generally applied in that field and (c) reflects all
substantive characteristics of the instrument (except for
those explicitly excluded by FASB ASC Topic 718).
The chosen valuation technique or model must
meet all three of the requirements stated above. In valuing
a particular instrument, certain techniques or models may
meet the first and second criteria but may not meet the
third criterion because the techniques or models are not
designed to reflect certain characteristics contained in the
instrument. For example, for a share option in which the
exercisability is conditional on a specified increase in the
price of the underlying shares, the Black-Scholes-Merton
closed-form model would not generally be an appropriate
valuation model because, while it meets both the first and
second criteria, it is not designed to take into account
that type of market condition.20
Further, the staff understands that a
company may consider multiple techniques or models that meet
the fair value measurement objective before making its
selection as to the appropriate technique or model. The
staff would not object to a company’s choice of a technique
or model as long as the technique or model meets the fair
value measurement objective. For example, a company is not
required to use a lattice model simply because that model
was the most complex of the models the company considered.
Question 3: [Omitted]
Question 4: Must
every company that issues share options or similar
instruments hire an outside third party to assist in
determining the fair value of the share options?
Interpretive
Response: No. However, the valuation of a company’s
share options or similar instruments should be performed by
a person with the requisite expertise.
______________________________
15 FASB ASC paragraph 718-10-30-1 states that this
guidance applies equally to awards classified as
liabilities.
16 FASB ASC paragraph
718-10-55-10.
17 FASB ASC paragraph
718-10-55-11.
18 FASB ASC paragraph
718-10-55-15 states, “The fair value of those instruments at
a single point in time is not a forecast of what the
estimated fair value of those instruments may be in the
future.”
19 Generally, the grant date for equity awards or
the reporting date for liability-classified awards.
20
See FASB ASC paragraphs 718-10-55-16 and
718-10-55-20.
As indicated in SAB Topic 14, fair-value-based estimates are not predictions of actual future events. As
long as an entity makes a good faith estimate in accordance with the principles in ASC 718, subsequent
changes to the fair-value-based measurement will not call into question the reasonableness of the
estimate. However, entities must consider the substantive terms of an award in a manner in which a
market participant would consider them. In addition, the SEC staff will not object to an entity’s valuation
technique provided that it meets all three of the following criteria in ASC 718-10-55-11:
- “It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic [ASC 718].”
- “It is based on established principles of financial economic theory and generally applied in that field. . . . Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).”
- “It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic [ASC 718], such as vesting conditions and reload features).”
For example, if an award contains a market condition, a Monte Carlo simulation is often used as a
valuation technique rather than a Black-Scholes-Merton model.
Further, as long as fair-value-based estimates are prepared by a person with the “requisite expertise,”
entities are not required to hire an outside third-party expert to assist in the valuation. For example, if a
Black-Scholes-Merton model is applied, a valuation expert may not be required for many types of stock
options.
4.3 Observable Market Price
To determine the fair-value-based measure of the underlying instrument in a share-based payment
arrangement, an entity must first consider whether there is an observable market price; that is, the price
that buyers are paying for an instrument (with the same or similar terms) in an active market, which is
the best evidence of fair value. An observable market price will generally only be available for shares of
public entities or for shares of nonpublic entities with recent transactions. For example, for grants of
restricted stock subject only to service or performance conditions, the market price of a public entity’s
common stock would be used as the fair-value-based measurement. However, for grants of stock
options, observable market prices would typically not exist (see Section 4.9.3 for additional information).
If an observable market price does not exist, an acceptable valuation technique must be used to
estimate the fair-value-based measure of the award.
See Section 4.12 for a discussion of the valuation of awards issued by nonpublic entities, and see
Section 4.9 for a discussion of option pricing models, which are valuation techniques used to estimate
the fair-value-based measure of options and similar instruments.
4.4 Measurement Date
For equity-classified awards, the measurement date is the grant date (i.e., the
date on which the measurement of the award is fixed). As discussed in Chapter 3, the service
inception date may precede the grant date for both employee and nonemployee awards.
As a result, even though an entity may begin to record compensation cost before the
grant date, the fair-value-based measure of an equity-classified award is not fixed
until the grant date. In periods before the grant date, compensation cost is
remeasured on the basis of the award’s fair-value-based measure at the end of each
reporting period to the extent that service has been rendered in proportion to the
total requisite service period. See Section 3.6.4 for guidance on accounting for a
share-based payment award when the service inception date precedes the grant
date.
For liability-classified awards, the ultimate measurement date is the settlement
date. That is, unlike equity-classified awards, liability-classified awards are
remeasured at their fair-value-based measure in each reporting period until
settlement. The changes in the fair-value-based measure of the liability-classified
award at the end of each reporting period are recognized as compensation cost either
immediately or over the remaining vesting period (or both), depending on the
employee’s requisite service period or the nonemployee’s vesting period. See
Chapter 7 for
further discussion of the accounting for liability-classified awards.
4.5 Market Conditions
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.
Fair Value Measurement Objectives and Application
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).
As discussed in Section
4.1, a market condition is not considered a vesting condition. Unlike
service and performance conditions that affect vesting, the effect of market
conditions is reflected in an award’s fair-value-based measure. In addition,
compensation cost is recognized for equity-classified awards with market conditions,
regardless of whether the market condition is achieved, as long as the good is
delivered or the service is rendered. See Section 3.5 for a discussion of how a market
condition affects the recognition of compensation cost.
For an entity to effectively incorporate a market condition into an award’s
fair-value-based measure, the valuation technique used must take into account all
possible outcomes of the market condition. That is, the valuation technique must
permit the entity to estimate the value of “path-dependent options.” ASC
718-10-30-14 states, in part, that “[a]wards with market conditions, as defined in
this Topic, are path-dependent options.” Lattice models and Monte Carlo simulations
are valuation techniques used to value path dependent options. The
Black-Scholes-Merton formula typically will not be appropriate when there are market
conditions.
The implementation guidance in ASC 718-20 provides the following examples of awards with market
conditions:
ASC 718-20
Example 5: Share Option With a Market Condition — Indexed Exercise Price
55-51 This Example illustrates the guidance in paragraph 718-10-30-15.
55-51A This
Example (see paragraphs 718-20-55-52 through 55-60)
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 in paragraphs
718-20-55-52 through 55-60 are equally applicable to
nonemployee awards with the same features as the awards in
this Example (that is, awards with market conditions that
affect exercise prices). Therefore, the guidance in those
paragraphs may serve as implementation guidance for similar
nonemployee awards.
55-51B
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.
55-52 Entity T grants share options whose exercise price varies with an index of the share prices of a group of
entities in the same industry, that is, a market condition. Assume that on January 1, 20X5, Entity T grants 100
share options on its common stock with an initial exercise price of $30 to each of 1,000 employees. The share
options have a maximum term of 10 years. The exercise price of the share options increases or decreases on
December 31 of each year by the same percentage that the index has increased or decreased during the year.
For example, if the peer group index increases by 10 percent in 20X5, the exercise price of the share options
during 20X6 increases to $33 ($30 × 1.10). On January 1, 20X5, the peer group index is assumed to be 400. The
dividend yield on the index is assumed to be 1.25 percent.
55-53 Each indexed share option may be analyzed as a share option to exchange 0.0750 (30 ÷ 400) shares
of the peer group index for a share of Entity T stock — that is, to exchange one noncash asset for another
noncash asset. A share option to purchase stock for cash also can be thought of as a share option to exchange
one asset (cash in the amount of the exercise price) for another (the share of stock). The intrinsic value of a
cash share option equals the difference between the price of the stock upon exercise and the amount — the
price — of the cash exchanged for the stock. The intrinsic value of a share option to exchange 0.0750 shares
of the peer group index for a share of Entity T stock also equals the difference between the prices of the two
assets exchanged.
55-54 To illustrate the equivalence of an indexed share option and the share option above, assume that an
employee exercises the indexed share option when Entity T’s share price has increased 100 percent to $60
and the peer group index has increased 75 percent, from 400 to 700. The exercise price of the indexed share
option thus is $52.50 ($30 × 1.75).
55-55 That is the same as the intrinsic value of a share option to exchange 0.0750 shares of the index for 1
share of Entity T stock.
55-56 Option-pricing models can be extended to value a share option to exchange one asset for another.
The principal extension is that the volatility of a share option to exchange two noncash assets is based on
the relationship between the volatilities of the prices of the assets to be exchanged — their cross-volatility.
In a share option with an exercise price payable in cash, the amount of cash to be paid has zero volatility, so
only the volatility of the stock needs to be considered in estimating that option’s fair value. In contrast, the
fair value of a share option to exchange two noncash assets depends on possible movements in the prices
of both assets — in this Example, fair value depends on the cross-volatility of a share of the peer group index
and a share of Entity T stock. Historical cross-volatility can be computed directly based on measures of Entity
T’s share price in shares of the peer group index. For example, Entity T’s share price was 0.0750 shares at the
grant date and 0.0857 (60 ÷ 700) shares at the exercise date. Those share amounts then are used to compute
cross-volatility. Cross-volatility also can be computed indirectly based on the respective volatilities of Entity T
stock and the peer group index and the correlation between them. The expected cross-volatility between Entity
T stock and the peer group index is assumed to be 30 percent.
55-57 In a share option with an exercise price payable in cash, the assumed risk-free interest rate (discount
rate) represents the return on the cash that will not be paid until exercise. In this Example, an equivalent share
of the index, rather than cash, is what will not be paid until exercise. Therefore, the dividend yield on the peer
group index of 1.25 percent is used in place of the risk-free interest rate as an input to the option-pricing
model.
55-58 The initial exercise price for the indexed share option is the value of an equivalent share of the peer
group index, which is $30 (0.0750 × $400). The fair value of each share option granted is $7.55 based on the
following inputs.
55-59 In this Example, the suboptimal exercise factor is 1.1. In Example 1 (see paragraph 718-20-55-4),
the suboptimal exercise factor is 2.0. See paragraph 718-20-55-8 for an explanation of the meaning of a
suboptimal exercise factor of 2.0.
55-60 The indexed share options have a three-year explicit service period. The market condition affects the
grant-date fair value of the award and its exercisability; however, vesting is based solely on the explicit service
period of three years. The at-the-money nature of the award makes the derived service period irrelevant in
determining the requisite service period in this Example; therefore, the requisite service period of the award
is three years based on the explicit service period. The accrual of compensation cost would be based on the
number of options for which the requisite service is rendered or is expected to be rendered depending on an
entity’s accounting policy in accordance with paragraph 718-10-35-3 (which is not addressed in this Example).
That cost would be recognized over the requisite service period as shown in Example 1 (see paragraph
718-20-55-4).
Example 6: Share Unit With Performance and Market Conditions
55-61 This Example illustrates the guidance in paragraphs 718-10-25-20 through 25-21, 718-10-30-27, and
718-10-35-4.
55-61A This
Example (see paragraphs 718-20-55-62 through 55-67)
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, both of the following are equally applicable
to nonemployee awards with the same features as the awards
in this Example (that is, awards with a specified time
period for vesting and the recognition of compensation cost
based on the achievement of particular performance
conditions):
-
The performance conditions in paragraph 718-20-55-62
-
Concepts about valuation, compensation cost reversal, 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 718-20-55-63 and 718-20-55-65 through 55-67.
Therefore, the guidance in those paragraphs may serve as
implementation guidance for similar nonemployee awards.
55-61B
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.
55-62 Entity T grants 100,000 share units to each of 10 vice presidents (1 million share units in total) on January
1, 20X5. Each share unit has a contractual term of three years and a vesting condition based on performance.
The performance condition is different for each vice president and is based on specified goals to be achieved
over three years (an explicit three-year service period). If the specified goals are not achieved at the end of
three years, the share units will not vest. Each share unit is convertible into shares of Entity T at contractual
maturity as follows:
- If Entity T’s share price has appreciated by a percentage that exceeds the percentage appreciation of the S&P 500 index by at least 10 percent (that is, the relative percentage increase is at least 10 percent), each share unit converts into 3 shares of Entity T stock.
- If the relative percentage increase is less than 10 percent but greater than zero percent, each share unit converts into 2 shares of Entity T stock.
- If the relative percentage increase is less than or equal to zero percent, each share unit converts into 1 share of Entity T stock.
- If Entity T’s share price has depreciated, each share unit converts into zero shares of Entity T stock.
55-63 Appreciation or depreciation for Entity T’s share price and the S&P 500 index is measured from the grant
date.
55-64 This market condition affects the ability to retain the award because the conversion ratio could be zero;
however, vesting is based solely on the explicit service period of three years, which is equal to the contractual
maturity of the award. That set of circumstances makes the derived service period irrelevant in determining the
requisite service period; therefore, the requisite service period of the award is three years based on the explicit
service period.
55-65 The share units’ conversion feature is based on a variable target stock price (that is, the target stock
price varies based on the S&P 500 index); hence, it is a market condition. That market condition affects the
fair value of the share units that vest. Each vice president’s share units vest only if the individual’s performance
condition is achieved; consequently, this award is accounted for as an award with a performance condition
(see paragraphs 718-10-55-60 through 55-63). This Example assumes that all share units become fully vested;
however, if the share units do not vest because the performance conditions are not achieved, Entity T would
reverse any previously recognized compensation cost associated with the nonvested share units.
55-66 The grant-date fair value of each share unit is assumed for purposes of this Example to be $36. Certain
option-pricing models, including Monte Carlo simulation techniques, have been adapted to value path-dependent
options and other complex instruments. In this case, the entity concludes that a Monte Carlo
simulation technique provides a reasonable estimate of fair value. Each simulation represents a potential
outcome, which determines whether a share unit would convert into three, two, one, or zero shares of stock.
For simplicity, this Example assumes that no forfeitures will occur during the vesting period. The grant-date
fair value of the award is $36 million (1 million × $36); management of Entity T expects that all share units will
vest because the performance conditions are probable of achievement. Entity T recognizes compensation
cost of $12 million ($36 million ÷ 3) in each year of the 3-year service period; the following journal entries are
recognized by Entity T in 20X5, 20X6, and 20X7.
55-67 Upon contractual maturity of the share units, four outcomes are possible; however, because all possible
outcomes of the market condition were incorporated into the share units’ grant-date fair value, no other entry
related to compensation cost is necessary to account for the actual outcome of the market condition. However,
if the share units’ conversion ratio was based on achieving a performance condition rather than on satisfying a
market condition, compensation cost would be adjusted according to the actual outcome of the performance
condition (see Example 4 [paragraph 718-20-55-47]).
4.6 Conditions That Affect Factors Other Than Vesting or Exercisability
ASC 718-10
Market, Performance, and Service Conditions That Affect Factors Other Than Vesting or Exercisability
30-15 Market, performance, and
service conditions (or any combination thereof) may affect
an award’s exercise price, contractual term, quantity,
conversion ratio, or other factors that are considered in
measuring an award’s grant-date fair value. A grant-date
fair value shall be estimated for each possible outcome of
such a performance or service condition, and the final
measure of compensation cost shall be based on the amount
estimated at the grant date for the condition or outcome
that is actually satisfied. Paragraphs 718-10-55-64 through
55-66 provide additional guidance on the effects of market,
performance, and service conditions that affect factors
other than vesting or exercisability. Examples 2 (see
paragraph 718-20-55-35); 3 (see paragraph 718-20-55-41); 4
(see paragraph 718-20-55-47); 5 (see paragraph
718-20-55-51); and 7 (see paragraph 718-20- 55-68) provide
illustrations of accounting for awards with such
conditions.
Market, Performance, and Service Conditions That Affect Factors Other Than
Vesting and Exercisability
55-64 Market, performance, and
service conditions may affect an award’s exercise price,
contractual term, quantity, conversion ratio, or other
pertinent factors that are relevant in measuring an award’s
fair value. For instance, an award’s quantity may double, or
an award’s contractual term may be extended, if a
company-wide revenue target is achieved. Market conditions
that affect an award’s fair value (including exercisability)
are included in the estimate of grant-date fair value (see
paragraph 718-10-30-15). Performance or service conditions
that only affect vesting are excluded from the estimate of
grant-date fair value, but all other performance or service
conditions that affect an award’s fair value are included in
the estimate of grant-date fair value (see that same
paragraph). Examples 3, 4, and 6 (see paragraphs
718-20-55-41, 718-20-55-47, and 718-20-55-61) provide
further guidance on how performance conditions are
considered in the estimate of grant-date fair value.
55-65 An award may be indexed to a factor in addition to the entity’s share price. If that factor is not a market,
performance, or service condition, that award shall be classified as a liability for purposes of this Topic (see
paragraphs 718-10-25-13 through 25-14A). An example would be an award of options whose exercise price is
indexed to the market price of a commodity, such as gold. Another example would be a share award that will
vest based on the appreciation in the price of a commodity, such as gold; that award is indexed to both the
value of that commodity and the issuing entity’s shares. If an award is so indexed, the relevant factors shall be
included in the fair value estimate of the award. Such an award would be classified as a liability even if the entity
granting the share-based payment instrument is a producer of the commodity whose price changes are part or
all of the conditions that affect an award’s vesting conditions or fair value.
As discussed in Section
4.1.1, service and performance conditions typically affect either the
vesting or the exercisability of a share-based payment award, and such vesting
conditions are not directly factored into the fair-value-based measure of an award
under ASC 718. However, if service or performance conditions affect factors other than vesting or exercisability (e.g., exercise price,
contractual term, quantity, or conversion ratio), the grant-date fair-value-based
measure should be calculated for each possible outcome. As discussed in Section 3.4.2, initial
accruals of compensation cost should be based on the probable outcome, and the final
measure of compensation cost should be adjusted to reflect the grant-date
fair-value-based measure of the outcome that is actually achieved. See the next
section for examples that illustrate the application of this guidance.
4.6.1 Market, Performance, and Service Conditions
The example below illustrates the accounting for an award that contains a
performance condition that affects the number of options that will vest.
ASC 718-20
Example 2: Share Option Award Under Which the Number of Options to Be Earned Varies
55-35 This Example illustrates the guidance in paragraph 718-10-30-15.
55-35A This
Example (see paragraphs 718-20-55-36 through 55-40)
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, all of the following
are equally applicable to nonemployee awards with the
same features as the awards in this Example (that is,
the number of options earned varies on the basis of the
achievement of particular performance conditions):
-
Certain valuation assumptions in paragraph 718-20-55-36
-
Total compensation cost considerations provided in paragraphs 718-20-55-37 through 55-39 (that is, an entity must consider if it is probable that specific performance conditions will be achieved for an award with a specified time period for vesting and performance conditions)
-
Forfeiture adjustments in paragraph 718-20-55-40.
55-35B
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.
55-36 This Example shows the computation of compensation cost if Entity T grants an award of share options
with multiple performance conditions. Under the award, employees vest in differing numbers of options
depending on the amount by which the market share of one of Entity T’s products increases over a three-year
period (the share options cannot vest before the end of the three-year period). The three-year explicit service
period represents the requisite service period. On January 1, 20X5, Entity T grants to each of 1,000 employees
an award of up to 300 10-year-term share options on its common stock. If market share increases by at least
5 percentage points by December 31, 20X7, each employee vests in at least 100 share options at that date.
If market share increases by at least 10 percentage points, another 100 share options vest, for a total of 200.
If market share increases by more than 20 percentage points, each employee vests in all 300 share options.
Entity T’s share price on January 1, 20X5, is $30 and other assumptions are the same as in Example 1 (see
paragraph 718-20-55-4). The grant-date fair value per share option is $14.69. While the vesting conditions in
this Example and in Example 1 (see paragraph 718-20-55-4) are different, the equity instruments being valued
have the same estimate of grant-date fair value. That is a consequence of the modified grant-date method,
which accounts for the effects of vesting requirements or other restrictions that apply during the vesting period
by recognizing compensation cost only for the instruments that actually vest. (This discussion does not refer
to awards with market conditions that affect exercisability or the ability to retain the award as described in
paragraphs 718-10-55-60 through 55-63.)
55-37 The compensation cost of the award depends on the estimated number of options that will vest. Entity
T must determine whether it is probable that any performance condition will be achieved, that is, whether
the growth in market share over the 3-year period will be at least 5 percent. Accruals of compensation cost
are initially based on the probable outcome of the performance conditions — in this case, different levels
of market share growth over the three-year vesting period — and adjusted for subsequent changes in the
estimated or actual outcome. If Entity T determines that no performance condition is probable of achievement
(that is, market share growth is expected to be less than 5 percentage points), then no compensation cost
is recognized; however, Entity T is required to reassess at each reporting date whether achievement of any
performance condition is probable and would begin recognizing compensation cost if and when achievement
of the performance condition becomes probable.
55-38 Paragraph 718-10-25-20 requires accruals of cost to be based on the probable outcome of performance
conditions. Accordingly, this Topic prohibits Entity T from basing accruals of compensation cost on an amount
that is not a possible outcome (and thus cannot be the probable outcome). For instance, if Entity T estimates
that there is a 90 percent, 30 percent, and 10 percent likelihood that market share growth will be at least 5
percentage points, at least 10 percentage points, and greater than 20 percentage points, respectively, it would
not try to determine a weighted average of the possible outcomes because that number of shares is not a
possible outcome under the arrangement.
55-39 The following table shows the compensation cost that would be recognized in 20X5, 20X6, and 20X7 if
Entity T estimates at the grant date that it is probable that market share will increase at least 5 but less than 10
percentage points (that is, each employee would receive 100 share options). That estimate remains unchanged
until the end of 20X7, when Entity T’s market share has increased over the 3-year period by more than 10
percentage points. Thus, each employee vests in 200 share options.
55-40 As in Example 1, Case A (see paragraph 718-20-55-10), Entity T experiences actual forfeiture rates of
5 percent in 20X5, and in 20X6 changes its estimate of forfeitures for the entire award from 3 percent to 6
percent per year. In 20X6, cumulative compensation cost is adjusted to reflect the higher forfeiture rate. By the
end of 20X7, a 6 percent forfeiture rate has been experienced, and no further adjustments for forfeitures are
necessary. Through 20X5, Entity T estimates that 913 employees (1,000 × .973) will remain in service until the
vesting date. At the end of 20X6, the number of employees estimated to remain in service is adjusted for the
higher forfeiture rate, and the number of employees estimated to remain in service is 831 (1,000 × .943). The
compensation cost of the award is initially estimated based on the number of options expected to vest, which
in turn is based on the expected level of performance and the fair value of each option. That amount would
be adjusted as needed for changes in the estimated and actual forfeiture rates and for differences between
estimated and actual market share growth. The amount of compensation cost recognized (or attributed) when
achievement of a performance condition is probable depends on the relative satisfaction of the performance
condition based on performance to date. Entity T determines that recognizing compensation cost ratably over
the three-year vesting period is appropriate with one-third of the value of the award recognized each year.
The examples below illustrate the accounting for an award with either a
performance condition (Example 3) or a market condition (Example 7) that affects
the exercise price of stock options.
ASC 718-20
Example 3: Share Option Award Under Which the Exercise Price Varies
55-41 This Example illustrates the guidance in paragraph 718-10-30-15.
55-41A This
Example (see paragraphs 718-20-55-42 through 55-46)
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, both of the following
are equally applicable to nonemployee awards with the
same features as the awards in this Example (that is, an
immediately vested and exercisable award with an
exercise price that varies on the basis of the
achievement of particular performance conditions):
-
Certain valuation assumptions in paragraphs 718-20-55-42 through 55-43
-
The total compensation cost considerations provided in paragraphs 718-20-55-44 through 55-46 (that is, an entity must consider if it is probable that specific performance conditions will be achieved).
Therefore, the guidance in those paragraphs may serve as
implementation guidance for similar nonemployee
awards.
55-41B
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.
55-42 This Example shows the computation of compensation cost if Entity T grants a share option award with
a performance condition under which the exercise price, rather than the number of shares, varies depending
on the level of performance achieved. On January 1, 20X5, Entity T grants to its chief executive officer 10-year
share options on 10,000 shares of its common stock, which are immediately vested and exercisable (an
explicit service period of zero). The share price at the grant date is $30, and the initial exercise price also is
$30. However, that price decreases to $15 if the market share for Entity T’s products increases by at least
10 percentage points by December 31, 20X6, and provided that the chief executive officer continues to be
employed by Entity T and has not previously exercised the options (an explicit service period of 2 years, which
also is the requisite service period).
55-43 Entity T estimates at the grant date the expected level of market share growth, the exercise price of the
options, and the expected term of the options. Other assumptions, including the risk-free interest rate and
the service period over which the cost is attributed, are consistent with those estimates. Entity T estimates at
the grant date that its market share growth will be at least 10 percentage points over the 2-year performance
period, which means that the expected exercise price of the share options is $15, resulting in a fair value of
$19.99 per option. Option value is determined using the same assumptions noted in paragraph 718-20-55-7
except the exercise price is $15 and the award is not exercisable at $15 per option for 2 years.
55-44 Total compensation cost to be recognized if the performance condition is satisfied would be $199,900
(10,000 × $19.99). Paragraph 718-10-30-15 requires that the fair value of both awards with service conditions
and awards with performance conditions be estimated as of the date of grant. Paragraph 718-10-35-3 also
requires recognition of cost for the number of instruments for which the requisite service is provided. For this
performance award, Entity T also selects the expected assumptions at the grant date if the performance goal is
not met. If market share growth is not at least 10 percentage points over the 2-year period, Entity T estimates
a fair value of $13.08 per option. Option value is determined using the same assumptions noted in paragraph
718-20-55-7 except the award is immediately vested.
55-45 Total compensation cost to be recognized if the performance goal is not met would be $130,800 (10,000
× $13.08). Because Entity T estimates that the performance condition would be satisfied, it would recognize
compensation cost of $130,800 on the date of grant related to the fair value of the fully vested award and
recognize compensation cost of $69,100 ($199,900 – $130,800) over the 2-year requisite service period related
to the condition. Because of the nature of the performance condition, the award has multiple requisite service
periods that affect the manner in which compensation cost is attributed. Paragraphs 718-10-55-67 through
55-79 provide guidance on estimating the requisite service period.
55-46 During the two-year requisite service period, adjustments to reflect any change in estimate about
satisfaction of the performance condition should be made, and, thus, aggregate cost recognized by the end of
that period reflects whether the performance goal was met.
Example 7: Share Option With Exercise Price That Increases by a Fixed Amount or Fixed Percentage
55-68 This Example illustrates the guidance in paragraph 718-10-30-15.
55-68A This Example (see
paragraphs 718-20-55-69 through 55-70) 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 in
paragraphs 718-20-55-69 through 55-70 are equally
applicable to nonemployee awards with the same features
as the awards in this Example (that is, awards with
exercise prices that increase by a fixed amount or fixed
percentage). Therefore, the guidance in those paragraphs
may serve as implementation guidance for similar
nonemployee awards.
55-68B
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.
55-69 Some entities grant share options with exercise prices that increase by a fixed amount or a constant
percentage periodically. For example, the exercise price of the share options in Example 1 (see paragraph
718-20-55-4) might increase by a fixed amount of $2.50 per year. Lattice models and other valuation
techniques can be adapted to accommodate exercise prices that change over time by a fixed amount. Such an
arrangement has a market condition and may have a derived service period.
55-70 Share options with exercise prices that increase by a constant percentage also can be valued using an
option-pricing model that accommodates changes in exercise prices. Alternatively, those share options can be
valued by deducting from the discount rate the annual percentage increase in the exercise price. That method
works because a decrease in the risk-free interest rate and an increase in the exercise price have a similar
effect — both reduce the share option value. For example, the exercise price of the share options in Example
1 (see paragraph 718-20-55-4) might increase at the rate of 1 percent annually. For that example, Entity T’s
share options would be valued based on a risk-free interest rate less 1 percent. Holding all other assumptions
constant from that Example, the value of each share option granted by Entity T would be $14.34.
The example below illustrates the accounting for an award with performance
conditions that affect the vesting and transferability of stock options.
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.
The example below illustrates the accounting for an award with a performance
condition that affects the quantity of restricted stock awards earned.
Example 4-1
On January 1, 20X6, Entity A grants 100,000 restricted stock awards to its employees. The restricted stock awards have a grant-date fair-value-based measure of $30 per share and vest at the end of the third year of service. The number of restricted stock awards that vest at the end of the three-year service period is based on the target EBITDA growth rate (performance condition) as indicated in the following table:
Compensation cost for the awards is based on the probable outcome of the performance condition. If, on the grant date, the probable outcome is that the EBITDA growth rate target of 8 percent will be met, initial accruals of compensation cost should reflect vesting of 100,000 restricted stock awards. Accruals of compensation cost should be adjusted for subsequent changes in the estimated or actual outcome. For example, if the actual EBITDA growth rate at the end of the three-year period is 6 percent, or it becomes probable that the EBITDA growth rate will be 6 percent, the cumulative compensation cost recognized should be adjusted to reflect vesting of 50,000 restricted stock awards (100,000 restricted stock awards × 50 percent payout).
The journal entries below illustrate the accounting for the awards.
As of December 31, 20X8, the actual EBITDA growth rate is 6 percent, resulting in a 50 percent payout.
4.6.2 Other Conditions
An entity must carefully evaluate the terms and conditions of an award. If the entity determines that
the award is indexed to a factor other than a market, performance, or service condition (i.e., an “other”
condition), the award is classified as a share-based liability under ASC 718-10-25-13 (unless certain
exceptions apply). Such other condition should also be reflected in the estimate of the award’s fair-value-based
measure. For example, an entity may grant a restricted stock award that indexes the quantity
of shares that will vest to oil price changes. Even if the entity is in the oil and gas industry, the award is
classified as a liability. Accordingly, the fair-value-based measure of the award should be remeasured at
the end of each reporting period until settlement and should reflect changes in the market price of oil.
4.7 Nonvested 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).
ASC 718-10
Nonvested or Restricted Shares
30-17 A nonvested equity share
or nonvested equity share unit shall be measured at its fair
value as if it were vested and issued on the grant date.
As discussed in Section
3.3, a nonvested share, commonly known as restricted stock, is an
award that a grantee earns once the grantee has provided the good or service
required under the terms of the share-based payment arrangement. Further, as
discussed throughout this Roadmap, the measurement basis under ASC 718 is a
fair-value-based measurement, which excludes the effects of service and performance
conditions that are vesting conditions. Therefore, restricted stock (with only
service and performance conditions) should generally be measured at the fair value
of the entity’s common stock as if the restricted stock were vested and issued on
the grant date (an entity may need to adjust the fair value for dividends, as
discussed below). It would not be appropriate for the fair value of the entity’s
common stock to be discounted to reflect that the shares being valued are not
vested.
While service and performance vesting conditions do not affect the
fair-value-based measure of restricted stock, the initial measurement of restricted
stock could be affected by factors such as a market condition, as discussed in ASC
718-10-30-14; a postvesting restriction, as discussed in ASC 718-10-30-10; or
whether the grantee is entitled to dividends. As indicated in paragraph B93 of FASB Statement 123(R), if a grantee holding a restricted stock award is not entitled to
receive dividends (i.e., the grantee does not have the right of a normal
shareholder), the fair-value-based measure of the award would be lower than the fair
value of a normal equity share if the entity is expected to pay dividends. An entity
should estimate the fair-value-based measure of restricted stock that does not
entitle the grantee to dividends during the service (vesting) period by reducing the
fair value of its common stock by the present value of expected dividends to be paid
before the end of the service (vesting) period. The present value of the expected
dividends should be calculated by using an appropriate risk-free interest rate as
the discount rate. See Section
4.9.2.4 for a discussion of how dividends paid on grantee stock
options during the expected term affect the valuation of such awards, and see
Section 12.4.3 for
a discussion of how dividend-paying restricted stock awards affect the computation
of EPS.
4.8 Restricted Shares
ASC 718-10 — Glossary
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.
ASC 718-10
Vesting Versus Nontransferability
30-10 To satisfy the
measurement objective in paragraph 718-10-30-6, the
restrictions and conditions inherent in equity instruments
awarded are treated differently depending on whether they
continue in effect after the requisite service period or the
nonemployee’s vesting period. A restriction that continues
in effect after an entity has issued awards, 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 equity 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).
30-10A On an
award-by-award basis, an entity may elect to use the
contractual term as the expected term when estimating the
fair value of a nonemployee award to satisfy the measurement
objective in paragraph 718-10-30-6. Otherwise, an entity
shall apply the guidance in this Topic in estimating the
expected term of a nonemployee award, which may result in a
term less than the contractual term of the award.
30-10B When a nonpublic entity chooses
to measure a nonemployee share-based payment award by estimating
its expected term and applies the practical expedient in
paragraph 718-10-30-20A, it must apply the practical expedient
to all nonemployee awards that meet the conditions in paragraph
718-10-30-20B. However, a nonpublic entity may still elect, on
an award-by-award basis, to use the contractual term as the
expected term as described in paragraph 718-10-30-10A.
Nonvested or Restricted Shares
30-18 Nonvested shares granted
in share-based payment transactions usually are referred to
as restricted shares, but this Topic reserves that term for
fully vested and outstanding shares whose sale is
contractually or governmentally prohibited for a specified
period of time.
30-19 A restricted share
awarded to a grantee, that is, a share that will be
restricted after the grantee has a vested right to it, shall
be measured at its fair value, which is the same amount for
which a similarly restricted share would be issued to third
parties. Example 8 (see paragraph 718-20-55-71) provides an
illustration of accounting for an award of nonvested shares
to employees.
Fair Value Measurement Objectives and Application
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).
A restricted share is a fully vested and outstanding share whose sale is
prohibited for a specified period. For example, as described in Section 3.3, a grantee may be
granted a fully vested share but may be restricted from selling it for a two-year
period. If the grantee ceases delivering goods or rendering services to the entity
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, including any discounts relative to the fair value of the shares
without a postvesting restriction. This discount is often referred to as a discount
for lack of marketability (DLOM) or discount for illiquidity.
Entities must be able to provide objective and verifiable evidence supporting
the amount of the discount. In determining an appropriate discount, entities should
consider the following remarks by Barry Kanczuker, then associate chief accountant in
the SEC’s Office of the Chief Accountant, at the 2015 AICPA Conference on Current
SEC and PCAOB Developments:
I would now like to turn to an
observation regarding the impact of post-vesting restrictions on the measurement
of share-based awards. The measurement of share-based awards impacts
compensation expense. Post-vesting restrictions, such as transfer or sale
restrictions, are a common feature of many share-based payment
arrangements.
ASC 718 provides guidance on the
accounting for share-based awards when the sale of the underlying shares is
prohibited for a period of time subsequent to the awards vesting date. The
post-vesting restrictions should be considered when estimating the grant-date
fair value of the award [ASC 718-10-30-10]. I would expect that a post-vesting
restriction may result in a discount relative to the market value of common
stock to reflect that the market shares can be freely traded while restricted
shares cannot. The assumptions used in determining the value of the share-based
award should be attributes that a market participant would consider related to
the underlying award, rather than an attribute related to the individual holding
the award.
Some market participants have indicated that
post-vesting holding restrictions on share-based payment awards can result in
significantly lower stock compensation expense. While post-vesting restrictions
should be considered in estimating the fair value of share-based payments [ASC
718-10-30-10], when evaluating the appropriateness of measurement in this area,
we continue to look to the guidance in ASC 718-10-55-5, which states that “. . .
if shares are traded in an active market, post-vesting restrictions may have
little, if any, effect on the amount at which the shares being valued would be
exchanged”. With that being said, I would encourage you to consult with the
Staff if you believe that you have a fact pattern in which a post-vesting
restriction results in a significant discount being applied to the grant-date
fair value of a share-based award. [Footnotes omitted]
In addition, entities should consider remarks by Sandie Kim, then professional accounting fellow in
the SEC’s Office of the Chief Accountant, at the 2007 AICPA Conference on Current SEC and PCAOB
Developments:
Statement 123(R) establishes fair value as the measurement objective in accounting for share-based payment
arrangements. While the actual measurement of share-based payment arrangements is not necessarily at fair
value and Statement 157 does not apply to such arrangements, Statement 123(R) nonetheless states that the
valuation and assumptions used should be consistent with the fair value measurement objective.
One analysis that may sometimes be difficult in valuing any security, not just those issued in share-based
payment arrangements, is determining which assumptions should be incorporated in the valuation because
they are attributes a market participant would consider (it is an attribute of the security), versus an attribute a
specific holder of the security would consider. For example, one common term we see in share-based payment
arrangements is a restriction that prohibits the transfer or sale of securities. If the security contains such a
restriction that continues after the requisite service period, that post-vesting restriction may be factored as a
reduction in the value of the security. As a reminder, the staff has previously communicated that the discount
calculated should be specific to the security, and not derived based on general rules of thumb.
On the other hand, we have also seen instances in which assumptions related to a specific holder attribute
were incorporated in the valuation of share-based payments. While the determination of which assumptions
to incorporate is judgmental, we believe that it would be difficult to substantiate that assumptions that reflect
an attribute of a specific holder versus a market participant would be appropriate. Statement 123(R) specifies
that the assumptions should reflect information available to form the basis for an amount at which the
instrument being valued would be exchanged, and that the assumptions used should not represent the biases
of a particular party. For example, we have heard arguments that a significant discount should be taken on
certain share-based payment awards because the securities were issued to a group of executives that were
subject to higher taxes than other employees. The staff does not believe this assumption is consistent with a
fair value measurement objective. As an additional observation, Statement 157 also refers to assumptions that
are incorporated in the fair value of a security because they are specific to the security (that is, attributes of the
security) and would, therefore, transfer to market participants. [Footnotes omitted]
There are several valuation techniques used to determine a DLOM, as further
described in Section
4.12.1.
4.8.1 Options on Restricted Shares
If an entity grants options to acquire restricted shares (as defined in ASC 718), it should take into
account the effect of the postvesting restriction by using the restricted share value as an input in the
option pricing model. That is, the discount for the postvesting restriction should not be applied to the
output of the option pricing model.
For example, assume that a public entity issues an option with a four-year
service (vesting) condition and a postvesting restriction that prohibits the
grantee from selling the shares obtained upon exercising the option for another
two years. If the entity estimates the fair-value-based measure of the option by
using a Black-Scholes-Merton formula, the input used for the current market
price of the underlying share generally will not be the quoted market price of
the entity’s common stock since the underlying share contains a postvesting
restriction. Rather, the entity should generally use the fair value of a similar
restricted share as the input for the current market price (i.e., the fair value
of a share containing similar restrictions on transferability for a period of
two years). The fair value of a restricted share typically should be lower than
the fair value of a similar share without any restrictions. Therefore, using the
fair value of a restricted share in the Black-Scholes-Merton formula will result
in an estimated fair-value-based measure of the option that is lower than that
of an option without any postvesting restrictions on the underlying share (if
all other inputs remain the same).
A restriction on the ability to sell or transfer the option itself is different from a restriction on the
underlying share. If the option (as opposed to the underlying share) is nontransferable, which is typically
the case for employee stock options, the expected-term assumption is adjusted to reflect the restriction
rather than the input associated with the current market price of the underlying share. This restriction
generally leads to the early exercise of the option (before the end of the contractual term), and since a
discount is factored into the expected-term assumption, no additional discount should be applied to the
estimated fair-value-based measure derived from the option-pricing model. See Section 4.9.2.2.
4.8.2 Limited Population of Transferees
In certain cases, the terms of a share-based payment arrangement may permit the transfer of shares
only to a limited population, such as in an offering under Rule 144A of the Securities Act of 1933. A
limited population of transferees is not a prohibition on the sale of the instrument and therefore is
not considered a restriction under ASC 718. As described in Section 4.7, the fair-value-based measure
of restricted stock (i.e., nonvested shares) is calculated at the fair value of the entity’s common stock
as if the restricted stock were vested and issued on the grant date. An entity should not discount that
value solely because the entity’s common stock could be transferred to only a limited population of
transferees.
4.9 Option Pricing Models
ASC 718-10 — Glossary
Closed-Form Model
A valuation model that uses an equation to produce an estimated fair value. The Black-Scholes-Merton formula is a closed-form model. In the context of option valuation, both closed-form models and lattice models are based on risk-neutral valuation and a contingent claims framework. The payoff of a contingent claim, and thus its value, depends on the value(s) of one or more other assets. The contingent claims framework is a valuation methodology that explicitly recognizes that dependency and values the contingent claim as a function of the value of the underlying asset(s). One application of that methodology is risk-neutral valuation in which the contingent claim can be replicated by a combination of the underlying asset and a risk-free bond. If that replication is possible, the value of the contingent claim can be determined without estimating the expected returns on the underlying asset. The Black-Scholes-Merton formula is a special case of that replication.
Intrinsic Value
The amount by which the fair value of the
underlying stock exceeds the exercise price of an option.
For example, an option with an exercise price of $20 on a
stock whose current market price is $25 has an intrinsic
value of $5. (A nonvested share may be described as an
option on that share with an exercise price of zero. Thus,
the fair value of a share is the same as the intrinsic value
of such an option on that share.)
Lattice Model
A model that produces an estimated fair
value based on the assumed changes in prices of a financial
instrument over successive periods of time. The binomial
model is an example of a lattice model. In each time period,
the model assumes that at least two price movements are
possible. The lattice represents the evolution of the value
of either a financial instrument or a market variable for
the purpose of valuing a financial instrument. In this
context, a lattice model is based on risk-neutral valuation
and a contingent claims framework. See Closed-Form Model for
an explanation of the terms risk-neutral valuation and
contingent claims framework.
Time Value
The portion of the fair value of an option that exceeds its intrinsic value. For example, a call option with an exercise price of $20 on a stock whose current market price is $25 has intrinsic value of $5. If the fair value of that option is $7, the time value of the option is $2 ($7 – $5).
ASC 718-10
30-7 The fair value of an equity share option or similar instrument shall be measured based on the observable market price of an option with the same or similar terms and conditions, if one is available (see paragraph 718-10-55-10).
30-8 Such market prices for equity
share options and similar instruments granted in share-based
payment transactions are frequently not available; however, they
may become so in the future.
30-9 As such, the fair value of an equity share option or similar instrument shall be estimated using a valuation technique such as an option-pricing model. For this purpose, a similar instrument is one whose fair value differs from its intrinsic value, that is, an instrument that has time value. For example, a share appreciation right that requires net settlement in equity shares has time value; an equity share does not. Paragraphs 718-10-55-4 through 55-47 provide additional guidance on estimating the fair value of equity instruments, including the factors to be taken into account in estimating the fair value of equity share options or similar instruments as described in paragraphs 718-10-55-21 through 55-22.
Valuation Techniques
55-15 Valuation techniques used for
share options and similar instruments granted in share-based
payment transactions estimate the fair value of those
instruments at a single point in time (for example, at the grant
date). The assumptions used in a fair value measurement are
based on expectations at the time the measurement is made, and
those expectations reflect the information that is available at
the time of measurement. The fair value of those instruments
will change over time as factors used in estimating their fair
value subsequently change, for instance, as share prices
fluctuate, risk-free interest rates change, or dividend streams
are modified. Changes in the fair value of those instruments are
a normal economic process to which any valuable resource is
subject and do not indicate that the expectations on which
previous fair value measurements were based were incorrect. The
fair value of those instruments at a single point in time is not
a forecast of what the estimated fair value of those instruments
may be in the future.
55-16 A lattice model (for example,
a binomial model) and a closed-form model (for example, the
Black-Scholes-Merton formula) are among the valuation techniques
that meet the criteria required by this Topic for estimating the
fair values of share options and similar instruments granted in
share-based payment transactions. A Monte Carlo simulation
technique is another type of valuation technique that satisfies
the requirements in paragraph 718-10-55-11. Other valuation
techniques not mentioned in this Topic also may satisfy the
requirements in that paragraph. Those valuation techniques or
models, sometimes referred to as option-pricing models, are
based on established principles of financial economic theory.
Those techniques are used by valuation professionals, dealers of
derivative instruments, and others to estimate the fair values
of options and similar instruments related to equity securities,
currencies, interest rates, and commodities. Those techniques
are used to establish trade prices for derivative instruments
and to establish values in adjudications. As discussed in
paragraphs 718-10-55-21 through 55-50, both lattice models and
closed-form models can be adjusted to account for the
substantive characteristics of share options and similar
instruments granted in share-based payment transactions.
55-17 This Topic does not specify a
preference for a particular valuation technique or model in
estimating the fair values of share options and similar
instruments granted in share-based payment transactions. Rather,
this Topic requires the use of a valuation technique or model
that meets the measurement objective in paragraph 718-10-30-6
and the requirements in paragraph 718-10-55-11. The selection of
an appropriate valuation technique or model will depend on the
substantive characteristics of the instrument being valued.
Because an entity may grant different types of instruments, each
with its own unique set of substantive characteristics, an
entity may use a different valuation technique for each
different type of instrument. The appropriate valuation
technique or model selected to estimate the fair value of an
instrument with a market condition must take into account the
effect of that market condition. The designs of some techniques
and models better reflect the substantive characteristics of a
particular share option or similar instrument granted in
share-based payment transactions. Paragraphs 718-10-55-18
through 55-20 discuss certain factors that an entity should
consider in selecting a valuation technique or model for its
share options or similar instruments.
55-18 The Black-Scholes-Merton
formula assumes that option exercises occur at the end of an
option’s contractual term, and that expected volatility,
expected dividends, and risk-free interest rates are constant
over the option’s term. If used to estimate the fair value of
instruments in the scope of this Topic, the Black-Scholes-Merton
formula must be adjusted to take account of certain
characteristics of share options and similar instruments that
are not consistent with the model’s assumptions (for example,
exercising before the end of the option’s contractual term when
estimating expected term). Because of the nature of the formula,
those adjustments take the form of weighted-average assumptions
about those characteristics. In contrast, a lattice model can be
designed to accommodate dynamic assumptions of expected
volatility and dividends over the option’s contractual term, and
estimates of expected option exercise patterns during the
option’s contractual term, including the effect of blackout
periods. Therefore, the design of a lattice model more fully
reflects the substantive characteristics of particular share
options or similar instruments. Nevertheless, both a lattice
model and the Black-Scholes-Merton formula, as well as other
valuation techniques that meet the requirements in paragraph
718-10-55-11, can provide a fair value estimate that is
consistent with the measurement objective and fair-value-based
method of this Topic.
55-19 Regardless of the valuation
technique or model selected, an entity shall develop reasonable
and supportable estimates for each assumption used in the model,
including the share option or similar instrument’s expected
term, taking into account both the contractual term of the
option and the effects of grantees’ expected exercise and
postvesting termination behavior. The term supportable is
used in its general sense: capable of being maintained,
confirmed, or made good; defensible. An application is
supportable if it is based on reasonable arguments that consider
the substantive characteristics of the instruments being valued
and other relevant facts and circumstances.
ASC 718 describes fair value, in a fair-value-based measurement, as the amount
at which market participants would be willing to conduct transactions. In situations in
which there is an absence of an observable market price, which is generally the case for
options and similar instruments granted to an employee or nonemployee, an entity should
use a valuation technique to estimate the fair-value-based measure. Currently, the
Black-Scholes-Merton (closed-form) and binomial (lattice or open-form) models are the
most commonly used valuation techniques for options and similar instruments. While ASC
718 does not prescribe a particular valuation technique, it should (1) be applied in a
manner consistent with the fair-value-based measurement objective and the other
requirements in ASC 718, (2) be based on established principles of financial theory (and
generally applied in the valuation field), and (3) reflect all substantive
characteristics of an award.
An example of a closed-form model that is commonly used to value options and similar instruments is the Black-Scholes-Merton formula. In a closed-form model, an entity employs an equation to estimate the fair-value-based measure by using key determinants of a stock option’s value, such as the current market price of the underlying share, exercise price, expected volatility of the underlying share, time to exercise (i.e., expected term), dividend rate, and a risk-free interest rate for the expected term of the award. Because of the nature of the formula, those inputs are held constant throughout the option’s term.
The key difference between a closed-form model and a lattice model is that in a
lattice model, entities may assume variations to the inputs during the contractual term
of the award. The selection of an appropriate valuation technique will therefore depend
on the substantive characteristics of the award being valued. For example, with a
lattice model, the expected term of the award is an output that will depend on a
grantee’s exercise and postvesting behavior. The lattice model also allows entities to
vary the volatility of the underlying share price, the risk-free interest rate, and the
expected dividends on the underlying shares, since changes in these factors are expected
to occur over the contractual term of the option. A lattice approach can be used to
directly model the effect of different expected periods before exercise on the
fair-value-based measure of the option, whereas it is assumed under the
Black-Scholes-Merton model that exercise occurs at the end of the option’s expected
term.
A lattice model may therefore be better suited to capture and reflect the substantive characteristics of certain types of share-based payment awards. For example, it would generally not be appropriate for an entity to use the Black-Scholes-Merton model to value a stock option in which the exercisability depends on a specified increase in the price of the underlying shares (i.e., a market condition). This is because the Black-Scholes-Merton model is not designed to take into account this type of market condition and therefore does not incorporate all of the substantive characteristics unique to the stock option that is being valued. However, a lattice model such as a Monte Carlo simulation can be used to determine the fair-value-based measure of an award containing a market condition. This is because it can incorporate path-dependent options related to when the market condition will be met, thereby reflecting the substantive characteristics of the stock option being valued. Whether it is practical to use a lattice model is based on a variety of factors, including the availability of reliable data to support the variations in the inputs. Entities should develop reasonable and supportable estimates for inputs and underlying assumptions, regardless of the valuation technique applied.
The Interpretive Response to Question 2 of SAB Topic 14.C states that the SEC staff understands that an entity may consider multiple techniques or models that meet the fair-value-based measurement objective and that the entity would not be required to select a model (e.g., a lattice model) “simply because that model [is] the most complex of the models . . . considered.” If an entity’s choice of model or technique meets the fair-value-based measurement objective, the SEC will not object to it.
Entities may use a different valuation technique to estimate the
fair-value-based measure of different types of share-based payment awards. However, they
should use the selected model consistently for similar types of awards with similar
characteristics. For example, an entity may use a lattice model to estimate the
fair-value-based measure of awards with market conditions and use the
Black-Scholes-Merton formula to estimate the fair-value-based measure of awards that
contain only a service or performance condition. In addition, an entity may use a
lattice model to estimate the fair-value-based measure of employee stock options and the
Black-Scholes-Merton formula to estimate the fair-value-based measure of awards in an
employee stock purchase plan (ESPP).
Regardless of the valuation technique used, an option’s value is generally
composed of its intrinsic value and time value. Intrinsic value is the excess of the
fair value of the underlying stock over the exercise price. In many cases, options are
granted “at-the-money,” which means the exercise price is equal to the fair value of the
underlying stock (i.e., the intrinsic value is zero). If the fair value of the
underlying stock exceeds the exercise price, the option is “in-the-money,” and if the
fair value of the underlying stock is less than the exercise price, the option is
“out-of-the-money,” or “underwater.”
The excess of the total fair value of an option over its intrinsic value is referred to as time value. While an option may not have intrinsic value at the time of grant, all options typically have time value. This is because the holder of an option (1) does not have to pay the exercise price until the option is exercised and (2) has the ability to profit from appreciation of the underlying stock while limiting its loss or downside risk. Therefore, all else being equal, the longer the time until option expiration and the higher the volatility of the underlying stock, the greater the time value. See Section 4.9.2 for a discussion of the effect of the various inputs used in an option pricing model on the estimation of the fair-value-based measure of a share-based payment award.
4.9.1 Change in Valuation Technique
ASC 718-10
55-20 An entity shall change the valuation technique it uses to estimate fair value if it concludes that a different technique is likely to result in a better estimate of fair value (see paragraph 718-10-55-27). For example, an entity that uses a closed-form model might conclude, when information becomes available, that a lattice model or another valuation technique would provide a fair value estimate that better achieves the fair value measurement objective and, therefore, change the valuation technique it uses.
Consistent Use of Valuation Techniques and Methods for Selecting Assumptions
55-27 Assumptions used to
estimate the fair value of equity and liability
instruments granted in share-based payment transactions
shall be determined in a consistent manner from period
to period. For example, an entity might use the closing
share price or the share price at another specified time
as the current share price on the grant date in
estimating fair value, but whichever method is selected,
it shall be used consistently. The valuation technique
an entity selects to estimate fair value for a
particular type of instrument also shall be used
consistently and shall not be changed unless a different
valuation technique is expected to produce a better
estimate of fair value. A change in either the valuation
technique or the method of determining appropriate
assumptions used in a valuation technique is a change in
accounting estimate for purposes of applying Topic 250,
and shall be applied prospectively to new awards.
SEC Staff Accounting Bulletins
SAB Topic 14.C, Valuation Methods
[Excerpt]
Question 3: In
subsequent periods, may a company change the valuation
technique or model chosen to value instruments with
similar characteristics?21
Interpretive
Response: As long as the new technique or model
meets the fair value measurement objective as described
in Question 2 above, the staff would not object to a
company changing its valuation technique or
model.22 A change in the valuation
technique or model used to meet the fair value
measurement objective would not be considered a change
in accounting principle.23 As such, a company
would not be required to file a preferability letter
from its independent accountants as described in Rule
10-01(b)(6) of Regulation S-X when it changes valuation
techniques or models. However, the staff would not
expect that a company would frequently switch between
valuation techniques or models, particularly in
circumstances where there was no significant variation
in the form of share-based payments being valued.
Disclosure in the footnotes of the basis for any change
in technique or model would be appropriate.24
SAB Topic 14.D, Certain Assumptions Used
in Valuation Methods [Excerpt]
FASB ASC Topic 718’s (Compensation —
Stock Compensation Topic) fair value measurement
objective for equity instruments awarded to grantees for
goods or services is to estimate the grant-date fair
value of the equity instruments that the entity is
obligated to issue when grantees have delivered the good
or rendered the service and satisfied any other
conditions necessary to earn the right to benefit from
the instruments.25 In order to meet this fair
value measurement objective, management will generally
be required to develop estimates regarding (1) the
expected volatility of its company’s share price; (2)
the expected term of the option, taking into account
both the contractual term of the option and the effects
of grantees’ expected exercise and post-vesting
termination behavior; and (3) the determination of the
current price of the underlying share. The staff is
providing guidance in the following sections related to
the expected volatility, expected term and current share
price assumptions to assist public entities in applying
those requirements.
______________________________
21 FASB ASC paragraph
718-10-55-17 indicates that an entity may use different
valuation techniques or models for instruments with
different characteristics.
22 The staff believes that a
company should take into account the reason for the
change in technique or model in determining whether the
new technique or model meets the fair value measurement
objective. For example, changing a technique or model
from period to period for the sole purpose of lowering
the fair value estimate of a share option would not meet
the fair value measurement objective of the Topic.
23 FASB ASC paragraph
718-10-55-27.
24See generally FASB
ASC paragraph 718-10-50-1.
25 FASB ASC paragraph
718-10-30-6. FASB ASC paragraph 718-10-30-1 states that
this guidance applies equally to awards classified as
liabilities.
In the Interpretive Response to Question 3 of SAB Topic 14.C, the SEC staff
indicated that an entity may change its valuation technique or model as long as
the new technique or model meets the fair-value-based measurement objective in
ASC 718 (see Section 4.9
for more information about selecting a technique for valuing a share-based
payment award). However, the staff also stated that it would not expect an
entity to frequently switch between valuation techniques or models, especially
when there is “no significant variation in the form of share-based payments
being valued.” An entity should change its valuation technique or model only to
improve the estimate of the fair-value-based measure, not simply to reduce the
amount of compensation cost recognized.
An entity’s change to its valuation technique, model, or assumptions should be accounted for as a change in estimate and should be applied prospectively to new or modified awards. A change in valuation method will not affect the fair-value-based measure of previously issued awards; awards issued before the application of the new technique should not be remeasured or revalued unless they are modified.
4.9.2 Assumptions in an Option Pricing Model
ASC 718-10
Selecting Assumptions for Use in an Option Pricing Model
55-21 If an observable market price is not available for a share option or similar instrument with the same or similar terms and conditions, an entity shall estimate the fair value of that instrument using a valuation technique or model that meets the requirements in paragraph 718-10-55-11 and takes into account, at a minimum, all of the following:
- The exercise price of the option.
- The expected term of the option. This should take into account both the contractual term of the option and the effects of grantees’ expected exercise and postvesting termination behavior. In a closed-form model, the expected term is an assumption used in (or input to) the model, while in a lattice model, the expected term is an output of the model (see paragraphs 718-10-55-29 through 55-34, which provide further explanation of the expected term in the context of a lattice model).
- The current price of the underlying share.
- The expected volatility of the price of the underlying share for the expected term of the option.
- The expected dividends on the underlying share for the expected term of the option (except as provided in paragraphs 718-10-55-44 through 55-45).
- The risk-free interest rate(s) for the expected term of the option.
55-22 The term
expected in (b); (d); (e); and (f) in
paragraph 718-10-55-21 relates to expectations at the
measurement date about the future evolution of the
factor that is used as an assumption in a valuation
model. The term is not necessarily used in the same
sense as in the term expected future cash flows
that appears elsewhere in the Codification. The phrase
expected term of the option in (d); (e); and
(f) in paragraph 718-10-55-21 applies to both
closed-form models and lattice models (as well as all
other valuation techniques). However, if an entity uses
a lattice model (or other similar valuation technique,
for instance, a Monte Carlo simulation technique) that
has been modified to take into account an option’s
contractual term and grantees’ expected exercise and
postvesting termination behavior, then (d); (e); and (f)
in paragraph 718-10-55-21 apply to the contractual term
of the option.
55-23 There is likely to be a range of reasonable estimates for expected volatility, dividends, and term of the option. If no amount within the range is more or less likely than any other amount, an average of the amounts in the range (the expected value) shall be used. In a lattice model, the assumptions used are to be determined for a particular node (or multiple nodes during a particular time period) of the lattice and not over multiple periods, unless such application is supportable.
While ASC 718 does not require entities to use a particular valuation model to determine the fair-value-based measure of options and similar instruments, the valuation model used must, at a minimum, incorporate the following inputs in accordance with ASC 718-10-55-21:
- The exercise price of the award.
- The expected term of the award.
- The current market price of the underlying share.
- The expected volatility of the underlying share price over the expected term of the award.
- The expected dividends on the underlying share over the expected term of the award.
- The risk-free interest rate over the expected term of the award.
If a lattice model is used, the expected term would be an output of the model. Accordingly, the expected volatility, expected dividends, and risk-free interest rate would be determined for the option’s contractual term.
An individual option pricing model input that fluctuates might affect the other
inputs. For example, as volatility increases, more option holders might take
advantage of the increases in share prices by exercising their options earlier.
The increase in the number of exercises will affect the expected term, which in
turn may necessitate an adjustment to the expected dividend and risk-free
interest rates. Therefore, as long as all other variables
are held constant, the effects of a change in each individual input
factor on the fair-value-based measure of a stock option are as follows:
-
Exercise price of the award and current market price of the underlying share — The current market price of the underlying share for an award granted by a public entity is usually the quoted market price of the entity’s common stock on the grant date. However, there may be instances in which a public entity adjusts the quoted market price of its common stock on the grant date for certain share-based payment awards that are granted when the entity possesses material nonpublic information (i.e., spring-loaded awards; see Section 4.9.2.6 for additional considerations related to such awards). In addition, if the share has a postvesting restriction, see Section 4.8.1 for guidance on incorporating the postvesting restriction in the option pricing model. The exercise price is the amount of cash a grantee is required to pay to exercise the award. An increase in the exercise price will result in a decrease in the award’s fair-value-based measure, whereas an increase in the current market price will result in an increase in that measure. Accordingly, the relationship between the exercise price of an award and the current market price of the entity’s common stock will affect the award’s fair-value-based measure. That is, on the grant date, an option that is issued in-the-money (i.e., the exercise price is less than the current market price of the entity’s common stock so the option has intrinsic value) will have a greater fair-value-based measure than an option issued at-the-money or out-of-the-money.
-
Expected term of the award — The expected term of an award is the period during which the award is expected to be outstanding (i.e., the period from the service inception date, which is usually the grant date, to the date of expected exercise or settlement). An award’s fair-value-based measure increases as its expected term increases as a result of the increase in the award’s time value. The time value of an award is the portion of an award’s fair-value-based measure that is based on (1) the amount of time remaining until the expiration date of the award and (2) the notion that the underlying components that constitute the value of the award may change during that time. See Section 4.9.2.2 for a discussion of factors to consider in the estimation of the expected term of an award and of the SEC staff’s views on estimating the expected term.
-
Expected volatility of the underlying share price — Expected volatility of the underlying share price is a probability-weighted measure of the expected dispersion of share prices about the mean share price over the expected term of the award. The fair value of an option increases with an increase in volatility. A high volatility indicates a greater fluctuation in the share price (up or down from the mean share price), potentially resulting in a greater benefit for the option holder. For example, if an option is issued at-the-money, the holder of an option with a highly volatile share price will be more likely to exercise the option when the share price fluctuates to a higher value (and sell that share for a profit) than a holder of a similar option with a less volatile underlying share price. See Section 4.9.2.3 for a discussion of (1) factors to consider in the estimation of the expected volatility of the underlying share price and (2) the SEC staff’s views on estimating the expected volatility. In addition, an entity that is valuing a spring-loaded award would consider whether a marketplace participant would take into account the material nonpublic information when estimating expected volatility.
-
Expected dividends on the underlying share — The expected dividends on the underlying share represent the expected dividends or dividend rate that will be paid out on the underlying shares during the expected term of the award. Expected dividends should be included in the valuation model only if the award holders are not entitled to receive those dividends before exercise. Consequently, as expected dividends increase, the fair-value-based measure of the award decreases. See Section 4.9.2.4 for a discussion of how dividends paid on stock options before exercise affect the valuation of such awards.
-
Risk-free interest rate for the expected term of the award — The risk-free rate is a theoretical rate at which an investment earns interest without incurring any risk (i.e., the valuation is risk neutral). This risk-neutral notion is used extensively in option pricing theory, under which all assets may be assumed to have expected returns equal to the risk-free rate. Higher interest rates will increase the fair-value-based measure of an award by increasing the award’s time value. See Section 4.9.2.1 for guidance on selecting an appropriate risk-free interest rate.
The effect of an increase in each of the above inputs (assuming that all other
inputs remain constant) is summarized in the table below.
Increase in Input | Effect on Award’s Fair Value |
---|---|
Current market price of underlying share | Increase |
Exercise price | Decrease |
Expected term | Increase |
Expected volatility | Increase |
Expected dividends | Decrease |
Risk-free interest rate | Increase |
Developing assumptions to be used in an option-pricing model generally involves assessing historical experience and considering whether such historical experience is relevant to the development of future expectations. See ASC 718-10-55-24 and 55-25 below.
ASC 718-10
55-24 Historical experience
is generally the starting point for developing
expectations about the future. Expectations based on
historical experience shall be modified to reflect ways
in which currently available information indicates that
the future is reasonably expected to differ from the
past. The appropriate weight to place on historical
experience is a matter of judgment, based on relevant
facts and circumstances. For example, an entity with two
distinctly different lines of business of approximately
equal size may dispose of the one that was significantly
less volatile and generated more cash than the other. In
that situation, the entity might place relatively little
weight on volatility, dividends, and perhaps grantees’
exercise and postvesting termination behavior from the
predisposition (or disposition) period in developing
reasonable expectations about the future. In contrast,
an entity that has not undergone such a restructuring
might place heavier weight on historical experience.
That entity might conclude, based on its analysis of
information available at the time of measurement, that
its historical experience provides a reasonable estimate
of expected volatility, dividends, and grantees’
exercise and postvesting termination behavior. This
guidance is not intended to suggest either that
historical volatility is the only indicator of expected
volatility or that an entity must identify a specific
event in order to place less weight on historical
experience. Expected volatility is an expectation of
volatility over the expected term of an option or
similar instrument; that expectation shall consider all
relevant factors in paragraph 718-10-55-37, including
possible mean reversion. Paragraphs 718-10-55-35 through
55-41 provide further guidance on estimating expected
volatility.
55-25 In certain circumstances, historical information may not be available. For example, an entity whose common stock has only recently become publicly traded may have little, if any, historical information on the volatility of its own shares. That entity might base expectations about future volatility on the average volatilities of similar entities for an appropriate period following their going public. A nonpublic entity will need to exercise judgment in selecting a method to estimate expected volatility and might do so by basing its expected volatility on the average volatilities of otherwise similar public entities. For purposes of identifying otherwise similar entities, an entity would likely consider characteristics such as industry, stage of life cycle, size, and financial leverage. Because of the effects of diversification that are present in an industry sector index, the volatility of an index should not be substituted for the average of volatilities of otherwise similar entities in a fair value measurement.
4.9.2.1 Risk-Free Interest Rate
ASC 718-10
Selecting or Estimating the Risk-Free Rate for the Expected Term
55-28 Option-pricing models call for the risk-free interest rate as an assumption to take into account, among other things, the time value of money. A U.S. entity issuing an option on its own shares must use as the risk-free interest rates the implied yields currently available from the U.S. Treasury zero-coupon yield curve over the contractual term of the option if the entity is using a lattice model incorporating the option’s contractual term. If the entity is using a closed-form model, the risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model. For entities based in jurisdictions outside the United States, the risk-free interest rate is the implied yield currently available on zero-coupon government issues denominated in the currency of the market in which the share (or underlying share), which is the basis for the instrument awarded, primarily trades. It may be necessary to use an appropriate substitute if no such government issues exist or if circumstances indicate that the implied yield on zero-coupon government issues is not representative of a risk-free interest rate.
The risk-free interest rate is the theoretical rate of return of an investment with zero risk (since option pricing models are risk-neutral valuations). The risk-free interest rate represents the interest an investor would expect from a risk-free investment over a specified period. This rate is associated with the time value of money since an option holder does not have to pay for the underlying stock until the option is exercised. In the United States, the risk-free interest rate is assumed to be a treasury rate, with a remaining term equal to the expected term of the award (e.g., U.S. Treasury zero-coupon issues).
4.9.2.2 Expected Term
ASC 718-10
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).
Selecting or Estimating the Expected Term
55-29 The fair value of a traded (or transferable) share option is based on its contractual term because rarely is it economically advantageous to exercise, rather than sell, a transferable share option before the end of its contractual term. Employee share options generally differ from transferable share options in that employees cannot sell (or hedge) their share options — they can only exercise them; because of this, employees generally exercise their options before the end of the options’ contractual term. Thus, the inability to sell or hedge an employee share option effectively reduces the option’s value because exercise prior to the option’s expiration terminates its remaining life and thus its remaining time value. In addition, some employee share options contain prohibitions on exercise during blackout periods. To reflect the effect of those restrictions (which may lead to exercise before the end of the option’s contractual term) on employee options relative to transferable options, this Topic requires that the fair value of an employee share option or similar instrument be based on its expected term, rather than its contractual term (see paragraphs 718-10-55-5 and 718-10-55-21).
55-29A Paragraph
718-10-30-10A states that, on an award-by-award
basis, an entity may elect to use the contractual
term as the expected term when estimating the fair
value of a nonemployee award to satisfy the
measurement objective in paragraph 718-10-30-6.
Otherwise, an entity shall apply the guidance in
this Topic in estimating the expected term of a
nonemployee award, which may result in a term less
than the contractual term of the award. If an entity
does not elect to use the contractual term as the
expected term, similar considerations discussed in
paragraph 718-10-55-29, such as the inability to
sell or hedge a nonemployee award, apply when
estimating its expected term.
55-30 The expected term of an employee share option or similar instrument is the period of time for which the instrument is expected to be outstanding (that is, the period of time from the service inception date to the date of expected exercise or other expected settlement). The expected term is an assumption in a closed-form model. However, if an entity uses a lattice model that has been modified to take into account an option’s contractual term and employees’ expected exercise and post-vesting employment termination behavior, the expected term is estimated based on the resulting output of the lattice. For example, an entity’s experience might indicate that option holders tend to exercise their options when the share price reaches 200 percent of the exercise price. If so, that entity might use a lattice model that assumes exercise of the option at each node along each share price path in a lattice at which the early exercise expectation is met, provided that the option is vested and exercisable at that point. Moreover, such a model would assume exercise at the end of the contractual term on price paths along which the exercise expectation is not met but the options are in-the-money at the end of the contractual term. The terms at-the-money, in-the-money, and out-of-the-money are used to describe share options whose exercise price is equal to, less than, or greater than the market price of the underlying share, respectively. The valuation approach described recognizes that employees’ exercise behavior is correlated with the price of the underlying share. Employees’ expected post-vesting employment termination behavior also would be factored in. Expected term, which is a required disclosure (see paragraphs 718-10-50-2 through 50-2A), then could be estimated based on the output of the resulting lattice. An example of an acceptable method for purposes of financial statement disclosures of estimating the expected term based on the results of a lattice model is to use the lattice model’s estimated fair value of a share option as an input to a closed-form model, and then to solve the closed-form model for the expected term. Other methods also are available to estimate expected term.
55-31 Other factors that may affect expectations about employees’ exercise and post-vesting employment termination behavior include the following:
- The vesting period of the award. An option’s expected term must at least include the vesting period. 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.
- Employees’ historical exercise and post-vesting employment termination behavior for similar grants.
- Expected volatility of the price of the underlying share. An entity also might consider whether the evolution of the share price affects an employee’s exercise behavior (for example, an employee may be more likely to exercise a share option shortly after it becomes in-the-money if the option had been out-of-the-money for a long period of time).
- Blackout periods and other coexisting arrangements such as agreements that allow for exercise to automatically occur during blackout periods if certain conditions are satisfied.
- Employees’ ages, lengths of service, and home jurisdictions (that is, domestic or foreign).
55-32 If sufficient information about employees’ expected exercise and post-vesting employment termination behavior is available, a method like the one described in paragraph 718-10-55-30 might be used because that method reflects more information about the instrument being valued (see paragraph 718-10-55-18). However, expected term might be estimated in some other manner, taking into account whatever relevant and supportable information is available, including industry averages and other pertinent evidence such as published academic research.
SEC Staff Accounting Bulletins
SAB Topic 14.D.2, Certain
Assumptions Used in Valuation Methods: Expected Term
[Excerpt]
FASB ASC paragraph 718-10-55-29
states, “The fair value of a traded (or
transferable) share option is based on its
contractual term because rarely is it economically
advantageous to exercise, rather than sell, a
transferable share option before the end of its
contractual term. Employee share options generally
differ from transferable [or tradable] share options
in that employees cannot sell (or hedge) their share
options — they can only exercise them; because of
this, employees generally exercise their options
before the end of the options’ contractual term.
Thus, the inability to sell or hedge an employee
share option effectively reduces the option’s value
[compared to a transferable option] because exercise
prior to the option’s expiration terminates its
remaining life and thus its remaining time value.”
Accordingly, FASB ASC Topic 718 requires that when
valuing an employee share option under the
Black-Scholes-Merton framework the fair value of
employee share options be based on the share
options’ expected term rather than the contractual
term.
FASB ASC paragraph 718-10-55-29A states, “On an
award-by-award basis, an entity may elect to use the
contractual term as the expected term when
estimating the fair value of a nonemployee award to
satisfy the measurement objective in paragraph
718-10-30-6. Otherwise, an entity shall apply the
guidance in [Topic 718] in estimating the expected
term of a nonemployee award, which may result in a
term less than the contractual term of the award. If
an entity does not elect to use the contractual term
as the expected term, similar considerations
discussed in paragraph 718-10-55-29, such as the
inability to sell or hedge a nonemployee award,
apply when estimating its expected term.”
The staff believes the estimate of
expected term should be based on the facts and
circumstances available in each particular case.
Consistent with our Topic 14 introductory guidance
regarding reasonableness, the fact that other
possible estimates are later determined to have more
accurately reflected the term does not necessarily
mean that the particular choice was unreasonable.
The staff reminds registrants of the expected term
disclosure requirements described in FASB ASC
subparagraph 718-10-50-2(f)(2)(i).
Facts:
Company D utilizes the Black-Scholes-Merton
closed-form model to value its share options for the
purposes of determining the fair value of the
options under FASB ASC Topic 718. Company D recently
granted share options to its employees. Based on its
review of various factors, Company D determines that
the expected term of the options is six years, which
is less than the contractual term of ten years.
Question 1:
When determining the fair value of the share options
in accordance with FASB ASC Topic 718, should
Company D consider an additional discount for
nonhedgability and nontransferability?
Interpretive
Response: No. FASB ASC paragraph 718-10-55-29
indicates that nonhedgability and nontransferability
have the effect of increasing the likelihood that an
employee share option will be exercised before the
end of its contractual term. Nonhedgability and
nontransferability therefore factor into the
expected term assumption (in this case reducing the
term assumption from ten years to six years), and
the expected term reasonably adjusts for the effect
of these factors. Accordingly, the staff believes
that no additional reduction in the term assumption
or other discount to the estimated fair value is
appropriate for these particular
factors.61
Question 2:
Should forfeitures or terms that stem from
forfeitability be factored into the determination of
expected term?
Interpretive
Response: No. FASB ASC Topic 718 indicates
that the expected term that is utilized as an
assumption in a closed-form option-pricing model or
a resulting output of a lattice option pricing model
when determining the fair value of the share options
should not incorporate restrictions or other terms
that stem from the pre-vesting forfeitability of the
instruments. Under FASB ASC Topic 718, these
pre-vesting restrictions or other terms are taken
into account by ultimately recognizing compensation
cost only for awards for which grantees deliver the
good or render the service.62
Question 3:
Can a company’s estimate of expected term ever be
shorter than the vesting period?
Interpretive
Response: No. The vesting period forms the
lower bound of the estimate of expected
term.63 . . .
Question 5:
What approaches could a company use to estimate the
expected term of its employee share options?
Interpretive
Response: A company should use an approach
that is reasonable and supportable under FASB ASC
Topic 718’s fair value measurement objective, which
establishes that assumptions and measurement
techniques should be consistent with those that
marketplace participants would be likely to use in
determining an exchange price for the share
options.65 If, in developing its
estimate of expected term, a company determines that
its historical share option exercise experience is
the best estimate of future exercise patterns, the
staff will not object to the use of the historical
share option exercise experience to estimate
expected term.66
A company may also conclude that its
historical share option exercise experience does not
provide a reasonable basis upon which to estimate
expected term. This may be the case for a variety of
reasons, including, but not limited to, the life of
the company and its relative stage of development,
past or expected structural changes in the business,
differences in terms of past equity-based share
option grants,67 or a lack of variety of
price paths that the company may have
experienced.68
FASB ASC Topic 718 describes other
alternative sources of information that might be
used in those cases when a company determines that
its historical share option exercise experience does
not provide a reasonable basis upon which to
estimate expected term. For example, a lattice model
(which by definition incorporates multiple price
paths) can be used to estimate expected term as an
input into a Black-Scholes-Merton closed-form
model.69 In addition, FASB ASC
paragraph 718-10-55-32 states that “. . . expected
term might be estimated in some other manner, taking
into account whatever relevant and supportable
information is available, including industry
averages and other pertinent evidence such as
published academic research.” For example, data
about exercise patterns of employees in similar
industries and/or situations as the company’s might
be used.
______________________________
61 The staff notes the
existence of academic literature that supports the
assertion that the Black-Scholes-Merton closed-form
model, with expected term as an input, can produce
reasonable estimates of fair value. Such literature
includes J. Carpenter, “The exercise and valuation
of executive stock options,” Journal of Financial
Economics, May 1998, pp. 127–158; C. Marquardt, “The
Cost of Employee Stock Option Grants: An Empirical
Analysis,” Journal of Accounting Research, September
2002, pp. 1191–1217); and J. Bettis, J. Bizjak and
M. Lemmon, “Exercise behavior, valuation, and the
incentive effect of employee stock options,” Journal
of Financial Economics, May 2005, pp. 445–470, as
well as more recent studies.
62 FASB ASC paragraph
718-10-30-11.
63 FASB ASC paragraph
718-10-55-31.
65 FASB ASC paragraph
718-10-55-13.
66 Historical share
option exercise experience encompasses data related
to share option exercise, post-vesting termination,
and share option contractual term expiration.
67 For example, if a
company had historically granted share options that
were always in-the-money, and will grant
at-the-money options prospectively, the exercise
behavior related to the in-the-money options may not
be sufficient as the sole basis to form the estimate
of expected term for the at-the-money grants.
68 For example, if a
company had a history of previous equity-based share
option grants and exercises only in periods in which
the company’s share price was rising, the exercise
behavior related to those options may not be
sufficient as the sole basis to form the estimate of
expected term for current option grants.
69 FASB ASC paragraph
718-10-55-30.
ASC 718 does not specify a method for estimating the expected term of an award; however, such a method must be objectively supportable. Similarly, historical observations should be accompanied by information about why future observations are not expected to change, and any adjustments to these observations should be supported by objective data. ASC 718-10-55-31 provides the following factors an entity may consider in estimating the expected term of an award:
- The vesting period of the award — Options generally cannot be exercised before vesting; thus, an option’s expected term cannot be less than its vesting period.
- Historical exercise and postvesting employment termination behavior for similar grants — Historical experience should be an entity’s starting point in determining expectations of future exercise and postvesting behavior. Historical exercise patterns should be modified when current information suggests that future behavior will differ from past behavior. For example, rapid increases in an entity’s stock price after the release of a new product in the past could have caused more grantees to exercise their options as soon as the options vested. If a similar increase in the entity’s stock price is not expected, the entity should consider whether adjusting the historical exercise patterns is appropriate.
- Expected volatility of the underlying share price — An increase in the volatility of the underlying share price tends to result in an increase in exercise activity because more grantees take advantage of increases in an entity’s share price to realize potential gains on the exercise of the option and subsequent sale of the underlying shares. ASC 718-10-55-31(c) states, “An entity also might consider whether the evolution of the share price affects [a grantee’s] exercise behavior (for example, [a grantee] may be more likely to exercise a share option shortly after it becomes in-the-money if the option had been out-of-the-money for a long period of time).” The exercise behavior based on the evolution of an entity’s share price can be more easily incorporated into a lattice model than into a closed-form model.
- Blackout periods — A blackout period is a period during which exercise of an option is contractually or legally prohibited. Blackout periods and other arrangements that affect the exercise behavior associated with options can be included in a lattice model. Unlike a closed-form model, a lattice model can be used to calculate the expected term of an option by taking into account restrictions on exercises and other postvesting exercise behavior.
- Employees’ ages, lengths of service, and home jurisdictions — Historical exercise information could have been affected by the profile of the employee group. For example, during a bull market, some entities are more likely to have greater turnover of employees since more opportunities are available. Many such employees will exercise their options as early as possible. These historical exercise patterns should be adjusted if similar turnover rates are not expected to recur in the future.
If historical exercise and postvesting behavior are not readily available or do
not provide a reasonable basis upon which to estimate the expected term,
alternative sources of information may be used. For example, an entity may
use a lattice model to estimate the expected term (the expected term is not
an input in the lattice model but rather is inferred on the basis of the
output of the lattice model). In addition, an entity may consider using
other relevant and supportable information such as industry averages or
published academic research. When an entity takes external peer group
information into account, there should be evidence that such information has
been sourced from entities with comparable facts and circumstances. Further,
entities may use practical expedients to estimate the expected term for
certain awards. See Section
4.9.2.2.2 for a discussion of a public entity’s use of the SEC’s
“simplified method” to estimate the expected term for “plain-vanilla”
options. See Section
4.9.2.2.3 for a discussion of a nonpublic entity’s use of a
practical expedient to estimate the expected term for certain options that
is similar to the simplified method available to public entities.
As discussed above, an entity measures stock options under
ASC 718 by using an expected term that takes into account the effects of
grantees’ expected exercise and postvesting behavior. However, determining
an expected term for nonemployee awards could be challenging because
entities may not have sufficient historical data related to the early
exercise behavior of nonemployees, particularly if nonemployee awards are
not frequently granted. In addition, nonemployee stock option awards may not
be exercised before the end of the contractual term if they do not contain
certain features typically found in employee stock option awards (e.g.,
nontransferability, nonhedgeability, and truncation of the contractual term
because of postvesting service termination). Accordingly, ASC 718 allows an
entity to elect on an award-by-award basis to use the contractual term as
the expected term for nonemployee awards. If an entity elects not to use the
contractual term for a particular award, the entity must estimate the
expected term. However, a nonpublic entity can make an accounting policy
election to apply a practical expedient to estimate the expected term for
awards that meet the conditions in ASC 718-10-30-20B (see discussion in
Section
9.4.2.1). See Section 9.4.1 for additional
information. In accordance with ASC 718-10-55-29A, if an entity does not
elect to use the contractual term as the expected term for a particular
award and, for a nonpublic entity, does not apply the practical expedient to
estimate the expected term, the entity should consider factors similar to
those in ASC 718-10-55-29 when estimating the expected term for nonemployee
awards.
4.9.2.2.1 Aggregation Into Homogenous Groups
ASC 718-10
55-33 Option value increases at a decreasing rate as the term lengthens (for most, if not all, options). For example, a two-year option is worth less than twice as much as a one-year option, other things equal. Accordingly, estimating the fair value of an option based on a single expected term that effectively averages the differing exercise and postvesting employment termination behaviors of identifiable groups of employees will potentially misstate the value of the entire award.
55-34 Aggregating individual awards into relatively homogeneous groups with respect to exercise and postvesting employment termination behaviors and estimating the fair value of the options granted to each group separately reduces such potential misstatement. An entity shall aggregate individual awards into relatively homogeneous groups with respect to exercise and postvesting employment termination behaviors regardless of the valuation technique or model used to estimate the fair value. For example, the historical experience of an employer that grants options broadly to all levels of employees might indicate that hourly employees tend to exercise for a smaller percentage gain than do salaried employees.
SEC Staff Accounting
Bulletins
SAB Topic 14.D.2, Certain
Assumptions Used in Valuation Methods: Expected
Term [Excerpt]
Question
4: FASB ASC paragraph 718-10-55-34 indicates
that an entity shall aggregate individual awards
into relatively homogenous groups with respect to
exercise and post-vesting employment termination
behaviors for the purpose of determining expected
term, regardless of the valuation technique or
model used to estimate the fair value. How many
groupings are typically considered sufficient?
Interpretive
Response: As it relates to employee groupings,
the staff believes that an entity may generally
make a reasonable fair value estimate with as few
as one or two groupings.64
______________________________
64 The staff believes
the focus should be on groups of employees with
significantly different expected exercise
behavior. Academic research suggests two such
groups might be executives and non-executives. A
study by S. Huddart found executives and other
senior managers to be significantly more patient
in their exercise behavior than more junior
employees. (Employee rank was proxied for by the
number of options issued to that employee.) See S.
Huddart, “Patterns of stock option exercise in the
United States,” in: J. Carpenter and D. Yermack,
eds., Executive Compensation and Shareholder
Value: Theory and Evidence (Kluwer, Boston, MA,
1999), pp. 115–142. See also S. Huddart and
M. Lang, “Employee stock option exercises: An
empirical analysis,” Journal of Accounting and
Economics, 1996, pp. 5–43.
When estimating the expected-term assumption, entities should aggregate
individual awards into relatively homogeneous groups if identifiable
groups of grantees display or are expected to display significantly
different exercise behaviors. For employee groupings, the SEC staff
believes that a reasonable fair-value-based estimate can be made on the
basis of as few as one or two groupings. The SEC staff believes that the
focus should be on groups of employees with significantly different
exercise behavior, such as executives and nonexecutives.
4.9.2.2.2 Simplified Method for Public Entities
SEC Staff Accounting
Bulletins
SAB Topic 14.D.2, Certain
Assumptions Used in Valuation Methods: Expected
Term [Excerpt]
Facts:
Company E grants equity share options to its
employees that have the following basic
characteristics:70
-
The share options are granted at-the-money;
-
Exercisability is conditional only on performing service through the vesting date;71
-
If an employee terminates service prior to vesting, the employee would forfeit the share options;
-
If an employee terminates service after vesting, the employee would have a limited time to exercise the share options (typically 30–90 days); and
-
The share options are nontransferable and nonhedgeable.
Company E utilizes the
Black-Scholes-Merton closed-form model for valuing
its employee share options.
Question
6: As share options with these “plain-vanilla”
characteristics have been granted in significant
quantities by many companies in the past, is the
staff aware of any “simple” methodologies that can
be used to estimate expected term?
Interpretive
Response: The staff understands that an entity
that is unable to rely on its historical exercise
data may find that certain alternative
information, such as exercise data relating to
employees of other companies, is not easily
obtainable. As such, some companies may encounter
difficulties in making a refined estimate of
expected term. Accordingly, if a company concludes
that its historical share option exercise
experience does not provide a reasonable basis
upon which to estimate expected term, the staff
will accept the following “simplified” method for
“plain vanilla” options consistent with those in
the fact set above: expected term = ((vesting term
+ original contractual term) / 2). Assuming a ten
year original contractual term and graded vesting
over four years (25% of the options in each grant
vest annually) for the share options in the fact
set described above, the resultant expected term
would be 6.25 years.72 Academic
research on the exercise of options issued to
executives provides some general support for
outcomes that would be produced by the application
of this method.73
Examples of situations in which
the staff believes that it may be appropriate to
use this simplified method include the following:
-
A company does not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term due to the limited period of time its equity shares have been publicly traded.
-
A company significantly changes the terms of its share option grants or the types of employees that receive share option grants such that its historical exercise data may no longer provide a reasonable basis upon which to estimate expected term.
-
A company has or expects to have significant structural changes in its business such that its historical exercise data may no longer provide a reasonable basis upon which to estimate expected term.
The staff understands that a
company may have sufficient historical exercise
data for some of its share option grants but not
for others. In such cases, the staff will accept
the use of the simplified method for only some but
not all share option grants. The staff also does
not believe that it is necessary for a company to
consider using a lattice model before it decides
that it is eligible to use this simplified method.
Further, the staff will not object to the use of
this simplified method in periods prior to the
time a company’s equity shares are traded in a
public market.
If a company uses this
simplified method, the company should disclose in
the notes to its financial statements the use of
the method, the reason why the method was used,
the types of share option grants for which the
method was used if the method was not used for all
share option grants, and the periods for which the
method was used if the method was not used in all
periods. Companies that have sufficient historical
share option exercise experience upon which to
estimate expected term may not apply this
simplified method. In addition, this simplified
method is not intended to be applied as a
benchmark in evaluating the appropriateness of
more refined estimates of expected term.
The staff does not expect that
such a simplified method would be used for share
option grants when more relevant detailed
information is available to the company.
______________________________
70 Employee share
options with these features are sometimes referred
to as “plain-vanilla” options.
71 In this fact
pattern the requisite service period equals the
vesting period.
72 Calculated as [[[1
year vesting term (for the first 25% vested) plus
2 year vesting term (for the second 25% vested)
plus 3 year vesting term (for the third 25%
vested) plus 4 year vesting term (for the last 25%
vested)] divided by 4 total years of vesting] plus
10 year contractual life] divided by 2; that is,
(((1+2+3+4)/4) + 10) /2 = 6.25 years.
73 J.N. Carpenter,
“The exercise and valuation of executive stock
options,” Journal of Financial Economics, 1998,
pp. 127–158 studies a sample of 40 NYSE and AMEX
firms over the period 1979–1994 with share option
terms reasonably consistent to the terms presented
in the fact set and example. The mean time to
exercise after grant was 5.83 years and the median
was 6.08 years. The “mean time to exercise” is
shorter than expected term since the study’s
sample included only exercised options. Other
research on executive options includes (but is not
limited to) J. Carr Bettis; John M. Bizjak; and
Michael L. Lemmon, “Exercise behavior, valuation,
and the incentive effects of employee stock
options,” Journal of Financial Economics, May
2005, pp. 445–470. One of the few studies on
nonexecutive employee options the staff is aware
of is S. Huddart, “Patterns of stock option
exercise in the United States,” in: J. Carpenter
and D. Yermack, eds., Executive Compensation and
Shareholder Value: Theory and Evidence (Kluwer,
Boston, MA, 1999), pp. 115–142.
Under the SEC’s guidance in Questions 5 and 6 of SAB Topic 14.D.2, if a public
entity concludes that “its historical share option exercise experience
does not provide a reasonable basis upon which to estimate expected
term,” the entity may use what the SEC staff describes as a “simplified
method” to develop the expected-term estimate. (A practical expedient
similar to the simplified method is available to nonpublic entities; see
Section
4.9.2.2.3.) Under the simplified method, the public entity
uses an average of the vesting term and the original contractual term of
an award. The method applies only to awards that qualify as
“plain-vanilla” options (see Section 4.9.2.2.2.1).
The SEC staff believes that public entities should stop using the simplified
method for stock option grants if more detailed external information
about exercise behavior becomes available. In addition, the staff issues
comments related to the use of the simplified method and, in certain
instances, registrants have been asked to explain why they believe that
they were unable to reasonably estimate the expected term on the basis
of their historical stock option exercise information.
In accordance with the SEC’s guidance in Question 6 of SAB Topic 14.D.2, a
registrant that uses the simplified method should disclose in the notes
to its financial statements (1) that the simplified method was used, (2)
the reason the method was used, (3) the types of stock option grants for
which the simplified method was used if it was not used for all stock
option grants, and (4) the period(s) for which the simplified method was
used if it was not used in all periods presented.
4.9.2.2.2.1 Characteristics of a Plain-Vanilla Option
As the SEC states in SAB Topic 14.D.2, the simplified method applies only to awards that qualify as plain-vanilla options. A share-based payment award must possess all of the following characteristics to qualify as a plain-vanilla option:
- “The share options are granted at-the-money.”
- “Exercisability is conditional only on performing service through the vesting date” (i.e., the requisite service period equals the vesting period).
- “If an employee terminates service prior to vesting, the employee would forfeit the share options.”
- “If an employee terminates service after vesting, the employee would have a limited time to exercise the share options (typically 30–90 days).”
- “The share options are nontransferable and nonhedgeable.”
If an award has a performance or market condition, it would not be considered a plain-vanilla option. The examples below illustrate two types of awards, among other types, that do not qualify as plain-vanilla options and therefore would not be eligible for the simplified method of estimating the expected term of an award. Entities should evaluate all awards to determine whether they qualify as plain-vanilla options.
Example 4-2
In 20X1, an entity granted employee stock options and used the simplified method
to estimate the options’ expected term. After the
original grant date, the entity established that
it had incorrectly determined the grant date for
its options granted in 20X1 and that the options
were actually granted in-the-money. Because the
options were not granted at-the-money, they do not
qualify as plain-vanilla options.
Example 4-3
In 20X1, an entity granted employee stock options that either (1) vest at the end of the seventh year of service or (2) accelerate vesting if certain defined EBITDA targets are met before that date. Because the options’ exercisability depends on a performance condition as well as a service condition, they do not qualify as plain-vanilla options.
4.9.2.2.2.2 Calculating the Expected Term by Using the Simplified Method
The examples below illustrate how to calculate the expected term for
plain-vanilla options with a graded-vesting schedule and a
cliff-vesting schedule.
Example 4-4
Simplified Method for an Award With Graded Vesting
An entity grants at-the-money employee stock options, each with a contractual
term of 10 years. The options meet the criteria
for plain-vanilla options outlined in Question 6
of SAB Topic 14.D.2 and vest in 33.3 percent
increments (tranches) each year over the next
three years. Therefore, under the simplified
method, the expected term of the options would be
six years, calculated as follows:
Example 4-5
Simplified Method for an Award With Cliff Vesting
An entity grants at-the-money employee stock options, each with a contractual
term of 10 years. The options meet the criteria
for plain-vanilla options outlined in Question 6
of SAB Topic 14.D.2. The options vest at the end
of the fourth year of service. Therefore, under
the simplified method, the expected term of the
awards would be 7 years, or (4-year vesting term +
10-year contractual life) ÷ 2.
4.9.2.2.3 Expected-Term Practical Expedient for Nonpublic Entities
ASC 718-10
Nonpublic Entity — Practical Expedient for Expected Term
30-20A For an award that meets the conditions in paragraph 718-10-30-20B, a nonpublic entity may make an
entity-wide accounting policy election to estimate the expected term using the following practical expedient:
- If vesting is only dependent upon a service condition, a nonpublic entity shall estimate the expected term as the midpoint between the employee’s requisite service period or the nonemployee’s vesting period and the contractual term of the award.
- If vesting is dependent upon satisfying a performance condition, a nonpublic entity first would determine whether the performance condition is probable of being achieved.
-
If the nonpublic entity concludes that the performance condition is probable of being achieved, the nonpublic entity shall estimate the expected term as the midpoint between the employee’s requisite service period (a nonpublic entity shall consider the guidance in paragraphs 718-10-55-69 through 55-79 when determining the requisite service period of the award) or the nonemployee’s vesting period and the contractual term.
-
If the nonpublic entity concludes that the performance condition is not probable of being achieved, the nonpublic entity shall estimate the expected term as either:
-
The contractual term if the service period is implied (that is, the requisite service period or the nonemployee’s vesting period is not explicitly stated but inferred based on the achievement of the performance condition at some undetermined point in the future)
-
The midpoint between the employee’s requisite service period or the nonemployee’s vesting period and the contractual term if the requisite service period is stated explicitly.
-
-
Paragraph 718-10-55-50A provides implementation guidance on the practical expedient.
30-20B A nonpublic entity that elects to apply the practical expedient in paragraph 718-10-30-20A shall apply
the practical expedient to a share option or similar award that has all of the following characteristics:
- The share option or similar award is granted at the money.
- The grantee has only a limited time to exercise the award (typically 30–90 days) if the grantee no longer provides goods, terminates service after vesting, or ceases to be a customer.
- The grantee can only exercise the award. The grantee cannot sell or hedge the award.
- The award does not include a market condition.
A nonpublic entity that elects to apply the
practical expedient in paragraph 718-10-30-20A may
always elect to use the contractual term as the
expected term when estimating the fair value of a
nonemployee award as described in paragraph
718-10-30-10A. However, a nonpublic entity must
apply the practical expedient in paragraph
718-10-30-20A for all nonemployee awards that have
all the characteristics listed in this paragraph
if that nonpublic entity does not elect to use the
contractual term as the expected term and that
nonpublic entity elects the accounting policy
election to apply the practical expedient in
paragraph 718-10-30-20A.
Selecting or Estimating the Expected Term
55-34A A nonpublic entity may make an accounting policy election to apply a practical expedient to estimate
the expected term for certain awards that do not include a market condition (see paragraphs 718-10-30-20A
through 30-20B). Paragraph 718-10-55-50A provides implementation guidance on the practical expedient.
Nonpublic Entity — Practical Expedient for Expected Term
55-50A In accordance with paragraph 718-10-30-20A, a nonpublic entity may elect a practical expedient to
estimate the expected term. For liability-classified awards, an entity would update the estimate of the expected
term each reporting period until settlement. The updated estimate should reflect the loss of time value
associated with the award and any change in the assessment of whether a performance condition is probable
of being achieved.
A nonpublic entity may make an entity-wide accounting policy election to estimate the expected term of
its awards by using a practical expedient similar to the simplified method available to public companies
(see Section 4.9.2.2.2). Awards for which the practical expedient may be used must have satisfied
all the requirements described in ASC 718-10-30-20B above. Those requirements are similar to the
conditions that must be met for public entities to use the simplified method, but there are some notable
differences. For example, nonpublic entities can apply the practical expedient to awards with service
or performance conditions; however, public entities can apply the simplified method only to awards
with service conditions. In addition, to use the simplified method, a public company is required under
SAB Topic 14.D.2 to “conclude that its historical share option exercise experience does not provide a
reasonable basis upon which to estimate [the] expected term” of its awards, whereas a nonpublic entity
can elect to use the practical expedient irrespective of its historical exercise experience.
The practical expedient for nonpublic entities also applies to
liability-classified awards measured at a fair-value-based amount even
if the award ceases to be at-the-money upon remeasurement. For these
awards, an entity should update its estimate of the expected term as of
each reporting period until settlement. The updated estimate should
reflect any change in the assessment of whether it is probable that a
performance condition will be met (if applicable).
Determination of the expected term under this practical
expedient is based on whether the awards have service or performance
conditions. If vesting depends only on a service condition, the expected
term is the midpoint between the employee’s requisite service period or
the nonemployee’s vesting period and the contractual term of the award.
For example, if the requisite service period is 4 years and the
contractual term is 10 years, the expected term would be 7 years. If
vesting is based on satisfaction of a performance condition, the
expected term depends on whether it is probable that the performance
condition will be met. If it is probable that the performance condition
will be met, the expected term is the midpoint between the employee’s
requisite service period or the nonemployee’s vesting period (whether
explicit or implicit) and the contractual term of the award. However, if
it is not probable that the performance condition will be met, the
expected term can be either (1) the contractual term of the award if the
vesting period is implied (see Section 3.6.2) or (2) the midpoint
between the employee’s requisite service period or the nonemployee’s
vesting period and the contractual term of the award if the service
period is explicitly stated (see Section 3.6.1).
For nonemployee awards, a nonpublic entity may elect the practical expedient in
ASC 718-10-30-20A described above. However, on an award-by-award basis,
a nonpublic entity can always elect to estimate the fair value of the
award by using the contractual term as the expected term. If a nonpublic
entity elects to use this practical expedient, it must do so for all
nonemployee awards that meet the criteria described in ASC 718-10-30-20B
and for which the nonpublic entity does not use the contractual
term.
The decision tree below shows how to determine the expected term under the
practical expedient for nonpublic entities.1
4.9.2.3 Expected Volatility
ASC 718-10
55-25 In certain circumstances, historical information may not be available. For example, an entity whose
common stock has only recently become publicly traded may have little, if any, historical information on the
volatility of its own shares. That entity might base expectations about future volatility on the average volatilities
of similar entities for an appropriate period following their going public. A nonpublic entity will need to exercise
judgment in selecting a method to estimate expected volatility and might do so by basing its expected volatility
on the average volatilities of otherwise similar public entities. For purposes of identifying otherwise similar
entities, an entity would likely consider characteristics such as industry, stage of life cycle, size, and financial
leverage. Because of the effects of diversification that are present in an industry sector index, the volatility of
an index should not be substituted for the average of volatilities of otherwise similar entities in a fair value
measurement.
Selecting or Estimating the Expected Volatility
55-35 As with other aspects of estimating fair value, the objective is to determine the assumption about
expected volatility that marketplace participants would be likely to use in determining an exchange price for an
option.
55-36 Volatility is a measure
of the amount by which a financial variable, such as
share price, has fluctuated (historical volatility)
or is expected to fluctuate (expected volatility)
during a period. Option-pricing models require
expected volatility as an assumption because an
option’s value is dependent on potential share
returns over the option’s term. The higher the
volatility, the more the returns on the shares can
be expected to vary — up or down. Because an
option’s value is unaffected by expected negative
returns on the shares, other things equal, an option
on a share with higher volatility is worth more than
an option on a share with lower volatility. This
Topic does not specify a method of estimating
expected volatility; rather, the following paragraph
provides a list of factors that shall be considered
in estimating expected volatility. An entity’s
estimate of expected volatility shall be reasonable
and supportable.
55-37 Factors to consider in estimating expected volatility include the following:
- Volatility of the share price, including changes in that volatility and possible mean reversion of that volatility. Mean reversion refers to the tendency of a financial variable, such as volatility, to revert to some long-run average level. Statistical models have been developed that take into account the mean-reverting tendency of volatility. In computing historical volatility, for example, an entity might disregard an identifiable period of time in which its share price was extraordinarily volatile because of a failed takeover bid if a similar event is not expected to recur during the expected or contractual term. If an entity’s share price was extremely volatile for an identifiable period of time, due to a general market decline, that entity might place less weight on its volatility during that period of time because of possible mean reversion. Volatility over the most recent period is generally commensurate with either of the following:
- The contractual term of the option if a lattice model is being used to estimate fair value
- The expected term of the option if a closed-form model is being used. An entity might evaluate changes in volatility and mean reversion over that period by dividing the contractual or expected term into regular intervals and evaluating evolution of volatility through those intervals.
- The implied volatility of the share price determined from the market prices of traded options or other traded financial instruments such as outstanding convertible debt, if any.
- For a public entity, the length of time its shares have been publicly traded. If that period is shorter than the expected or contractual term of the option, the term structure of volatility for the longest period for which trading activity is available shall be more relevant. A newly public entity also might consider the expected volatility of similar entities. In evaluating similarity, an entity would likely consider factors such as industry, stage of life cycle, size, and financial leverage. A nonpublic entity might base its expected volatility on the expected volatilities of entities that are similar except for having publicly traded securities.
- Appropriate and regular intervals for price observations. If an entity considers historical volatility in estimating expected volatility, it shall use intervals that are appropriate based on the facts and circumstances and that provide the basis for a reasonable fair value estimate. For example, a publicly traded entity would likely use daily price observations, while a nonpublic entity with shares that occasionally change hands at negotiated prices might use monthly price observations.
- Corporate and capital structure. An entity’s corporate structure may affect expected volatility (see paragraph 718-10-55-24). An entity’s capital structure also may affect expected volatility; for example, highly leveraged entities tend to have higher volatilities.
55-38 Although use of unadjusted historical volatility may be appropriate for some entities (or even for most
entities in some time periods), a marketplace participant would not use historical volatility without considering
the extent to which the future is likely to differ from the past.
55-39 A closed-form model, such as the Black-Scholes-Merton formula, cannot incorporate a range of expected
volatilities over the option’s expected term (see paragraph 718-10-55-18). Lattice models can incorporate
a term structure of expected volatility; that is, a range of expected volatilities can be incorporated into the
lattice over an option’s contractual term. Determining how to incorporate a range of expected volatilities into
a lattice model to provide a reasonable fair value estimate is a matter of judgment and shall be based on a
careful consideration of the factors listed in paragraph 718-10-55-37 as well as other relevant factors that are
consistent with the fair value measurement objective of this Topic.
55-40 An entity shall establish a process for estimating expected volatility and apply that process consistently
from period to period (see paragraph 718-10-55-27). That process:
- Shall comprehend an identification of information available to the entity and applicable factors such as those described in paragraph 718-10-55-37
- Shall include a procedure for evaluating and weighting that information.
55-41 The process developed by an entity shall be determined by the information available to it and its
assessment of how that information would be used to estimate fair value. For example, consistent with
paragraph 718-10-55-24, an entity’s starting point in estimating expected volatility might be its historical
volatility. That entity also shall consider the extent to which currently available information indicates that future
volatility will differ from the historical volatility. An example of such information is implied volatility (from traded
options or other instruments).
SEC Staff Accounting Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
FASB ASC paragraph 718-10-55-36
states, “Volatility is a measure of the amount by
which a financial variable, such as share price, has
fluctuated (historical volatility) or is expected to
fluctuate (expected volatility) during a period.
Option-pricing models require an estimate of
expected volatility as an assumption because an
option’s value is dependent on potential share
returns over the option’s term. The higher the
volatility, the more the returns on the share can be
expected to vary — up or down. Because an option’s
value is unaffected by expected negative returns on
the shares, other things [being] equal, an option on
a share with higher volatility is worth more than an
option on a share with lower volatility.”
Facts:
Company B is a public entity whose common shares
have been publicly traded for over twenty years.
Company B also has multiple options on its shares
outstanding that are traded on an exchange (“traded
options”). Company B grants share options on January
2, 20X6.
Question 1:
What should Company B consider when estimating
expected volatility for purposes of measuring the
fair value of its share options?
Interpretive
Response: FASB ASC Topic 718 does not specify
a particular method of estimating expected
volatility. However, the Topic does clarify that the
objective in estimating expected volatility is to
ascertain the assumption about expected volatility
that marketplace participants would likely use in
determining an exchange price for an
option.26 FASB ASC Topic 718 provides a
list of factors entities should consider in
estimating expected volatility.27 Company
B may begin its process of estimating expected
volatility by considering its historical
volatility.28 However, Company B should
also then consider, based on available information,
how the expected volatility of its share price may
differ from historical volatility.29
Implied volatility30 can be useful in
estimating expected volatility because it is
generally reflective of both historical volatility
and expectations of how future volatility will
differ from historical volatility.
The staff believes that companies
should make good faith efforts to identify and use
sufficient information in determining whether taking
historical volatility, implied volatility or a
combination of both into account will result in the
best estimate of expected volatility. The staff
believes companies that have appropriate traded
financial instruments from which they can derive an
implied volatility should generally consider this
measure. The extent of the ultimate reliance on
implied volatility will depend on a company’s facts
and circumstances; however, the staff believes that
a company with actively traded options or other
financial instruments with embedded
options31 generally could place greater
(or even exclusive) reliance on implied volatility.
(See the Interpretive Responses to
Questions 3 and 4 [reproduced in Section 4.9.2.3.2 of
this Roadmap].)
The process used to gather and
review available information to estimate expected
volatility should be applied consistently from
period to period. When circumstances indicate the
availability of new or different information that
would be useful in estimating expected volatility, a
company should incorporate that information.
Question 5:
What disclosures would the staff expect Company B to
include in its financial statements and MD&A
regarding its assumption of expected volatility?
Interpretive
Response: FASB ASC paragraph 718-10-50-2
prescribes the minimum information needed to achieve
the Topic’s disclosure objectives.52
Under that guidance, Company B is required to
disclose the expected volatility and the method used
to estimate it.53 Accordingly, the staff
expects that, at a minimum, Company B would disclose
in a footnote to its financial statements how it
determined the expected volatility assumption for
purposes of determining the fair value of its share
options in accordance with FASB ASC Topic 718. For
example, at a minimum, the staff would expect
Company B to disclose whether it used only implied
volatility, historical volatility, or a combination
of both, and how it determined any significant
adjustments to historical volatility.
In addition, Company B should
consider the requirements of Regulation S-K Item
303(b)(3) regarding critical accounting estimates in
MD&A. A company should determine whether its
evaluation of any of the factors listed in Questions
2 and 3 of this section, such as consideration of
future events in estimating expected volatility,
resulted in an estimate that involves a significant
level of estimation uncertainty and has had or is
reasonably likely to have a material impact on the
financial condition or results of operations of the
company.
______________________________
26 FASB ASC paragraph
718-10-55-35.
27 FASB ASC paragraph
718-10-55-37.
28 FASB ASC paragraph
718-10-55-40.
29
Ibid.
30 Implied volatility is the volatility
assumption inherent in the market prices of a
company’s traded options or other financial
instruments that have option-like features. Implied
volatility is derived by entering the market price
of the traded financial instrument, along with
assumptions specific to the financial options being
valued, into a model based on a constant volatility
estimate (e.g., the Black-Scholes-Merton
closed-form model) and solving for the unknown
assumption of volatility.
31 The staff believes
implied volatility derived from embedded options can
be utilized in determining expected volatility if,
in deriving the implied volatility, the company
considers all relevant features of the instruments
(e.g., value of the host instrument, value
of the option, etc.). The staff believes the
derivation of implied volatility from other than
simple instruments (e.g., a simple
convertible bond) can, in some cases, be
impracticable due to the complexity of multiple
features.
52 FASB ASC paragraph 718-10-50-1.
53 FASB ASC subparagraph
718-10-50-2(f)(2)(ii).
Volatility is a measure of the amount by which a share price has fluctuated (historical volatility) or is
expected to fluctuate (expected volatility) during a period. In option pricing models, expected volatility is
required to be an assumption because the option’s value is based on potential share returns over the
option’s term. ASC 718 does not specify a method for estimating the expected volatility of the underlying
share price; however, ASC 718-10-55-35 clarifies that the objective of such estimation is to ascertain
the “assumption about expected volatility [of the underlying share price] that marketplace participants
would be likely to use in determining an exchange price for an option.”
ASC 718-10-55-37 lists factors that entities would consider in estimating the expected volatility of the
underlying share price. The method selected to perform the estimation should be applied consistently
from period to period, and entities should adjust the factors or assign more weight to an individual
factor only on the basis of objective information that supports such adjustments. The Interpretive
Response to Question 1 of SAB Topic 14.D.1 notes that entities should incorporate into the estimate any
relevant new or different information that would be useful. Further, they should “make good faith efforts
to identify and use sufficient information in determining whether taking historical volatility, implied
volatility or a combination of both into account will result in the best estimate of expected volatility” of
the underlying share price. See Section 4.9.2.3.1 through Section 4.9.2.3.3 for additional discussion of
the SEC staff’s views on estimating the expected volatility of an underlying share price.
Entities would consider the following factors in estimating expected volatility:
- Historical volatility of the underlying share price — Entities typically value stock options by using the historical volatility of the underlying share price. Under a closed-form model, such volatility is based on the most recent volatility of the share price over the expected term of the option; under a lattice model, it is based on the contractual term. ASC 718-10-55-37(a) states that an entity may disregard the volatility of the share price for an identifiable period if the volatility resulted from a condition (e.g., a failed takeover bid) specific to the entity, and the condition is not expected to recur during the expected or contractual term. If the condition is not specific to the entity (e.g., general market declines), the entity generally would not be allowed to disregard or place less weight on the volatility of its share price during that period unless objectively verifiable evidence supports the expectation that market volatility will revert to a mean that will differ materially from the volatility during the specified period. The SEC staff believes that an entity’s decision to disregard a period of historical volatility should be based on one or more discrete and specific historical events that are not expected to occur again during the term of the option. In addition, the entity should not give recent periods more weight than earlier periods.In certain circumstances, an entity may rely exclusively on historical volatility. However, because the objective of estimating expected volatility is to ascertain the assumptions that marketplace participants are likely to use, exclusive reliance may not be appropriate if there are future events that could reasonably affect expected volatility (e.g., a future merger that was recently announced). In addition, an entity that is valuing a spring-loaded award (see description in Section 4.9.2.6) would consider whether it should factor material nonpublic information into its determination of historical volatility.See Section 4.9.2.3.1 for a discussion of the SEC staff’s views on the computation of historical volatility and on circumstances in which an entity can rely exclusively on historical volatility.
- Implied volatility of the underlying share price — The implied volatility of the underlying share price is not the same as the historical volatility of the underlying share price because it is derived from the market prices of an entity’s traded options or other traded financial instruments with option-like features and not from the entity’s own shares. Entities can use the Black-Scholes-Merton formula to calculate implied volatility by including the fair value of the option (i.e., the market price of the traded option) and other inputs (stock price, exercise price, expected term, dividend rate, and risk-free interest rate) in the calculation and solving for volatility. When valuing employee or nonemployee stock options, entities should carefully consider whether the implied volatility of a traded option is an appropriate basis for expected volatility of the underlying share price. For example, traded options usually have much shorter terms than employee or nonemployee stock options, and the calculated implied volatility may not take into account the possibility of mean reversion. To compensate for mean reversion, entities use statistical tools for calculating a long-term implied volatility. For example, entities with traded options whose terms range from 2 to 12 months can plot the volatility of these options on a curve and use statistical tools to plot a long-term implied volatility for a traded option with an expected or a contractual term equal to an employee or nonemployee stock option.Generally, entities that can observe sufficiently extensive trading of options and can therefore plot an accurate long-term implied volatility curve should place greater weight on implied volatility than on the historical volatility of their own share price (particularly if they do not meet the SEC’s conditions for relying exclusively on historical volatility). That is, a traded option’s volatility is more informative in the determination of expected volatility of an entity’s stock price than historical stock price volatility, since option prices take into account the option trader’s forecasts of future stock price volatility. In determining the extent of reliance on implied volatility, an entity should consider the volume of trading in its traded options and its underlying shares, the ability to synchronize the variables used to derive implied volatility (as close to the grant date of employee or nonemployee stock options as reasonably practicable), the similarity of the exercise prices of its traded options to its employee or nonemployee stock options, and the length of the terms of its traded options and employee or nonemployee stock options. In addition, an entity that is valuing a spring-loaded award (see description in Section 4.9.2.6) would consider whether material nonpublic information affects the extent of reliance on implied volatility when estimating the expected volatility.See Section 4.9.2.3.2 for a discussion of the SEC staff’s views on the extent of reliance on implied volatility and on circumstances in which an entity can rely exclusively on implied volatility.
- Limitations on availability of historical data — Public entities should compare the length of time an entity’s shares have been publicly traded with the expected or contractual term of the option. A newly public entity may also consider the expected volatility of the share prices of similar public entities. In determining comparable public entities, that entity would consider factors such as industry, stage of life cycle, size, and financial leverage. See Section 4.9.2.3.3 for a discussion of the SEC staff’s views on the use of comparable public entities to estimate expected volatility.Nonpublic entities may also base the expected volatility of their share prices on the expected volatility of similar public entities’ share prices, and they may consider the same factors as those described above for a newly public entity. When a nonpublic entity is unable to reasonably estimate its entity-specific volatility or that of similar public entities, it may use a calculated value. See Section 4.13.2 for a discussion of when a nonpublic entity may use the historical volatility of an appropriate industry sector index and what a nonpublic entity should consider in selecting and computing the historical volatility of an appropriate industry sector index.
- Data intervals — An entity that considers the historical volatility of its share price when estimating the expected volatility of its share price should use intervals for price observations that (1) are appropriate on the basis of its facts and circumstances (e.g., given the frequency of its trades and the length of its trading history) and (2) provide a basis for a reasonable estimate of a fair-value-based measure. Daily, weekly, or monthly price observations may be sufficient; however, if an entity’s shares are thinly traded, weekly or monthly price observations may be more appropriate than daily price observations. See the next section for a discussion of the SEC staff’s views on frequency of price observations.
- Changes in corporate and capital structure — An entity’s corporate and capital structure could affect the expected volatility of its share price (e.g., share price volatility tends to be higher for highly leveraged entities). In estimating expected volatility, an entity should take into account significant changes to its corporate and capital structure, since the historical volatility of a share price for a period when the entity was, for example, highly leveraged may not represent future periods when the entity is not expected to be highly leveraged (or vice versa).
4.9.2.3.1 Historical Volatility
The SEC staff provides the following guidance on computing historical volatility of the underlying share
price in the valuation of a share-based payment award:
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
Question
2: What should Company B consider if computing
historical volatility?32
Interpretive Response: The following should be
considered in the computation of historical
volatility:
1. Method of Computing
Historical Volatility —
The staff believes the method
selected by Company B to compute its historical
volatility should produce an estimate that is
representative of a marketplace participant's
expectations about Company B’s future volatility
over the expected (if using a Black-Scholes-Merton
closed-form model) or contractual (if using a
lattice model) term33 of its share
options. Certain methods may not be appropriate
for longer term share options if they weight the
most recent periods of Company B’s historical
volatility much more heavily than earlier
periods.34 For example, a method that
applies a factor to certain historical price
intervals to reflect a decay or loss of relevance
of that historical information emphasizes the most
recent historical periods and thus would likely
bias the estimate to this recent
history.35
2. Amount of Historical Data
—
FASB ASC subparagraph
718-10-55-37(a) indicates entities should consider
historical volatility over a period generally
commensurate with the expected or contractual
term, as applicable, of the share option. The
staff believes Company B could utilize a period of
historical data longer than the expected or
contractual term, as applicable, if it reasonably
believes the additional historical information
will improve the estimate. For example, assume
Company B decided to utilize a
Black-Scholes-Merton closed-form model to estimate
the value of the share options granted on January
2, 20X6 and determined that the expected term was
six years. Company B would not be precluded from
using historical data longer than six years if it
concludes that data would be relevant.
3. Frequency of Price
Observations —
FASB ASC subparagraph
718-10-55-37(d) indicates an entity should use
appropriate and regular intervals for price
observations based on facts and circumstances that
provide the basis for a reasonable fair value
estimate. Accordingly, the staff believes Company
B should consider the frequency of the trading of
its shares and the length of its trading history
in determining the appropriate frequency of price
observations. The staff believes using daily,
weekly or monthly price observations may provide a
sufficient basis to estimate expected volatility
if the history provides enough data points on
which to base the estimate.36 Company B
should select a consistent point in time within
each interval when selecting data
points.37
4. Consideration of Future
Events —
The objective in estimating
expected volatility is to ascertain the
assumptions that marketplace participants would
likely use in determining an exchange price for an
option.38 Accordingly, the staff
believes that Company B should consider those
future events that it reasonably concludes a
marketplace participant would also consider in
making the estimation. For example, if Company B
has recently announced a merger with a company
that would change its business risk in the future,
then it should consider the impact of the merger
in estimating the expected volatility if it
reasonably believes a marketplace participant
would also consider this event.
The staff believes that careful consideration is
required to determine whether material non-public
information is currently available (or would be
available) to the issuer that would be considered
by a marketplace participant in estimating the
expected volatility.39 For example, if
Company B has entered into a material transaction
that has not yet been announced prior to its grant
of equity instruments, the specific facts and
circumstances of the material transaction may lead
Company B to conclude that the impact of this
event should be included in estimating the
expected volatility when determining the
grant-date fair value of those equity
instruments.
5. Exclusion of Periods of
Historical Data —
In some instances, due to a
company’s particular business situations, a period
of historical volatility data may not be relevant
in evaluating expected volatility.40 In
these instances, that period should be
disregarded. The staff believes that if Company B
disregards a period of historical volatility, it
should be prepared to support its conclusion that
its historical share price during that previous
period is not relevant to estimating expected
volatility due to one or more discrete and
specific historical events and that similar events
are not expected to occur during the expected term
of the share option. The staff believes these
situations would be rare.
______________________________
32
See FASB ASC paragraph 718-10-55-37.
33 For purposes of
this staff accounting bulletin, the phrase
“expected or contractual term, as applicable” has
the same meaning as the phrase “expected (if using
a Black-Scholes-Merton closed-form model) or
contractual (if using a lattice model) term of a
share option.”
34 FASB ASC
subparagraph 718-10-55-37(a) states that entities
should consider historical volatility over a
period generally commensurate with the expected or
contractual term, as applicable, of the share
option. Accordingly, the staff believes methods
that place extreme emphasis on the most recent
periods may be inconsistent with this
guidance.
35 Generalized
Autoregressive Conditional Heteroskedasticity
(“GARCH”) is an example of a method that
demonstrates this characteristic.
36 Further, if shares
of a company are thinly traded the staff believes
the use of weekly or monthly price observations
would generally be more appropriate than the use
of daily price observations. The volatility
calculation using daily observations for such
shares could be artificially inflated due to a
larger spread between the bid and asked quotes and
lack of consistent trading in the market.
37 FASB ASC
paragraph 718-10-55-40 states that a company
should establish a process for estimating expected
volatility and apply that process consistently
from period to period. In addition, FASB ASC
paragraph 718-10-55-27 indicates that assumptions
used to estimate the fair value of instruments
granted in share-based payment transactions should
be determined in a consistent manner from period
to period.
38 FASB ASC paragraph
718-10-55-35.
39 FASB ASC paragraph 718-10-55-13
states “assumptions shall reflect information that
is (or would be) available to form the basis for
an amount at which the instruments being valued
would be exchanged. In estimating fair value, the
assumptions used shall not represent the biases of
a particular party.”
40 FASB ASC paragraph
718-10-55-37.
In addition, the SEC staff provides the following guidance on determining when an entity may rely
exclusively on historical volatility in estimating expected volatility:
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
Question
4: Are there situations in which it is
acceptable for Company B to rely exclusively on
either implied volatility or historical volatility
in its estimate of expected volatility?
Interpretive
Response: As stated above, FASB ASC Topic 718
does not specify a method of estimating expected
volatility; rather, it provides a list of factors
that should be considered and requires that an
entity’s estimate of expected volatility be
reasonable and supportable.46 Many of
the factors listed in FASB ASC Topic 718 are
discussed in Questions 2 and 3 above. The
objective of estimating volatility, as stated in
FASB ASC Topic 718, is to ascertain the assumption
about expected volatility that marketplace
participants would likely use in determining an
exchange price for an option.47 The
staff believes that a company, after considering
the factors listed in FASB ASC Topic 718, could,
in certain situations, reasonably conclude that
exclusive reliance on either historical or implied
volatility would provide an estimate of expected
volatility that meets this stated objective. . .
.
The staff would not object to
Company B placing exclusive reliance on historical
volatility when the following factors are present,
so long as the methodology is consistently applied:
-
Company B has no reason to believe that its future volatility over the expected or contractual term, as applicable, is likely to differ from its past;50
-
The computation of historical volatility uses a simple average calculation method;
-
A sequential period of historical data at least equal to the expected or contractual term of the share option, as applicable, is used; and
-
A reasonably sufficient number of price observations are used, measured at a consistent point throughout the applicable historical period.51
______________________________
46 FASB ASC
paragraphs 718-10-55-36 through 718-10-55-37.
47 FASB ASC paragraph
718-10-55-35.
50
See FASB ASC paragraph 718-10-55-38. A
change in a company’s business model that results
in a material alteration to the company’s risk
profile is an example of a circumstance in which
the company’s future volatility would be expected
to differ from its historical volatility. Other
examples may include, but are not limited to, the
introduction of a new product that is central to a
company’s business model or the receipt of U.S.
Food and Drug Administration approval for the sale
of a new prescription drug.
51 If the expected or
contractual term, as applicable, of the employee
share option is less than three years, the staff
believes monthly price observations would not
provide a sufficient amount of data.
4.9.2.3.2 Implied Volatility
The SEC staff guidance on the extent of an entity’s reliance on implied
volatility in estimating expected volatility is provided below.
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
Question
3: What should Company B consider when
evaluating the extent of its reliance on the
implied volatility derived from its traded
options?
Interpretive
Response: To achieve the objective of
estimating expected volatility as stated in FASB
ASC paragraphs 718-10-55-35 through 718-10-55-41,
the staff believes Company B generally should
consider the following in its evaluation: 1) the
volume of market activity of the underlying shares
and traded options; 2) the ability to synchronize
the variables used to derive implied volatility;
3) the similarity of the exercise prices of the
traded options to the exercise price of the
newly-granted share options; 4) the similarity of
the length of the term of the traded and
newly-granted share options;41 and 5)
consideration of material non-public
information.
1. Volume of Market Activity
—
The staff believes Company B
should consider the volume of trading in its
underlying shares as well as the traded options.
For example, prices for instruments in actively
traded markets are more likely to reflect a
marketplace participant’s expectations regarding
expected volatility.
2. Synchronization of the
Variables —
Company B should synchronize the
variables used to derive implied volatility. For
example, to the extent reasonably practicable,
Company B should use market prices (either traded
prices or the average of bid and asked quotes) of
the traded options and its shares measured at the
same point in time. This measurement should also
be synchronized with the grant of the share
options; however, when this is not reasonably
practicable, the staff believes Company B should
derive implied volatility as of a point in time as
close to the grant of the share options as
reasonably practicable.
3. Similarity of the Exercise
Prices —
The staff believes that when
valuing an at-the-money share option, the implied
volatility derived from at- or near-the-money
traded options generally would be most
relevant.42 If, however, it is not
possible to find at- or near-the-money traded
options, Company B should select multiple traded
options with an average exercise price close to
the exercise price of the share
option.43
4. Similarity of Length of Terms
—
The staff believes that when
valuing a share option with a given expected or
contractual term, as applicable, the implied
volatility derived from a traded option with a
similar term would be the most relevant. However,
if there are no traded options with maturities
that are similar to the share option’s contractual
or expected term, as applicable, then the staff
believes Company B could consider traded options
with a remaining maturity of six months or
greater.44 However, when using traded
options with a term of less than one
year,45 the staff would expect the
company to also consider other relevant
information in estimating expected volatility. In
general, the staff believes more reliance on the
implied volatility derived from a traded option
would be expected the closer the remaining term of
the traded option is to the expected or
contractual term, as applicable, of the share
option.
5. Consideration of Material Nonpublic
Information —
When a company is in possession of material
non-public information, the staff believes that
the related guidance in the interpretive response
to Question 2 above would also be relevant in
determining whether the implied volatility
appropriately reflects a marketplace participant's
expectations of future volatility.
The staff believes Company B’s
evaluation of the factors above should assist in
determining whether the implied volatility
appropriately reflects the market's expectations
of future volatility and thus the extent of
reliance that Company B reasonably places on the
implied volatility.
______________________________
41
See generally Options, Futures, and Other
Derivatives by John C. Hull (Pearson, 11th
Edition, 2021).
42 Implied
volatilities of options differ systematically over
the “moneyness” of the option. This pattern of
implied volatilities across exercise prices is
known as the “volatility smile” or “volatility
skew.” Studies such as “Implied Volatility” by
Stewart Mayhew, Financial Analysts Journal,
July-August 1995, as well as more recent studies,
have found that implied volatilities based on
near-the-money options do as well as sophisticated
weighted implied volatilities in estimating
expected volatility. In addition, the staff
believes that because near-the-money options are
generally more actively traded, they may provide a
better basis for deriving implied volatility.
43 The staff
believes a company could use a weighted-average
implied volatility based on traded options that
are either in-the-money or out-of-the-money. For
example, if the share option has an exercise price
of $52, but the only traded options available have
exercise prices of $50 and $55, then the staff
believes that it is appropriate to use a weighted
average based on the implied volatilities from the
two traded options; for this example, a 40% weight
on the implied volatility calculated from the
option with an exercise price of $55 and a 60%
weight on the option with an exercise price of
$50.
44 The staff believes
it may also be appropriate to consider the entire
term structure of volatility provided by traded
options with a variety of remaining maturities. If
a company considers the entire term structure in
deriving implied volatility, the staff would
expect a company to include some options in the
term structure with a remaining maturity of six
months or greater.
45 The staff believes
the implied volatility derived from a traded
option with a term of one year or greater would
typically not be significantly different from the
implied volatility that would be derived from a
traded option with a significantly longer
term.
In addition, the SEC staff provides the following guidance on when it may be acceptable for an entity to
rely exclusively on implied volatility in estimating expected volatility:
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
Question
4: Are there situations in which it is
acceptable for Company B to rely exclusively on
either implied volatility or historical volatility
in its estimate of expected volatility?
Interpretive
Response: As stated above, FASB ASC Topic 718
does not specify a method of estimating expected
volatility; rather, it provides a list of factors
that should be considered and requires that an
entity’s estimate of expected volatility be
reasonable and supportable.46 Many of
the factors listed in FASB ASC Topic 718 are
discussed in Questions 2 and 3 above. The
objective of estimating volatility, as stated in
FASB ASC Topic 718, is to ascertain the assumption
about expected volatility that marketplace
participants would likely use in determining an
exchange price for an option.47 The
staff believes that a company, after considering
the factors listed in FASB ASC Topic 718, could,
in certain situations, reasonably conclude that
exclusive reliance on either historical or implied
volatility would provide an estimate of expected
volatility that meets this stated objective.
The staff would not object to
Company B placing exclusive reliance on implied
volatility when the following factors are present,
as long as the methodology is consistently
applied:
-
Company B utilizes a valuation model that is based upon a constant volatility assumption to value its share options;48
-
The implied volatility is derived from options that are actively traded;
-
The market prices (trades or quotes) of both the traded options and underlying shares are measured at a similar point in time to each other and on a date reasonably close to the fair value measurement date of the share options;
-
The traded options have exercise prices that are both (a) near-the-money and (b) close to the exercise price of the share options;49
-
The remaining maturities of the traded options on which the estimate is based are at least one year, and
-
Material nonpublic information that would be considered in a marketplace participant's expectation of future volatility does not exist.
______________________________
46 FASB ASC paragraphs 718-10-55-36
through 718-10-55-37.
47 FASB ASC paragraph
718-10-55-35.
48 FASB ASC
paragraphs 718-10-55-18 and 718-10-55-39 discuss
the incorporation of a range of expected
volatilities into option pricing models. The staff
believes that a company that utilizes an option
pricing model that incorporates a range of
expected volatilities over the option’s
contractual term should consider the factors
listed in FASB ASC Topic 718, and those discussed
in the Interpretive Responses to Questions 2 and 3
above, to determine the extent of its reliance
(including exclusive reliance) on the derived
implied volatility.
49 When
near-the-money options are not available, the
staff believes the use of a weighted-average
approach, as noted previously, may be appropriate.
4.9.2.3.3 Estimating Expected Volatility by Using Other Comparable Entities
If an entity is newly public or nonpublic, it may have limited historical data and no other traded financial
instruments from which to estimate expected volatility. In such cases, as discussed in the SEC guidance
below, it may be appropriate for the entity to base its estimate of expected volatility on the historical,
expected, or implied volatility of comparable entities.
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
Facts:
Company C is a newly public entity with limited
historical data on the price of its
publicly-traded shares and no other traded
financial instruments. Company C believes that it
does not have sufficient company-specific
information regarding the volatility of its share
price on which to base an estimate of expected
volatility.
Question
6: What other sources of information should
Company C consider in order to estimate the
expected volatility of its share price?
Interpretive
Response: FASB ASC Topic 718 provides guidance
on estimating expected volatility for newly-public
and nonpublic entities that do not have
company-specific historical or implied volatility
information available.54 Company C may
base its estimate of expected volatility on the
historical, expected or implied volatility of
similar entities whose share or option prices are
publicly available. In making its determination as
to similarity, Company C would likely consider the
industry, stage of life cycle, size and financial
leverage of such other entities.55
______________________________
54 FASB ASC paragraphs 718-10-55-25 and
718-10-55-51.
55 FASB ASC paragraph
718-10-55-25.
4.9.2.4 Expected Dividends
ASC 718-10
Selecting or Estimating Expected Dividends
55-42 Option-pricing models generally call for expected dividend yield as an assumption. However, the models
may be modified to use an expected dividend amount rather than a yield. An entity may use either its expected
yield or its expected payments. Additionally, an entity’s historical pattern of dividend increases (or decreases)
shall be considered. For example, if an entity has historically increased dividends by approximately 3 percent
per year, its estimated share option value shall not be based on a fixed dividend amount throughout the share
option’s expected term. As with other assumptions in an option-pricing model, an entity shall use the expected
dividends that would likely be reflected in an amount at which the option would be exchanged (see paragraph
718-10-55-13).
55-43 As with other aspects of estimating fair value, the objective is to determine the assumption about expected
dividends that would likely be used by marketplace participants in determining an exchange price for the option.
Dividend Protected Awards
55-44 Expected dividends are taken into account in using an option-pricing model to estimate the fair value
of a share option because dividends paid on the underlying shares reduce the fair value of those shares and
option holders generally are not entitled to receive those dividends. However, an award of share options
may be structured to protect option holders from that effect by providing them with some form of dividend
rights. Such dividend protection may take a variety of forms and shall be appropriately reflected in estimating
the fair value of a share option. For example, if a dividend paid on the underlying shares is applied to reduce
the exercise price of the option, the effect of the dividend protection is appropriately reflected by using an
expected dividend assumption of zero.
In using an option-pricing model to estimate the fair-value-based measure of a
stock option, an entity usually takes into account expected dividends
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, an award of stock options may be structured to
protect holders by giving them dividend rights that take various forms. An
entity should appropriately reflect such dividend protection in estimating
the fair-value-based measure of a stock option. For example, the 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. For a discussion of the recognition of dividends or dividend
equivalents, see Section
3.10.
4.9.2.5 Credit Risk and Dilution
ASC 718-10
Selecting or Considering Credit Risk
55-46 An entity may need to consider the effect of its credit risk on the estimated fair value of liability awards
that contain cash settlement features because potential cash payoffs from the awards are not independent
of the entity’s risk of default. Any credit-risk adjustment to the estimated fair value of awards with cash
payoffs that increase with increases in the price of the underlying share is expected to be de minimis because
increases in an entity’s share price generally are positively associated with its ability to liquidate its liabilities.
However, a credit-risk adjustment to the estimated fair value of awards with cash payoffs that increase with
decreases in the price of the entity’s shares may be necessary because decreases in an entity’s share price
generally are negatively associated with an entity’s ability to liquidate its liabilities.
Consider Dilution
55-48 Traded options
ordinarily are written by parties other than the
entity that issues the underlying shares, and when
exercised result in an exchange of already
outstanding shares between those parties. In
contrast, exercise of share options as part of a
share-based payment transaction results in the
issuance of new shares by the entity that wrote the
option (the grantor), which increases the number of
shares outstanding. That dilution might reduce the
fair value of the underlying shares, which in turn
might reduce the benefit realized from option
exercise.
55-49 If the market for an
entity’s shares is reasonably efficient, the effect
of potential dilution from the exercise of share
options that are part of a share-based payment
transaction will be reflected in the market price of
the underlying shares, and no adjustment for
potential dilution usually is needed in estimating
the fair value of the grantee share options. For a
public entity, an exception might be a large grant
of options that the market is not expecting, and
also does not believe will result in commensurate
benefit to the entity. For a nonpublic entity, on
the other hand, potential dilution may not be fully
reflected in the share price if sufficient
information about the frequency and size of the
entity’s grants of equity share options is not
available for third parties who may exchange the
entity’s shares to anticipate the dilutive
effect.
55-50 An entity shall consider whether the potential dilutive effect of an award of share options needs to be
reflected in estimating the fair value of its options at the grant date. For public entities, the expectation is that
situations in which such a separate adjustment is needed will be rare.
ASC 718-10-55-46 states that in estimating the fair-value-based measure of share-based payment
awards that are classified as liabilities, “[a]n entity may need to consider the effect of its credit risk.” The
entity may need to do so if the award is settled in cash “because potential cash payoffs from the awards
are not independent of the entity’s risk of default.” Since the fair-value-based measure of awards that
are settled in cash typically increases with increases in the entity’s stock price, a significant credit risk
adjustment is not expected. However, if the opposite is true (i.e., the fair-value-based measure of the
award increases with decreases in the entity’s stock price), a credit risk adjustment may be necessary.
ASC 718 also indicates that a dilution adjustment for public entities is
expected to be rare.
4.9.2.6 Current Market Price of the Underlying Share
SEC Staff Accounting Bulletins
SAB Topic 14.D.3, Certain
Assumptions Used in Valuation Methods: Current Price
of the Underlying Share (Including Considerations
for Spring-Loaded Grants)
FASB ASC paragraph 718-10-55-21
states that “if an observable market price is not
available for a share option or similar instrument
with the same or similar terms and conditions, an
entity shall estimate the fair value of that
instrument using a valuation technique or model that
meets the requirements in paragraph 718-10-55-11,”
and requires such valuation technique or model to
take into account, at a minimum a number of factors
including the current price of the underlying
share.
FASB ASC paragraph 718-10-55-27
states, “Assumptions used to estimate the fair value
of equity and liability instruments granted in
share-based payment transactions shall be determined
in a consistent manner from period to period. For
example, an entity might use the closing share price
or the share price at another specified time as the
current share price on the grant date in estimating
fair value, but whichever method is selected, it
shall be used consistently.”
For a valuation technique to be
consistent with the fair value measurement objective
and the other requirements of Topic 718, the staff
believes that a consistently applied method to
determine the current price of the underlying share
should include consideration of whether adjustments
to observable market prices (e.g., the closing share
price or the share price at another specified time)
are required. Such adjustments may be required, for
example, when the observable market price does not
reflect certain material non-public information
known to the company but unavailable to marketplace
participants at the time the market price is
observed.
Determining whether an adjustment to
the observable market price is necessary, and if so,
the magnitude of any adjustment, requires
significant judgment. The staff acknowledges that
companies generally possess non-public information
when entering into share-based payment transactions.
The staff believes that an observable market price
on the grant date is generally a reasonable and
supportable estimate of the current price of the
underlying share in a share-based payment
transaction, for example, when estimating the
grant-date fair value of a routine annual grant to
employees that is not designed to be
spring-loaded.
However, companies should carefully
consider whether an adjustment to the observable
market price is required, for example, when
share-based payments arrangements are entered into
in contemplation of or shortly before a planned
release of material non-public information, and such
information is expected to result in a material
increase in share price. The staff believes that
non-routine spring-loaded grants merit particular
scrutiny by those charged with compensation and
financial reporting governance. Additionally, when a
company has a planned release of material non-public
information within a short period of time after the
measurement date of a share-based payment, the staff
believes a material increase in the market price of
the company’s shares upon release of such
information indicates marketplace participants would
have considered an adjustment to the observable
market price on the measurement date to determine
the current price of the underlying share.
Facts:
Company D is a public company that entered into a
material contract with a customer after market
close. Subsequent to entering into the contract but
before the market opens the next trading day,
Company D awards share options to its executives.
The share option award is non-routine, and the award
is approved by the Board of Directors in
contemplation of the material contract. Company D
expects the share price to increase significantly
once the announcement of the contract is made the
next day. Company D’s accounting policy is to
consistently use the closing share price on the day
of the grant as the current share price in
estimating the grant-date fair value of share
options.
Question 1:
Should Company D make an adjustment to the closing
share price to determine the current price of shares
underlying share options?
Interpretive
Response: Prior to awarding share options in
this fact pattern, the staff expects Company D to
consider whether such awards are consistent with its
policies and procedures, including the terms of the
compensation plan approved by shareholders, other
governance policies, and legal requirements. The
staff reminds companies of the importance of strong
corporate governance and controls in granting share
options, as well as the requirements to maintain
effective internal control over financial reporting
and disclosure controls and procedures.
In estimating the grant-date fair
value of share options in this fact pattern, absent
an adjustment to the closing share price to reflect
the impact of Company D’s new material contract with
a customer, the staff believes the closing share
price would not be a reasonable and supportable
estimate and, without an adjustment the valuation of
the award would not meet the fair value measurement
objective of FASB ASC Topic 718 because the closing
share price would not reflect a price that is
unbiased for marketplace participants at the time of
the grant.74
Question 2:
What disclosures would the staff expect Company D to
include in its financial statements regarding its
determination of the current price of shares
underlying newly-granted share options?
Interpretive
Response: FASB ASC paragraph 718-10-50-1
requires disclosure of information that enables
users of the financial statements to understand,
among other things, the nature and terms of
share-based payment arrangements that existed during
the period and the potential effects of those
arrangements on shareholders. FASB ASC paragraph
718-10-50-2 prescribes the minimum information
needed to achieve the Topic’s disclosure objectives,
including a description of the method used and
significant assumptions used to estimate the fair
value of awards under share-based payment
arrangements.
Accordingly, the staff expects that,
at a minimum, Company D would disclose in a footnote
to its financial statements how it determined the
current price of shares underlying share options for
purposes of determining the grant-date fair value of
its share options in accordance with FASB ASC Topic
718. For example, the staff would expect Company D
to disclose its accounting policy related to how it
identifies when an adjustment to the closing price
is required, how it determined the amount of the
adjustment to the closing share price, and any
significant assumptions used to determine such
adjustment, if material. Further, the
characteristics of the share options, including
their spring-loaded nature, may differ from Company
D’s other share-based payment arrangements to such
an extent Company D should disclose information
regarding these share options separately from other
share-based payment arrangements to allow investors
to understand Company D’s use of share-based
compensation.75
Additionally, Company D should
consider the applicability of MD&A and other
disclosure requirements, including those related to
liquidity and capital resources, results of
operations, critical accounting estimates, executive
compensation, and transactions with related
persons.76
______________________________
74 FASB ASC paragraph
718-10-55-13.
75 ASC 718-10-50-1 and
718-10-50-2(g).
76 Items 303, 402, and
404 of Regulation S-K.
SAB 120 amends SAB Topic 14.D to add considerations related
to spring-loaded awards. Under SAB 120, an entity that grants or modifies a
share-based payment award while in possession of positive material nonpublic
information should consider whether adjustments to the current price of the
underlying share are appropriate when determining the award’s
fair-value-based measure. We believe that any adjustments required as a
result of the SAB would be related only to the determination of a
fair-value-based measure in accordance with ASC 718 and would not extend to
the determination of fair value under ASC 820. As discussed in Section 4.1, the
definition and determination of fair value differ under these two standards.
In SAB 120, the SEC staff acknowledges that an entity should
use significant judgment when determining whether an adjustment to the
observable market price is necessary. The SAB also notes that a material
increase in the market price of the entity’s shares upon the release of
“material non-public information within a short period of time after the
measurement date” indicates that “marketplace participants would have
considered an adjustment to the observable market price on the measurement
date.” SAB 120 further indicates that it is not uncommon for entities to
possess nonpublic information when entering into share-based payment
transactions and that an observable market price on the measurement date is
“generally a reasonable and supportable estimate of the current price of the
underlying share in a share-based payment transaction, for example, when
estimating the grant-date fair value of a routine annual grant to employees
that is not designed to be spring-loaded.” However, the SAB does not limit
an entity’s consideration of grants or modifications to those that are
nonroutine. Therefore, an entity should have policies and procedures in
place that allow it to identify when a grant or a modification is
spring-loaded in nature. SAB 120 also provides the SEC staff’s views on the
disclosure expectation regarding spring-loaded awards (see Section 13.10 for
more information).
4.9.3 Market-Based Measure of Stock Options
In FASB Statement 123(R) (which was issued in 2004 and later codified as ASC
718), the Board observed in paragraph B62 of the Basis for Conclusions that at
some future date, market prices for equity share options with conditions similar
to those in certain employee options may become available. Currently, it is not
common for an entity to establish a fair-value-based measure for employee or
nonemployee stock options by issuing similar instruments to third-party
investors. If such an approach is taken, entities should exercise judgment in
determining whether an option or similar instrument is being traded in an active
market and whether the instrument being traded is similar to the employee or
nonemployee stock option being valued.
In a memorandum issued in August 2005, the SEC’s Office of
Economic Analysis (OEA) presented its conclusions regarding a review of various
market-based approaches for estimating the fair-value of employee stock options.
The OEA indicated that any market-based approach must contain the following
three elements:
-
A credible information plan that enables prospective buyers and sellers to price the instrument. For example, the plan should provide information about the exercise behavior of the employees in the grant. It should be easily accessible to all market participants to reduce the potential for adverse selection.
-
A market pricing mechanism through which the instrument can be traded to generate a price. It should encourage participation in the market in order to promote competition among willing buyers and sellers.
The OEA memorandum does not provide additional guidance on the last two elements
above. However, the OEA discussed two approaches related to instrument design:
(1) the “tracking” approach and (2) a “terms-and-conditions” approach. Under the
tracking approach, an entity issues an instrument that incorporates rights to
future payouts that are identical to the future flows of net receipts by
employees or net obligations of the entity under the grant. Under a
terms-and-conditions approach, an entity issues an instrument that replicates
the substantive terms and conditions of the employee stock options. For example,
the holder of the instrument would face the same restrictions against trading
and hedging that an employee faces under the terms of the granted options. On
the basis of its analysis of each approach, the OEA concluded that instruments
designed for valuing employee stock options under the tracking approach can
yield reasonable estimates of fair value as defined in ASC 718. Conversely, the
OEA indicated that instruments designed under a terms-and-conditions approach do
not result in reasonable estimates of fair value.
Footnotes
1
If the award contains market conditions, the use
of this practical expedient is not permitted.
[2]
The OCA memorandum states, “Under the
proposals that we have seen, the amount of market
instruments that would be issued is a fraction of the
total option grant (generally 5–15 percent of the
grant). Alternatively, a company could transfer part or
all of its grant obligations to a third party that would
meet the grant’s stock delivery obligation. We have not
evaluated the adequacy of any grant size or volume to
the achievement of the valuation objective.”
[3]
The OCA memorandum states that the “net
payment may be in the form of securities or cash.”
4.10 Valuation of Awards With Graded Vesting Schedule
ASC 718-20
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.
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). For example, an entity may grant an employee 1,000 stock options that
vest over four years in increments of 25 percent each year. As discussed in
Section 4.9.2.2,
vesting indirectly affects the fair-value-based measure of a stock option by
affecting the expected-term assumption. For options and similar instruments with
graded vesting, an entity can either estimate separate fair-value-based measures for
each vesting tranche, each with a different expected term, or estimate the
fair-value-based measure of the entire award by using a single weighted-average
expected term. Regardless of the valuation approach, for employee awards with graded
vesting and only service conditions, an entity can still make a policy decision to
recognize compensation cost on a straight-line basis over the total requisite
service period of the entire award (see Section 3.6.5).
4.11 Difficulty of Estimation
ASC 718-10
Difficulty of Estimation
30-21 It should be possible to reasonably estimate the fair value of most equity share options and other equity
instruments at the date they are granted. Section 718-10-55 illustrates techniques for estimating the fair values
of several instruments with complicated features. However, in rare circumstances, it may not be possible
to reasonably estimate the fair value of an equity share option or other equity instrument at the grant date
because of the complexity of its terms.
Intrinsic Value Method
30-22 An equity instrument for which it is not possible to reasonably estimate fair value at the grant date shall
be accounted for based on its intrinsic value (see paragraph 718-20-35-1 for measurement after issue date).
ASC 718-20
Fair Value Not Reasonably Estimable
35-1 An equity instrument for
which it is not possible to reasonably estimate fair value
at the grant date shall be remeasured at each reporting date
through the date of exercise or other settlement. The final
measure of compensation cost shall be the intrinsic value of
the instrument at the date it is settled. Compensation cost
for each period until settlement shall be based on the
change (or a portion of the change, depending on the
percentage of the requisite service that has been rendered
for an employee award or the percentage that would have been
recognized had the grantor paid cash for the goods or
services instead of paying with a nonemployee award at the
reporting date) in the intrinsic value of the instrument in
each reporting period. The entity shall continue to use the
intrinsic value method for those instruments even if it
subsequently concludes that it is possible to reasonably
estimate their fair value.
ASC 718-10-30-21 states, in part, that “in rare
circumstances, it may not be possible to reasonably estimate [the
fair-value-based measure of a share-based payment award as of] the
grant date because of the complexity of its terms” (emphasis added).
That is, there is a strong presumption under ASC 718 that the
fair-value-based measure can be estimated unless there is
substantial evidence to the contrary. Paragraph B103 of FASB
Statement 123(R) emphasizes this presumption by stating that, “[i]n
light of the variety of options and option-like instruments
currently trading in external markets and the advances in methods of
estimating their fair values,” entities should be able to reasonably
estimate the fair-value-based measure of most awards as of the grant
date. Accordingly, accounting for a share-based payment award by
using the intrinsic-value method under ASC 718-20-35-1 would be
permitted only in the unlikely event that there is substantial
evidence indicating that it is not possible to reasonably estimate
the fair-value-based measure of the award.
4.12 Valuation of Nonpublic Entity Awards
ASC 718-10
Fair-Value-Based
30-2 A share-based payment
transaction shall be measured based on the fair value (or in
certain situations specified in this Topic, a calculated
value or intrinsic value) of the equity instruments
issued.
ASC 718 identifies three ways for a nonpublic entity to measure share-based payment awards:
- By using fair value, which is the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties; that is, other than in a forced or liquidation sale.
- By using a calculated value, which is a measure of the value of a stock option or similar instrument determined by substituting the historical volatility of an appropriate industry sector index for the expected volatility of a nonpublic entity’s share price in an option-pricing model. See Section 4.13.2.
- By using intrinsic value, which is the amount by which the fair value of the underlying stock exceeds the exercise price of an option or similar instrument. See Section 4.13.3.
Nonpublic entities should make an effort to value their equity-classified awards
by using a fair-value-based measure. A nonpublic entity may look to recent sales of
its common stock directly to investors or common stock transactions in secondary
markets. However, observable market prices for a nonpublic entity’s equity shares
may not exist. In such an instance, a nonpublic entity could apply many of the
principles of ASC 820 to determine the fair value of its common stock, often by
using either a market approach or an income approach (or both). A “top-down method
may be applied,” which involves first valuing the entity, then subtracting the fair
value of debt, and then using the resulting equity valuation as a basis for
allocating the equity value among the entity’s equity securities. While not
authoritative, the AICPA’s Accounting and Valuation Guide Valuation of Privately-Held-Company
Equity Securities Issued as Compensation (the AICPA
Valuation Guide)4 emphasizes the importance of contemporaneous valuations from independent
valuation specialists to determine the fair value of equity securities.
4.12.1 Cheap Stock
The SEC often focuses on “cheap stock”5 issues in connection with a nonpublic entity’s preparation for an IPO. The
SEC staff is interested in the rationale for any difference between the fair
value measurements of the underlying common stock of share-based payment awards
and the anticipated IPO price. In addition, the SEC staff will challenge
valuations that are significantly lower than prices paid by investors to acquire
similar stock. If the differences cannot be reconciled, a nonpublic entity may
be required to record a cheap-stock charge. Since share-based payments are often
a compensation tool to attract and retain employees or nonemployees, a
cheap-stock charge could be material and, in some cases, lead to a restatement
of the financial statements.
An entity preparing for an IPO should refer to paragraph 7520.1 of the SEC Division
of Corporation Finance’s Financial Reporting Manual (FRM), which outlines
considerations for registrants when the “estimated fair value of the stock is
substantially below the IPO price.” In such situations, registrants should be
able to reconcile the change in the estimated fair value of the underlying
equity between the award grant date and the IPO by taking into account, among
other things, intervening events and changes in assumptions that support the
change in fair value.
The SEC staff has frequently inquired about a registrant’s
pre-IPO valuations. Specifically, during the registration statement process, the
SEC staff may ask an entity to (1) reconcile its recent fair values with the
anticipated IPO price (including significant intervening events), (2) describe
its valuation methods, (3) justify its significant valuation assumptions, and
(4) discuss the weight it gives to stock sale transactions. We encourage
entities planning an IPO in the foreseeable future to use the AICPA Valuation
Guide6 and to consult with their valuation specialists. Further, they should
ensure that their pre-IPO valuations are appropriate and that they are prepared
to respond to questions the SEC may have during the registration statement
process.
The AICPA Valuation Guide highlights differences between pre-IPO and post-IPO
valuations. One significant difference is that the valuation of nonpublic entity
securities often includes a DLOM. The DLOM can be determined by using several
valuation techniques and is significantly affected by the underlying volatility
of the stock and the period the stock is illiquid.
The AICPA Valuation Guide describes three foundational methods for estimating the
DLOM: the protective put model, the Longstaff model, and the quantitative
marketability discount model. However, it is assumed under the Longstaff model
that the investor is able to perfectly time the market and therefore maximize
proceeds. Since an investor typically does not have that timing ability, the
Longstaff model is generally not appropriate to use. In addition, use of the
quantitative marketability discount model may not be appropriate for complex
capital structures or when it is assumed that there are long holding periods.
While all put-based methods may have limitations, the protective
put model, also known as the Chaffee model or European7 protective put model, is widely used to calculate the DLOM. Entities
perform the calculation on the basis of an at-the-money put with a life equal to
the period of restriction, divided by the marketable stock value. The following
are two commonly used variations of the protective put model:
- Finnerty model — Under this model, also known as the average-strike put option model, an entity estimates the DLOM as an average-strike Asian8 put which measures the difference between the average price over the holding period and the final price.
- Asian protective put model — Under this model, an entity estimates the DLOM as an average-price Asian put that measures the difference between the current price and the average price over the holding period. The Asian protective put model results in DLOMs that are lower than those calculated under the protective put model and, for low volatility stocks, those calculated under the Finnerty model. For high volatility stocks, it results in DLOMs that are higher than those calculated under the Finnerty model.
4.12.2 ISOs, NQSOs, and Internal Revenue Code Section 409A
When granting share-based payment awards, a nonpublic entity should be mindful of
the tax treatment of such awards and the related implications. Section 409A of
the Internal Revenue Code (IRC) contains requirements related to nonqualified
deferred compensation plans that can affect the taxability of holders of
share-based payment awards. If a nonqualified deferred compensation plan (e.g.,
one issued in the form of share-based payments) fails to comply with certain IRC
rules, the tax implications and penalties at the federal level (and potentially
the state level) can be significant for holders.
Under U.S. tax law, stock option awards can generally be categorized into two groups:
- Statutory options, including incentive stock options (ISOs) and ESPPs that are qualified under IRC Sections 422 and 423, respectively. The exercise of an ISO or a qualified ESPP does not result in a tax deduction for the entity unless the employee or former employee makes a disqualifying disposition. While an ISO may result in favorable tax treatment for the recipient, certain eligibility conditions must be met.
- Nonstatutory options (also known as NQSOs or NSOs). The exercise of an NQSO results in a tax deduction for the issuing entity that is equal to the intrinsic value of the option when exercised.
The ISOs and ESPPs described in IRC Sections 422 and 423, respectively, are
specifically exempt from the requirements of IRC Section 409A. Other NQSOs are
outside the scope of IRC Section 409A if certain requirements are met. One
significant requirement is that the exercise price must not be below the fair
market value of the underlying stock as of the grant date. Accordingly, it is
imperative to establish a supportable fair market value of the stock to avoid
unintended tax consequences for the issuer and holder. While IRC Section 409A
also applies to public entities, the valuation of share-based payment awards for
such entities is subject to less scrutiny because the market prices of the
shares associated with the awards are generally observable. Among other details,
entities should understand (1) which of their compensation plans and awards are
subject to the provisions of IRC Section 409A and (2) how they can ensure that
those plans and awards remain compliant with IRC Section 409A and thereby avoid
unintended tax consequences of noncompliance.
A company’s failure to comply with the requirements in IRC
Section 409A related to nonqualified deferred compensation plans may affect how
the fair value of existing and future share-based compensation is determined and
how those awards are taxed. Specifically, if the form and operation of
compensation arrangements do not comply with the requirements in IRC Section
409A, service providers will be required to include the compensation in their
taxable income sooner than they would need to under general tax rules (e.g.,
vesting as opposed to exercise of an option) and service providers will be
subject to an additional 20 percent federal income tax plus interest on the
amount included in their taxable income. Although the tax is imposed on the
individuals receiving the compensation, in certain instances, an entity may
decide to pay the additional tax liabilities on behalf of its employees. Among
IRC Section 409A’s many requirements, valuation of the stock on the grant date
is critical, and grantees should establish the fair market value of their shares
to ensure compliance with IRC Section 409A. Both nonqualified and statutory
options are subject to IRC Section 409A unless they otherwise meet its criteria
for treatment as exempt stock rights. It is important for an entity to consult
with tax advisers regarding the tax effects of both existing and planned
share-based compensation plans to determine whether it is subject to the
requirements in IRC Section 409A or other IRC sections.
In addition, when recognizing compensation cost, many nonpublic entities use
their IRC Section 409A assessments to value their share-based payments. Because
those assessments are used for tax purposes, nonpublic entities should carefully
consider whether they are also appropriate for measuring share-based payment
awards under ASC 718.
See Chapter 10 of Deloitte’s Roadmap
Income
Taxes for a discussion of the income tax effects of
share-based payments.
4.12.3 Purchases of Shares From Grantees
4.12.3.1 Entity Purchases of Shares From Grantees
ASC 718-20
Repurchase or Cancellation
35-7 The amount of cash or
other assets transferred (or liabilities incurred)
to repurchase an equity award shall be charged to
equity, to the extent that the amount paid does not
exceed the fair value of the equity instruments
repurchased at the repurchase date. Any excess of
the repurchase price over the fair value of the
instruments repurchased shall be recognized as
additional compensation cost. An entity that
repurchases an award for which the promised goods
have not been delivered or the service has not been
rendered has, in effect, modified the employee’s
requisite service period or nonemployee’s vesting
period to the period for which goods have already
been delivered or service already has been rendered,
and thus the amount of compensation cost measured at
the grant date but not yet recognized shall be
recognized at the repurchase date.
To provide liquidity or for other reasons, entities may sometimes repurchase
vested common stock from their share-based payment award grantees. In some
cases, the price paid for the shares exceeds their fair value at the time of
the transaction, and the excess would generally be recognized as additional
compensation cost in accordance with ASC 718-20-35-7. In addition, an
entity’s practice of repurchasing shares, or an arrangement that permits
repurchase, could affect the classification of share-based payment awards.
See Sections
5.6 and 6.10 for additional discussion of how an entity’s past
practice affects classification.
4.12.3.2 Investor Purchases of Shares From Grantees
ASC 718-10
15-4 Share-based payments
awarded to a grantee by a related party or other
holder of an economic interest in the entity as
compensation for goods or services provided to the
reporting entity are share-based payment
transactions to be accounted for under this Topic
unless the transfer is clearly for a purpose other
than compensation for goods or services to the
reporting entity. The substance of such a
transaction is that the economic interest holder
makes a capital contribution to the reporting
entity, and that entity makes a share-based payment
to the grantee in exchange for services rendered or
goods received. An example of a situation in which
such a transfer is not compensation is a transfer to
settle an obligation of the economic interest holder
to the grantee that is unrelated to goods or
services to be used or consumed in a grantor’s own
operations.
ASC 718-10 — Glossary
Economic Interest in an Entity
Any type or form of pecuniary interest or arrangement that an entity could issue or be a party to, including
equity securities; financial instruments with characteristics of equity, liabilities, or both; long-term debt and
other debt-financing arrangements; leases; and contractual arrangements such as management contracts,
service contracts, or intellectual property licenses.
On occasion, existing investors (such as private equity or venture capital
investors) intending to increase their stake in an emerging nonpublic entity
may undertake transactions with other shareholders in connection with or
separately from a recent financing round. These transactions may include the
purchase of shares of common or preferred stock by investors from the
founders of the nonpublic entity or other individuals who are also
considered employees. Because the transactions are between grantees of the
nonpublic entity and existing shareholders and are related to the transfer
of outstanding shares, the nonpublic entity may not be directly involved in
them (though it may be indirectly involved by facilitating the exchange or
not exercising a right of first refusal). If the price paid for the shares
exceeds their fair value at the time of the transaction, it may be difficult
to demonstrate that the transaction is not compensatory and the nonpublic
entity would most likely be required to recognize compensation cost for the
excess, even if the entity is not directly involved in the transaction. It
is important for a nonpublic entity to recognize that transactions such as
these may be subject to the guidance in ASC 718-10-15-4 because the
investors are considered holders of an economic interest in the entity.
Although the presumption in such transactions is that any consideration in
excess of the fair value of the shares is compensation paid to employees,
entities should consider whether the amount paid is related to an existing
relationship or to an obligation that is unrelated to the employees’
services to the entity in assessing whether the payment is “clearly for a
purpose other than compensation for services to the reporting entity.” Even
though it is difficult to demonstrate that a non–fair value transaction with
employees is clearly for other purposes, AIN-APB 25 (superseded by FASB Statement 123(R)) describes situations when doing so may be possible,
including those in which:
-
“[T]he relationship between the stockholder and the corporation’s employee is one which would normally result in generosity (i.e., an immediate family relationship).”
-
“[T]he stockholder has an obligation to the employee which is completely unrelated to the latter’s employment (e.g., the stockholder transfers shares to the employee because of personal business relationships in the past, unrelated to the present employment situation).”
In all situations, the determination of whether a transaction should be accounted for under ASC 718
should be based on an entity’s specific facts and circumstances.
In addition, there may be situations in which, as part of a financing
transaction between a nonpublic entity and a new investor that is acquiring
a significant ownership interest in the nonpublic entity, the new investor
repurchases common shares in the nonpublic entity from employees of the
nonpublic entity. For example, the investor may not have participated in a
prior financing arrangement and may be purchasing convertible preferred
stock from the nonpublic entity and common stock from the nonpublic entity’s
existing employees. In this scenario, the investor pays the same price to
purchase the preferred stock from the nonpublic entity and the common stock
from the employees. While it did not hold an economic interest before
entering into the transaction with the nonpublic entity, the new investor is
not unlike a party that already holds such an interest and may be similarly
motivated to compensate employees.
As noted in ASC 718-10-15-4, a share-based payment arrangement between the
holder of an economic interest in a nonpublic entity and an employee of the
nonpublic entity should be accounted for under ASC 718 unless the
arrangement “is clearly for a purpose other than compensation for goods or
services.” If a new investor purchases common stock valued at an amount
based on the value of the preferred stock, we would generally expect the
analysis to be similar to that performed by a preexisting investor that
purchases common stock from a nonpublic entity’s employees.
Shares purchased from grantees by a related party or an economic interest
holder may include shares that have been vested (or have been issued as a
result of the exercise of options) for less than six months (i.e., the
shares are considered immature). We do not believe that a reporting entity
would generally consider a history of investor purchases of immature shares
from grantees (regardless of whether such purchases are conducted at fair
value or at an amount that exceeds fair value) when assessing whether it has
established a past practice of settling immature shares that results in a
substantive liability (see Sections 5.6 and 6.10 for additional discussion
of how an entity’s past practice affects classification). Generally, if the
reporting entity otherwise classifies the shares as equity, purchases of
such shares by the related party or economic interest holder do not satisfy
a liability on the reporting entity’s behalf. Rather, the purchaser (often
through a tender offer to grantees that is, in part, organized by the
reporting entity) is making an investment decision to establish or increase
its ownership interest in the reporting entity and thereby is the party
making a payment as the principal in the purchase transaction with grantees.
Accordingly, a related party or an economic interest holder that directly
makes such a purchase from grantees would not change the substantive terms
of the share-based payment arrangement that requires the reclassification of
the shares from equity to a liability.
4.12.3.2.1 Valuation Considerations
While the examples above describe situations in which it
is likely that the nonpublic entity would recognize additional
compensation cost, we are aware of circumstances in which a secondary
market transaction between an investor and a nonpublic entity’s
employees represents an orderly arm’s-length transaction conducted at
fair value. In such cases, the nonpublic entity has adequate support for
a conclusion that the transaction was conducted at fair value and
therefore did not result in additional compensation cost. Such secondary
transactions are likely to be relevant in the nonpublic entity’s common
stock valuation, which is typically performed by a third-party valuation
firm to ensure compliance with IRC Section 409A and determine the
fair-value-based measure of the nonpublic entity’s share-based payment
arrangements (see Section 4.12.2).
When an entity does conclude that a secondary transaction includes a
compensatory element that must be recognized, there may have also been
indicators that the secondary transaction was conducted at fair value.
In such situations (i.e., there are indicators that (1) the transaction
was conducted at fair value and (2) there is a compensatory element), an
entity should consider whether to give some weight to the transaction
when determining the fair value of the common shares.
4.12.3.2.2 Tax Considerations
For tax purposes, stock repurchases are generally treated either as
capital (e.g., capital gain) or as dividend-equivalent redemptions
(e.g., ordinary dividend income to the extent that the entity has
earnings and profits). Repurchases from current or former service
providers (i.e., current or former employees or independent contractors)
give rise to questions about whether any of the proceeds should be
treated as compensation for tax purposes.
In the assessment of whether a portion of the payment is compensation, a
critical tax issue is what value is appropriate for the nonpublic entity
to use when determining the effect of the capital redemption. That is,
the nonpublic entity must determine whether some portion of the
consideration for the repurchase represents something other than fair
value for the common stock (e.g., compensation cost). When a repurchase
exceeds the fair value of the common stock, there is risk that some of
the purchase consideration is compensation for tax purposes. The
determination of whether such excess is compensatory depends on the
facts and circumstances, and there can be disparate treatment for book
and tax purposes with respect to compensation transactions as well as
ambiguity in the existing tax code. Relevant factors include whether the
repurchase is (1) performed by the nonpublic entity or an existing
investor or (2) part of arm’s-length negotiations with a new investor
that may not have the same information as the nonpublic entity about
what is considered to be the fair market value of the stock. If the
purchaser is not the nonpublic entity, it is relevant whether the shares
will be held by the buyer, or whether they can be converted into a
different class of stock or put back to the nonpublic entity. Another
factor is whether an offer to sell at a higher price is limited to
service providers or is available to shareholders more generally.
If the repurchase resulted in compensation for tax purposes, the
nonpublic entity would include such compensation on Form W-2 (for
employees) or Form 1099-MISC (for independent contractors). While any
tax liability resulting from additional compensation is the obligation
of the individual, the nonpublic entity has an obligation to (1)
withhold income and payroll taxes from payments to employees and (2)
remit the employer share of payroll tax. A nonpublic entity that does
not withhold payroll taxes from an employee in a transaction in which
the excess purchase price is compensatory becomes responsible for the
tax and should evaluate whether to accrue a liability in accordance with
the guidance in ASC 450. That guidance addresses the proper accounting
treatment of non-income-tax contingencies such as sales and use taxes,
property taxes, and payroll taxes.
An estimated loss contingency, such as a payroll tax liability, is
accrued (i.e., expensed) if (1) it is probable that the liability has
been incurred as of the date of the financial statements and (2) the
amount of the liability is reasonably estimable. A loss contingency must
be disclosed if (1) the loss is probable as of the date of the financial
statements or it is reasonably possible that the liability has been
incurred and (2) the amount is material to the financial statements.
With respect to a payroll tax liability, the liability recorded as a tax
transaction should be the best estimate of the probable amount due to
the tax authority under the applicable law, which would include interest
and penalties. In addition, the nonpublic entity would need to evaluate
whether it has any arrangements in place with its employees that would
make it responsible for its employees’ tax liability. If the best
estimate of the liability is a range, and if one amount in the range
represents a better estimate than any other amount in the range, that
amount should be recorded in accordance with ASC 450-20-30-1. If no
amount in the range is a better estimate than any other amount, the
minimum amount in the range should be used to record the liability in
accordance with ASC 450-20-30-1.
An entity has a legal right to seek reimbursement for the payroll tax
liability (although not for income tax withholding, penalties, or
interest) from employees if the IRS makes a determination to seek the
withholdings from the entity. Accordingly, an entity could record an
offsetting receivable from the employees for the payroll tax
withholdings. However, the entity will need to assess the collectability
of such a receivable, including whether the entity has sufficient
evidence of an employee’s ability to reimburse the entity for the
payroll tax liability and whether the entity has the intent to collect
this liability from the employee.
The following is an example of a disclosure that an
entity may make about its repurchase of common stock from its employees
when it has incurred a payroll tax liability as a result of not
withholding payroll taxes:
In connection with our
Series A financing, we repurchased common shares from our employees.
The transaction was undertaken to provide liquidity to our employees
and allows us to offer investors additional Series A shares without
further dilution of the existing shareholders. While we have viewed
the transaction to be a capital transaction for tax purposes, tax
authorities could challenge this characterization and consider a
portion of the payment to be compensation to the employees, which
would require us to remit payroll tax withholdings to the tax
authorities. For the probable amount of taxes and penalties that may
be payable, the Company has recorded a liability of $5 million,
which represents the low end of the range of probable amounts of
payroll tax withholdings and penalties that would be payable. The
ultimate payment amount could exceed the liability recorded, and we
estimate that the reasonably possible range of such payment could be
up to $8 million.
Given the complexities of this type of transaction, including the
evaluation of existing tax law, entities should consult with their
auditors and tax specialists when quantifying the liability under ASC
450.
Note that if a payment is considered compensation, a deduction of the
same amount would also be allowed (subject to all applicable rules
related to deductions for compensation expense).
4.12.4 Interpolation Considerations for Valuing Share-Based Compensation
Early-stage companies often obtain independent valuations once
per year. However, the dates of the valuations do not always coincide with the
grant date, or other relevant measurement date, for a share-based payment award.
As a result, management must assess the current fair value of the underlying
shares as of the measurement date.
Management should consider qualitative and quantitative factors
when assessing the current fair value of the underlying shares as of the
measurement date if a current independent valuation is not readily available. A
current independent valuation could be based on a recent arm’s-length willing
buyer, on a willing seller transaction (an “orderly transaction”9), or on value indications under the income and market approaches that are
reconciled to a value estimate. The relevance of qualitative and quantitative
factors becomes greater as the period between the most recent valuation and the
measurement date increases.
We believe that when management performs its assessment of fair
value, it should consider the factors outlined in the AICPA Valuation Guide.
However, those factors are not all-inclusive since an entity’s specific
circumstances may affect valuation. In the absence of an orderly transaction or
of the data needed for an entity to apply the income and market approaches, the
entity should work with its auditor and an independent valuation specialist to
ensure that it has properly identified all relevant factors that could affect
the fair value of the underlying share price.
When evaluating the factors in the AICPA Valuation Guide,
management should determine whether there have been any positive or negative
changes to the fair value of the underlying shares since the most recent
independent valuation. Accordingly, management may consider the following in
making its determination:
- Material changes in strategic relationships with major suppliers or customers — A loss or gain of a major supplier or customer that was not factored into the previous valuation can materially affect the entity. Changes in the financial health and profitability of strategic suppliers or customers can also affect the entity’s valuation.
- Material changes in enterprise cost structure and financial condition — A change in the cost structure flexibility (i.e., relationship between fixed and variability cost) may affect the entity’s previous expectations regarding its cash burn rate and future financial strength.
- Material changes in the management team’s competence — A change in the experience and competence of the management team may affect the entity’s future strategic objectives and direction.
- Material changes in existing proprietary technology, products, or services — The nature of the industry, patents, exclusive license arrangements, and enterprise-owned and developed intellectual property may significantly affect an entity’s valuation. Entities that do not have proprietary technology should evaluate whether there is a high likelihood of product obsolescence.
- Material changes in workforce and workforce skills — The quality of the workforce as a result of specialized knowledge or skills of key employees can be a significant input into certain entities’ valuation.
- Material change in the state of the industry and economy — Local, national, and global economic conditions may adversely or positively affect an entity.
- Material third-party arm’s-length transactions in the entity’s equity10 — These types of transactions may be indicators of fluctuation in the fair value of the underlying shares.
- Material changes in valuation assumptions used in the last valuation — The likelihood of the occurrence of a liquidity event, such as an IPO or a merger or an acquisition, or significant changes in the financial metrics or the valuations of the entity’s publicly traded comparable companies.
Entities that grant equity between two independent valuations or
after an independent valuation should consider using an interpolation or
extrapolation framework to estimate the fair value of the underlying shares.
Such frameworks may include linear interpretation, hockey stick interpolation,
or the consideration of equity granted after the most recent valuation
(extrapolation). Entities should evaluate the appropriateness of using an
interpolation framework and should consider the factors outlined above if they
use such a framework.
The examples below illustrate circumstances in which the use of
an interpolation framework may be appropriate.
Example 4-6
Company X performed an independent
valuation of its common stock as of December 15, 20X8,
and September 18, 20X9. Company X’s common stock value
increased from $1.50 to $2.25 between December 15, 20X8,
and September 18, 20X9. On April 1, 20X9, X granted
500,000 options on its common stock to its employees,
with an exercise price of $1.50. Company X evaluated the
qualitative and quantitative factors discussed above and did not identify any
significant events that occurred during this interim
period that would have caused a material change in fair
value of the common stock. Further, over this period,
management monitored its industry and peer group
multiples and observed that these valuation inputs did
not suggest a change in the fair value of X’s common
stock.
We believe that in the absence of an
orderly transaction or data necessary for an entity to
apply the income and market approaches, it is acceptable
for management to perform a linear interpolation between
the December 15, 20X8, and September 18, 20X9, valuation
dates to determine the fair value of the common stock as
of April 1, 20X9.
After performing a linear interpolation,
X concluded that the fair value of the common stock as
of April 1, 20X9, was $1.79. When valuing the 500,000
options granted on April 1, 20X9, management would use
$1.79 as the fair value of the common stock. The graphic
below illustrates X’s linear interpolation.
Example 4-7
Hockey Stick Interpolation
Assume the same facts as in the example
above; however, Company X’s operating results were
higher than originally forecasted in the December 15,
20X8, valuation model. Specifically, X performed above
expectations during the interim period July 1, 20X9,
through September 18, 20X9. Its performance was
primarily influenced by higher than expected customer
acquisitions and improved pricing. Before July 1, 20X9,
management evaluated the qualitative and quantitative
factors discussed above and did
not identify any significant events that occurred before
July 1, 20X9, that would have caused a material change
in fair value of the common stock. Management therefore
concluded that the common stock valuation was flat
during this period.
We believe that in the absence of an
orderly transaction or of the data necessary for the
application of the income and market approaches, it is
acceptable for management to perform a “hockey stick”
interpolation between the December 15, 20X8, and
September 18, 20X9, valuation to determine the fair
value of the common stock as of April 1, 20X9. This is
because management has evidence that the increase in the
fair value of the common stock was primarily
attributable to better-than-expected growth from July 1,
20X9, through September 18, 20X9. The graphic below
illustrates X’s interpolation.
As suggested in the graphic above, X
concluded that the fair value of the common stock as of
April 1, 20X9, was $1.50. However, if management had
granted options on its common stock between July 20X9
and September 20X9, management would use the
interpolation framework above to determine the fair
value of the common stock.
Example 4-8
Equity Granted After
the Most Recent Valuation (Extrapolation)
After performing an independent
valuation of its common stock as of July 1, 20X9,
Company Y, which has a calendar year-end, concluded that
the fair value of the common stock was $2.00. On
December 1, 20X9, Y granted 500,000 options that can be
exercised on Y’s common stock. On March 1, 20X0, Y will
issue its financial statements without having an updated
independent valuation of its common stock (i.e., it will
only have the July 1, 20X9, valuation).
Company Y is generating revenue but is
currently operating at a loss. At the time of Y’s July
1, 20X9, common stock valuation, management forecasted
FYX9 revenue of $10 million and FYX0 revenue of $25
million. As of December 1, 20X9, management revaluated
its actual and forecasted revenue and concluded that
there were no material changes to its original revenue
forecast. Management considered the qualitative and
quantitative factors discussed above in determining
whether the common stock fair value had changed. On the
basis of its assessment as well as its unchanged revenue
forecast, management concluded that the common stock
fair value had remained flat and that there was no
evidence that the fair value of the common stock had
materially increased or decreased since the July 1,
20X9, valuation. As a result, when valuing the options
granted on December 1, 20X9, management used $2.00 as
the fair value of the common stock.
Assume the same facts as those above;
however, revenue for fiscal year 20X9 and forecasted
fiscal year 20X0 is 10 percent above the July 1, 20X9,
amount forecasted in the previous valuation. In this
scenario, management should develop a reasonable method
to reflect an increase in the fair value of the common
stock between July 1, 20X9, and December 1, 20X9. For
example, on the basis of Y’s July 1, 20X9, valuation,
management can approximate the incremental impact on its
common stock as a result of the revenue increase in
fiscal years 20X9 and 20X0. Using this amount as a
benchmark, management could approximate the fair value
of the common stock as of December 1, 20X9.
See Deloitte’s March 17, 2017, Financial Reporting Alert for a
discussion of disclosure considerations.
Footnotes
4
The AICPA Valuation Guide provides best-practice guidance
for valuing the equity securities of nonpublic entities. It discusses, among
other topics, possible methods of allocating enterprise value to underlying
securities, enterprise-and industry-specific attributes that should be
considered in the determination of fair value, best practices for supporting
fair value, and recommended disclosures for a registration statement.
5
Cheap stock refers to issuances of equity securities
before an IPO in which the value of the shares is below the IPO
price.
6
See footnote 4.
7
A European option can be exercised only on the
expiration date.
8
An Asian option, or average option, is an option
contract in which the payoff is based on the average price of
the stock over a specific period (as opposed to a single
point).
9
ASC 820 defines an orderly transaction as a “transaction
that assumes exposure to the market for a period before the measurement
date to allow for marketing activities that are usual and customary for
transactions involving such assets or liabilities; it is not a forced
transaction (for example, a forced liquidation or distress sale).” In
private-company financing transactions, the usual and customary
marketing activities generally include time for the investors to perform
due diligence and to discuss the company’s plans with management, the
board of directors, or both.
4.13 Practical Expedients for Nonpublic Entities
4.13.1 Application
There are several practical expedients in ASC 718 that are available only to nonpublic entities. To apply
them, an entity will need to first ensure that it meets the definition of a nonpublic entity as defined in
ASC 718 (see Section 1.7).
4.13.1.1 Fair-Value-Based Measurement Exceptions
Two alternatives to fair-value-based measurement are available to nonpublic entities:
- Calculated value — A nonpublic entity that cannot reasonably estimate the fair-value-based measure of its options and similar instruments (because it is not practicable to estimate the expected volatility of its stock price) should use the historical volatility of an appropriate industry sector index to calculate an award’s value. This amount is referred to as a calculated value. See Section 4.13.2 for a discussion of a nonpublic entity’s use of the historical volatility of an appropriate industry sector index in valuing a share-based payment award.
- Intrinsic value — For liability-classified awards, nonpublic entities can elect as an accounting policy to measure all of their liability-classified awards at either intrinsic value or a fair-value-based measure. See Section 4.13.3 for additional information.
The table below summarizes the use of these measurement alternatives.
Public Entities | Nonpublic Entities | |
---|---|---|
Equity-classified awards | Fair-value-based measure | Either:
|
Liability-classified awards | Fair-value-based measure,
remeasured in each reporting
period until settlement | Either:
|
* Expected volatility is based on the entity’s own share price or
comparable public entities. ** Expected volatility is based on the historical volatility of an
appropriate industry sector index; a calculated
value is used when it is not practicable to estimate
the expected volatility of an entity’s own share
price. |
4.13.1.2 Expected-Term Practical Expedient
A nonpublic entity may make an entity-wide accounting policy election to use a practical expedient to
estimate the expected term of certain options and similar instruments. The practical expedient can be
used only for awards that meet certain conditions. See Section 4.9.2.2.3 for additional information.
4.13.1.3 Practical Expedient for the Current Price Input for Equity Classified Awards
ASC 718-10
30-20C As a practical
expedient, a nonpublic entity may use a value
determined by the reasonable application of a
reasonable valuation method as the current price of
its underlying share for purposes of determining the
fair value of an award that is classified as equity
in accordance with paragraphs 718-10-25-6 through
25-18 at grant date or upon a modification. This
practical expedient may not be used for awards
classified as liabilities in accordance with
paragraphs 718-10-25-6 through 25-18.
Nonpublic entities may elect to use a practical expedient to
determine the current price input of equity-classified share-based payment
awards issued to both employees and nonemployees on a
measurement-date-by-measurement-date basis. The guidance in ASC
718-10-30-20G notes that a valuation performed in accordance with specified
U.S. Treasury regulations related to IRC Section 409A is an example of a
reasonable valuation method under the practical expedient. It also
explicitly refers to other valuation approaches under IRC Section 409A that
are presumed to be reasonable.
Unlike the transition guidance provided by the SEC for
entities that elect the intrinsic value or calculated value practical
expedients when changing from nonpublic to public entity status (see
Section
4.13.4), there is no similar transition guidance related to
the practical expedient for the current price input. Therefore, an entity
that no longer meets the criteria to be a nonpublic entity would have to
reverse the practical expedient’s effect in its historical financial
statements. Consequently, before electing the practical expedient, nonpublic
entities that could become public entities should carefully consider the
potential future costs of having to perform such a reversal.
4.13.2 Calculated Value
ASC 718-10
Nonpublic Entity — Calculated Value for Nonemployee
Awards
30-19A
Similar to employee equity share options and similar
instruments, a nonpublic entity may not be able to
reasonably estimate the fair value of nonemployee awards
because it is not practicable for the nonpublic entity
to estimate the expected volatility of its share price.
In that situation, the nonpublic entity shall account
for nonemployee equity share options and similar
instruments on the basis of a value calculated using the
historical volatility of an appropriate industry sector
index instead of the expected volatility of the
nonpublic entity’s share price (the calculated value) in
accordance with paragraph 718-10-30-20. A nonpublic
entity’s use of calculated value shall be consistent
between employee share-based payment transactions and
nonemployee share-based payment transactions.
Nonpublic Entity — Calculated Value
30-20 A nonpublic entity may not be able to reasonably estimate the fair value of its equity share options and
similar instruments because it is not practicable for it to estimate the expected volatility of its share price. In
that situation, the entity shall account for its equity share options and similar instruments based on a value
calculated using the historical volatility of an appropriate industry sector index instead of the expected volatility
of the entity’s share price (the calculated value). Throughout the remainder of this Topic, provisions that apply
to accounting for share options and similar instruments at fair value also apply to calculated value. Paragraphs
718-10-55-51 through 55-58 and Example 9 (see paragraph 718-20-55-76) provide additional guidance on
applying the calculated value method to equity share options and similar instruments granted by a nonpublic
entity.
Calculated Value for Certain Nonpublic Entities
55-51 Nonpublic entities may have sufficient information available on which to base a reasonable and
supportable estimate of the expected volatility of their share prices. For example, a nonpublic entity that has
an internal market for its shares, has private transactions in its shares, or issues new equity or convertible debt
instruments may be able to consider the historical volatility, or implied volatility, of its share price in estimating
expected volatility. Alternatively, a nonpublic entity that can identify similar public entities for which share or
option price information is available may be able to consider the historical, expected, or implied volatility of
those entities’ share prices in estimating expected volatility. Similarly this information may be used to estimate
the fair value of its shares or to benchmark various aspects of its performance (see paragraph 718-10-55-25).
55-52 This Topic requires all
entities to use the fair-value-based method to account
for share-based payment arrangements that are classified
as equity instruments. However, if it is not practicable
for a nonpublic entity to estimate the expected
volatility of its share price, paragraphs 718-10-30-19A
through 30-20 require it to use the calculated value
method. Alternatively, it may not be possible for a
nonpublic entity to reasonably estimate the fair value
of its equity share options and similar instruments at
the date they are granted because the complexity of the
award’s terms prevents it from doing so. In that case,
paragraphs 718-10-30-21 through 30-22 require that the
nonpublic entity account for its equity instruments at
their intrinsic value, remeasured at each reporting date
through the date of exercise or other settlement.
55-53 Many nonpublic entities
that plan an initial public offering likely will be able
to reasonably estimate the fair value of their equity
share options and similar instruments using the guidance
on selecting an appropriate expected volatility
assumption provided in paragraphs 718-10-55-35 through
55-41.
55-54 Estimating the expected volatility of a nonpublic entity’s shares may be difficult and that the resulting
estimated fair value may be more subjective than the estimated fair value of a public entity’s options. However,
many nonpublic entities could consider internal and industry factors likely to affect volatility, and the average
volatility of comparable entities, to develop an estimate of expected volatility. Using an expected volatility
estimate determined in that manner often would result in a reasonable estimate of fair value.
55-55 For purposes of this Topic, it is not practicable for a nonpublic entity to estimate the expected volatility of
its share price if it is unable to obtain sufficient historical information about past volatility, or other information
such as that noted in paragraph 718-10-55-51, on which to base a reasonable and supportable estimate
of expected volatility at the grant date of the award without undue cost and effort. In that situation, this
Topic requires a nonpublic entity to estimate a value for its equity share options and similar instruments by
substituting the historical volatility of an appropriate industry sector index for the expected volatility of its share
price as an assumption in its valuation model. All other inputs to a nonpublic entity’s valuation model shall be
determined in accordance with the guidance in paragraphs 718-10-55-4 through 55-47.
55-56 There are many different indexes available to consider in selecting an appropriate industry sector index.
For example, Dow Jones Indexes maintain a global series of stock market indexes with industry sector splits
available for many countries, including the United States. The historical values of those indexes are easily
obtainable from its website. An appropriate industry sector index is one that is representative of the industry
sector in which the nonpublic entity operates and that also reflects, if possible, the size of the entity. If a
nonpublic entity operates in a variety of different industry sectors, then it might select a number of different
industry sector indexes and weight them according to the nature of its operations; alternatively, it might select
an index for the industry sector that is most representative of its operations. If a nonpublic entity operates in
an industry sector in which no public entities operate, then it shall select an index for the industry sector that is
most closely related to the nature of its operations. However, in no circumstances shall a nonpublic entity use
a broad-based market index like the S&P 500, Russell 3000, or Dow Jones Wilshire 5000 because those indexes
are sufficiently diversified as to be not representative of the industry sector, or sectors, in which the nonpublic
entity operates.
55-57 A nonpublic entity shall use the selected index consistently, unless the nature of the entity’s operations
changes such that another industry sector index is more appropriate, in applying the calculated value method
in both the following circumstances:
- For all of its equity share options or similar instruments
- In each accounting period.
55-58 The calculation of the historical volatility of an appropriate industry sector index shall be made using
the daily historical closing values of the index selected for the period of time prior to the grant date (or service
inception date) of the equity share option or similar instrument that is equal in length to the expected term
of the equity share option or similar instrument. If daily values are not readily available, then an entity shall
use the most frequent observations available of the historical closing values of the selected index. If historical
closing values of the index selected are not available for the entire expected term, then a nonpublic entity shall
use the closing values for the longest period of time available. The method used shall be consistently applied
(see paragraph 718-10-55-27). Example 9 (see paragraph 718-20-55-77) provides an illustration of accounting
for an equity share option award granted by a nonpublic entity that uses the calculated value method.
As discussed in Section 4.12, nonpublic entities should try to use a fair-value-based measure to value
their equity-classified awards. However, there may be instances in which a nonpublic entity may not
be able to reasonably estimate the fair-value-based measure of its options and similar instruments
because it is not practicable for it to estimate the expected volatility of its share price. In these cases, the
nonpublic entity should substitute the historical volatility of an appropriate industry sector index for the
expected volatility of its own share price. In assessing whether it is practicable to estimate the expected
volatility of its own share price, the entity should consider the following factors:
- Whether the entity has an internal market for its shares (e.g., investors or employees can purchase and sell shares).
- Previous issuances of equity in a private transaction or convertible debt provide indications of the historical or implied volatility of the entity’s share price.
- Whether there are similarly sized public entities (including those within an index) in the same industry whose historical or implied volatilities could be used as a substitute for the nonpublic entity’s expected volatility.
If, after considering the relevant factors, the nonpublic entity determines that estimating the expected
volatility of its own share price is not practicable, it should use the historical volatility of an appropriate
industry sector index as a substitute in estimating the fair-value-based measure of its awards.
An appropriate industry sector index would be one that is narrow enough to reflect the nonpublic
entity’s nature and size (if possible). For example, the use of the Philadelphia Exchange (PHLX)
Semiconductor Sector Index is not an appropriate industry sector index for a small nonpublic software
development entity because it represents neither the industry in which the nonpublic entity operates
nor the size of the entity. The volatility of an index of smaller software entities would be a more
appropriate substitute for the entity’s expected volatility of its own share price.
Under ASC 718-10-55-58, an entity that uses an industry sector index to determine the expected
volatility of its own share price must use the index’s historical volatility (rather than its implied volatility).
However, ASC 718-10-55-56 states that “in no circumstances shall a nonpublic entity use a broad-based
market index like the S&P 500, Russell 3000, or Dow Jones Wilshire 5000” (emphasis added).
A nonpublic entity’s conclusion that estimating the expected volatility of its
own share price is not practicable may be subject to scrutiny. We would
typically expect that a nonpublic entity that can identify an appropriate
industry sector index would be able to identify similar entities from the
selected index to estimate the expected volatility of its own share price and
would therefore be required to use the fair-value-based measurement method.
In measuring awards, a nonpublic entity should switch from using a calculated
value to using a fair-value-based measure when it (1) can subsequently estimate
the expected volatility of its own share price or (2) becomes a public entity.
ASC 718-10-55-27 states, in part, that the “valuation technique an entity
selects [should] be used consistently and [should] not be changed unless a
different valuation technique is expected to produce a better estimate” of a
fair-value-based measure (or, in this case, a change to a fair-value-based
measure). The guidance goes on to state that a change in valuation technique
should be accounted for as a change in accounting estimate under ASC 250 and
should be applied prospectively to new awards. Therefore, for existing
equity-classified awards (i.e., unvested equity awards that were granted before
an entity switched from the calculated value method to a fair-value-based
measure), an entity would continue to recognize compensation cost on the basis
of the calculated value determined as of the grant date unless the award is
subsequently modified. An entity should use the fair-value-based method to
measure all awards granted after it switches from the calculated value method.
ASC 718 provides the example below of when it may be appropriate for a nonpublic
entity to use the calculated value method.
ASC 718-20
Example 9: Share Award Granted by a Nonpublic Entity That Uses the Calculated Value Method
55-76 This Example illustrates
the guidance in paragraphs 718-10-30-19A through
30-20.
55-76A This
Example (see paragraphs 718-20-55-77 through 55-83)
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, an entity should
substitute the historical volatility of an appropriate
industry sector index for expected volatility in
accordance with paragraph 718-10-30-20 when measuring
the grant-date fair value of nonemployee awards with
similar facts and circumstances (that is, an entity has
determined that it is not practicable for it to estimate
the expected volatility of its share price), as
illustrated in paragraphs 718-20-55-77 through 55-80.
Therefore, the guidance in those paragraphs may serve as
implementation guidance for similar nonemployee
awards.
55-76B Compensation cost
attribution for awards to nonemployees may be the same as or
different from that which is illustrated in paragraph
718-20-55-81 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.
55-77 On January 1, 20X6, Entity W, a small nonpublic entity that develops, manufactures, and distributes
medical equipment, grants 100 share options to each of its 100 employees. The share price at the grant date is
$7. The options are granted at-the-money, cliff vest at the end of 3 years, and have a 10-year contractual term.
Entity W estimates the expected term of the share options granted as 5 years and the risk-free rate as 3.75
percent. For simplicity, this Example assumes that no forfeitures occur during the vesting period and that no
dividends are expected to be paid in the future, and this Example does not reflect the accounting for income
tax consequences of the awards.
55-78 Entity W does not maintain an internal market for its shares, which are rarely traded privately. It has not
issued any new equity or convertible debt instruments for several years and has been unable to identify any
similar entities that are public. Entity W has determined that it is not practicable for it to estimate the expected
volatility of its share price and, therefore, it is not possible for it to reasonably estimate the grant-date fair value
of the share options. Accordingly, Entity W is required to apply the provisions of paragraph 718-10-30-20 in
accounting for the share options under the calculated value method.
55-79 Entity W operates exclusively in the medical equipment industry. It visits the Dow Jones Indexes website
and, using the Industry Classification Benchmark, reviews the various industry sector components of the Dow
Jones U.S. Total Market Index. It identifies the medical equipment subsector, within the health care equipment
and services sector, as the most appropriate industry sector in relation to its operations. It reviews the current
components of the medical equipment index and notes that, based on the most recent assessment of its share
price and its issued share capital, in terms of size it would rank among entities in the index with a small market
capitalization (or small-cap entities). Entity W selects the small-cap version of the medical equipment index as
an appropriate industry sector index because it considers that index to be representative of its size and the
industry sector in which it operates. Entity W obtains the historical daily closing total return values of the selected
index for the five years immediately before January 1, 20X6, from the Dow Jones Indexes website. It calculates
the annualized historical volatility of those values to be 24 percent, based on 252 trading days per year.
55-80 Entity W uses the inputs that it has determined above in a Black-Scholes-Merton option-pricing formula,
which produces a value of $2.05 per share option. This results in total compensation cost of $20,500 (10,000 ×
$2.05) to be accounted for over the requisite service period of 3 years.
55-81 For each of the 3 years ending December 31, 20X6, 20X7, and 20X8, Entity W will recognize
compensation cost of $6,833 ($20,500 ÷ 3). The journal entry for each year is as follows.
55-82 The share option award granted by a nonpublic entity that used the calculated value method is as follows.
55-83 Assuming that all 10,000 share options are exercised on the same day in 20Y2, the accounting for the
option exercise will follow the same pattern as in Example 1, Case A (see paragraph 718-20-55-10) and will
result in the following journal entry.
At exercise the journal entry is as follows.
4.13.3 Intrinsic Value
ASC 718-30
Nonpublic Entity
30-2 A nonpublic entity shall
make a policy decision of whether to measure all of its
liabilities incurred under share-based payment
arrangements (for employee and nonemployee awards)
issued in exchange for distinct goods or services at
fair value or at intrinsic value. However, a nonpublic
entity shall initially and subsequently measure awards
determined to be consideration payable to a customer (as
described in paragraph 606-10-32-25) at fair value.
Nonpublic Entity
35-4
Regardless of the measurement method initially selected
under paragraph 718-10-30-20, a nonpublic entity shall
remeasure its liabilities under share-based payment
arrangements at each reporting date until the date of
settlement. The fair-value-based method is preferable
for purposes of justifying a change in accounting
principle under Topic 250. Example 1 (see paragraph
718-30-55-1) provides an illustration of accounting for
an instrument classified as a liability using the
fair-value-based method. Example 2 (see paragraph
718-30-55-12) provides an illustration of accounting for
an instrument classified as a liability using the
intrinsic value method. A nonpublic entity shall
subsequently measure awards determined to be
consideration payable to a customer (as described in
paragraph 606-10-32-25) at fair value.
Nonpublic entities can make a policy election to measure all
liability-classified awards (not including awards determined to be consideration
payable to a customer under ASC 606) at intrinsic value (instead of at their
fair-value-based measure or calculated value) as of the end of each reporting
period until the award is settled. However, it is preferable for an entity to
use the fair-value-based method to justify a change in accounting principle
under ASC 250 (see Section
4.13.4 for a discussion of how to record the effects of the
change when a nonpublic entity becomes a public entity). Therefore, a nonpublic
entity that has elected to measure its liability-classified awards at a
fair-value-based measure (or calculated value) would not be permitted to
subsequently change to the intrinsic-value method.
The example below illustrates the application of the intrinsic value method for
liability-classified awards granted by a nonpublic entity.
ASC 718-30
Example 2: Award Granted by a Nonpublic Entity That Elects the Intrinsic Value Method
55-12 This Example illustrates the guidance in paragraphs 718-30-35-4 and 718-740-25-2 through 25-4.
55-12A This
Example (see paragraphs 718-30-55-13 through 55-20)
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, a nonpublic entity can
make the accounting policy election in paragraph
718-30-30-2 to change its measurement of all
liability-classified nonemployee awards from fair value
to intrinsic value and remeasure those awards each
reporting period as illustrated in this Example.
Therefore, the guidance in this Example may serve as
implementation guidance for similar liability-classified
nonemployee awards.
55-12B Compensation cost
attribution for awards to nonemployees may be the same or
different for liability-classified 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.
55-13 On January 1, 20X6, Entity W, a nonpublic entity that has chosen the accounting policy of using the
intrinsic value method of accounting for share-based payments that are classified as liabilities in accordance
with paragraphs 718-30-30-2 and 718-30-35-4, grants 100 cash-settled stock appreciation rights with a 5-year
life to each of its 100 employees. Each stock appreciation right entitles the holder to receive an amount in
cash equal to the increase in value of 1 share of Entity W’s stock over $7. The awards cliff-vest at the end
of three years of service (an explicit and requisite service period of three years). For simplicity, the Example
assumes that no forfeitures occur during the vesting period and does not reflect the accounting for income tax
consequences of the awards.
55-14 Because of Entity W’s accounting policy decision to use intrinsic value, all of its share-based payments
that are classified as liabilities are recognized at intrinsic value (or a portion thereof, depending on the
percentage of requisite service that has been rendered) at each reporting date through the date of settlement;
consequently, the compensation cost recognized in each year of the three-year requisite service period will
vary based on changes in the liability award’s intrinsic value. As of December 31, 20X6, Entity W stock is valued
at $10 per share; hence, the intrinsic value is $3 per stock appreciation right ($10 – $7), and the intrinsic value
of the award is $30,000 (10,000 × $3). The compensation cost to be recognized for 20X6 is $10,000 ($30,000
÷ 3), which corresponds to the service provided in 20X6 (1 year of the 3-year service period). For convenience,
this Example assumes that journal entries to account for the award are performed at year-end. The journal
entry for 20X6 is as follows.
55-15 As of December 31, 20X7, Entity W stock is valued at $8 per share; hence, the intrinsic value is $1 per
stock appreciation right ($8 – $7), and the intrinsic value of the award is $10,000 (10,000 × $1). The decrease
in the intrinsic value of the award is $20,000 ($10,000 – $30,000). Because services for 2 years of the 3-year
service period have been rendered, Entity W must recognize cumulative compensation cost for two-thirds of
the intrinsic value of the award, or $6,667 ($10,000 × 2/3); however, Entity W recognized compensation cost of
$10,000 in 20X5. Thus, Entity W must recognize an entry in 20X7 to reduce cumulative compensation cost to
$6,667.
55-16 As of December 31, 20X8, Entity W stock is valued at $15 per share; hence, the intrinsic value is $8 per
stock appreciation right ($15 – $7), and the intrinsic value of the award is $80,000 (10,000 × $8). The cumulative
compensation cost recognized as of December 31, 20X8, is $80,000 because the award is fully vested. The
journal entry for 20X8 is as follows.
55-17 The share-based liability award at intrinsic value is as follows.
55-18 For simplicity, this Example assumes that all of the stock appreciation rights are settled on the day that
they vest, December 31, 20X8, when the share price is $15 and the intrinsic value is $8 per share. The cash paid
to settle the stock appreciation rights is equal to the share-based compensation liability of $80,000.
55-19 At exercise the journal entry is as follows.
55-20 If the stock appreciation rights had not been settled, Entity W would continue to remeasure those
remaining awards at intrinsic value at each reporting date through the date they are exercised or otherwise
settled.
4.13.4 Transition From Nonpublic to Public Entity Status
SEC Staff Accounting Bulletins
SAB Topic 14.B, Transition From
Nonpublic to Public Entity Status
Facts: Company A
is a nonpublic entity4 that first files a
registration statement with the SEC to register its
equity securities for sale in a public market on January
2, 20X8. As a nonpublic entity, Company A had been
assigning value to its share options5 under
the calculated value method prescribed by FASB ASC Topic
718, Compensation — Stock Compensation,6 and
had elected to measure its liability awards based on
intrinsic value. Company A is considered a public entity
on January 2, 20X8 when it makes its initial filing with
the SEC in preparation for the sale of its shares in a
public market.
Question 1: How should Company A
account for the share options that were granted prior to
January 2, 20X8 for which the requisite service has not
been rendered by January 2, 20X8?
Interpretive
Response: Prior to becoming a public entity,
Company A had been assigning value to its share options
under the calculated value method. The staff believes
that Company A should continue to follow that approach
for those share options that were granted prior to
January 2, 20X8, unless those share options are
subsequently modified, repurchased or
cancelled.7 If the share options are
subsequently modified, repurchased or cancelled, Company
A would assess the event under the public company
provisions of FASB ASC Topic 718. For example, if
Company A modified the share options on February 1,
20X8, any incremental compensation cost would be
measured under FASB ASC subparagraph 718-20-35-3(a), as
the fair value of the modified share options over the
fair value of the original share options measured
immediately before the terms were
modified.8
Question 2: How should Company A
account for its liability awards granted prior to
January 2, 20X8 that are fully vested but have not been
settled by January 2, 20X8?
Interpretive
Response: As a nonpublic entity, Company A had
elected to measure its liability awards subject to FASB
ASC Topic 718 at intrinsic value.9 When
Company A becomes a public entity, it should measure the
liability awards at their fair value determined in
accordance with FASB ASC Topic 718.10 In that
reporting period there will be an incremental amount of
measured cost for the difference between fair value as
determined under FASB ASC Topic 718 and intrinsic value.
For example, assume the intrinsic value in the period
ended December 31, 20X7 was $10 per award. At the end of
the first reporting period ending after January 2, 20X8
(when Company A becomes a public entity), assume the
intrinsic value of the award is $12 and the fair value
as determined in accordance with FASB ASC Topic 718 is
$15. The measured cost in the first reporting period
after December 31, 20X7 would be $5.11
Question 3:
After becoming a public entity, may Company A
retrospectively apply the fair-value-based method to its
awards that were granted prior to the date Company A
became a public entity?
Interpretive
Response: No. Before becoming a public entity,
Company A did not use the fair-value-based method for
either its share options or its liability awards. The
staff does not believe it is appropriate for Company A
to apply the fair-value-based method on a retrospective
basis, because it would require the entity to make
estimates of a prior period, which, due to hindsight,
may vary significantly from estimates that would have
been made contemporaneously in prior
periods.12
Question 4: Upon
becoming a public entity, what disclosures should
Company A consider in addition to those prescribed by
FASB ASC Topic 718?13
Interpretive
Response: In the registration statement filed on
January 2, 20X8, Company A should clearly describe in
MD&A the change in accounting policy that will be
required by FASB ASC Topic 718 in subsequent periods and
the reasonably likely material future
effects.14 In subsequent filings, Company
A should provide financial statement disclosure of the
effects of the changes in accounting policy. In
addition, Company A should consider the requirements of
Item 303(b)(3) of Regulation S-K regarding critical
accounting estimates in MD&A.
______________________________
4 Defined in the FASB ASC
Master Glossary.
5 For purposes of this staff
accounting bulletin, the phrase “share options” is used
to refer to “share options or similar instruments.”
6 FASB ASC paragraph
718-10-30-20 requires a nonpublic entity to use the
calculated value method when it is not able to
reasonably estimate the fair value of its equity share
options and similar instruments because it is not
practicable for it to estimate the expected volatility
of its share price. FASB ASC paragraph 718-10-55-51
indicates that a nonpublic entity may be able to
identify similar public entities for which share or
option price information is available and may consider
the historical, expected, or implied volatility of those
entities’ share prices in estimating expected
volatility. The staff would expect an entity that
becomes a public entity and had previously measured its
share options under the calculated value method to be
able to support its previous decision to use calculated
value and to provide the disclosures required by FASB
ASC subparagraph 718-10-50-2(f)(2)(ii).
7 This view is consistent with the FASB’s basis for rejecting full retrospective application of FASB ASC Topic 718 as described in the basis for conclusions of Statement 123R, paragraph B251.
8 FASB ASC paragraph
718-20-55-94. The staff believes that because Company A
is a public entity as of the date of the modification,
it would be inappropriate to use the calculated value
method to measure the original share options immediately
before the terms were modified.
9 FASB ASC paragraph
718-30-30-2.
10 FASB ASC paragraph
718-30-35-3.
11 $15 fair value less $10
intrinsic value equals $5 of incremental cost.
12 This view is consistent with the FASB’s basis for rejecting full retrospective application of FASB ASC Topic 718 as described in the basis for conclusions of Statement 123R, paragraph
B251.
13 FASB ASC Section
718-10-50.
14
See Item 303 of Regulation S-K.
The calculated value and intrinsic value measurement alternatives available to a
nonpublic entity are no longer appropriate once the entity is considered a
public entity.11 In addition, public entities use the expected-term practical expedient
(for determining the expected term of certain options and similar instruments)
differently than nonpublic entities. To estimate the expected term as a midpoint
between the requisite service period and the contractual term of an award,
entities will need to comply with the requirements of the SEC’s simplified
method (see Section
4.9.2.2.2).
In SAB Topic 14.B, the SEC discusses various transition issues associated with
the valuation of share-based payment awards related to an entity that becomes a
public entity (e.g., when it files its initial registration statement with the
SEC), including the following:
-
If a nonpublic entity historically measured equity-classified share-based payment awards at their calculated value, the newly public entity should continue to use that approach for share-based payment awards granted before the date on which it becomes a public entity unless those awards are subsequently modified, repurchased, or canceled, in which case the entity would assess the event under the public company provisions of ASC 718.
-
If a nonpublic entity historically measured liability-classified share-based payment awards on the basis of their intrinsic value and the awards are still outstanding, the newly public entity should measure those liability awards at their fair-value-based measurement upon becoming a public entity.
-
Upon becoming a public entity, the entity is prohibited from retrospectively applying the fair-value-based method to measure its awards if it used calculated value or intrinsic value before the date on which it became a public entity.
-
Upon becoming a public entity, the entity should clearly describe in its MD&A the change in accounting policy that will be required by ASC 718 in subsequent periods and any reasonably likely material future effects of the change.
SAB Topic 14 does not provide transition guidance for entities that are changing
from nonpublic to public entity status and have applied the practical expedient
for determining the current price of their underlying shares (see Section 4.13.1.3). Thus, an entity that no
longer meets the criteria to be a nonpublic entity would have to reverse the
practical expedient’s effect in its historical financial statements.
In addition, the SEC’s guidance does not address how an entity should account
for a change from the intrinsic value method for measuring liability-classified
awards to the fair-value-based method. In informal discussions, the SEC staff
indicated that it would be acceptable to record the effect of such a change as
compensation cost in the current period or to record it as the cumulative effect
of a change in accounting principle in accordance with ASC 250. While the
preferred approach is to treat the effect of the change as a change in
accounting principle under ASC 250, with the cumulative effect of the change
recorded accordingly, recording it as compensation cost is not objectionable
given the SEC’s position. Under either approach, entities’ financial statements
should include the appropriate disclosures.
ASC 250-10-45-5 states, in part, that an “entity shall report a change in
accounting principle through retrospective application of the new accounting
principle to all prior periods, unless it is impracticable to do so.”
Retrospective application of the effects of a change from intrinsic value to
fair value would be impracticable because objectively determining the
assumptions an entity would have used for the prior periods would be difficult
without the use of hindsight. Therefore, the change would be recorded as a
cumulative-effect adjustment to retained earnings and applied prospectively, as
discussed in ASC 250-10-45-6 and 45-7. This conclusion is consistent with the
guidance in SAB Topic 14.B that states that entities changing from nonpublic to
public status are not permitted to apply the fair-value-based method
retrospectively.
The example below illustrates how to record the effects of a change from the
intrinsic value method to the fair-value-based method.
Example 4-9
Company A (with a calendar year-end) uses the intrinsic value method to account
for its liability-classified SARs, which are fully
vested on December 31, 20X6. On February 15, 20X7, A
files its initial registration statement with the SEC
for an IPO. Assume the following intrinsic values and
fair values:
In its financial statements included in the initial registration statement, A should use the intrinsic value method to account for the SARs. As a result of filing its initial registration statement with the SEC, A must change its method for valuing its SARs from the intrinsic value method to the fair-value-based method. For the period from January 1, 20X7, through February 15, 20X7, A should therefore record compensation cost of $3 under the intrinsic value method and should record $2 as either an adjustment to retained earnings or compensation cost to account for the change from the intrinsic value method to the fair-value-based method.
Footnotes
11
The definition of a “public entity” in ASC 718 includes
an entity that “[m]akes a filing with a regulatory agency in preparation
for the sale of any class of equity securities in a public market.” The
definition therefore includes an entity that has filed its initial
registration statement with the SEC before the effective date of an
IPO.
Chapter 5 — Classification
Chapter 5 — Classification
5.1 General
ASC 718-10
Determining Whether to Classify a Financial Instrument as a Liability or as Equity
25-6 This paragraph through paragraph 718-10-25-19A provide guidance for determining whether certain financial instruments awarded in share-based payment transactions are liabilities. In determining whether an instrument not specifically discussed in those paragraphs shall be classified as a liability or as equity, an entity shall apply generally accepted accounting principles (GAAP) applicable to financial instruments issued in transactions not involving share-based payment.
An entity’s measurement of compensation cost for awards within the scope of ASC
718 differs depending on whether the entity determines that the awards are
classified as equity or liabilities (i.e., a fair-value-based measure as of the
grant date for most equity-classified awards versus a fair-value-based measure as of
the end of each reporting period until settlement for liability-classified awards).
The classification of share-based payment awards can be complex. While classifying a
cash-settled award as a liability may seem straightforward, entities must consider
the features and conditions of every award. Generally, the following types of awards
(with certain exceptions, including those noted below) must be classified as
liabilities in accordance with ASC 718-10-25-6 through 25-19A:
Types of Awards | Discussion | Exceptions |
---|---|---|
Awards that would be classified as liabilities under ASC 480 | Although share-based payment awards subject to ASC 718 are outside the scope of ASC 480, ASC 718-10-25-7 requires an entity 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. See ASC 718-10-25-7 and 25-8 and Section 5.2 for a discussion of how to apply the classification criteria in ASC 480 to share-based payment awards. | In determining the classification of share-based payment awards under ASC 480,
entities should take into account the scope exceptions
related to ASC 480, as discussed in ASC 718-10-25-8 and
Section 5.2.1, as
well as any specific exceptions in ASC 718-10-25-8 through
25-19A. |
Stock awards subject to repurchase features that do not subject the grantee to
the risks and rewards of equity share ownership for a
reasonable period | ASC 718-10-25-9 and 25-10 distinguish between repurchase features that are within the control of the issuer and those that are not within the control of the issuer. See Section 5.3 for guidance on determining the classification of callable and puttable stock awards. | ASC 718-10-25-9(a) does not require liability classification for contingent
repurchase features that are not within the grantee’s
control and for which it is not probable that the
contingency will occur. In addition, ASC 718-10-25-18
exempts from liability classification, under certain
circumstances, repurchases that are used to satisfy the
employer’s statutory tax withholding requirements. See
Section 5.7.2. |
Stock options or similar instruments for which (1) the underlying shares are
classified as liabilities or (2) the options or similar
instruments can be required to be settled in cash or other
assets | ASC 718-10-25-11 and 25-12 require that stock options or similar instruments be classified as a liability if the (1) underlying shares are classified as a liability or (2) the options or similar instruments must be settled in cash or the grantee can require the entity to settle in cash. See Section 5.4 for guidance on determining the classification of stock options for which cash settlement could be required. | ASC 718-10-25-11(b) does not require liability classification for contingent
cash settlement features that are not within the grantee’s
control and for which it is not probable that the
contingency will occur. ASC 718-10-25-16 and 25-17 exempt
from liability classification, under certain circumstances,
broker-assisted cashless exercises. In addition, ASC
718-10-25-18 exempts from liability classification, under
certain circumstances, repurchases of shares upon option
exercises that are used to satisfy the employer’s statutory
tax withholding requirements. See Section 5.7.2. |
Awards with conditions or other features that are indexed to something other
than a market, performance, or service condition | Under ASC 718-10-25-13, awards indexed to something other than a market, performance, or service condition must be classified as a liability. See Section 5.5 for a discussion of other conditions. | ASC 718-10-25-14 and 25-14A exempt stock options with a fixed exercise price in
a foreign currency awarded to a grantee of a foreign
operation from liability classification provided that the
exercise price is denominated in (1) the foreign operation’s
functional currency, (2) the currency in which the foreign
operation's employees are paid, or (3) the currency of a
market in which a substantial portion of the entity’s equity
securities trades. |
Awards that are substantive liabilities because (1) the grantee has the choice
of settlement in cash or shares or (2) the entity can choose
the method of settlement but does not have the intent, past
practice, or ability to settle with shares | ASC 718-10-25-15 states that to determine an award’s classification, an entity should evaluate the award’s substantive terms as well as the entity’s past practices and its ability to settle in shares. See Section 5.6 for a discussion of factors that an entity with a choice of settlement method may consider in determining an award’s classification. | ASC 718-10-25-15(a) states that a requirement to deliver registered shares does not imply, by itself, that an entity does not have the ability to settle the award in shares. |
Certain awards that may become subject to other applicable GAAP | Other applicable GAAP (e.g., ASC 815) may apply to awards that are originally
accounted for as share-based payment awards under ASC 718
but are modified after a grantee (1) whose awards are vested
is no longer providing goods or services, (2) whose awards
are vested is no longer a customer, or (3) is no longer an
employee. In addition, once vested, a convertible instrument
award granted to a nonemployee becomes subject to other
applicable GAAP. See ASC 718-10-35-9 through 35-14 in
Section 5.8 as well as Section
9.5 for a discussion of when share-based
payment awards subject to ASC 718 become subject to other
applicable GAAP. | Under ASC 718-10-35-9 through 35-14, certain freestanding instruments issued to
grantees may never become subject to other GAAP. In
addition, an award would not be subject to other GAAP if the
award is modified (after a grantee whose awards are vested
is no longer providing goods or services, after a grantee
whose awards are vested is no longer a customer, or the
grantee is no longer an employee) solely to reflect an
equity restructuring that meets certain conditions under ASC
718-10-35-10A. |
5.2 ASC 480
ASC 718-10
25-7 Topic 480 excludes from its scope instruments that are accounted for under this Topic. Nevertheless, unless paragraphs 718-10-25-8 through 25-19A require otherwise, an entity shall apply the classification criteria in Section 480-10-25 and paragraphs 480-10-15-3 through 15-4 in determining whether to classify as a liability a freestanding financial instrument given to a grantee in a share-based payment transaction. Paragraphs 718-10-35-9 through 35-14 provide criteria for determining when instruments subject to this Topic subsequently become subject to Topic 480 or to other applicable GAAP.
25-8 In determining the classification of an instrument, an entity shall take into account the classification requirements as established by Topic 480. In addition, a call option written on an instrument that is not classified as a liability under those classification requirements (for example, a call option on a mandatorily redeemable share for which liability classification is not required for the specific entity under the requirements) also shall be classified as equity so long as those equity classification requirements for the entity continue to be met, unless liability classification is required under the provisions of paragraphs 718-10-25-11 through 25-12.
ASC 480-10
Mandatorily Redeemable Financial Instruments
25-4 A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity.
25-5 A financial instrument that embodies a conditional obligation to redeem the instrument by transferring assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the condition is resolved, or the event becomes certain to occur.
25-6 In determining if an instrument is mandatorily redeemable, all terms within a redeemable instrument shall be considered. The following items do not affect the classification of a mandatorily redeemable financial instrument as a liability:
- A term extension option
- A provision that defers redemption until a specified liquidity level is reached
- A similar provision that may delay or accelerate the timing of a mandatory redemption.
25-7 If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption of that instrument is conditional and, therefore, the instrument does not meet the definition of mandatorily redeemable financial instrument in this Subtopic. However, that financial instrument would be assessed at each reporting period to determine whether circumstances have changed such that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the event is no longer conditional). If the event has occurred, the condition is resolved, or the event has become certain to occur, the financial instrument is reclassified as a liability.
Obligations to Repurchase Issuer’s Equity Shares by Transferring Assets
25-8 An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:
- It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
- It requires or may require the issuer to settle the obligation by transferring assets.
25-9 In this Subtopic, indexed to is used interchangeably with based on variations in the fair value of. The phrase requires or may require encompasses instruments that either conditionally or unconditionally obligate the issuer to transfer assets. If the obligation is conditional, the number of conditions leading up to the transfer of assets is irrelevant.
25-10 Examples of financial instruments that meet the criteria in paragraph 480-10-25-8 include forward purchase contracts or written put options on the issuer’s equity shares that are to be physically settled or net cash settled.
25-11 All obligations that permit the holder to require the issuer to transfer assets result in liabilities, regardless of whether the settlement alternatives have the potential to differ.
25-12 Certain financial instruments that embody obligations that are liabilities within the scope of this Subtopic also may contain characteristics of assets but be reported as single items. Some examples include the following:
- Net-cash-settled or net-share-settled forward purchase contracts
- Certain combined options to repurchase the issuer’s shares.
25-13 An instrument that requires the issuer to settle its obligation by issuing another instrument (for example, a note payable in cash) ultimately requires settlement by a transfer of assets, accordingly:
- When applying paragraphs 480-10-25-8 through 25-12, this also would apply for an instrument settled with another instrument that ultimately may require settlement by a transfer of assets (warrants for puttable shares).
- It is clear that a warrant for mandatorily redeemable shares would be a liability under this Subtopic.
Certain Obligations to Issue a Variable Number of Shares
25-14 A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following:
- A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)
- Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to the Standard and Poor’s S&P 500 Index and settleable with a variable number of the issuer’s equity shares)
- Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled). . . .
Although 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.
Under ASC 480-10-25 and ASC 480-10-15-3 and 15-4,
liability classification is required if an award
meets any of the criteria in the table below. In
addition, ASC 718-10-25-8 clarifies that the scope
exceptions in ASC 480 for certain mandatorily
redeemable financial instruments also apply to
share-based payment awards within the scope of ASC
718. See Section 5.2.1 for
more information.
ASC 480 Instruments | Examples of Share-Based Payment Awards | Comments |
---|---|---|
Mandatorily redeemable financial instruments described in ASC 480-10-25-4
through 25-7, and defined in the ASC master glossary as “financial instruments
issued in the form of shares that embody an unconditional obligation requiring
the issuer to redeem the instrument by transferring its assets at a specified or
determinable date (or dates) or upon an event that is certain to occur.” |
| The repurchase or redemption feature must be unconditional (i.e., the entity and grantee cannot choose the method of settlement). In addition, no other features of the instrument’s terms can exist that would cause the shares not to be redeemed. For example, preferred shares that may be converted into common shares before the specified redemption date(s) would not result in liability classification for the preferred shares if the conversion feature is substantive.
ASC 480 includes a scope exception for certain mandatorily redeemable financial
instruments of nonpublic entities and certain mandatorily redeemable
noncontrolling interests of all entities (public and nonpublic). See Section 5.2.1. |
A financial instrument, other than an outstanding share, that embodies (or is indexed to) an obligation to repurchase shares (conditionally or unconditionally) by transferring cash or other assets as described in ASC 480-10-25-8 through 25-13. |
| The guidance in ASC 480 only applies if the repurchase feature is considered
“freestanding” (e.g., a legally detachable written put option). Most share
repurchase features are embedded and not legally detachable.
Under ASC 718, the following
exceptions apply to certain awards with repurchase features that would otherwise
be classified as liabilities under ASC 480:
|
A financial instrument that embodies certain obligations to issue a variable
number of shares when the obligation’s monetary value is based, solely or
predominantly, on any one of the following items described in ASC 480-10-25-14:
|
| Awards that are based on monetary values at inception unrelated to increases in the fair value of an entity’s equity and settled in a variable number of shares will most likely result in share-settled debt arrangements, accounted for as share-based liabilities. |
In accordance with ASC 480-10-25-14, an entity must classify a share-based
payment award as a liability if the award requires the entity to issue a variable number of
shares when the obligation’s monetary value is fixed. An obligation of this nature does not
expose the grantee to the risks and rewards of a typical equity ownership in an entity
because the monetary value of the award is not indexed to the fair value of the underlying
shares that will be provided upon settlement. In the examples below, the entity’s obligation
related to awards granted to employees would meet the criteria under ASC 480-10-25-14 and
thus liability classification would be required.
Example 5-1
Variations in Something Other Than the Fair Value of the Issuer’s Equity Shares
Entity A grants employee stock options with an exercise price established on the grant date equal to a fixed multiple of its trailing 12 months EBITDA. It is assumed that the EBITDA multiple does not represent a reasonable approximation of the fair value of A’s equity shares. The settlement price of the options as of the vesting date is also established according to a fixed multiple of the same trailing 12 months EBITDA of A. Any excess of the options’ settlement price as of the vesting date over the options’ exercise price as of the grant date is paid to the employees in a variable number of A’s shares on the basis of the fair value of A’s shares on the vesting date. Because the monetary value of the options (1) is indexed solely to variations in an operating performance measure of A (i.e., EBITDA) and (2) will be settled in a variable number of A’s shares, the options will be classified as a share-based liability.
Example 5-2
Settlement
in a Variable Number of Shares on the Basis of a
Fixed Monetary Amount
Entity B is a real estate
brokerage firm that has a network of real estate agents who are employees. Upon
hiring an agent as an employee, B and the employee enter into a share-based
payment arrangement. The terms of the agreement specify that upon the closing of
the employee’s first real estate sale, B will issue to the employee shares of
common stock equal to $1,000 on the basis of the fair value of B’s common stock
as of the date of the closing. The agent will vest in the award at the end of
the second year of service following the date of the closing (cliff vesting).
Because B has granted an award for a fixed monetary amount to be settled in a
variable number of shares, the award is initially classified as a liability.
Once the number of shares of common stock to be issued under the award is fixed
(upon the closing of the employee’s first real estate sale), and as long as all
criteria for equity classification are met, the award would be reclassified as
equity.
Example 5-3
Variable Number of Shares Based on Earnings That Exceed a Specified
Amount
Entity A grants employees an award of options on A’s common stock. The number
of options that vest is based on A’s earnings over a 12-month period. The award
cliff-vests at the end of the 12-month period. The number of awards that vest is
calculated as follows: for each $500,000 increment of A’s earnings that exceed
$2 million, not to exceed $5 million for the 12-month period after the grant
date, 25,000 options will vest.
Although 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. A similar arrangement in which awards are not within the
scope of ASC 718 would meet the criteria for classification as a liability under
ASC 480-10-25-14(b) because under such an arrangement, the entity would be
required to issue a variable number of options on its common shares that derive
their value from something other than the fair value of the entity’s equity
shares (e.g., value derived from earnings over a 12-month period). However, ASC
718 does not require these awards to be classified as a liability because the
issuance of a variable number of shares is indexed to A’s earnings, which
represents a performance condition under ASC 718. Accordingly, as long as all
other criteria for equity classification are met, the award would be classified
as equity.
5.2.1 ASC 480 Scope Exceptions That Apply to Share-Based Payments Within the Scope of ASC 718
In determining the classification of
share-based payment awards under ASC 480,
nonpublic entities should consider the scope
exceptions related to ASC 480 described in ASC
718-10-25-8. The exceptions apply to certain
mandatorily redeemable financial instruments that
either represent noncontrolling interests or are
issued by nonpublic entities that are not SEC
registrants. For example, the classification
guidance in ASC 480 does not apply to mandatorily
redeemable financial instruments of nonpublic
entities that are not SEC registrants unless they
are mandatorily redeemable on fixed dates for
amounts that are either fixed or are determined by
reference to an external index (e.g., an interest
rate index or currency index).
In addition, if a mandatorily
redeemable financial instrument qualifies for one of the exceptions in ASC 480-10, the
issuer should consider the applicability of ASC 480-10-S99-3A to that instrument. See
Section 5.10 for a
discussion and examples of the application of ASR 268 and ASC 480-10-S99-3A to certain
redeemable securities. For detailed guidance on the application of ASC 480, see Deloitte’s
Roadmap Distinguishing Liabilities
From Equity.
5.3 Share Repurchase Features
ASC 718-10
25-9 Topic 480 does not apply to outstanding shares embodying a conditional obligation to transfer assets, for example, shares that give the grantee the right to require the grantor to repurchase them for cash equal to their fair value (puttable shares). A put right may be granted to the grantee in a transaction that is related to a share-based compensation arrangement. If exercise of such a put right would require the entity to repurchase shares issued under the share-based compensation arrangement, the shares shall be accounted for as puttable shares. A puttable (or callable) share awarded to a grantee as compensation shall be classified as a liability if either of the following conditions is met:
- The repurchase feature permits the grantee to avoid bearing the risks and rewards normally associated with equity share ownership for a reasonable period of time from the date the good is delivered or the service is rendered and the share is issued. A grantee begins to bear the risks and rewards normally associated with equity share ownership when all the goods are delivered or all the service has been rendered and the share is issued. A repurchase feature that can be exercised only upon the occurrence of a contingent event that is outside the grantee’s control (such as an initial public offering) would not meet this condition until it becomes probable that the event will occur within the reasonable period of time.
- It is probable that the grantor would prevent the grantee from bearing those risks and rewards for a reasonable period of time from the date the share is issued.
25-10 A puttable (or callable) share that does not meet either of those conditions shall be classified as equity (see paragraph 718-10-55-85).
Classification of Certain Awards With Repurchase Features
55-84 The following paragraph further explains the guidance in paragraphs 718-10-25-9 through 25-12.
55-85 An entity may, for example, grant shares under a share-based compensation arrangement that the grantee can put (sell) to the grantor (the entity) shortly after the vesting date for cash equal to the fair value of the shares on the date of repurchase. That award of puttable shares would be classified as a liability because the repurchase feature permits the grantee to avoid bearing the risks and rewards normally associated with equity share ownership for a reasonable period of time from the date the share is issued (see paragraph 718-10-25-9(a)). Alternatively, an entity might grant its own shares under a share-based compensation arrangement that may be put to the grantor only after the grantee has held them for a reasonable period of time after vesting but at a fixed redemption amount. Those puttable shares also would be classified as liabilities under the requirements of this Topic because the repurchase price is based on a fixed amount rather than variations in the fair value of the grantor’s shares. The grantee cannot bear the risks and rewards normally associated with equity share ownership for a reasonable period of time because of that redemption feature. However, if a share with a repurchase feature gives the grantee the right to sell shares back to the entity for a fixed amount over the fair value of the shares at the date of repurchase, paragraph 718-20-35-7 requires that the fixed amount over the fair value be recognized and attributed as additional compensation cost over the employee’s requisite service period (with a corresponding liability being accrued). The fixed amount over the fair value of a nonemployee award should be recognized as additional compensation cost over the vesting period (with a corresponding liability being accrued) in accordance with paragraph 718-10-25-2C.
A stock award (e.g., restricted stock) may include repurchase
features on the underlying shares (e.g., puttable and
callable shares). The type of an award’s repurchase features
can affect its classification. Call options and put options
are the most common types of repurchase features. A call
option repurchase feature allows (but does not require) the
entity to repurchase vested shares held by a grantee. A put
option repurchase feature allows (but does not require) the
grantee to cause the entity to repurchase vested shares that
the grantee holds. The repurchase price associated with call
and put options can vary (e.g., fair value, fixed amount,
cost, formula value). In addition, the ability to exercise a
repurchase feature is often contingent on certain events
(e.g., termination of employment, change in control). A
right of first refusal, which gives the grantor the ability
to repurchase shares from the grantee before the grantee
sells the shares to a third party, is an example of a
contingent call option.
|
To determine the classification of a stock award (i.e., as liability or equity),
an entity must understand the terms of the repurchase features associated with it.
The decision trees and discussion throughout this section are intended to help an
entity determine how such features affect the classification of awards. The guidance
applies only to stock awards subject to ASC 718 that contain conditional features (e.g., call or put options) to transfer cash or other
assets at settlement. This section therefore does not apply
to the following awards:
-
Stock awards subject to ASC 718 that contain unconditional obligations to transfer cash or other assets. These awards are generally classified as share-based liabilities under ASC 718-10-25-7. See Section 5.2 for a discussion of applying the classification criteria in ASC 480 to share-based payment awards.
-
Stock options or similar instruments that have cash settlement or repurchase features subject to ASC 718. These awards are generally classified in accordance with ASC 718-10-25-11 and 25-12. See Section 5.4 for a discussion of the steps to follow in determining the classification of stock options with cash settlement or repurchase features. However, because ASC 718-10-25-11 requires liability classification for options and similar instruments if the underlying shares are classified as liabilities, ASC 718-10-25-9 and 25-10 apply to stock options or similar instruments in which the underlying shares are puttable or callable. Accordingly, an entity would apply the guidance in this section to determine the classification of those types of stock options or similar instruments. In addition, while grantees generally begin to bear the risks and rewards of share ownership when stock awards vest, they do not do so when stock options vest. Rather, grantees begin to bear the risks and rewards of share ownership when the stock options are exercised and the underlying shares are issued or issuable.
The determination of whether the grantee bears the risks and rewards normally
associated with equity share ownership for a reasonable period is based on whether
the repurchase feature is measured at fair value upon repurchase. If the repurchase
feature is measured at fair value, the grantee bears the risks and rewards of equity
share ownership by holding the shares (upon vesting for stock awards and upon
exercise for stock option awards) for six months or more. If the repurchase feature
is not measured at fair value, the grantee may not bear the risks and rewards of
equity share ownership as long as the repurchase feature is outstanding, and the
six-month period does not apply. As a result, many non–fair value repurchase
features result in an award’s classification as a liability. However, the
classification analysis will also depend on whether the repurchase feature is
exercisable upon a contingent event, as further discussed below.
Much of the guidance below is based on analogies to Issue 23 of EITF Issue 00-23. While EITF Issue 00-23 was superseded by ASC 718 (previously issued as FASB Statement 123(R)), some of the superseded guidance is still relevant in the determination of whether a grantee bears the risks and rewards of equity share ownership (provided that it is consistent with ASC 718-10-25-9 and 25-10).
5.3.1 Repurchase Features — Puttable Stock Awards
To appropriately classify a stock award with a put option, an entity must first
determine whether the put option’s exercisability is contingent on the occurrence of
an event. If the contingent event is solely within the control of the grantee (e.g.,
voluntary termination), the repurchase feature should be analyzed as if it is
noncontingent. Noncontingent puttable shares are generally classified as liabilities
unless the put option is measured at fair value and cannot be exercised for at least
six months after the shares have vested. Contingently puttable shares may require
liability classification depending, in part, on whether the contingent event is
solely within the grantee’s control. See the next section and Section 5.3.1.2 for
discussions of how such noncontingent puttable shares and contingently puttable
shares, respectively, should be evaluated under ASC 718-10-25-9(a).
If the put option does not result in liability classification, SEC registrants must consider the requirements of ASR 268 (FRR Section 211) and ASC 480-10-S99-3A, as discussed in SAB Topic 14.E. In accordance with that guidance, SEC registrants must present as temporary (or mezzanine) equity stock awards (otherwise classified as equity) that are subject to redemption features that are not solely within the control of the issuer. Temporary-equity classification is required if the puttable stock awards qualify for equity classification under the requirements of ASC 718 (e.g., a stock award that is puttable at fair value by the grantee more than six months after vesting). Puttable stock awards classified as temporary equity should be recognized at their redemption value. See Section 5.10 for discussion and examples of the application of ASR 268 and ASC 480-10-S99-3A to share-based payment awards with repurchase features.
5.3.1.1 Repurchase Features — Noncontingent Puttable Stock Awards
1
If the repurchase feature is measured at fair
value, the employee bears the risks and rewards of equity share
ownership by holding the shares for six months or more after the
shares are issued or issuable (i.e., the shares become
“mature”). If the repurchase feature is not measured at fair
value, the employee may not bear the risks and rewards of equity
share ownership as long as the repurchase feature is
outstanding.
Liability classification is required if the noncontingent put option permits the
grantee to avoid bearing the risks and rewards normally associated with
share ownership for a reasonable period from the date on which the stock
award is vested and the shares are issued or issuable. When determining
classification, an entity also needs to consider the option’s repurchase
price.
If the repurchase price is measured at fair value upon repurchase, to avoid
liability classification, a grantee must bear the risks and rewards of share
ownership for at least a period of six months from the date on which the
stock award is vested and the shares are issued or issuable (for stock
options, this would be the period from the date on which the award is
exercised). A noncontingent put option (the exercise of which is in the
grantee’s control) that allows the grantee to exercise the put option
within six months of the vesting of the stock award results in
liability classification of the stock award, even if the grantee is unlikely
to exercise the put option during that period. If the grantee holds the
shares for six months, the shares become “mature” and are reclassified to
equity. If the noncontingent put option cannot be exercised within six
months of vesting, the put option would not cause the stock award to be
classified as a liability.
If the repurchase price is not measured at fair value as of the repurchase date (e.g., repurchase at a formula price), the grantee may not be subject to the risks and rewards of share ownership for as long as the put option is outstanding, regardless of whether the repurchase feature can only be exercised six months after the stock award vests. Therefore, if the repurchase price is not measured at fair value, the stock award (or some portion of the award) will generally be classified as a liability until the put option expires or is settled.
An exception to this requirement is a repurchase feature that enables entities
to satisfy their statutory tax withholding requirements (see Example 5-5). See ASC
718-10-25-18 and Section
5.7.2 for a discussion of the effect of statutory tax
withholding amounts on the classification of share-based payment awards.
Entities must continually assess their stock awards to ensure that they are
appropriately classified. This assessment should occur in each reporting
period on an individual-grantee basis. Awards that are initially classified
as liability awards may subsequently be classified as equity awards if, for
example, the repurchase feature expires or, for fair value repurchase
features, the shares are held for at least six months from the date the
stock awards vested (i.e., the shares are no longer immature). See
Section 6.8.2 for a discussion of
liability-to-equity modifications.
The examples below illustrate noncontingent put options commonly found in share-based payment arrangements.
Example 5-4
Repurchase at Fair Value
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). The stock awards give the employee the right to require A to buy back its shares at their then-current fair value 12 months from the date the stock awards are fully vested.
The repurchase feature will not result in liability classification of the stock awards since the employee is required to bear the risks and rewards of share ownership for more than 6 months (i.e., 12 months) after the stock awards have vested. However, if A is an SEC registrant, it must apply the requirements in ASR 268 and ASC 480-10-S99-3A.
Example 5-5
Repurchase at Fair Value — Statutory Tax Withholding Requirements
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). When the awards vest, the employee can require A to repurchase a portion of its shares at their then-current fair value to meet A’s statutory tax withholding requirements.
The repurchase feature will not result in liability classification of the stock awards under ASC 718-10-25-18 as long as the employee cannot require A to repurchase its shares in an amount that exceeds the maximum statutory tax rate(s) in its applicable jurisdiction(s) and A has a statutory tax withholding requirement. A repurchase feature giving the employee the right to require the repurchase of shares in excess of the maximum statutory tax rate(s) in its applicable jurisdiction(s) or in circumstances in which A does not have a statutory tax withholding requirement as of the vesting date will result in liability classification for the entire award.
Example 5-6
Repurchase at a Fixed Price — Award With Two
Components
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). The stock awards give the employee the right to require A to buy back its shares at a fixed amount 12 months from the date the stock awards are fully vested.
The repurchase feature will result in liability classification of the stock awards since the employee is not subject to the risks and rewards of share ownership for as long as the repurchase feature is outstanding, regardless of whether the repurchase feature can only be exercised more than six months after the shares vest. That is, the repurchase price is fixed at the inception of the arrangement and is therefore not measured at fair value. The stock award would generally be accounted for as an award with a liability and equity component in a manner similar to a combination award, as described in ASC 718-10-55-120 through 55-130. The liability component is based on the fixed amount for which the employee can require A to repurchase its shares, and the equity component is recognized as a call option with an exercise price equal to the fixed amount for which the employee can require A to repurchase its shares. If the fixed-price repurchase feature expires, the liability component is reclassified to equity.
Example 5-7
Repurchase at a Fixed Amount Over Fair Value
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). The stock awards give the employee the right to require A to buy back its shares 12 months from the date the stock awards are fully vested. The repurchase amount will be based on the fair value of A’s shares on the date the employee exercises the put option plus $100 per share.
The repurchase feature will not result in liability
classification of the stock awards for the
portion of the awards subject to the repurchase
feature at fair value since the employee is required
to bear the risks and rewards of share ownership for
more than 6 months (i.e., 12 months) after the stock
awards have vested. However, if A is an SEC
registrant, it must apply the requirements in ASR
268 and ASC 480-10-S99-3A. In addition, ASC
718-20-35-7 and ASC 718-10-55-85 require the
recognition of additional compensation cost for the
excess of the repurchase price over the
fair-value-based measure of an award (i.e., $100 per
share). The additional compensation cost is
recognized over the requisite service period of the
stock awards (i.e., two years), with a corresponding
amount recognized as a liability.
Example 5-8
Repurchase at a Formula Price
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). The stock awards give the employee the right to require A to buy back its shares 12 months from the date the stock awards are fully vested. The repurchase amount will be based on a multiple of A’s earnings.
The repurchase feature will result in liability
classification of the stock awards if the
repurchase amount is not measured at fair value;
therefore, the employee would not be subject to the
risks and rewards of share ownership regardless of
whether the repurchase feature can only be exercised
more than six months after the shares vest. Entity A
will recognize the liability at its fair-value-based
measure by using the formula price as of each
reporting period.
Example 5-9
Repurchase Stock Options at Fair Value
Entity A grants 1,000 stock options to an employee
that vest at the end of the second year of service
(cliff vesting). The stock options give the employee
the right to require A to buy back its shares at
their then-current fair value 12 months from the
date the stock options are exercised.
The repurchase feature will not result in
liability classification of the stock options
since the employee is required to bear the risks and
rewards of share ownership for more than 6 months
(i.e., 12 months) after the stock options have been
exercised and the shares are outstanding.
5.3.1.2 Repurchase Features — Contingently Puttable Stock Awards
3
The probability analysis for a fair value
repurchase feature is performed for the six-month “window” that
the shares are “immature” (i.e., within six months of vesting).
For a non–fair value repurchase feature, the analysis is
performed for the entire period that the repurchase feature is
outstanding. The analysis is generally performed on an
individual-grantee basis and must be updated continually.
An entity should analyze a put option that becomes exercisable only upon the occurrence of a specified future event (i.e., the triggering event) to determine whether the triggering event is solely within the control of the grantee (i.e., the party that can exercise the put option). An entity should disregard triggering events solely within the control of the grantee and analyze the repurchase feature as if it is noncontingent (i.e., as if the triggering event already occurred) to determine whether it permits the grantee to avoid bearing the risks and rewards normally associated with share ownership for a reasonable period from the date the stock award is vested and the share is issued or issuable. See Section 5.3.1.1 for a discussion of the effect of noncontingent repurchase features on the classification of puttable stock awards.
If the triggering event is not solely within the control of the grantee, the
entity should assess, on an individual-grantee basis, the probability that
the triggering event will occur. Liability classification is required for
stock awards with fair value repurchase features if (1) it is probable that
the triggering event will occur within six months of the date the stock
awards vest and (2) the repurchase feature will permit the grantee to avoid
bearing the risks and rewards normally associated with share ownership for
six or more months after the date the stock award is vested and the shares
are issued or issuable. In addition, liability classification is generally
required for stock awards with non–fair value repurchase features if (1) it
is probable that the triggering event will occur while the repurchase
feature is outstanding and (2) the repurchase feature will permit the
grantee to avoid bearing the risks and rewards normally associated with
share ownership while the repurchase feature is outstanding.
Equity classification is appropriate for stock awards with fair value repurchase features in which
occurrence of the triggering event is (1) not solely within the control of the grantee and (2) not probable
or only probable after the grantee has been subject to the risks and rewards normally associated with
share ownership for six or more months from the date the stock award is vested and the shares are
issued or issuable. If repurchase features are not measured at fair value, equity classification would
generally only be appropriate for stock awards in which occurrence of the triggering event is (1) not
solely within the control of the grantee and (2) not probable while the repurchase feature is outstanding.
Common triggering events for employee awards
include:
Entities must continually assess their stock awards to ensure that they are
appropriately classified. This assessment should occur in each reporting
period on an individual-grantee basis. Awards that are initially classified
as equity awards may be subsequently classified as liability awards as a
result of a change in probability assessment. Likewise, awards that are
initially classified as liability awards may subsequently be classified as
equity awards if, for example, (1) there is a change in probability
assessment, (2) the repurchase feature expires, or, (3) for fair value
repurchase features, the shares are held for at least six months from the
date on which the stock awards vested (i.e., the shares are no longer
immature). See Section 6.8.2 for a
discussion of liability-to-equity modifications.
Example 5-10
Contingent Put Right — Change in Control
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). The stock awards give the employee the right to require A to buy back its shares once a change in control occurs. The repurchase amount will be based on the fair value of A’s shares on the date the employee exercises the put option.
The repurchase feature will not result in liability classification of the stock awards but may result in liability classification when it becomes probable that a change in control will occur. As discussed in Section 3.4.2.1, it is generally not considered probable that a change in control will occur until the change in control is consummated.
If the change in control occurs six months after the stock awards vest, equity classification will remain appropriate since the employee would have been subject to the risks and rewards normally associated with share ownership for at least a period of six months from the date the stock awards vested. However, if A is an SEC registrant, it must apply the requirements in ASR 268 and ASC 480-10-S99-3A.
5.3.2 Repurchase Features — Callable Stock Awards
In a manner similar to its treatment of a put option, an entity that grants a stock award with a call option must, to appropriately classify it, first determine whether the call option’s exercisability is contingent on the occurrence of a triggering event. However, unlike contingently puttable shares, all contingent events are assessed for probability, irrespective of whether the triggering event is solely within the grantee’s control. See Sections 5.3.2.1 and 5.3.2.2 for a discussion of how such noncontingent callable shares and contingently callable shares, respectively, should be evaluated under ASC 718-10-25-9(b).
Unlike put options, call options that do not result in liability classification are not assessed by SEC registrants in accordance with the requirements of ASR 268 and ASC 480-10-S99-3A because the redemption feature is solely within the control of the issuer, and that guidance applies only to awards with redemption features not solely within the control of the issuer. That is, a stock award with terms that only permit the entity to repurchase the shares will never be classified as temporary equity.
5.3.2.1 Repurchase Features — Noncontingent Callable Stock Awards
4
See footnote 3.
ASC 718-10-25-9(b) requires liability classification of stock awards when (1) the entity has the ability to
call the shares upon the vesting of the award (i.e., the call option is noncontingent) and (2) it is probable
that the call option will be exercised before the grantee has been subject to the risks and rewards
normally associated with share ownership for a reasonable period from the date the stock award is
vested and the shares are issued or issuable. The requirement to assess probability is different from
the requirement in ASC 718-10-25-9(a). That guidance does not permit an assessment of the grantee’s
probability of exercising a noncontingent put option. That is, a repurchase feature allowing grantees
to exercise a noncontingent put option within six months of the vesting of the stock awards will always
result in liability classification of the stock award, even if the grantee is unlikely to exercise the put
option.
The probability assessment in ASC 718-10-25-9(b) should be based on (1) the
entity’s stated representations that it has the positive intent not to call
the shares while they are immature (i.e., within six months of vesting for
fair value repurchase features and while the call option is outstanding for
non–fair value repurchase features) and (2) all other relevant facts and
circumstances. In assessing all other relevant facts and circumstances, the
entity may analogize to the guidance in superseded Issue 23(a) of EITF Issue
00-23, which indicates that an entity should consider the following
additional factors:
-
“The frequency with which the [grantor] has called immature shares in the past.”
-
“The circumstances under which the [grantor] has called immature shares in the past.”
-
“The existence of any legal, regulatory, or contractual limitations on the [grantor’s] ability to repurchase shares.”
-
“Whether the [grantor] is a closely held, private company.”
If the repurchase price is measured at fair value upon repurchase, to avoid liability classification, a grantee must bear the risks and rewards of share ownership for at least a period of six months from the date the stock award is vested and the shares are issued or issuable. A noncontingent call option (the exercise of which is in the entity’s control) that allows the entity to exercise the call option within six months of the vesting of the stock award results in liability classification of the stock award if it is probable that the entity will exercise the call option within those six months. If it is not probable that the entity will exercise the call option within those six months, the call option will not cause the stock award to be classified as a liability. In addition, if the noncontingent call option cannot be exercised within six months of vesting, the call option would not cause the stock award to be classified as a liability, and a probability assessment is not required.
An exception to liability classification is a repurchase feature that enables
entities to satisfy their statutory tax withholding requirements (see
Example
5-5). See ASC 718-10-25-18 and Section 5.7.2 for a discussion of the
effect of statutory tax withholding amounts on the classification of
share-based payment awards.
If the repurchase price is not measured at fair value on the repurchase date
(e.g., a formula price), the grantee may not be subject to the risks and
rewards of share ownership for as long as the call option is outstanding,
regardless of whether the repurchase feature can only be exercised more than
six months after the stock award vests. Therefore, the probability
assessment should be performed for all periods for which the repurchase
feature is outstanding. If the repurchase price is not measured at fair
value, the stock award will generally be classified as a liability if it is
probable that the entity will exercise the call option while the call option
is outstanding. If it is not probable that the entity will exercise the call
option while the call option is outstanding, the call option will not cause
the stock award to be classified as a liability. An exception to liability
classification can be applied if the repurchase price is at a fixed amount
over the fair value on the repurchase date. In this case, if it is not
probable that the call option will be exercised for at least six months from
the date the stock awards vest but it is still probable that the call option
will be exercised while the repurchase feature is outstanding, only the
fixed amount in excess of fair value would be classified as a liability
award. Further, it is generally probable that a noncontingent call feature
that allows the entity to repurchase shares at a price that is below fair value or potentially below fair value on
the repurchase date will be exercised irrespective of the holding period.
However, the entity should evaluate the repurchase provision to determine
whether, in substance, it represents a vesting condition or clawback feature
(see Section
5.3.4 for further discussion).
Entities must continually assess their stock awards to ensure that they are
appropriately classified. This assessment should occur in each reporting
period on an individual-grantee basis. Awards may initially be classified as
equity awards but, as a result of a change in the probability assessment,
may subsequently be classified as liability awards. Likewise, awards that
are initially classified as liability awards may subsequently be classified
as equity awards if, for example, (1) there is a change in the probability
assessment, (2) the repurchase feature expires, or (3) for fair value
repurchase features, the shares are held for at least six months from the
date the stock awards vested (i.e., the shares are no longer immature). See
Section 6.8.2 for a discussion of
liability-to-equity modifications.
Example 5-11
Noncontingent Call Right
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). The employee is restricted from selling A’s shares to a third party for 12 months after they vest. During this 12-month period, A has the right to call its shares at their then-current fair value.
Entity A should assess the probability that it will call the shares within six months of the vesting of the stock awards. Liability classification is required if it is probable that the shares will be called within six months from the date the stock awards vest.
If A is an SEC registrant and the stock awards are not classified as a liability, temporary equity classification of the stock awards will not be required under ASC 480-10-S99-3A because that guidance does not apply to stock awards with redemption features that are solely within the control of the issuer.
5.3.2.2 Repurchase Features — Contingently Callable Stock Awards
5
See footnote 3.
An entity should analyze a contingent call option that becomes exercisable only
upon the occurrence of a specified future event (i.e., the triggering event)
to determine whether it is probable that the triggering event will occur on
an individual-grantee basis. For repurchase features that are measured at
fair value as of the repurchase date, the probability assessment should
cover the period during which the shares are immature (i.e., within six
months of vesting). For repurchase features that are not measured at fair
value as of the repurchase date, the probability assessment should generally
cover the period during which the repurchase feature is outstanding. In the
latter situation, whether the shares are immature or mature is generally not
relevant to the probability assessment since the grantee would generally not
be subject to the risks and rewards of share ownership if the non–fair value
repurchase feature is exercised, regardless of whether the repurchase
feature is exercised more than six months after the shares vest. In
addition, unlike the put option assessment, the probability assessment may
be performed regardless of whether the occurrence of the triggering event is
solely in the control of the party that can exercise the repurchase feature
(i.e., the entity for call options). If it is not probable that the
triggering event will occur while the shares are immature (for fair value
repurchase features) or at any time before the repurchase feature expires
(for non–fair value repurchase features), the repurchase feature will not
result in liability classification. If it is probable that the triggering
event will occur while the shares are immature (for fair value repurchase
features) or at any time before the repurchase feature expires (for non–fair
value repurchase features), the entity should analyze the repurchase feature
as if it is noncontingent (i.e., as if the triggering event already
occurred). See Section
5.3.2.1 for a discussion of the accounting for noncontingent
repurchase features associated with a call option.
Like noncontingent callable stock awards, contingently callable stock awards
must be continually assessed by entities to ensure that they are
appropriately classified. This assessment should occur in each reporting
period on an individual-grantee basis. Awards may be initially classified as
equity awards but, as a result of a change in the probability assessment,
may be subsequently classified as liability awards. Likewise, awards that
are initially classified as liability awards may be subsequently classified
as equity awards if, for example, (1) there is a change in the probability
assessment, (2) the repurchase feature expires, or (3) for fair value
repurchase features, the shares are held for at least six months after the
awards vest (i.e., the shares are no longer immature). See Section 6.8.2 for a discussion of
liability-to-equity modifications.
Example 5-12
Contingent Call
Right — Termination
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). If employment is terminated for any reason after vesting, A has the right to call its shares at their then-current fair value.
Entity A should assess the probability that employment will terminate within six months of the vesting of the stock awards (this assessment is performed on an individual-employee basis). If it is not probable that employment will terminate within six months of vesting, the stock awards are classified as equity. If it is probable that employment will terminate within six months of vesting, A should treat the repurchase feature as if it is noncontingent and determine whether it is probable that it will call the shares within six months from the date the stock awards vest.
Example 5-13
Contingent Call Right — Termination
Entity A grants 1,000 shares of restricted stock to an employee that vest at the end of the second year of service (cliff vesting). If employment is terminated for any reason after vesting, A has the right to call its shares at a formula price that is not fair value. The call option expires if A effects an IPO or undergoes a change in control.
Entity A should assess the probability that employment will terminate while the
repurchase feature is outstanding. While it is
certain that employment will terminate at some
point, in certain circumstances it may be
appropriate to perform the probability assessment
(on an individual-employee basis) for the period
before an expected IPO or change in control (e.g.,
there is a single controlling shareholder that has
an exit strategy for the entity and a past practice
of fulfilling similar exit strategies for its
investments). If it is not probable that employment
will terminate during that period, the stock awards
are classified as equity. If it is probable that
employment will terminate during that period, A
should treat the repurchase feature as if it is
noncontingent and determine whether it is probable
that it will call the shares during that period. If
the formula price could potentially be below fair
value on the repurchase date, it is generally
probable that the call feature will be exercised and
that the award would therefore typically be
classified as a liability.
5.3.3 Book-Value Plans for Employees
ASC 718-10
Example 8: Book Value Plans for Employees
55-131 A nonpublic entity that is not a Securities and Exchange Commission (SEC) registrant has two classes of stock. Class A is voting and held only by the members of the founding family, and Class B (book value shares) is nonvoting and held only by employees. The purchase price of Class B shares is a formula price based on book value. Class B shares require that the employee, six months after retirement or separation from the entity, sell the shares back to the entity for cash at a price determined by using the same formula used to establish the purchase price. Class B shares may not be required to be accounted for as liabilities pursuant to Topic 480 because the entity is a nonpublic entity that is not an SEC registrant. Nevertheless, Class B shares may be classified as liabilities if they are granted as part of a share-based payment transaction and those shares contain certain repurchase features meeting criteria in paragraph 718-10-25-9; this Example assumes that Class B shares do not meet those criteria. Because book value shares of public entities generally are not indexed to their stock prices, such shares would be classified as liabilities pursuant to this Topic.
55-132 Determining whether a transaction involving Class B shares is compensatory will depend on the terms of the arrangement. For instance, if an employee acquires 100 shares of Class B stock in exchange for cash equal to the formula price of those shares, the transaction is not compensatory because the employee has acquired those shares on the same terms available to all other Class B shareholders and at the current formula price based on the current book value. Subsequent changes in the formula price of those shares held by the employee are not deemed compensation for services.
55-133 However, if an employee acquires 100 shares of Class B stock in exchange for cash equal to 50 percent of the formula price of those shares, the transaction is compensatory because the employee is not paying the current formula price. Therefore, the value of the 50 percent discount should be attributed over the requisite service period. However, subsequent changes in the formula price of those shares held by the employee are not compensatory.
Certain employee share-based payment transactions that are based on a book or
formula plan may not be compensatory or classified as liabilities. If employees
purchase shares at a formula price and the shares have repurchase features that
use that same formula price, there may be no compensation cost if the same
formula price is used for all transactions in the same class of shares (or in
substantially similar classes of shares). In such circumstances, the formula
price essentially establishes the fair value of the shares. The entity must
still evaluate the repurchase feature under ASC 718-10-25-9 to determine whether
it would cause the shares to be classified as liabilities. If the repurchase
price essentially is measured at fair value, liability classification would not
be required if the repurchase feature can only be exercised after six months.
See Sections 5.3.1
and 5.3.2 for a
discussion of the treatment of repurchase features with a fair value repurchase
price.
5.3.4 Repurchase Features That Function as Vesting Conditions or Clawback Features
Some awards have repurchase features exercisable by an entity (i.e., call options) with a repurchase price that is (1) equal to the cost of the shares or (2) the lower of cost or fair value. The repurchase features for such awards function as in-substance vesting conditions or clawback features, and do not affect the awards’ classification (i.e., the analysis in Sections 5.3.1 and 5.3.2 related to repurchase features is not required) because they do not represent, in substance, cash settlement features. See Sections 3.4.3 and 3.9 for further discussion of features that function as vesting conditions and clawback features.
Footnotes
1
If the repurchase feature is measured at fair
value, the employee bears the risks and rewards of equity share
ownership by holding the shares for six months or more after the
shares are issued or issuable (i.e., the shares become
“mature”). If the repurchase feature is not measured at fair
value, the employee may not bear the risks and rewards of equity
share ownership as long as the repurchase feature is
outstanding.
3
The probability analysis for a fair value
repurchase feature is performed for the six-month “window” that
the shares are “immature” (i.e., within six months of vesting).
For a non–fair value repurchase feature, the analysis is
performed for the entire period that the repurchase feature is
outstanding. The analysis is generally performed on an
individual-grantee basis and must be updated continually.
4
See footnote 3.
5
See footnote 3.
5.4 Stock Options
ASC 718-10
25-11 Options or similar instruments on shares shall be classified as liabilities if either of the following conditions is met:
- The underlying shares are classified as liabilities.
- The entity can be required under any circumstances to settle the option or similar instrument by transferring cash or other assets. A cash settlement feature that can be exercised only upon the occurrence of a contingent event that is outside the grantee’s control (such as an initial public offering) would not meet this condition until it becomes probable that event will occur.
25-12 For example, a Securities and Exchange Commission (SEC) registrant may grant an option to a grantee that, upon exercise, would be settled by issuing a mandatorily redeemable share. Because the mandatorily redeemable share would be classified as a liability under Topic 480, the option also would be classified as a liability.
The sections below discuss guidance on the classification of stock options and similar instruments. See Section 5.3 for guidance on determining the
classification of puttable and callable stock awards.
5.4.1 Classification of Underlying Shares
Stock options and similar instruments are classified as liabilities if the underlying shares are classified as liabilities. For example, if the underlying shares of an option award have repurchase features, an entity would first consider whether to classify the underlying shares as liabilities under ASC 718. See Section 5.3 for guidance on the classification of shares with repurchase features. While grantees generally begin to bear the risks and rewards of share ownership when stock awards vest, they do not do so when stock options vest. Rather, grantees begin to bear the risks and rewards of share ownership when the stock options are exercised and the underlying shares are issued or issuable.
5.4.2 Cash Settlement Features
When stock option awards contain cash settlement features, an entity should
perform the steps indicated in the table and decision tree below. Note that
these steps only apply to stock options and similar
instruments subject to ASC 718 that contain features that transfer cash or other
assets upon settlement. They therefore do not apply to
the following awards:
-
Stock options and similar instruments that will be settled upon the issuance of shares that themselves must be classified as liabilities under ASC 718-10-25-11(a) and 25-12. See the previous section.
-
Share-based payment awards of puttable or callable shares subject to ASC 718. Such awards must be classified in accordance with ASC 718-10-25-9 and 25-10. See Section 5.3 for guidance on determining the classification of puttable and callable stock awards. ASC 718-10-25-9 and 25-10 also apply to stock options and similar instruments in which the underlying shares are puttable or callable. The grantee does not begin to bear the risks and rewards normally associated with share ownership of such instruments until they are exercised.
The table and decision tree below outline an entity’s step-by-step analysis in determining the
classification of stock options and similar instruments with cash settlement features.
Determining the Classification of Employee Stock Options and Similar Instruments With Cash
Settlement Features | ||
---|---|---|
Step | Question | Answer |
1
|
Is cash settlement required, or can the
grantee elect either cash or
share settlement of the stock option or similar
instrument (i.e., is the method of settlement within the
grantee’s control)?
|
If yes, proceed to step 1a. If no,
proceed to step 2.
|
a. Is the requirement to cash settle or the
grantee’s election to cash settle contingent on the
occurrence of an event?
|
If yes, proceed to step 1b. If no,
classify the stock option or similar instrument as a
share-based liability.
| |
b. If the requirement to cash settle or the
grantee’s election to cash settle is contingent on
the occurrence of an event, is the contingent event
within the grantee’s control (e.g., voluntary
termination of employment)?
|
If yes, classify the stock option or
similar instrument as a share-based liability. If no,
proceed to step 1c.
| |
c. If the requirement to cash settle or the
grantee’s election to cash settle is contingent on
the occurrence of an event that is not within the
grantee’s control (e.g., a change in control), is it
probable that the contingent event will occur?
|
If yes, classify the stock option or
similar instrument as a share-based liability. If no,
proceed to step 2.
| |
2
|
Can the entity
choose the method of settlement (i.e., cash or share
settlement) of the stock option or similar
instrument?
|
If yes, proceed to step 2a. If no,
proceed to step 3.
|
a. Is the entity’s election contingent on the
occurrence of an event?
|
If yes, proceed to step 2b. If no,
proceed to step 2c.
| |
b. If the entity’s election is contingent on the
occurrence of an event, is the contingent event
solely within the grantee’s control or is it
probable that the event will occur?
|
If yes, proceed to step 2c. If no,
proceed to step 3.
| |
c. Does the entity have the intent and ability to
settle the stock option or similar instrument in the
entity’s shares?
|
If yes, proceed to step 3. If no,
classify the stock option or similar instrument as a
share-based liability.
| |
3 | Is temporary-equity classification of the stock
option or similar instrument required under SAB
Topic 14.E? This step applies to SEC registrants,
and non-SEC registrants may elect not to apply it. | If yes, classify the stock option or similar
instrument outside of permanent equity as
temporary (or mezzanine) equity. If no, classify the
stock option or similar instrument as permanent
equity. |
5.4.2.1 Noncontingent Cash Settlement Features (Including Tandem and Combination Awards)
Many cash settlement features are not contingent on the occurrence of an event.
If an entity is required to settle stock options or similar instruments in
cash or other assets (e.g., cash-settled SARs), the awards should be
classified as liabilities. Similarly, if the grantee can elect either cash
or share settlement of stock options or similar instruments (e.g., tandem
awards), the awards should be classified as liabilities. ASC 718 provides
the examples below of tandem and combination awards for which the grantee
can elect the method of settlement.
ASC 718-10
Example 7: Tandem Awards
55-116 A tandem award is an award with two or more components in which exercise of one part cancels the other(s). In contrast, a combination award is an award with two or more separate components, all of which can be exercised. The following Cases illustrates one aspect of the guidance in paragraph 718-10-25-15:
- Share option or cash settled stock appreciation rights (Case A)
- Phantom shares or share options (Case B).
55-116A
Cases A and B of this Example (see paragraphs
718-10-55-117 through 55-130) describe employee
awards. However, the principles on accounting for
employee awards, except for compensation cost
attribution, are the same for nonemployee awards.
Therefore, the guidance in these Cases may serve as
implementation guidance for nonemployee awards.
55-116B
Compensation cost attribution for awards to
nonemployees may be the same as or different from
the attribution for the employee awards in Case A
(see paragraph 718-10-55-119) and Case B (see
paragraph 718-10-55-130). 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
transactions.
Case A: Share Option or Cash Settled Stock Appreciation Rights
55-117 This Case illustrates the accounting for a tandem award in which employees have a choice of either share options or cash-settled stock appreciation rights. Entity T grants to its employees an award of 900,000 share options or 900,000 cash-settled stock appreciation rights on January 1, 20X5. The award vests on December 31, 20X7, and has a contractual life of 10 years. If an employee exercises the stock appreciation rights, the related share options are cancelled. Conversely, if an employee exercises the share options, the related stock appreciation rights are cancelled.
55-118 The tandem award results in Entity T’s incurring a liability because the employees can demand settlement in cash. If Entity T could choose whether to settle the award in cash or by issuing stock, the award would be an equity instrument unless Entity T’s predominant past practice is to settle most awards in cash or to settle awards in cash whenever requested to do so by the employee, indicating that Entity T has incurred a substantive liability as indicated in paragraph 718-10-25-15. In this Case, however, Entity T incurs a liability to pay cash, which it will recognize over the requisite service period. The amount of the liability will be adjusted each year to reflect changes in its fair value. If employees choose to exercise the share options rather than the stock appreciation rights, the liability is settled by issuing stock.
55-119 The fair value of the stock appreciation rights at the grant date is $12,066,454, as computed in Example 1 (see paragraph 718-30-55-1), because the value of the stock appreciation rights and the value of the share options are equal. Accordingly, at the end of 20X5, when the assumed fair value per stock appreciation right is $10, the amount of the liability is $8,214,060 (821,406 cash-settled stock appreciation rights expected to vest × $10). One-third of that amount, $2,738,020, is recognized as compensation cost for 20X5. At the end of each year during the vesting period, the liability is remeasured to its fair value for all stock appreciation rights expected to vest. After the vesting period, the liability for all outstanding vested awards is remeasured through the date of settlement.
Case B: Phantom Shares or Share Options
55-120 This Case illustrates a tandem award in which the components have different values after the grant date, depending on movements in the price of the entity’s stock. The employee’s choice of which component to exercise will depend on the relative values of the components when the award is exercised.
55-121 Entity T grants to its chief executive officer an immediately vested award consisting of the following two parts:
- 1,000 phantom share units (units) whose value is always equal to the value of 1,000 shares of Entity T’s common stock
- Share options on 3,000 shares of Entity T’s stock with an exercise price of $30 per share.
55-122 At the grant date, Entity T’s share price is $30 per share. The chief executive officer may choose whether to exercise the share options or to cash in the units at any time during the next five years. Exercise of all of the share options cancels all of the units, and cashing in all of the units cancels all of the share options. The cash value of the units will be paid to the chief executive officer at the end of five years if the share option component of the tandem award is not exercised before then.
55-123 With a 3-to-1 ratio of share options to units, exercise of 3 share options will produce a higher gain than receipt of cash equal to the value of 1 share of stock if the share price appreciates from the grant date by more than 50 percent. Below that point, one unit is more valuable than the gain on three share options. To illustrate that relationship, the results if the share price increases 50 percent to $45 are as follows.
55-124 If the price of Entity
T’s common stock increases to $45 per share from its
price of $30 at the grant date, each part of the
tandem grant will produce the same net cash payment
(ignoring transaction costs) to the chief executive
officer. If the price increases to $44, the value of
1 share of stock exceeds the gain on exercising 3
share options, which would be $42 [3 × ($44 – $30)].
But if the price increases to $46, the gain on
exercising 3 share options, $48 [3 × ($46 – $30)],
exceeds the value of 1 share of stock.
55-125 At the grant date, the chief executive officer could take $30,000 cash for the units and forfeit the share options. Therefore, the total value of the award at the grant date must exceed $30,000 because at share prices above $45, the chief executive officer receives a higher amount than would the holder of 1 share of stock. To exercise the 3,000 options, the chief executive officer must forfeit the equivalent of 1,000 shares of stock, in addition to paying the total exercise price of $90,000 (3,000 × $30). In effect, the chief executive officer receives only 2,000 shares of Entity T stock upon exercise. That is the same as if the share option component of the tandem award consisted of share options to purchase 2,000 shares of stock for $45 per share.
55-126 The cash payment obligation associated with the units qualifies the award as a liability of Entity T. The maximum amount of that liability, which is indexed to the price of Entity T’s common stock, is $45,000 because at share prices above $45, the chief executive officer will exercise the share options.
55-127 In measuring compensation cost, the award may be thought of as a combination — not tandem — grant of both of the following:
- 1,000 units with a value at grant of $30,000
- 2,000 options with a strike price of $45 per share.
55-128 Compensation cost is measured based on the combined value of the two parts.
55-129 The fair value per share option with an exercise price of $45 is assumed to be $10. Therefore, the total value of the award at the grant date is as follows.
55-130 Therefore, compensation cost recognized at the date of grant (the award is immediately vested) would be $30,000 with a corresponding credit to a share-based compensation liability of $30,000. However, because the share option component is the substantive equivalent of 2,000 deep out-of-the-money options, it contains a derived service period (assumed to be 2 years). Hence, compensation cost for the share option component of $20,000 would be recognized over the requisite service period. The share option component would not be remeasured because it is not a liability. That total amount of both components (or $50,000) is more than either of the components by itself, but less than the total amount if both components (1,000 units and 3,000 share options with an exercise price of $30) were exercisable. Because granting the units creates a liability, changes in the liability that result from increases or decreases in the price of Entity T’s share price would be recognized each period until exercise, except that the amount of the liability would not exceed $45,000.
Many compensation arrangements include payments of both equity and cash. In some cases, the cash component represents a liability-classified share-based payment award that is accounted for separately from the equity-classified component (i.e., as a combination award). The examples below illustrate the accounting for arrangements that are settled partially in cash and partially in equity.
Example 5-14
Entity A grants to an executive
restricted stock and stock options that vest at the
end of four years (cliff vesting). The award
requires A to reimburse the executive in cash for
federal income taxes at a rate of 37 percent when
the employee is taxed, which is when the employee
vests in the restricted stock or exercises its stock
options. Provided that all the criteria for equity
classification have been met, the restricted stock
and stock options will be separately accounted for
as equity-classified share-based payment awards
under ASC 718. In addition, because A is required to
pay the executive in cash amounts that are indexed
to the fair value of the underlying stock, those
obligations are separately accounted for as
liability-classified awards under ASC 718. The tax
obligation associated with the restricted stock is
accounted for as cash-settled RSUs and measured on
the basis of 37 percent of the value of the
underlying restricted stock. In addition, the tax
obligation associated with the stock options is
accounted for as cash-settled SARs. Both
liability-classified awards are required to be
remeasured in each reporting period and recognized
as compensation cost.
Example 5-15
Entity A establishes an entity-wide
bonus program that provides each employee with an
annual targeted compensation rate. At the beginning
of every year, each employee is notified of his or
her targeted rate and the composition in shares of
common stock and cash, which both vest over a
one-year period (cliff vesting). Employee B’s
targeted rate is $100,000 with a 50/50
equity-to-cash split, and each share is worth $50;
therefore, B will receive a cash bonus of $50,000
and a stock award worth $50,000 (1,000 shares, which
is $50,000 divided by the stock price of $50). If,
upon vesting, the value of B’s total compensation is
below the targeted rate, B will receive an
additional cash bonus for the difference. If the
stock price increases from the grant date, no
additional cash bonus is paid. However, if the stock
price decreases from the grant date, B will receive
a cash bonus equal to the decrease in value. For
example, if B receives stock worth $60,000 on the
vesting date, B will not receive any additional cash
bonus. By contrast, if the stock is worth $40,000 on
the vesting date, B will receive an additional cash
bonus of $10,000. In effect, A has guaranteed that
the employee will be paid a minimum of $100,000 in
cash and equity upon earning the bonus.
The $50,000 cash bonus is not
subject to ASC 718 since it is not indexed to A’s
equity value (i.e., it is recognized as a
fixed-price liability over the one-year vesting
period). Provided that all the criteria for equity
classification have been met, the restricted stock
award will be separately accounted for as an
equity-classified award under ASC 718 and recognized
as compensation cost over the one-year requisite
service period. The cash-settled guarantee is
indexed to A’s common stock and is therefore
accounted for as a put option under ASC 718. That
cash-settled share-based liability should be
remeasured in each reporting period and recognized
as compensation cost over the one-year requisite
service period.
An entity that can elect a settlement method should consider the guidance in ASC
718-10-25-15, which requires an entity to continually evaluate its intent
and ability to settle in shares. In addition, an entity’s past practices
related to cash settlement could indicate that the awards should be
classified as substantive liabilities. Section 5.6 discusses considerations
for an entity that can choose the method of settlement in determining the
classification of options and similar instruments.
5.4.2.2 Contingent Cash Settlement Features
An entity should analyze a contingent cash settlement feature that becomes exercisable only upon the
occurrence of a specified future event (i.e., the triggering event) to determine whether the triggering
event is within the control of the grantee. Triggering events within the grantee’s control should be
ignored in the entity’s analysis, and the entity should assess the options or similar instruments as if the
triggering event has already occurred. Options or similar instruments that require or permit the grantee
to cash settle the options or similar instruments must be classified as liabilities. Alternatively, options or
similar instruments that permit the entity to choose settlement in cash or shares are not classified as
liabilities unless they are substantive liabilities under ASC 718-10-25-15.
ASC 718-10-25-11 states that if a contingent cash settlement feature becomes
exercisable upon a triggering event that is not within the control of the
grantee, and the grantee can choose the method of
settlement or the entity is required to settle in cash or other assets, the
stock option or similar instrument will not result in liability
classification if it is not probable that the triggering event will occur.
The assessment of probability is required while an award is within the scope
of ASC 718 and is generally performed on an individual-grantee basis. For
example, a stock option that can require cash settlement upon a change in
control should not be classified as a liability unless a change in control
is considered probable. Generally, a change in control is not considered
probable until the event that triggers it has occurred (e.g., when a
business combination has been consummated).
If a contingent cash settlement feature becomes exercisable upon a triggering
event that is not within the control of the grantee, and the entity can determine the method of settlement, the
stock option or similar instrument will not result in liability
classification if it is not probable that the event will occur. The
probability assessment is required while an award is within the scope of ASC
718 and is generally performed on an individual-grantee basis. If it becomes
probable that the triggering event will occur, the entity must consider the
substantive terms of the option or similar instrument under ASC
718-10-25-15, including the entity’s intent and ability to settle the option
or similar instrument in shares and the entity’s past practices of settling
options or similar instruments. Section 5.6 discusses considerations
for an entity that can choose the method of settlement in determining the
classification of options and similar instruments.
Note that SEC registrants must consider the requirements of ASR 268 (FRR Section
211) and ASC 480-10-S99-3A, as discussed in SAB Topic 14.E. In accordance
with that guidance, SEC registrants must present outside of permanent equity
(i.e., as temporary or mezzanine equity) options and similar instruments
(otherwise classified as equity) that are subject to cash settlement
features that are not solely within the control of the issuer. Temporary
equity classification is required even if the options or similar instruments
otherwise qualify for equity classification under ASC 718 (e.g., an option
that can be cash settled upon a change in control). See Section 5.10 for a
discussion and example of the application of ASR 268 and ASC 480-10-S99-3A
to stock options with a contingent cash settlement feature.
The redemption value at issuance is based on the cash settlement feature of the
option or similar instrument. For example, the redemption value of an option
that can be cash settled at intrinsic value is the intrinsic value of the
option. Thus, if a stock option is granted at-the-money, its initial
carrying value would be zero. Subsequent remeasurement in temporary equity
is not required under ASC 480-10-S99-3A unless it is probable that the
triggering event will occur, in which case the option or similar instrument
would be reclassified as a liability under ASC 718. As indicated in ASC
718-10-35-15, an entity would account for a reclassified stock option or
similar instrument in essentially the same way it would account for a
modification that changes the award’s classification from equity to
liability. See Section
6.8.1 for a discussion and examples of the accounting for the
modification of an award that changes the award’s classification from equity
to liability.
An entity does not need to consider ASC 480-10-S99-3A if it can choose the method of settlement (i.e., cash or share settlement) since that guidance applies only to awards with redemption features not solely within the control of the issuer. An option or similar instrument with terms that allow the entity to choose the method of settlement will never be classified as temporary equity.
5.4.2.3 Early Exercise of a Stock Option or Similar Instrument
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.
Because the awards are exercised before vesting, 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 is effectively to require the grantee to provide goods or
services to receive any economic benefit from the award. Because the repurchase feature functions
as a forfeiture provision, an entity would not consider the provisions of ASC 718-10-25-9 and 25-10 to
determine the classification of the award. In addition, because the early exercise is not considered to
be a substantive exercise for accounting purposes, the payment received by the entity for the exercise
price should generally be recognized as a deposit liability. See Section 3.4.3 for additional discussion on an early exercise of a stock option or similar instrument.
5.4.3 Net Share Settlement Features
Some share-based payment arrangements contain features that allow grantees to net share settle
vested options or similar instruments. These features, which are sometimes referred to as stock option
pyramiding, phantom stock-for-stock exercises, or immaculate cashless exercises, allow the grantee to
exercise an option without having to pay the exercise price in cash. As a result of the settlement feature,
the grantee receives upon exercise a number of shares with a fair value equal to the intrinsic value of
the exercised options.
A net share settlement feature by itself does not result in liability
classification of an option. An option that can be net share settled is no
different from a share-settled SAR and is not required to be classified as a
share-based liability. However, an option may include other features that result
in liability classification. See Section 5.4.2 for guidance on determining
the classification of stock options with cash settlement features.
5.4.4 Broker-Assisted Cashless Exercise
ASC 718-10 — Glossary
Broker-Assisted Cashless Exercise
The simultaneous exercise by a grantee of a share option and sale of the shares through a broker (commonly
referred to as a broker-assisted exercise).
Generally, under this method of exercise:
- The grantee authorizes the exercise of an option and the immediate sale of the option shares in the open market.
- On the same day, the entity notifies the broker of the sale order.
- The broker executes the sale and notifies the entity of the sales price.
- The entity determines the minimum statutory tax-withholding requirements.
- By the settlement day (generally three days later), the entity delivers the stock certificates to the broker.
- On the settlement day, the broker makes payment to the entity for the exercise price and the minimum statutory withholding taxes and remits the balance of the net sales proceeds to the grantee.
ASC 718-10
25-16 A provision that permits grantees to effect a broker-assisted cashless exercise of part or all of an award of share options through a broker does not result in liability classification for instruments that otherwise would be classified as equity if both of the following criteria are satisfied:
- The cashless exercise requires a valid exercise of the share options.
- The grantee is the legal owner of the shares subject to the option (even though the grantee has not paid the exercise price before the sale of the shares subject to the option).
25-17 A broker that is a related party of the entity must sell the shares in the open market within a normal settlement period, which generally is three days, for the award to qualify as equity.
The exercise of stock options and similar instruments is often accomplished through a broker. A feature that permits grantees to effect a broker-assisted cashless exercise would not be deemed a cash settlement feature (that could cause liability classification) if the criteria in ASC 718-10-25-16 and 25-17 are met.
In addition, while ASC 718 does not define a “legal owner,” paragraph 245 of EITF Issue 00-23 states:
As the legal owner of the shares, the employee assumes market risk from
the moment of exercise4 until the broker effects the sale in
the open market. While the period of time that the employee is exposed
to such risk may be inconsequential, it is no less of a period of time
than might lapse if the employee paid cash for the full exercise price
and immediately sold the shares through an independent broker. If the
employee were never the legal owner of the option shares, the stock
option would be in substance a stock appreciation right for which
[liability] accounting is required. If the related-party broker acquires
the shares for its own account rather than selling the shares in the
open market, the grantor has, in effect, paid cash to an employee to
settle an award, which is a transaction for which compensation expense
should be recognized. Conversely, the sale of the option shares in the
open market provides evidence that the marketplace, not the grantor
(through its affiliate), has acquired the option shares.
_________________________________________________
4 Under many cashless exercise programs, the broker will
notify the employee if the aggregate sales price for the option shares
is less than the aggregate exercise price. In that situation, the
employee may elect not to exercise the options. As a result, the moment
of exercise is deemed to be the moment that the shares are sold.
While EITF Issue 00-23 was not codified in ASC 718, we believe that it is
appropriate for entities to consider in determining whether the grantee is the
legal owner of the shares.
5.5 Indexation to Other Factors
ASC 718-10
25-13 An award 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 shall be classified as a liability for purposes of this Topic, and the additional factor shall be reflected in estimating the fair value of the award. Paragraph 718-10-55-65 provides examples of such awards.
55-65 An award may be indexed to a factor in addition to the entity’s share price. If that factor is not a market, performance, or service condition, that award shall be classified as a liability for purposes of this Topic (see paragraphs 718-10-25-13 through 25-14A). An example would be an award of options whose exercise price is indexed to the market price of a commodity, such as gold. Another example would be a share award that will vest based on the appreciation in the price of a commodity, such as gold; that award is indexed to both the value of that commodity and the issuing entity’s shares. If an award is so indexed, the relevant factors shall be included in the fair value estimate of the award. Such an award would be classified as a liability even if the entity granting the share-based payment instrument is a producer of the commodity whose price changes are part or all of the conditions that affect an award’s vesting conditions or fair value.
ASC 718-10-25-13 indicates that when an award is indexed to a factor in addition
to the entity’s share price and that factor is not a market, performance, or service
condition (i.e., it is an “other” condition), the award must be classified as a liability. For example, an entity may link the exercise price of a stock option to the change in the CPI or another similar index (such as the retail price index in the United Kingdom) to eliminate the effect of inflation on the option’s value. Paragraph B127 of the Basis for Conclusions of FASB Statement 123(R) explains the
FASB’s reasoning for this treatment as follows:
The Board concluded that the terms of such an award do not establish an ownership relationship because the extent to which (or whether) the employee benefits from the award depends on something other than changes in the entity’s share price. That conclusion is consistent with the Board’s conclusion in Statement 150 that a share-settled obligation is a liability
if it does not expose the holder of the instrument to certain risks and
rewards, including the risk of changes in the price of the issuing entity’s
equity shares, that are similar to those to which an owner is exposed.
A feature that adjusts the exercise price of an option for changes in the CPI
does not meet the definition of a market, performance, or service condition.
Accordingly, such an award must be classified as a liability. By contrast, an entity
may (1) estimate the change in the CPI (or another similar index) over an option’s
vesting period or its expected life and (2) set a fixed exercise price that is
adjusted for that estimate. Because the exercise price is established as of the
grant date and not linked to the actual change in the CPI (or another similar
index), the option is not considered to be indexed to a factor other than a market,
performance, or service condition. Accordingly, such an award, if it otherwise meets
the criteria for equity classification, is classified as equity.
In addition, questions have arisen related to the evaluation of
whether an award is indexed to an “other” condition or includes a feature that is a
vesting or market condition. A vesting condition that is based on an entity’s
financial performance and is referenced solely to the grantor’s own operation in
relation to a peer group (e.g., attaining an EPS growth rate that outperforms the
average EPS growth rate of peer companies in the same industry) is a performance
condition (see Sections
3.4.2 and 9.3.2.2 for discussions of employee and nonemployee awards,
respectively). Note that in these circumstances, ASC 718 requires the performance
measure ascribed to the award to be “defined by reference to the same
performance measure of another entity or group of entities” (emphasis added). That
is, if the performance measures are not equivalent, the condition is not a
performance condition as defined in ASC 718-10-20 and would result in the award’s
classification as a liability. Examples of market conditions that are defined by
reference to an index include (1) 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) and (2) 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 (see Section
3.5). An entity must carefully evaluate the terms and conditions of each
award and use judgment in determining whether an award is indexed to a factor that
is not a market, performance, or service condition.
Example 5-16
Liability-Classified Award
Entity A grants employee stock options with a grant-date exercise price equal to the market price of A’s shares that increases monthly for inflation (on the basis of changes in the CPI) through the date of exercise.
Because the options’ value is indexed to the CPI and the change in the CPI is a factor that is not considered a market, performance, or service condition, the options must be classified as a liability. Entity A must remeasure the options at their fair-value-based measure in each reporting period until settlement.
Alternatively, if the options’ terms only require monthly adjustments to the exercise price for changes in CPI through the vesting date, the options would be classified as a liability only until the vesting date. That is, A only must remeasure the options at their fair-value-based measure in each reporting period until the vesting date. On the vesting date, the options’ value no longer is indexed to the CPI; therefore, as long as all the other criteria for equity classification have been met, the award would be reclassified as equity.
Example 5-17
Equity-Classified Award
Entity A grants employee stock options with a grant-date exercise price equal to the grant-date market price of A’s shares that increases annually by 3 percent (on the basis of A’s estimate of annual inflation) through the date of exercise. Before considering the effects of the 3 percent annual increase to the exercise price, A determines that the options should be classified as equity.
Because the options’ value is not indexed to a factor other than a market, performance, or service condition (e.g., a change in the CPI), the options would be classified as equity. Accordingly, the fair-value-based measure of the options is fixed on the grant date, and the increasing exercise price is incorporated into the fair-value-based measure of the options.
ASC 718 provides an exception to liability classification when the exercise price of stock options is denominated in a foreign currency and certain conditions are met. See Section 5.7.1 for a discussion of this exception.
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.
5.7 Exceptions to Liability Classification
5.7.1 Foreign Currency
ASC 718-10
25-14 For this purpose, an award of equity share options granted to a grantee of an entity’s foreign operation
that provides for a fixed exercise price denominated either in the foreign operation’s functional currency or in
the currency in which the foreign operation’s employee’s pay is denominated shall not be considered to contain
a condition that is not a market, performance, or service condition. Therefore, such an award is not required to
be classified as a liability if it otherwise qualifies as equity. For example, equity share options with an exercise
price denominated in euros granted to employees or nonemployees of a U.S. entity’s foreign operation whose
functional currency is the euro are not required to be classified as liabilities if those options otherwise qualify
as equity. In addition, options granted to employees and nonemployees are not required to be classified as
liabilities even if the functional currency of the foreign operation is the U.S. dollar, provided that the foreign
operation’s employees are paid in euros.
25-14A For purposes of applying paragraph 718-10-25-13, a share-based payment award with an exercise
price denominated in the currency of a market in which a substantial portion of the entity’s equity securities
trades shall not be considered to contain a condition that is not a market, performance, or service condition.
Therefore, in accordance with that paragraph, such an award shall not be classified as a liability if it otherwise
qualifies for equity classification. For example, a parent entity whose functional currency is the Canadian dollar
grants equity share options with an exercise price denominated in U.S. dollars to grantees of a Canadian entity
with the functional and payroll currency of the Canadian dollar. If a substantial portion of the parent entity’s
equity securities trades on a U.S. dollar denominated exchange, the options are not precluded from equity
classification.
Stock options may have an exercise price that is denominated in a foreign currency (i.e., a currency that is not the entity’s functional currency). While such foreign currency would not be a service, performance, or market condition (i.e., it is an “other” condition), indexation to the currency, by itself, would not result in liability classification of the stock options if:
- A grantee of an entity’s foreign operation is awarded stock options with a fixed exercise price denominated in the foreign operation’s functional currency.
- A grantee of an entity’s foreign operation is awarded stock options with a fixed exercise price denominated in the currency in which the employee’s pay is denominated.
- A grantee is awarded stock options with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades.
5.7.2 Statutory Tax Withholding Obligation
ASC 718-10
25-18 Similarly, a provision for either direct or indirect (through a net-settlement feature) repurchase of shares issued upon exercise of options (or the vesting of nonvested shares), with any payment due employees withheld to meet the employer’s statutory withholding requirements resulting from the exercise, does not, by itself, result in liability classification of instruments that otherwise would be classified as equity. However, if the amount that is withheld, or may be withheld at the employee’s discretion, is in excess of the maximum statutory tax rates in the employees’ applicable jurisdictions, the entire award shall be classified and accounted for as a liability. That is, to qualify for equity classification, the employer must have a statutory obligation to withhold taxes on the employee’s behalf, and the amount withheld cannot exceed the maximum statutory tax rates in the employees’ applicable jurisdictions. The maximum statutory tax rates are based on the applicable rates of the relevant tax authorities (for example, federal, state, and local), including the employee’s share of payroll or similar taxes, as provided in tax law, regulations, or the authority’s administrative practices, not to exceed the highest statutory rate in that jurisdiction, even if that rate exceeds the highest rate that may be applicable to the specific award grantee.
25-19 Paragraph superseded by Accounting Standards Update No. 2016-09.
25-19A Paragraph 230-10-45-15 provides guidance on the classification on the statement of cash flows for cash paid to a tax authority by an employer when withholding shares from an employee’s award for tax-withholding purposes.
In connection with an entity’s statutory tax withholding obligation, many
share-based payment awards permit the entity to repurchase, either directly or
indirectly through a net settlement feature, a portion of the shares that would
otherwise be issued to employees (e.g., upon vesting of restricted stock or upon
stock option exercise). ASC 718-10-25-18 contains an exception to liability
classification for this share repurchase feature. Specifically, the net
settlement of an award for statutory tax withholding purposes would not, by
itself, result in liability classification of the award provided that (1) the
entity has a statutory obligation to withhold taxes on the employees’ behalf and
(2) the amount withheld for taxes does not exceed the maximum statutory tax
rates in the employees’ relevant tax jurisdictions. The maximum statutory tax
rate is based on the highest statutory tax rate in the employees’ jurisdictions
(determined on a jurisdiction-by-jurisdiction basis), even if that rate is more
than the highest rate applicable to a specific employee. If the amount withheld
exceeds the maximum statutory tax rate, the entire award is classified as a
liability.
If an entity issues an award to a grantee that meets the definition of an
employee under ASC 718-10 (i.e., is a common law employee) but the entity does
not have a statutory obligation to withhold taxes on behalf of the common law
employee, the exception to liability accounting under ASC 718-10-25-18 does not
apply.
5.7.2.1 Hypothetical Withholdings
If employees work in multiple jurisdictions (e.g., mobile employees) or are on
international assignment (e.g., “ex-pat” employees), an entity may apply a
“hypothetical” withholding rate to net settle their share-based payment
awards. The hypothetical amount for an ex-pat employee, for example, might
be based on the rate that would apply if the employee remained in the United
States. To avoid liability classification, the entity must have a statutory
obligation to withhold taxes on the employee’s behalf, and the amount
withheld cannot exceed the maximum statutory tax rates in the employee’s
relevant tax jurisdictions. If a third-party service provider is involved in
administering a company’s stock plan, management should take steps to ensure
that the service provider is (1) sufficiently conversant with the statutory
tax withholding obligations in the applicable jurisdiction(s) and (2) has
access to the necessary human resources and employment information needed to
calculate the minimum withholding.
5.7.2.2 Cash Settlement of Fractional Shares
Because shares are typically withheld from employees in whole-number increments (the issuance of fractional shares is typically prohibited), the value of a fractional share may be paid in cash directly to the employee. For example, if 24.3 shares would be withheld to satisfy the entity’s statutory tax withholding obligation, the entity typically withholds 25 shares and pays the difference (the value of a fractional 0.7 share) in cash directly to the employee. ASC 718-10-25-18 does not appear to require liability classification of an award as a result of a policy in which fractional shares must be cash settled. Therefore, if the cash-settled portion is considered de minimis to the employee, it is not considered a violation of ASC 718-10-25-18 to round up shares to meet the entity’s statutory tax withholding obligation (up to the maximum statutory tax rate(s) in the employee’s applicable jurisdiction(s)). However, an entity should evaluate the facts and circumstances of each arrangement to ensure that (1) its substance does not create a liability and (2) the cash settlement of the fractional share is, in fact, de minimis to the employee.
An arrangement may be a liability in substance, though, if (1) there are multiple exercises in small increments (thereby increasing the number of fractional shares that are cash settled and thus the amount of cash paid to a single employee) and (2) the entity’s per-share stock price is so high that the cash paid for a fractional share could be significant.
5.7.2.3 Changes in the Amount Withheld
The classification of awards can be affected by the manner in which an entity
remits tax savings to employees as a result of overpayments made during the
year to tax authorities to meet the entity’s statutory tax withholding
obligation. The example below illustrates how changes in the amount withheld
to meet an entity’s statutory tax withholding obligation can affect an
award’s classification.
Example 5-19
Entity A has a statutory tax withholding obligation for an employee’s restricted
stock award. The tax authorities allow A to
calculate the amount of taxes due on any date from
the vesting date of an award to A’s year-end. For
administrative ease, on the vesting date, A (1)
withheld, on the basis of the fair value of the
shares on that date, the amount of shares whose fair
value is equal to the employee’s taxes by applying
the maximum statutory tax rate in the employee’s
jurisdiction and (2) remitted that amount to the tax
authorities. At year-end, A decides to recalculate
the tax withholding amount (also by applying the
maximum statutory tax rate in the employee’s
jurisdiction), which results in a decreased
withholding because of a decrease in the fair value
of the entity’s shares from the vesting date. The
entity requests a refund from the tax authorities
for the overpayment and then remits the overpayment
to the employee.
Entity A’s classification of the award depends on how it remits the tax savings
(i.e., refund of overpayment) to the employee. If
the overpayment is remitted to the employee in cash,
the transaction substantively represents the
repurchase of shares for an amount in excess of the
maximum statutory tax rate in the employee’s
jurisdiction. As a result, in such circumstances,
the entire award would have to be classified as a
liability in accordance with ASC 718-10-25-18.
Alternatively, if the tax savings are remitted to
the employee in shares, A should, to avoid any
adverse accounting consequences, determine the
number of shares remitted to the employee by using
the fair value of the shares on the vesting date. In
essence, A would divide the employee’s tax
withholding determined at year-end (on the basis of
the maximum statutory tax rate in the employee’s
jurisdiction and the fair value of the shares on
that date) by the fair value of the shares as of the
vesting date to determine the amount that would have
been withheld as of the vesting date if A had known
the employee’s year-end taxes (on the basis of the
maximum statutory tax rate) as of the vesting date.
The excess number of shares between the new
calculation and initial calculation would then be
remitted to the employee.
5.7.2.4 Nonemployee Director Tax Withholdings
While a nonemployee member of an entity’s board of directors may be treated similarly to an employee under ASC 718 (see Section 2.3), the director is not considered an employee under the IRS’s statutory withholding requirements. Because an entity does not have any statutory tax withholding requirements in the United States related to nonemployee directors, the entity would not qualify for the exception to liability classification in ASC 718-10-25-18. Thus, an entity’s practice of withholding shares to satisfy the director’s tax obligation would result in liability classification of the entire award. The same would be true for other nonemployee recipients of share-based payment awards for which statutory tax withholding requirements would not apply (e.g., partners of partnerships or limited liability companies).
5.8 Awards That Become Subject to Other Guidance
ASC 718-10
Awards May Become Subject to Other Guidance
35-9 Paragraphs 718-10-35-10 through 35-14 are intended to apply to those instruments issued in share-based payment transactions with employees and nonemployees accounted for under this Topic, and to instruments exchanged in a business combination for share-based payment awards of the acquired business that were originally granted to grantees of the acquired business and are outstanding as of the date of the business combination.
35-9A Paragraph superseded by
Accounting Standards Update No. 2020-06.
35-10 A freestanding financial
instrument or a convertible security issued to a grantee
that is subject to initial recognition and measurement
guidance within this Topic shall continue to be subject to
the recognition and measurement provisions of this Topic
throughout the life of the instrument, unless its terms are
modified after any of the following:
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- A grantee vests in the award and is no longer providing goods or services.
- A grantee vests in the award and is no longer a customer.
- A grantee is no longer an employee.
35-10A Only for
purposes of paragraph 718-10-35-10, a modification does not
include a change to the terms of an award if that change is
made solely to reflect an equity restructuring provided that
both of the following conditions are met:
- There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved, that is, the holder is made whole) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
- All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.
35-11 Other modifications of
that instrument that take place after a grantee vests in the
award and is no longer providing goods or services, is no
longer a customer, or is no longer an employee should be
subject to the modification guidance in paragraph
718-10-35-14. Following modification, recognition and
measurement of the instrument shall be determined through
reference to other applicable GAAP.
35-12 Once the classification of an instrument is determined, the recognition and measurement provisions of this Topic shall be applied until the instrument ceases to be subject to the requirements discussed in paragraph 718-10-35-10. Topic 480 or other applicable GAAP, such as Topic 815, applies to a freestanding financial instrument that was issued under a share-based payment arrangement but that is no longer subject to this Topic. This guidance is not intended to suggest that all freestanding financial instruments shall be accounted for as liabilities pursuant to Topic 480, but rather that freestanding financial instruments issued in share-based payment transactions may become subject to that Topic or other applicable GAAP depending on their substantive characteristics and when certain criteria are met.
35-13 Paragraph superseded by Accounting Standards Update No. 2016-09.
35-14 An entity may modify (including cancel and replace) or settle a fully vested, freestanding financial
instrument after it becomes subject to Topic 480 or other applicable GAAP. Such a modification or settlement
shall be accounted for under the provisions of this Topic unless it applies equally to all financial instruments of
the same class regardless of the holder of the financial instrument. Following the modification, the instrument
continues to be accounted for under that Topic or other applicable GAAP. A modification or settlement of a
class of financial instrument that is designed exclusively for and held only by grantees (or their beneficiaries)
may stem from the employment or vendor relationship depending on the terms of the modification or
settlement. Thus, such a modification or settlement may be subject to the requirements of this Topic. See
paragraph 718-10-35-10 for a discussion of changes to awards made solely to reflect an equity restructuring.
5.8.1 Awards Modified When the Grantee Is No Longer Providing Goods or Services
A share-based payment award that is subject to ASC 718 generally does not become
subject to other applicable GAAP unless the award is modified when (1) the
individual is no longer an employee, (2) the nonemployee has vested in the award
and is no longer providing goods or services, or (3) the grantee is no longer a
customer. Modifications made to an award when the holder is no longer an
employee or the nonemployee has vested in the award and is no longer providing
goods or services should be accounted for under ASC 718-10-35-11 through 35-14.
After the modification, the award will become subject to other applicable GAAP
(e.g., ASC 815 and ASC 480). Note that once the award becomes subject to other
applicable GAAP, it is ineligible for any of ASC 718’s exceptions to liability
classification.
There are two exceptions to this guidance, however, related to (1) certain
equity restructurings (see the next section) and (2) convertible instruments
issued to nonemployees (see Section 9.5).
5.8.2 Equity Restructurings
ASC 718-10-35-10A clarifies the accounting treatment of changes to the terms of
a share-based payment award that are made solely to reflect an equity
restructuring. While an equity restructuring is considered a modification under
ASC 718-20-35-6, an entity does not treat it as a modification when applying ASC
718-10-35-10A (i.e., it is not subject to other applicable GAAP) if both of the
following conditions are met:
-
There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved. . .) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
-
All holders of the same class of equity instruments . . . are treated in the same manner.
5.9 Change in Classification Due to Change in Probable Settlement Outcome
ASC 718-10
Change in Classification Due to Change in Probable Settlement Outcome
35-15 An option or similar instrument that is classified as equity, but subsequently becomes a liability because the contingent cash settlement event is probable of occurring, shall be accounted for similar to a modification from an equity to liability award. That is, on the date the contingent event becomes probable of occurring (and therefore the award must be recognized as a liability), the entity recognizes a share-based liability equal to the portion of the award attributed to past performance (which reflects any provision for acceleration of vesting) multiplied by the award’s fair value on that date. To the extent the liability equals or is less than the amount previously recognized in equity, the offsetting debit is a charge to equity. To the extent that the liability exceeds the amount previously recognized in equity, the excess is recognized as compensation cost. The total recognized compensation cost for an award with a contingent cash settlement feature shall at least equal the fair value of the award at the grant date. The guidance in this paragraph is applicable only for options or similar instruments issued as part of compensation arrangements. That is, the guidance included in this paragraph is not applicable, by analogy or otherwise, to instruments outside share-based payment arrangements.
An award’s classification can change even if the terms and conditions are not modified. For example, an entity that can choose the settlement method of a stock option award could classify the award as equity upon initially concluding that it has the intent and ability to settle the award with shares. However, the entity could subsequently reclassify the award as a liability if it concludes that it no longer has the intent or ability to settle the award with shares (i.e., it will cash settle the option award). In addition, an entity that initially classifies a stock award as a liability (because a grantee has a noncontingent fair value put option on the shares) could reclassify the award as equity once the grantee has borne the risks and rewards of equity share ownership for six months after the stock award has vested, or for awards of stock options, six months after the option has been exercised.
If an award’s classification changes as a result of changes in an entity’s facts and circumstances (e.g., from equity-classified to liability-classified or vice versa), the entity should account for the change in a manner similar to a modification that changes classification, even if the award has not been modified. The accounting will depend on the classification of the award before and after the change in facts and circumstances. See Section 6.8 for further discussion of changes to the classification of an award as a result of its modification.
5.10 SEC Guidance on Temporary Equity
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
Background
1. This SEC staff announcement provides
the SEC staff’s views regarding the application of
Accounting Series Release No. 268, Presentation in
Financial Statements of “Redeemable Preferred
Stocks.”FN1
Scope
2. ASR 268 requires preferred securities
that are redeemable for cash or other assets to be
classified outside of permanent equity if they are
redeemable (1) at a fixed or determinable price on a fixed
or determinable date, (2) at the option of the holder, or
(3) upon the occurrence of an event that is not solely
within the control of the issuer. As noted in ASR 268, the
Commission reasoned that “[t]here is a significant
difference between a security with mandatory redemption
requirements or whose redemption is outside the control of
the issuer and conventional equity capital. The Commission
believes that it is necessary to highlight the future cash
obligations attached to this type of security so as to
distinguish it from permanent capital.”
3. Although ASR 268 specifically
describes and discusses preferred securities, the SEC staff
believes that ASR 268 also provides analogous guidance for
other redeemable equity instruments including, for example,
common stock, derivative instruments, noncontrolling
interests,FN2 securities held by an employee
stock ownership plan,FN3 and share-based payment
arrangements with employees.FN4 The SEC staff’s
views regarding the applicability of ASR 268 in certain
situations is described below. . . .
d. Share-based payment awards.
Equity-classified share-based payment arrangements
with employees are not subject to ASR 268 due solely
to either of the following:
-
Net cash settlement would be assumed pursuant to Paragraphs 815-40-25-11 through 25-16 solely because of an obligation to deliver registered shares.FN7
-
A provision in an instrument for the direct or indirect repurchase of shares issued to an employee exists solely to satisfy the employer’s minimum statutory tax withholding requirements (as discussed in Paragraphs 718-10-25-18 through 25-19). . . .
Classification
4. ASR 268 requires equity instruments
with redemption features that are not solely within the
control of the issuer to be classified outside of permanent
equity (often referred to as classification in “temporary
equity”). The SEC staff does not believe it is appropriate
to classify a financial instrument (or host contract) that
meets the conditions for temporary equity classification
under ASR 268 as a liability.FN10
5. Determining whether an equity
instrument is redeemable at the option of the holder or upon
the occurrence of an event that is solely within the control
of the issuer can be complex. The SEC staff believes that
all of the individual facts and circumstances surrounding
events that could trigger redemption should be evaluated
separately and that the possibility that any
triggering event that is not solely within the
control of the issuer could occur — without regard to
probability — would require the instrument to be classified
in temporary equity. . . .
Measurement
12. Initial measurement. The SEC
staff believes the initial carrying amount of a redeemable
equity instrument that is subject to ASR 268 should be its
issuance date fair value, except as follows: FN12
- For share-based payment arrangements with employees, the initial amount presented in temporary equity should be based on the redemption provisions of the instrument and the proportion of consideration received in the form of employee services at initial recognition. For example, upon issuance of a fully vested option that allows the holder to put the option back to the issuer at its intrinsic value upon a change in control, an amount representing the intrinsic value of the option at the date of issuance should be presented in temporary equity. . . .
13. Subsequent measurement. The
SEC staff’s views regarding the subsequent measurement of a
redeemable equity instrument that is subject to ASR 268 are
included in paragraphs 14–16. Paragraphs 14 and 15 discuss
the general views regarding subsequent measurement.
Paragraph 16 discusses the application of those general
views in the context of certain types of redeemable equity
instruments.
14. If an equity instrument subject to
ASR 268 is currently redeemable (for example, at the option
of the holder), it should be adjusted to its maximum
redemption amount at the balance sheet date. If the maximum
redemption amount is contingent on an index or other similar
variable (for example, the fair value of the equity
instrument at the redemption date or a measure based on
historical EBITDA), the amount presented in temporary equity
should be calculated based on the conditions that exist as
of the balance sheet date (for example, the current fair
value of the equity instrument or the most recent EBITDA
measure). The redemption amount at each balance sheet date
should also include amounts representing dividends not
currently declared or paid but which will be payable under
the redemption features or for which ultimate payment is not
solely within the control of the registrant (for example,
dividends that will be payable out of future
earnings).FN13
15. If an equity instrument subject to
ASR 268 is not currently redeemable (for example, a
contingency has not been met), subsequent adjustment of the
amount presented in temporary equity is unnecessary if it is
not probable that the instrument will become redeemable. If
it is probable that the equity instrument will become
redeemable (for example, when the redemption depends solely
on the passage of time), the SEC staff will not object to
either of the following measurement methods provided the
method is applied consistently:
- . Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates
- Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.
16. The following additional guidance is
relevant to the application of the SEC staff’s views in
paragraphs 14 and 15:
- For share-based payment arrangements with employees, the amount presented in temporary equity at each balance sheet date should be based on the redemption provisions of the instrument and should take into account the proportion of consideration received in the form of employee services (that is, the pattern of recognition of compensation cost pursuant to Topic 718). FN14 . . .
Reclassifications Into Permanent Equity
18. If classification of an equity instrument as temporary equity is no longer required (if, for example, a redemption feature lapses, or there is a modification of the terms of the instrument), the existing carrying amount of the equity instrument should be reclassified to permanent equity at the date of the event that caused the reclassification. Prior financial statements are not adjusted. Additionally, the SEC staff believes that it would be inappropriate to reverse any adjustments previously recorded to the carrying amount of the equity instrument (pursuant to paragraphs 14–16) in conjunction with such reclassifications.
__________________________________
FN1 ASR 268 (SEC Financial Reporting
Codification, Section No. 211, Redeemable Preferred
Stocks) is incorporated into SEC Regulation S-X,
Articles 5-02.27, 7-03.21, and 9-03.19. Hereafter, reference
is made only to ASR 268.
FN2 The Master Glossary defines noncontrolling
interest as “The portion of equity (net assets) in a
subsidiary not attributable, directly or indirectly, to a
parent. A noncontrolling interest is sometimes called a
minority interest.” ASR 268 applies to redeemable
noncontrolling interests (provided the redemption feature is
not considered a freestanding option within the scope of
Subtopic 480-10). Where relevant, specific classification
and measurement guidance pertaining to redeemable
noncontrolling interests has been included in this SEC staff
announcement.
FN3 ASR 268 applies to equity securities held by
an employee stock ownership plan (whether or not allocated)
that, by their terms, can be put to the registrant (sponsor)
for cash or other assets. Where relevant, specific
classification and measurement guidance pertaining to
employee stock ownership plans has been included in this SEC
staff announcement.
FN4 As indicated in Section 718-10-S99, ASR 268
applies to redeemable equity-classified instruments granted
in conjunction with share-based payment arrangements with
employees. Where relevant, specific classification and
measurement guidance pertaining to share-based payment
arrangements with employees has been included in this SEC
staff announcement.
FN7 See footnote 84 of Section 718-10-S99.
FN10 At the June 14, 2007 EITF meeting, the SEC
Observer stated that a financial instrument (or host
contract) that otherwise meets the conditions for temporary
equity classification may continue to be classified as a
liability provided the financial instrument (or host
contract) was classified and accounted for as a liability in
fiscal quarters beginning before September 15, 2007 and has
not subsequently been modified or subject to a remeasurement
(new basis) event.
FN12 SAB Topic 3C, Redeemable Preferred
Stock, states that the initial carrying amount of
redeemable preferred stock should be its fair value at date
of issue. The SEC staff believes this guidance should also
be applied to other similar redeemable equity instruments.
Consistent with Paragraph 820-10-30-3, the transaction price
will generally represent the initial fair value of the
equity instrument when the issuance occurs in an
arm’s-length transaction with an unrelated party and there
are no other unstated rights or privileges.
FN13 See also Section 260-10-45.
FN14 See also the Interpretative Response to
Question 2 in Section E of Section 718-10-S99.
SEC Staff Accounting Bulletins
SAB Topic 14.E, FASB ASC Topic 718,
Compensation — Stock Compensation, and Certain Redeemable
Financial Instruments
Certain financial instruments awarded in
conjunction with share-based payment arrangements have
redemption features that require settlement by cash or other
assets upon the occurrence of events that are outside the
control of the issuer.77 FASB ASC Topic 718
provides guidance for determining whether instruments
granted in conjunction with share-based payment arrangements
should be classified as liability or equity instruments.
Under that guidance, most instruments with redemption
features that are outside the control of the issuer are
required to be classified as liabilities; however, some
redeemable instruments will qualify for equity
classification.78 SEC Accounting Series
Release No. 268, Presentation in Financial Statements of
“Redeemable Preferred Stocks,”79 (“ASR 268”) and
related guidance80 address the classification and
measurement of certain redeemable equity instruments.
Facts: Under a
share-based payment arrangement, Company F grants to an
employee shares (or share options) that all vest at the end
of four years (cliff vest). The shares (or shares underlying
the share options) are redeemable for cash at fair value at
the holder’s option, but only after six months from the date
of share issuance (as defined in FASB ASC Topic 718).
Company F has determined that the shares (or share options)
would be classified as equity instruments under the guidance
of FASB ASC Topic 718. However, under ASR 268 and related
guidance, the instruments would be considered to be
redeemable for cash or other assets upon the occurrence of
events (e.g., redemption at the option of the holder)
that are outside the control of the issuer.
Question 1: While
the instruments are subject to FASB ASC Topic 718, is ASR
268 and related guidance applicable to instruments issued
under share-based payment arrangements that are classified
as equity instruments under FASB ASC Topic 718?
Interpretive
Response: Yes. The staff believes that registrants
must evaluate whether the terms of instruments granted in
conjunction with share-based payment arrangements that are
not classified as liabilities under FASB ASC Topic 718
result in the need to present certain amounts outside of
permanent equity (also referred to as being presented in
“temporary equity”) in accordance with ASR 268 and related
guidance.81
When an instrument ceases to be subject to
FASB ASC Topic 718 and becomes subject to the recognition
and measurement requirements of other applicable GAAP, the
staff believes that the company should reassess the
classification of the instrument as a liability or equity at
that time and consequently may need to reconsider the
applicability of ASR 268.
Question 2: How
should Company F apply ASR 268 and related guidance to the
shares (or share options) granted under the share-based
payment arrangements with employees that may be unvested at
the date of grant?
Interpretive
Response: Under FASB ASC Topic 718, when
compensation cost is recognized for instruments classified
as equity instruments, additional
paid-in-capital82 is increased. If the award
is not fully vested at the grant date, compensation cost is
recognized and additional paid-in-capital is increased over
time as services are rendered over the requisite service
period. A similar pattern of recognition should be used to
reflect the amount presented as temporary equity for
share-based payment awards that have redemption features
that are outside the issuer’s control but are classified as
equity instruments under FASB ASC Topic 718. The staff
believes Company F should present as temporary equity at
each balance sheet date an amount that is based on the
redemption amount of the instrument, but takes into account
the proportion of consideration received in the form of
employee services. Thus, for example, if a nonvested share
that qualifies for equity classification under FASB ASC
Topic 718 is redeemable at fair value more than six months
after vesting, and that nonvested share is 75% vested at the
balance sheet date, an amount equal to 75% of the fair value
of the share should be presented as temporary equity at that
date. Similarly, if an option on a share of redeemable stock
that qualifies for equity classification under FASB ASC
Topic 718 is 75% vested at the balance sheet date, an amount
equal to 75% of the intrinsic83 value of the
option should be presented as temporary equity at that
date.
Question 3: Would
the methodology described for employee awards in the
Interpretive Response to Question 2 above apply to
nonemployee awards to be issued in exchange for goods or
services with similar terms to those described above?
Interpretive
Response: The staff believes it would generally be
appropriate to apply the methodology described in the
Interpretive Response to Question 2 above to nonemployee
awards.
______________________________
77 The terminology “outside the
control of the issuer” is used to refer to any of the three
redemption conditions described in Rule 5-02.27 of
Regulation S-X that would require classification outside
permanent equity. That rule requires preferred securities
that are redeemable for cash or other assets to be
classified outside of permanent equity if they are
redeemable (1) at a fixed or determinable price on a fixed
or determinable date, (2) at the option of the holder, or
(3) upon the occurrence of an event that is not solely
within the control of the issuer.
78 FASB ASC paragraphs
718-10-25-6 through 718-10-25-19A.
79 ASR 268, July 27, 1979, Rule
5-02.27 of Regulation S-X.
80 Related guidance includes EITF Topic No. D-98, "Classification and Measurement of
Redeemable Securities," included in the FASB ASC in
paragraph 480-10-S99-3A.
81 Instruments granted in
conjunction with share-based payment arrangements with
employees that do not by their terms require redemption for
cash or other assets (at a fixed or determinable price on a
fixed or determinable date, at the option of the holder, or
upon the occurrence of an event that is not solely within
the control of the issuer) would not be assumed by the staff
to require net cash settlement for purposes of applying ASR
268 in circumstances in which FASB ASC Section 815-40-25,
Derivatives and Hedging — Contracts in Entity’s Own Equity —
Recognition, would otherwise require the assumption of net
cash settlement. See FASB ASC paragraph 815-40-25-11
(See FASB ASC paragraph 815-10-65-1 for the transition and
effective date information related to FASB ASU No. 2020-06,
Debt — Debt With Conversion and Other Options
(Subtopic 470-20) and Derivatives and Hedging —
Contracts in Entity's Own Equity (Subtopic 815-40):
Accounting for Convertible Instruments and Contracts in
an Entity's Own Equity, which superseded FASB ASC
paragraph 815-40-25-11.), which states, in part: “. . . the
events or actions necessary to deliver registered shares are
not controlled by an entity and, therefore, except under the
circumstances described in FASB ASC paragraph 815-40-25-16,
if the contract permits the entity to net share or
physically settle the contract only by delivering registered
shares, it is assumed that the entity will be required to
net cash settle the contract.” See also FASB ASC
subparagraph 718-10-25-15(a).
82 Depending on the fact pattern,
this may be recorded as common stock and additional paid in
capital.
83 The potential redemption
amount of the share option in this illustration is its
intrinsic value because the holder would pay the exercise
price upon exercise of the option and then, upon redemption
of the underlying shares, the company would pay the holder
the fair value of those shares. Thus, the net cash outflow
from the arrangement would be equal to the intrinsic value
of the share option. In situations where there would be no
cash inflows from the share option holder, the cash required
to be paid to redeem the underlying shares upon the exercise
of the put option would be the redemption value.
To determine the classification of an award otherwise classified as equity under
ASC 718, SEC registrants must consider the requirements of ASR 268 (FRR Section 211)
and ASC 480-10-S99-3A, as discussed in SAB Topic 14.E, on redeemable securities. SEC
registrants must present outside of permanent equity (i.e., as temporary or
mezzanine equity) share-based payment awards (otherwise classified as equity) that
are subject to redemption features not solely within the control of the issuer
(e.g., upon the occurrence of a triggering event such as a change in control of the
issuer). Temporary-equity classification may be required even if the share-based
payment awards otherwise qualify for equity classification under ASC 718 (e.g., a
stock award that is contingently puttable by the grantee more than six months after
vesting at the then-current fair value). Exceptions include the following:
-
The award does not require redemption for cash or other assets, and cash settlement would be possible only upon the issuer’s inability to deliver registered shares (as described in ASC 815-40-25-11 through 25-16).
-
The award permits direct or indirect share repurchases only to satisfy the issuer’s statutory tax withholding requirements (as described in ASC 718-10-25-18).
The following are examples of situations in which awards would be classified in
temporary equity (provided that liability classification would not be required
because of other features):
-
A stock award that may allow the grantee the right to require the issuer to repurchase shares for fair value at any time after six months from the date on which the shares are fully vested.
-
A stock award that would be settled in cash upon a triggering event that is not solely within the control of the issuer (e.g., upon a change in control of the issuer).
-
A stock option that may give the grantee the right to require the issuer to repurchase the option at the current intrinsic value upon a change in control.
ASC 480-10-S99-3A and SAB Topic 14.E require that SEC registrants recognize and measure an award with redemption features not solely within the control of the issuer in temporary equity as follows:
- At the award’s issuance, the entity should base the carrying value on its redemption value and the proportion attributed to the employee requisite service rendered or nonemployee’s vesting period recognized to date. This view is consistent with the treatment of compensation cost that increases over time as services are rendered over the requisite service period, which is addressed in the SEC staff’s response to Question 2 of SAB Topic 14.E.
- Until the award’s settlement, the entity should remeasure the award at the end of the reporting period on the basis of its redemption value and the proportion attributed to the employee requisite services rendered or nonemployee’s vesting period recognized to date. In other words, as the award begins to vest, the redemption amount would be accreted to temporary equity in accordance with the employee requisite services rendered or the nonemployee’s vesting period. Note that remeasurement is not required for an award issued with contingent repurchase features if it is not considered probable that the contingency would occur. The assessment of probability is generally performed on an individual-grantee basis.
- The amount of compensation cost recognized should be based on the award’s grant-date fair-value-based measure. Changes in the redemption value after the award is granted are recorded in equity and not as compensation cost recognized in earnings.
The redemption value at issuance is based on the redemption feature of the
award. For example, the redemption value of an award that is redeemable at intrinsic
value is the intrinsic value of the award. Thus, if a stock option is granted
at-the-money, its initial redemption value is zero. This is because when an option
is settled, the grantee receives the difference between the fair value of the
underlying shares and the exercise price (which are the same for an at-the-money
option). Alternatively, the redemption value of an option that is redeemable at fair
value is the fair value of the option. In a situation in which a stock option is
granted and the underlying share is redeemable at fair value, the redemption value
of the stock option is the intrinsic value and, after exercise, the redemption value
of the share is the fair value of the share. Subsequent remeasurement (if required
under ASC 480-10-S99-3A) will be based on the fair value of the issuer’s shares in
each period, less the exercise price of the award, if any. For guidance on
reclassifications between permanent and temporary equity, see Section 9.7.4 of Deloitte’s
Roadmap Distinguishing
Liabilities From Equity.
The example below illustrates the application of ASR 268 and ASC 480-10-S99-3A
to stock awards with repurchase features. Example 5-21 illustrates the application of
ASR 268 and ASC 480-10-S99-3A to stock options with a contingent cash settlement
feature.
Example 5-20
On January 1, 20X1, Entity A, an SEC registrant, grants 100,000 shares of restricted stock to an employee. The stock awards vest at the end of the fourth year of service (cliff vesting). The stock awards give the employee the right to require A to buy back A’s shares at their then-current fair value any time after six months from the date the stock awards are fully vested. The fair value of the shares is as follows:
- $10 on January 1, 20X1.
- $12 on December 31, 20X1.
- $7 on December 31, 20X2.
- $11 on December 31, 20X3.
- $14 on December 31, 20X4.
The repurchase feature will not result in liability classification of the stock awards since the employee will bear the risks and rewards of share ownership for a period of more than six months after the stock awards have vested. However, as an SEC registrant, A must apply ASR 268 and ASC 480-10-S99-3A. That guidance requires an SEC registrant to present outside of permanent equity (i.e., as temporary or mezzanine equity) share-based payment awards (otherwise classified as equity) that are subject to redemption features not solely within the control of the issuer.
Entity A should record the following journal entries:
Example 5-21
On January 1, 20X1, Entity A, an SEC registrant, grants 100,000 stock options to
an employee, each with a grant-date fair-value-based measure
of $8. The options are granted with a $10 exercise price
when A’s share price is $15 (i.e., the options have an
intrinsic value of $5 per share on the grant date). The
options vest at the end of the second year of service (cliff
vesting) and give the employee the right to require A to net
cash settle the options upon a change in control. On
February 1, 20X3, when the fair-value-based measure of the
options is $15, a change in control becomes probable. Note
that in accordance with ASC 805-20-55-50 and 55-51, which
discuss liabilities that are triggered upon the consummation
of a business combination, a change in control is generally
not considered probable until it occurs.
From the date of issuance, January 1, 20X1, to January 31, 20X3, the cash
settlement feature will not result in liability
classification of the options since the change in control is
not considered probable. However, on February 1, 20X3, when
the change in control becomes probable (i.e., the date it
occurs), the options must be reclassified as a share-based
liability. The reclassification is accounted for in a manner
similar to a modification that changes the awards’
classification from equity to liability. That is, on the
date the change in control occurs, A recognizes a
share-based liability for the portion of the options that
are related to prior service, multiplied by the options’
fair-value-based measure on that date. If the amount
recognized as a share-based liability is less than or equal
to the amount previously recognized in equity, the
offsetting amount is recorded to APIC (i.e., final
compensation cost cannot be less than the grant-date
fair-value-based measure). If, on the other hand, the amount
recognized as a share-based liability is greater than the
amount previously recognized in equity, the excess is
recognized as compensation cost either immediately (for
vested options) or over the remaining service (vesting)
period (for unvested options). Because the options are now
classified as a liability, they are remeasured at a
fair-value-based measure in each reporting period until
settlement.
In addition, as an SEC registrant, A must apply ASR 268 and ASC 480-10-S99-3A. As a result, from the date of issuance, January 1, 20X1, to January 31, 20X3, A must classify any grant-date intrinsic value outside of permanent equity (i.e., as temporary or mezzanine equity). ASC 480-10-S99-3A does not require subsequent remeasurement in temporary equity unless it is probable that the triggering event will occur. However, as noted above, on February 1, 20X3, when the change in control becomes probable, the options must be reclassified as a share-based liability.
Entity A should record the following journal entries:
Chapter 6 — Modifications
Chapter 6 — Modifications
6.1 Accounting for the Effects of Modifications
ASC 718-10 — Glossary
Modification
A change in the terms or conditions of a
share-based payment award.
ASC
718-20
Modification of an Award
35-2A An entity shall account for
the effects of a modification as described in paragraphs
718-20-35-3 through 35-9, unless all the following are
met:
- The fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the modified award is the same as the fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the original award immediately before the original award is modified. If the modification does not affect any of the inputs to the valuation technique that the entity uses to value the award, the entity is not required to estimate the value immediately before and after the modification.
- The vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified.
- The classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified.
The disclosure requirements in
paragraphs 718-10-50-1 through 50-2A and 718-10-50-4 apply
regardless of whether an entity is required to apply
modification accounting.
35-3 Except
as described in paragraph 718-20-35-2A, a modification of
the terms or conditions of an equity award shall be treated
as an exchange of the original award for a new award. In
substance, the entity repurchases the original instrument by
issuing a new instrument of equal or greater value,
incurring additional compensation cost for any incremental
value. The effects of a modification shall be measured as
follows:
- Incremental compensation cost shall be measured as the excess, if any, of the fair value of the modified award determined in accordance with the provisions of this Topic over the fair value of the original award immediately before its terms are modified, measured based on the share price and other pertinent factors at that date. As indicated in paragraph 718-10-30-20, references to fair value throughout this Topic shall be read also to encompass calculated value. The effect of the modification on the number of instruments expected to vest also shall be reflected in determining incremental compensation cost. The estimate at the modification date of the portion of the award expected to vest shall be subsequently adjusted, if necessary, in accordance with paragraph 718-10-35-1D or 718-10-35-3 and other guidance in Examples 14 through 15 (see paragraphs 718-20-55-107 through 55-121).
- 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 performance or service
conditions of the original award are not expected to
be satisfied. Thus, the total compensation cost
measured at the date of a modification shall be the
sum of the following:
-
The portion of the grant-date fair value of the original award for which the promised good is expected to be delivered (or has already been delivered) or the service is expected to be rendered (or has already been rendered) at that date
-
The incremental cost resulting from the modification.
Compensation cost shall be subsequently adjusted, if necessary, in accordance with paragraph 718-10-35-1D or 718-10-35-3 and other guidance in Examples 14 through 15 (see paragraphs 718-20-55-107 through 55-121). -
- A change in compensation cost for an equity award measured at intrinsic value in accordance with paragraph 718-20-35-1 shall be measured by comparing the intrinsic value of the modified award, if any, with the intrinsic value of the original award, if any, immediately before the modification.
35-3A 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 assess at the date of the
modification whether the performance or service conditions
of the original award are expected to be satisfied when
measuring the effects of the modification in accordance with
paragraph 718-20-35-3. However, the entity shall apply its
accounting policy to account for forfeitures when they occur
when subsequently accounting for the modified
award.
35-4
Examples 12 through 16 (see paragraphs 718-20-55-93 through
55-144) provide additional guidance on, and illustrate the
accounting for, modifications of both vested and nonvested
awards, including a modification that changes the
classification of the related financial instruments from
equity to liability or vice versa, and modifications of
vesting conditions. Paragraphs 718-10-35-9 through 35-14
provide additional guidance on accounting for modifications
of certain freestanding financial instruments that initially
were subject to this Topic but subsequently became subject
to other applicable generally accepted accounting principles
(GAAP).
Cancellation and
Replacement
35-8 Except as described in
paragraph 718-20-35-2A, cancellation of an award accompanied
by the concurrent grant of (or offer to grant) a replacement
award or other valuable consideration shall be accounted for
as a modification of the terms of the cancelled award. (The
phrase offer to grant is intended to cover situations
in which the service inception date precedes the grant
date.) Therefore, incremental compensation cost shall be
measured as the excess of the fair value of the replacement
award or other valuable consideration over the fair value of
the cancelled award at the cancellation date in accordance
with paragraph 718-20-35-3. Thus, the total compensation
cost measured at the date of a cancellation and replacement
shall be the portion of the grant-date fair value of the
original award for which the promised good is expected to be
delivered (or has already been delivered) or the service is
expected to be rendered (or has already been rendered) at
that date plus the incremental cost resulting from the
cancellation and replacement.
The guidance in this chapter primarily applies to modifications of
equity-classified share-based payment awards. Since liability awards are remeasured
at their fair value at the end of each reporting period, an entity does not need to
apply special guidance when accounting for modifications of such awards if their
classification does not change. See Section 6.8 for a discussion of modifications
that result in a change in classification, and see Section 7.4 for a discussion of modifications
of liability-classified awards.
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 certain factors are the same immediately before and
after the modification. As shown below, the three criteria in ASC 718-20-35-2A must
be met for a change in the terms or conditions of a share-based payment award not to
be accounted for as a modification under ASC 718-20-35-3.
1
Compare calculated value or intrinsic value, rather than
fair value, if such an alternative measurement method is used. See
Section
6.1.1 for additional discussion of the determination of
whether the fair value (or calculated or intrinsic value) of the
modified award equals that of the original award immediately before the
change occurs in the terms and conditions of the agreement.
A modification under ASC 718 is viewed as an exchange of the
original award for a new award, typically one with equal or greater value because
(1) share-based payment awards are meant to incentivize (rather than disincentivize)
employees and (2) the legal form of such an award may prevent the grantor from
modifying it without the consent of the grantee, and a grantee is not likely to
agree to a modification that results in an award of lesser value. However, if the
award is for stock options, the fair-value-based measure may be less than the
fair-value-based measure of the original award because a shorter vesting period may
result in a shorter expected term.
Any incremental value of the new (or modified) award generally is recorded as
additional compensation cost on the modification date (for vested awards) or over
the remaining vesting period (for unvested awards). The incremental value (i.e.,
incremental compensation cost) is computed as the excess of the fair-value-based
measure of the modified award on the modification date over the fair-value-based
measure of the original award immediately before the modification.
In addition to considering whether a modification results in
incremental compensation cost that must be recognized, an entity must determine
whether it should recognize the award’s original grant-date fair-value-based measure
for equity-classified awards. Total recognized compensation cost attributable to an
equity award that has been modified is, at least, the grant-date fair-value-based
measure of the original award unless the original award is not expected to vest
under its original terms (i.e., the service condition, the performance condition, or
neither is expected to be achieved). (See Sections 6.3.3 and 6.3.4 for illustrations of awards that have
been modified and are not expected to vest under the original vesting conditions.)
Therefore, total recognized compensation cost attributable to an award that has been
modified is generally the sum of (1) the grant-date fair-value-based measure of the
original award for which vesting has occurred or is expected to occur and (2) the
incremental compensation cost conveyed to the holder of the award as a result of the
modification, if any. However, if the original award is not expected to vest under
its original terms, any compensation cost recognized is based on the
modification-date fair-value-based measure of the modified award (i.e., the
grant-date fair-value-based measure of the original award is disregarded).
The examples below illustrate the application of modification
accounting to equity-classified awards and are based on Example 1 in ASC 718-20-55-4
through 55-9.
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.
55-4C
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.
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.
Example 12: Modifications and
Settlements
55-93 The
following Cases illustrate the accounting for modifications
of the terms of an award (see paragraphs 718-20-35-3 through
35-4) and are based on Example 1, Case A (see paragraph
718-20-55-10), in which Entity T granted its employees
900,000 share options with an exercise price of $30 on
January 1, 20X5:
- Modification of vested share options (Case A)
- Share settlement of vested share options (Case B)
- Modification of nonvested share options (Case C)
- Cash settlement of nonvested share options (Case D).
55-93A
Cases A through D (see paragraphs 718-20-55-94 through
55-102) describe employee awards. Specifically, each case is
an extension of Case A in Example 1. 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 methodology for determining the
additional compensation cost that an entity should recognize
upon modification or settlement in paragraphs 718-20-55-94
through 55-102 is equally applicable to nonemployee awards
with the same features as the awards in Cases A through D
(that is, awards with a specified period of time for
vesting). Therefore, the guidance in those paragraphs may
serve as implementation guidance for similar nonemployee
awards.
55-93B
All aspects of Case A (see paragraph 718-20-55-94) and Case
B (see paragraph 718-20-55-97) that illustrate a
modification and share settlement of vested share options,
respectively, including the immediate recognition of any
additional compensation cost, should be the same for both
employee awards and nonemployee awards.
55-93C
The compensation cost attribution for awards to nonemployees
may be the same or different for employee awards in Case C
(see paragraph 718-20-55-98), which illustrates the
modification of a nonvested share option. 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.
55-93D
All aspects of Case D (see paragraph 718-20-55-102), which
illustrates a cash settlement of a nonvested share option,
including the immediate recognition of any additional
compensation cost, should be the same for both employee
awards and nonemployee awards. That is because the cash
settlement of a nonvested share option effectively vests the
share option.
Case A: Modification of Vested Share Options
55-94 On
January 1, 20X9, after the share options have vested, the
market price of Entity T stock has declined to $20 per
share, and Entity T decides to reduce the exercise price of
the outstanding share options to $20. In effect, Entity T
issues new share options with an exercise price of $20 and a
contractual term equal to the remaining contractual term of
the original January 1, 20X5, share options, which is 6
years, in exchange for the original vested share options.
Entity T incurs additional compensation cost for the excess
of the fair value of the modified share options issued over
the fair value of the original share options at the date of
the exchange, measured as shown in the following paragraph.
A nonpublic entity using the calculated value would compare
the calculated value of the original award immediately
before the modification with the calculated value of the
modified award unless an entity has ceased to use the
calculated value, in which case it would follow the guidance
in paragraph 718-20-35-3(a) through (b) (calculating the
effect of the modification based on the fair value). The
modified share options are immediately vested, and the
additional compensation cost is recognized in the period the
modification occurs.
55-95 The
January 1, 20X9, fair value of the modified award is $7.14.
To determine the amount of additional compensation cost
arising from the modification, the fair value of the
original vested share options assumed to be repurchased is
computed immediately before the modification. The resulting
fair value at January 1, 20X9, of the original share options
is $3.67 per share option, based on their remaining
contractual term of 6 years, suboptimal exercise factor of
2, $20 current share price, $30 exercise price, risk-free
interest rates of 1.5 percent to 3.4 percent, expected
volatility of 35 percent to 50 percent and a 1.0 percent
expected dividend yield. The additional compensation cost
stemming from the modification is $3.47 per share option,
determined as follows.
55-96
Compensation cost already recognized during the vesting
period of the original award is $10,981,157 for 747,526
vested share options (see paragraphs 718-20-55-14 through
55-17). For simplicity, it is assumed that no share options
were exercised before the modification. Previously
recognized compensation cost is not adjusted. Additional
compensation cost of $2,593,915 (747,526 vested share
options × $3.47) is recognized on January 1, 20X9, because
the modified share options are fully vested; any income tax
effects from the additional compensation cost are recognized
accordingly.
Case B: Share Settlement of Vested Share
Options
55-97 Rather
than modify the option terms, Entity T offers to settle the
original January 1, 20X5, share options for fully vested
equity shares at January 1, 20X9. The fair value of each
share option is estimated the same way as shown in Case A,
resulting in a fair value of $3.67 per share option. Entity
T recognizes the settlement as the repurchase of an
outstanding equity instrument, and no additional
compensation cost is recognized at the date of settlement
unless the payment in fully vested equity shares exceeds
$3.67 per share option. Previously recognized compensation
cost for the fair value of the original share options is not
adjusted.
Case C: Modification of Nonvested Share Options
55-98 On January 1, 20X6, 1 year
into the 3-year vesting period, the market price of Entity T
stock has declined to $20 per share, and Entity T decides to
reduce the exercise price of the share options to $20. The
three-year cliff-vesting requirement is not changed. In
effect, in exchange for the original nonvested share
options, Entity T grants new share options with an exercise
price of $20 and a contractual term equal to the 9-year
remaining contractual term of the original share options
granted on January 1, 20X5. Entity T incurs additional
compensation cost for the excess of the fair value of the
modified share options issued over the fair value of the
original share options at the date of the exchange
determined in the manner described in paragraphs
718-20-55-95 through 55-96. Entity T adds that additional
compensation cost to the remaining unrecognized compensation
cost for the original share options at the date of
modification and recognizes the total amount ratably over
the remaining two years of the three-year vesting period.
Because the original vesting provision is not changed, the
modification has an explicit service period of two years,
which represents the requisite service period as well. Thus,
incremental compensation cost resulting from the
modification would be recognized ratably over the remaining
two years rather than in some other pattern.
55-99 The
January 1, 20X6, fair value of the modified award is $8.59
per share option, based on its contractual term of 9 years,
suboptimal exercise factor of 2, $20 current share price,
$20 exercise price, risk-free interest rates of 1.5 percent
to 4.0 percent, expected volatilities of 35 percent to 55
percent, and a 1.0 percent expected dividend yield. The fair
value of the original award immediately before the
modification is $5.36 per share option, based on its
remaining contractual term of 9 years, suboptimal exercise
factor of 2, $20 current share price, $30 exercise price,
risk-free interest rates of 1.5 percent to 4.0 percent,
expected volatilities of 35 percent to 55 percent, and a 1.0
percent expected dividend yield. Thus, the additional
compensation cost stemming from the modification is $3.23
per share option, determined as follows.
55-100 On
January 1, 20X6, the remaining balance of unrecognized
compensation cost for the original share options is $9.79
per share option. Using a value of $14.69 for the original
option as noted in paragraph 718-20-55-9 results in
recognition of $4.90 ($14.69 ÷ 3) per year. The unrecognized
balance at January 1, 20X6, is $9.79 ($14.69 – $4.90) per
option. The total compensation cost for each modified share
option that is expected to vest is $13.02, determined as
follows.
55-101 That
amount is recognized during 20X6 and 20X7, the two remaining
years of the requisite service period.
Example 16: Modifications Regarding
an Award’s Classification
Case B: Equity to Equity Modification
(Share Options to Shares)
55-134
Equity to equity modifications also are addressed in
Examples 12 (see paragraph 718-20-55-93) and 14 (see
paragraph 718-20-55-107). This Case is based on Example 1,
Case A (see paragraph 718-20-55-10), in which Entity T
granted its employees 900,000 options with an exercise price
of $30 on January 1, 20X5. At January 1, 20X9, after 747,526
share options have vested, the market price of Entity T
stock has declined to $8 per share, and Entity T offers to
exchange 4 options with an assumed per-share-option fair
value of $2 at the date of exchange for 1 share of nonvested
stock, with a market price of $8 per share. The nonvested
stock will cliff vest after two years of service. All option
holders elect to participate, and at the date of exchange,
Entity T grants 186,881 (747,526 ÷ 4) nonvested shares of
stock. Entity T considers the guidance in paragraph
718-20-35-2A. Because the change in the terms or conditions
of the award changes the vesting conditions of the award,
Entity T applies modification accounting. However, because
the fair value of the nonvested stock is equal to the fair
value of the options, there is no incremental compensation
cost. Entity T will not make any additional accounting
entries for the shares regardless of whether they vest,
other than possibly reclassifying amounts in equity;
however, Entity T will need to account for the ultimate
income tax effects related to the share-based compensation
arrangement.
Example
6-1
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. The options vest at the end of the fourth
year of service (cliff vesting). On January 1, 20X4, A
modifies the options, which does not affect their remaining
requisite service period. The fair-value-based measure of
the original options immediately before modification is $4,
and the fair-value-based measure of the modified options is
$6.
Over the first three years of service, A records $6,750 (1,000 options × $9
grant-date fair-value-based measure × 75% for three of four
years of services rendered) of cumulative compensation cost.
On the modification date, A computes the incremental
compensation cost as $2,000, or ($6 fair-value-based measure
of modified options – $4 fair-value-based measure of
original options immediately before the modification) ×
1,000 options. The $2,000 incremental compensation cost is
recorded over the remaining year of service. In addition, A
records the remaining $2,250 of compensation cost over the
remaining year of service attributable to the original
options. Therefore, total compensation cost associated with
these options is $11,000 ($9,000 grant-date fair-value-based
measure + $2,000 incremental fair-value-based measure)
recorded over four years of required service for both the
original and modified options.
Example
6-2
Assume all the same facts as in the example above, except that the options
contain a graded vesting schedule (i.e., 25 percent of the
options vest at the end of each year of service). In
accordance with the accounting policy it has elected under
ASC 718-10-35-8, A records compensation cost on a
straight-line basis over the total requisite service period
for the entire award.
For the first three years of service, Entity A records $6,750 (1,000 options ×
$9 grant-date fair-value-based measure × 75% for three of
four years of services rendered) of cumulative compensation
cost. On the date of modification, A computes the
incremental compensation cost as $2,000, or ($6
fair-value-based measure of modified options – $4
fair-value-based measure of original options immediately
before the modification) × 1,000 options. Entity A records
$1,500 of incremental compensation cost immediately because
75 percent of the options have vested.
The remaining
$500 of incremental compensation cost is recorded over the
remaining year of service. In addition, A records the
remaining $2,250 of compensation cost over the remaining
year of service attributable to the original options.
Therefore, total compensation cost associated with these
options is $11,000 ($9,000 grant-date fair-value-based
measure + $2,000 incremental fair-value-based
measure).
Example
6-3
Entity B grants to its employees RSUs that are classified as equity and have a
fair-value-based measure of $1 million on the grant date.
Before the awards vest, B subsequently modifies them to add
a contingent fair-value repurchase feature on the underlying
shares. Assume that the addition of the repurchase feature
does not change the
fair-value-based measure of the awards or their
classification and that the fair-value-based measure on the
modification date is $1.5 million (both immediately before
and after the modification). In addition, there are no other
changes to the awards (including their vesting conditions).
In accordance with ASC 718-20-35-2A, B would not apply
modification accounting because the fair-value-based
measure, vesting conditions, and classification of the
awards are the same immediately before and after the
modification. Accordingly, irrespective of whether the
awards are expected to vest on the modification date, any
compensation cost recognized will continue to be based on
the grant-date fair-value-based measure of $1 million.
Changing Lanes
In May 2021, the FASB issued ASU
2021-04, which clarifies the accounting for
modifications of freestanding equity-classified written call options that
are within the scope of ASC 815-40 and remain equity classified after the
modification. The ASU specifies that when freestanding equity-classified
written call options that are within the scope of ASC 815-40 are modified or
exchanged to compensate grantees in a share-based payment arrangement, an
entity should recognize the effects of such modification by applying the
guidance in ASC 718; however, classification of the options would still be
subject to the requirements of ASC 815-40.
6.1.1 The Fair Value Assessment
Modification accounting is not required if certain conditions
are met, one of which is that the fair-value-based measure (or calculated value
or intrinsic value if such an alternative measurement method is used) must be
the same immediately before and after the modification.
6.1.1.1 Determining Whether a Fair Value Calculation Is Required
An entity will not always need to estimate the
fair-value-based measure of a modified award. An entity might instead be
able to determine whether the modification affects any of the inputs used in
the valuation technique performed for the award. For example, if an entity
changes the net-settlement terms of its share-based payment arrangements
related to statutory tax withholding requirements, that change is not likely
to affect any inputs used to value the awards. If none of the inputs are
affected, the entity would not be required to estimate the fair-value-based
measure immediately before and after the modification (i.e., the entity
could conclude that the fair-value-based measure is the same).
6.1.1.2 Considering Whether Compensation Cost Recognized Has Changed
The evaluation of whether the fair-value-based measure has
changed should not be based on whether the compensation cost recognized has
changed. If an entity makes a modification that changes the fair-value-based
measure of an award, modification accounting would be applied. An entity’s
assessment of whether to apply modification accounting does not take into
account a change in recognized compensation cost. For example, if a
modification changes the fair-value-based measure of an award but it is not
probable that the award will vest both immediately before and after the
modification (a “Type IV improbable-to-improbable” modification), there may
be no change in compensation cost recognized on the modification date
because there is no compensation cost before and after the modification
(compensation cost is recognized only if it is probable that the award will
vest). However, modification accounting would be required (and a new
measurement determined as of the modification date) because the
fair-value-based measure has changed; the new measurement should be used if
it becomes probable that the modified award will subsequently vest.
6.1.1.3 Determining the Unit of Account
In paragraphs BC19 and BC20 of ASU 2017-09, the
FASB discusses the unit of account an entity would apply in determining
whether an award’s fair-value-based measure is the same immediately before
and after a modification. The discussion addresses questions from
stakeholders about whether an entity should compare the value of an award
immediately before and after a modification on the basis of (1) “the total
instruments in an award to [a grantee] that are modified” or (2) “each
individual instrument awarded to [a grantee] that is modified.” The Board
indicates that the unit of account should be consistent with that applied
under other guidance in ASC 718 and with the definition of an award in the
ASC master glossary. That is, an entity should use as the unit of account
the total of all modified instruments in the award rather than each
individual modified instrument awarded to the grantee.
Example 6-4
Entity C grants 10,000 stock options that become
significantly out-of-the-money after the grant date.
To retain the award’s original fair value, C
modifies it by lowering the options’ exercise price
and reducing their quantity to 5,000. If C were to
compare the fair-value-based measure of a single
stock option in the original award immediately
before the modification with the fair-value-based
measure of a single stock option in the modified
award immediately after the modification, the
measure immediately before would be less than the
measure immediately after the modification. If a
single stock option were the unit of account, C
would be required to apply modification accounting.
However, C must base its assessment on the ASC
master glossary’s definition of an award. Although
this award contains multiple instruments, the unit
of account on which C performs the fair value
assessment is the total of all modified instruments
awarded to the employee. Accordingly, C compares the
fair-value-based measure of the original 10,000
stock options with the fair-value-based measure of
the modified 5,000 stock options. In accordance with
ASC 718-20-35-2A, C would not apply modification
accounting if the fair-value-based measure, vesting
conditions, and classification of the awards are the
same immediately before and after the
modification.
Example 6-5
Entity D grants 1,000 equity-classified stock
options to an employee. All 1,000 options are
granted at the same time and contain the same terms
and conditions. In accordance with the definition of
“award” in the ASC master glossary, the employee’s
award consists of 1,000 options. After the grant
date, the options become significantly
out-of-the-money, so D decides to reprice 500 of
them by reducing their exercise price. However, D
retains the original exercise price for the other
500 options. Accordingly, the 500 modified options
are now the award as well as the unit of account in
D’s assessment of whether it must apply modification
accounting. Because the fair-value-based measure of
the 500 modified options has increased, D applies
modification accounting. However, because the other
500 stock options were not modified, that award is
not subject to modification accounting and continues
to be recognized on the basis of its grant-date
fair-value-based measure. While all 1,000 stock
options were the award and the unit of account when
granted, only the 500 modified stock options are the
award and the unit of account for modification
accounting purposes because they were the only
instruments modified. In accordance with the
definition of “award” in the ASC master glossary,
“[r]eferences to an award also apply to a portion of
an award.”
6.1.1.4 Determining Whether the Fair Value Is the Same Before and After Modification
In determining whether modification accounting is
appropriate, some practitioners have expressed uncertainty about whether the
fair-value-based measure of an award must be exactly the same
immediately before and after the modification (i.e., a binary assessment) or
whether they can apply judgment on the basis of the significance of the
change in the fair-value-based measure. The FASB explained in ASU 2017-09
that it decided not to establish specific requirements regarding the use of
judgment in this assessment, observing that entities must use judgment to
apply other aspects of ASC 718 and do so without relying on specific
guidance. Accordingly, an entity may need to use judgment in certain
circumstances to determine whether the fair-value-based measure of an award
is the same immediately before and after a modification. For example, as a
result of using judgment, an entity may reasonably conclude that the
fair-value-based measure is the same when a difference is de minimis and the
facts and circumstances indicate that the intent of the modification was to
retain the award’s original fair value.
Example 6-6
Entity E grants to an employee 1,000
equity-classified stock options that become
significantly out-of-the-money after the grant date.
To retain the award’s original fair value, E decides
to replace the 1,000 stock options with 423 RSUs.
The fair-value-based measure of the 1,000 stock
options immediately before the modification is
$100,000, and the fair-value-based measure of the
423 RSUs is $100,010. The difference is de minimis
and solely attributable to E’s having rounded up the
423 RSUs, which it does because it is precluded from
issuing fractional shares. Accordingly, E concludes
that the fair-value-based measure of the award is
the same immediately before and after the
modification.
6.1.2 Examples of Changes for Which Modification Accounting Would or Would Not Be Required
The Background Information and Basis for Conclusions of ASU
2017-09 provides examples (that “are educational in nature, are not
all-inclusive, and should not be used to override the guidance in paragraph
718-20-35-2A”) of changes to awards for which modification accounting generally
would or would not be required. The table below summarizes those examples.
Share-based payment plans commonly contain clawback provisions
that allow an entity to recoup awards upon certain contingent events (e.g.,
termination for cause, violation of a noncompete provision, material financial
statement restatement), as discussed in Section 3.9. Under ASC 718-10-30-24, such clawback provisions
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.
Example 6-7
Entity F grants 100,000 equity-classified stock options
to its CEO. A year after the grant date, F modifies the
award to add a well-defined, objective, and
nondiscretionary clawback provision related to a
material restatement of F’s financial statements. Entity
F concludes that the modification does not change the
award’s fair-value-based measure, vesting conditions, or
classification. In assessing whether the award’s
fair-value-based measure changes as a result of the
modification, F determines that the addition of the
clawback provision does not affect any of the inputs
used in the valuation technique since clawback
provisions generally are not reflected in estimates of
the fair-value-based measure of awards. As a result, F
concludes that it is not required to apply modification
accounting.
6.1.3 Tax Effects of Award Modifications
Modification of share-based payment agreements may have unintended tax consequences.
For example, a modification may affect the U.S. federal tax treatment of a
nonstatutory option (i.e., an NQSO) under IRC Section 409A, which could have
significant tax consequences for the grantee of the share-based payment award (see
Section 4.12.2 for additional information on nonstatutory options
and IRC Section 409A) or result in a disqualifying event of an ISO (see Section 6.5.1.2).
In addition, modification of a share-based payment plan may change
the deductibility of awards issued to a “covered employee” under IRC Section 162(m)
and how the limitations are applied for income tax purposes. IRC Section 162(m)
applies differently to (1) compensation arrangements entered into before November 2,
2017 (that have not been materially modified on or after that date), and (2)
compensation arrangements entered into on or after November 2, 2017. Compensation
arrangements that were in place before this date are effectively “grandfathered”
(i.e., legacy requirements apply). However, if a modification occurs on or after
this date, the award may no longer qualify for this exception. See Section 10.2.3 of Deloitte’s Roadmap Income Taxes for
additional information.
Given the potential for unintended tax consequences associated with modifications to
share-based compensation plans, entities are urged to consult with their tax
advisers.
Footnotes
1
Compare calculated value or intrinsic value, rather than
fair value, if such an alternative measurement method is used. See
Section
6.1.1 for additional discussion of the determination of
whether the fair value (or calculated or intrinsic value) of the
modified award equals that of the original award immediately before the
change occurs in the terms and conditions of the agreement.
6.2 Modification Date
To determine the accounting period in which to record any incremental compensation cost resulting from an award’s modification as well as to measure the modification’s effect, an entity must establish a modification date. For example, if the award is fully vested, the entity recognizes any incremental cost entirely on the modification date. When establishing the modification date, the entity considers the same conditions it does when establishing the grant date for the original share-based payment award.
As discussed in Section 3.2, a grant date is generally considered to be the date on which all of the following conditions have been met:
- The entity and grantee have reached a mutual understanding of the key terms and conditions of the share-based payment award (see Sections 3.2.2, 3.2.3, and 3.2.5).
- 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).
- All necessary approvals have been obtained. 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 shareholder approval is required but management and the members of the board of directors control enough votes to approve the arrangement, shareholder approval is essentially a formality or perfunctory. 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 (see Section 3.2.1).
- For awards to employees, the recipient meets the definition of an employee (see Section 2.2 for guidance on the definition of an employee).
6.3 Impact of Vesting Conditions
ASC 718-20
Example 14: Modifications of Awards With Performance and Service Vesting Conditions
55-107 Paragraphs 718-10-55-60 through 55-63 note that awards may vest based on service conditions, performance conditions, or a combination of the two. Modifications of market conditions that affect exercisability or the ability to retain the award are not addressed by this Example. A modification of vesting conditions is accounted for based on the principles in paragraph 718-20-35-3; that is, total recognized compensation cost for an equity award that is modified shall at least equal the fair value of the award at the grant date unless, at the date of the modification, the performance or service conditions of the original award are not expected to be satisfied. If awards are expected to vest under the original vesting conditions at the date of the modification, an entity shall recognize compensation cost if either of the following criteria is met:
- The awards ultimately vest under the modified vesting conditions
- The awards ultimately would have vested under the original vesting conditions.
55-108 In contrast, if at the date of modification awards are not expected to vest under the original vesting conditions, an entity should recognize compensation cost only if the awards vest under the modified vesting conditions. Said differently, if the entity believes that the original performance or service vesting condition is not probable of achievement at the date of the modification, the cumulative compensation cost related to the modified award, assuming vesting occurs under the modified performance or service vesting condition, is the modified award’s fair value at the date of the modification. The following Cases illustrate the application of those requirements:
- Type I probable to probable modification (Case A)
- Type II probable to improbable modification (Case B)
- Type III improbable to probable modification (Case C)
- Type IV improbable to improbable modification (Case D).
A modification that changes an award’s vesting conditions is accounted for in
the same manner as any other modification; that is, it is “treated as an exchange of
the original award for a new award” in accordance with ASC 718-20-35-3. Generally,
total recognized compensation cost of a modified award is, at least, the grant-date
fair-value-based measure of the original award unless the original award is not
expected to vest under its original terms (i.e., the service condition, the
performance condition, or neither is expected to be met). Therefore, in many
circumstances, total recognized compensation cost attributable to an award that has
been modified is (1) the grant-date fair-value-based measure of the original award
for which the vesting conditions have been met (i.e., the number of awards that have
been earned) or is expected to be met and (2) the incremental compensation cost
conveyed to the holder of the award as a result of the modification.
If, on the date of modification, it is expected (probable) that an award will
vest under its original vesting conditions, an entity records compensation cost if
it determines that the award ultimately (1) vests under the modified vesting
conditions or (2) would have vested under the original vesting conditions. For
modifications of an award whose vesting was probable under the original vesting
conditions, when determining the ultimate compensation to recognize, an entity would
need to consider not only whether the award actually vests under the modified
vesting conditions but also whether the award would have vested under its original
terms. See Type I and Type II modifications in the table below.
By contrast, if it is not expected (improbable) on the date
of modification that the award will vest under its original
vesting conditions, an entity records compensation cost only
if the award vests under the modified vesting conditions.
That is, if the entity did not expect an award to vest on
the basis of the original vesting conditions on the date of
modification, it would not have recorded cumulative
compensation cost. If the award vests under the modified
vesting conditions, total recognized compensation cost is
based on the number of awards that vest and the
fair-value-based measure of the modified award on the date
of modification. The grant-date fair-value-based measure of
the original award is not considered. See Type III and Type
IV modifications in the table below.
|
The various types of modifications, their accounting results, and the bases for
recognition of compensation cost are summarized in the table below (along with
cross-references to the applicable implementation guidance in ASC 718-20-55 and
Deloitte guidance).
Type of Modification | Accounting Result | Basis for Recognition of Compensation Cost | ASC 718 Guidance | Deloitte Guidance |
---|---|---|---|---|
Probable-to-probable (Type I modification) | Record compensation cost if the award ultimately (1) vests under the modified
terms or (2) would have vested under the original terms | Grant-date fair-value-based measure plus incremental fair-value-based measure conveyed on the modification date, if any | ASC 718-20-55-111 and 55-112 | |
Probable-to-improbable (Type II modification) | Record compensation cost if the award ultimately (1) vests under the original
terms or (2) would have vested under the modified terms | Grant-date fair-value-based measure plus incremental fair-value-based measure conveyed on the modification date, if any | ASC 718-20-55-113 through 55-115 | See Section 6.3.2
for an example in
ASC 718-20 (Type
II modifications
are expected to
be rare) |
Improbable-to-probable (Type III modification) | Record compensation cost if the award vests under the modified terms | Modification-date fair-value-based measure | ASC 718-20-55-116 and 55-117 | |
Improbable-to-improbable (Type IV modification) | Record compensation cost if the award vests under the modified terms | Modification-date fair-value-based measure | ASC 718-20-55-118 and 55-119 |
Section 6.3.7 addresses the unit-of-account
determination in the assessment of modification type.
6.3.1 Probable to Probable Modifications
The example below is based on the same facts as in Example 1 in ASC 718-20-55-4
through 55-9 (see Section
6.1).
ASC 718-20
Example 14: Modifications of Awards With Performance and Service Vesting Conditions
55-109 Cases A through D are all based on the same scenario: Entity T grants 1,000 share options to each of 10 employees in the sales department. The share options have the same terms and conditions as those described in Example 1 (see paragraph 718-20-55-4), except that the share options specify that vesting is conditional upon selling 150,000 units of product A (the original sales target) over the 3-year explicit service period. The grant-date fair value of each option is $14.69 (see paragraph 718-20-55-9). For simplicity, this Example assumes that no forfeitures will occur from employee termination; forfeitures will only occur if the sales target is not achieved. Example 15 (see paragraph 718-20-55-120) provides an additional illustration of a Type III modification.
55-109A
Cases A through D (see paragraphs 718-20-55-111 through
55-119) describe employee awards because the Cases use
the terms and conditions of the employee awards
presented as part of Example 1 of this Subtopic (see
paragraph 718-20-55-4). However, the principles about
determining the cumulative amount of compensation cost
that an entity should recognize because of a
modification to an employee award provided in Cases A
through D are the same for nonemployee awards that are
modified. Consequently, the guidance in paragraphs
718-20-55-111 through 55-119 should be applied to
determine the cumulative amount of compensation cost
that an entity should recognize because of a
modification to a nonemployee award.
55-109B Any additional
compensation cost should be recognized by applying the
guidance in paragraph 718-10-25-2C. That is, an asset or
expense must 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 awards. 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.
55-110 Cases A through D assume that the options are out-of-the-money when modified; however, that fact is not determinative in the illustrations (that is, options could be in- or out-of-the-money).
Case A: Type I Probable to Probable Modification
55-111 Based on historical sales patterns and expectations related to the future, management of Entity T believes at the grant date that it is probable that the sales target will be achieved. On January 1, 20X7, 102,000 units of Product A have been sold. During December 20X6, one of Entity T’s competitors declared bankruptcy after a fire destroyed a factory and warehouse containing the competitor’s inventory. To push the salespeople to take advantage of that situation, the award is modified on January 1, 20X7, to raise the sales target to 154,000 units of Product A (the modified sales target). Notwithstanding the nature of the modification’s probability of occurrence, the objective of this Case is to demonstrate the accounting for a Type I modification. Additionally, as of January 1, 20X7, the options are out-of-the-money because of a general stock market decline. No other terms or conditions of the original award are modified, and management of Entity T continues to believe that it is probable that the modified sales target will be achieved. Immediately before the modification, total compensation cost expected to be recognized over the 3-year vesting period is $146,900 or $14.69 multiplied by the number of share options expected to vest (10,000). Because no other terms or conditions of the award were modified, the modification does not affect the per-share-option fair value (assumed to be $8 in this Case at the date of the modification). Moreover, because the modification does not affect the number of share options expected to vest, no incremental compensation cost is associated with the modification.
55-112 This paragraph illustrates the cumulative compensation cost Entity T should recognize for the modified award based on three potential outcomes:
- Outcome 1 — achievement of the modified sales target. In Outcome 1, all 10,000 share options vest because the salespeople sold at least 154,000 units of Product A. In that outcome, Entity T would recognize cumulative compensation cost of $146,900.
- Outcome 2 — achievement of the original sales target. In Outcome 2, no share options vest because the salespeople sold more than 150,000 units of Product A but less than 154,000 units (the modified sales target is not achieved). In that outcome, Entity T would recognize cumulative compensation cost of $146,900 because the share options would have vested under the original terms and conditions of the award.
- Outcome 3 — failure to achieve either sales target. In Outcome 3, no share options vest because the modified sales target is not achieved; additionally, no share options would have vested under the original terms and conditions of the award. In that case, Entity T would recognize cumulative compensation cost of $0.
Example 6-8
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. The options vest only if A’s cumulative net income over the succeeding four-year period is greater than $5 million. Because the options are expected to vest, A begins to recognize compensation cost on a straight-line basis over the four-year service period. See the journal entries below.
On January 1, 20X4, A believes that it is probable that the performance condition will be achieved. To provide additional retention incentives to the employees for the fourth year of service, A modifies the performance condition to decrease the cumulative net-income target to $4.5 million. After the modification, A continues to believe that the options are expected to vest on the basis of the revised cumulative net income target. The modification does not affect any of the options’ other terms or conditions.
If the modified performance condition ($4.5 million) is subsequently met, A will
ultimately record total compensation cost ($9,000) on
the basis of the number of options expected to vest
(1,000 options if there are no forfeitures) and the
grant-date fair-value-based measure of the options of $9
over the vesting period.2 Because the modification does not affect any of
the options’ other terms or conditions, presumably the
fair-value-based measure before and after the
modification will be the same. Accordingly, there is no
incremental value conveyed to the holder of the options
and, therefore, no incremental compensation cost has to
be recorded in connection with this modification. See
the journal entry below.
Alternatively, if the modified performance condition ($4.5 million) is not
subsequently met, the options would not have vested
under either the original or the modified terms.
Accordingly, A should not recognize any cumulative
compensation cost for these options (i.e., any
previously recognized compensation cost should be
reversed). See the journal entry below.
6.3.2 Probable-to-Improbable Modifications
As discussed in Section 6.1, share-based
payment awards are designed to incentivize (rather than disincentivize)
employees. In addition, the legal form of share-based payment awards may prevent
modification without the consent of the grantee. Therefore, a company is not
likely to make a change in a vesting condition that would result in a Type II
(probable-to-improbable) modification, and for this reason, such modifications
are rare.
The example below is based on the same facts as in ASC 718-20-55-109 through
55-110 (see Section
6.3.1).
ASC 718-20
Example 14: Modifications of Awards With Performance and Service Vesting Conditions
Case B: Type II Probable to Improbable Modification
55-113 It is generally believed that Type II modifications will be rare; therefore, this illustration has been provided for the sake of completeness. Based on historical sales patterns and expectations related to the future, management of Entity T believes that at the grant date, it is probable that the sales target (150,000 units of product A) will be achieved. At January 1, 20X7, 102,000 units of product A have been sold and the options are out-of-the-money because of a general stock market decline. Entity T’s management implements a cash bonus program based on achieving an annual sales target for 20X7. The options are neither cancelled nor settled as a result of the cash bonus program. The cash bonus program would be accounted for using the same accounting as for other cash bonus arrangements. Concurrently, the sales target for the option awards is revised to 170,000 units of Product A. No other terms or conditions of the original award are modified. Management believes that the modified sales target is not probable of achievement; however, they continue to believe that the original sales target is probable of achievement. Immediately before the modification, total compensation cost expected to be recognized over the 3-year vesting period is $146,900 or $14.69 multiplied by the number of share options expected to vest (10,000). Because no other terms or conditions of the award were modified, the modification does not affect the per-share-option fair value (assumed in this Case to be $8 at the modification date). Moreover, because the modification does not affect the number of share options expected to vest under the original vesting provisions, Entity T would determine incremental compensation cost in the following manner.
55-114 In determining the fair value of the modified award for this type of modification, an entity shall use the greater of the options expected to vest under the modified vesting condition or the options that previously had been expected to vest under the original vesting condition.
55-115 This paragraph illustrates the cumulative compensation cost Entity T should recognize for the modified award based on three potential outcomes:
- Outcome 1 — achievement of the modified sales target. In Outcome 1, all 10,000 share options vest because the salespeople sold at least 170,000 units of Product A. In that outcome, Entity T would recognize cumulative compensation cost of $146,900.
- Outcome 2 — achievement of the original sales target. In Outcome 2, no share options vest because the salespeople sold more than 150,000 units of Product A but less than 170,000 units (the modified sales target is not achieved). In that outcome, Entity T would recognize cumulative compensation cost of $146,900 because the share options would have vested under the original terms and conditions of the award.
- Outcome 3 — failure to achieve either sales target. In Outcome 3, no share options vest because the modified sales target is not achieved; additionally, no share options would have vested under the original terms and conditions of the award. In that case, Entity T would recognize cumulative compensation cost of $0.
6.3.3 Improbable-to-Probable Modifications
The example below is based on the same facts as in ASC 718-20-55-109 through
55-110 (see Section
6.3.1).
ASC 718-20
Example 14: Modifications of Awards With Performance and Service Vesting Conditions
Case C: Type III Improbable to Probable Modification
55-116 Based on historical sales patterns and expectations related to the future, management of Entity T believes at the grant date that none of the options will vest because it is not probable that the sales target will be achieved. On January 1, 20X7, 80,000 units of Product A have been sold. To further motivate the salespeople, the sales target (150,000 units of Product A) is lowered to 120,000 units of Product A (the modified sales target). No other terms or conditions of the original award are modified. Management believes that the modified sales target is probable of achievement. Immediately before the modification, total compensation cost expected to be recognized over the 3-year vesting period is $0 or $14.69 multiplied by the number of share options expected to vest (zero). Because no other terms or conditions of the award were modified, the modification does not affect the per-share-option fair value (assumed in this Case to be $8 at the modification date). Since the modification affects the number of share options expected to vest under the original vesting provisions, Entity T will determine incremental compensation cost in the following manner.
55-117 This paragraph illustrates the cumulative compensation cost Entity T should recognize for the modified award based on three potential outcomes:
- Outcome 1 — achievement of the modified sales target. In Outcome 1, all 10,000 share options vest because the salespeople sold at least 120,000 units of Product A. In that outcome, Entity T would recognize cumulative compensation cost of $80,000.
- Outcome 2 — achievement of the original sales target and the modified sales target. In Outcome 2, Entity T would recognize cumulative compensation cost of $80,000 because in a Type III modification the original vesting condition is generally not relevant (that is, the modified award generally vests at a lower threshold of service or performance).
- Outcome 3 — failure to achieve either sales target. In Outcome 3, no share options vest because the modified sales target is not achieved; in that case, Entity T would recognize cumulative compensation cost of $0.
Example 6-9
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. The options vest only if A’s cumulative net income over the succeeding four-year period is greater than $5 million. Entity A believes that it is probable that the performance condition will be met (i.e., the options are expected to vest). Accordingly, A begins to recognize compensation cost on a straight-line basis over the four-year service period. See the journal entries below.
On December 31, 20X3, on the basis of its financial performance over the preceding three years, A does not believe that it is probable that the performance condition will be met (i.e., the options are not expected to vest). Accordingly, A should reverse any previously recognized compensation cost associated with these options. That is, because A does not expect the options to vest, cumulative recognized compensation cost as of December 31, 20X3, is zero (0 options expected to vest × $9 grant-date fair-value-based measure):
On January 1, 20X4, to restore retention incentives to employees for the fourth year of service, A modifies the performance condition to decrease the cumulative net income target to $3 million. The fair-value-based measure of the modified award as of the modification date is $12. After the modification, A believes that the options are expected to vest on the basis of the revised cumulative net income target. The modification does not affect any of the award’s other terms or conditions. Accordingly, A will record total compensation cost ($12,000) on the basis of the number of options expected to vest (1,000 options if there are no forfeitures) and the modification-date fair-value-based measure of the options of $12 over the remaining year of service. As demonstrated in Case C of Example 14 in ASC 718-20-55-116 and 55-117, since it is improbable that the options will vest before the modification, the compensation cost is based on the modification-date fair-value-based measure of the modified options. See the journal entries below.
Alternatively, if the modified performance condition ($3 million) subsequently
is not met, the options will not vest, and A should not
recognize any cumulative compensation cost for them
(i.e., it should reverse any compensation cost related
to the modified award that was previously recognized in
20X4).
The example below illustrates the accounting for an award that is modified to
continue vesting in conjunction with a termination of employment.
ASC 718-20
Example 15: Illustration of a Type III Improbable to Probable Modification
55-120 This Example illustrates the guidance in paragraph 718-20-35-3.
55-120A
This Example (see paragraph 718-20-55-121) describes
employee awards. However, the principle provided in
paragraph 718-20-55-121 is the same for nonemployee
awards that are modified. Consequently, that guidance
should be applied to determine the cumulative amount of
compensation cost, if any, that an entity should
recognize because of a modification to a nonemployee
award.
55-120B
Any additional compensation cost should be recognized by
applying the guidance in paragraph 718-10-25-2C. That
is, an asset or expense must 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 awards. 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.
55-121 On January 1, 20X7, Entity Z issues 1,000 at-the-money options with a 4-year explicit service condition to each of 50 employees that work in Plant J. On December 12, 20X7, Entity Z decides to close Plant J and notifies the 50 Plant J employees that their employment relationship will be terminated effective June 30, 20X8. On June 30, 20X8, Entity Z accelerates vesting of all options. The grant-date fair value of each option is $20 on January 1, 20X7, and $10 on June 30, 20X8, the modification date. At the date Entity Z decides to close Plant J and terminate the employees, the service condition of the original award is not expected to be satisfied because the employees cannot render the requisite service. Because Entity Z’s accounting policy is to estimate the number of forfeitures expected to occur in accordance with paragraph 718-10-35-3, any compensation cost recognized before December 12, 20X7, for the original award would be reversed. At the date of the modification, the fair value of the original award, which is $0 ($10 × 0 options expected to vest under the original terms of the award), is subtracted from the fair value of the modified award $500,000 ($10 × 50,000 options expected to vest under the modified award). The total recognized compensation cost of $500,000 will be less than the fair value of the award at the grant date ($1 million) because at the date of the modification, the original vesting conditions were not expected to be satisfied. If Entity Z’s accounting policy was to account for forfeitures when they occur in accordance with paragraph 718-10-35-3, then compensation cost recognized before December 12, 20X7, would not be reversed until the award is forfeited. However, Entity Z would be required to assess at the date of the modification whether the performance or service conditions of the original award are expected to be satisfied.
6.3.3.1 Modification in Connection With a Termination — Entity Elects to Estimate Forfeitures
As discussed above, for an entity that has a policy of estimating forfeitures in accordance with ASC 718-10-35-3, any previously recognized compensation cost is reversed if a grantee is expected to terminate employment or a nonemployee arrangement to provide goods or services and the vesting requirements in an award are no longer expected to be met. If the award is modified to accelerate vesting, compensation cost will be recognized on the basis of the modification-date fair-value-based measure of the award.
Example 6-10
On January 1, 20X1, Entity A grants 1,000 at-the-money employee stock options to its CEO, each with a grant-date fair-value-based measure of $9. The options vest if the CEO is employed for a five-year period (cliff vesting). In addition, A has a policy of estimating forfeitures, and it recognizes compensation cost on a straight-line basis over the five-year service period. Entity A records the following journal entry each year:
On July 1, 20X3, the CEO decides to terminate employment. The CEO and A reach a
severance agreement that permits the CEO to vest in
the options upon termination as long as the CEO
continues to provide service through December 31,
20X3, while A searches for a new CEO. On July 1,
20X3, it is no longer probable that the service
condition of the original award will be met.
Accordingly, A should reverse previously recognized
compensation cost of $4,500 associated with the
original options (1,000 options × $9 grant-date
fair-value-based measure ÷ 5-year vesting period ×
2.5 years of service). That is, because A does not
expect the options to vest, cumulative recognized
compensation cost as of July 1, 20X3, should be zero
(0 options expected to vest × $9 grant-date
fair-value-based measure). See the journal entry
below.
The fair-value-based measure of the modified award as of the modification date
is $15. The modification does not affect any of the
other terms or conditions of the award, and A
believes that the CEO will provide the requisite
service period of six months. Accordingly, A will
record total compensation cost of $15,000 on the
basis of the number of options expected to vest
(1,000 options) and the modification-date
fair-value-based measure of the options of $15 over
the remaining service period (i.e., six months).
Since it is improbable that the options will vest
before the modification and probable that the
options will vest after the modification,
compensation cost is based on the modification-date
fair-value-based measure of the modified options.
See the journal entry below.
6.3.3.2 Modification in Connection With a Termination — Entity Elects to Account for Forfeitures When They Occur
As discussed in Section 3.4.1, ASC 718-10-35-3 permits an entity to elect to account for forfeitures as
they occur. However, 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 the award
is modified on the termination date to accelerate vesting, previously recognized compensation cost
is not reversed until the termination date, and compensation cost will continue to be recognized on
the basis of the original award’s grant-date fair-value-based measure until the termination date. On
the termination and modification date, previously recognized compensation cost is reversed, and
compensation cost is recognized on the basis of the modified award’s modification-date fair-value-based
measure.
However, an award may be modified before termination to accelerate vesting upon the planned future termination event. On the basis of discussions with the FASB staff, there are two acceptable views regarding the accounting for these improbable-to-probable modifications:
- View 1 — The original award is substantively forfeited upon modification. Because the award is modified and will be vested upon termination (i.e., the original award no longer exists and has been replaced by a new award), forfeiture does not occur on the termination date. In addition, the guidance in ASC 718-10-35-1D and ASC 718-10-35-3 allows entities to elect, as a policy, to account for forfeitures when they occur, but it was not intended to change the accounting for modifications. Therefore, previously recognized compensation cost for the original award should be reversed on the modification date. Compensation cost for the modified award should be determined on the basis of the modification-date fair-value-based measure and recognized over the employee’s remaining service period or nonemployee’s vesting period.
- View 2 — A forfeiture of the original award has not occurred upon modification (i.e., since employment has not yet been terminated or the nonemployee arrangement has not yet been terminated, the original award is not forfeited). Previously recognized compensation cost should not be reversed on the modification date. Instead, the modification-date fair-value-based measure of the modified award less the previously recognized compensation cost should be recognized over the employee’s remaining service period or nonemployee’s vesting period. If the modification-date fair-value-based measure of the modified award is lower than the previously recognized compensation cost, no further compensation cost is recognized, and that difference should be reversed upon termination when forfeiture of the original award has occurred.
If an award whose vesting becomes improbable as a result of a planned future termination is not modified, previously recognized compensation cost should not be reversed, and compensation cost should continue to be recognized until the award is forfeited (i.e., upon termination). Upon termination, previously recognized compensation cost is reversed.
Example 6-11
Assume the same facts as in Example 6-10,
except that Entity A has a policy of recognizing
forfeitures when they occur.
If A applies View 1 above, it would record the same journal entries as it did in
Example
6-10.
If it applies View 2, it would recognize compensation cost on a straight-line
basis over the five-year service period (as it did
in Example
6-10) and record the following journal
entry each year:
On July 1, 20X3, the award is modified. Because the original award has not been
forfeited, previously recognized compensation cost
is not reversed. Entity A will recognize the
modification-date fair-value-based measure of the
modified award of $15,000 (1,000 options × $15
modification-date fair-value-based measure) less the
previously recognized compensation cost of $4,500
(1,000 options × $9 grant-date fair-value-based
measure ÷ 5-year vesting period × 2.5 years of
service) over the remaining service period (i.e.,
six months). See the journal entry below.
6.3.4 Improbable-to-Improbable Modification
The example below is based on the same facts as in ASC 718-20-55-109 through
55-110 (see Section
6.3.1).
ASC 718-20
Example 14: Modifications of Awards With Performance and Service Vesting Conditions
Case D: Type IV Improbable to Improbable Modification
55-118 Based on historical sales patterns and expectations related to the future, management of Entity T believes that at the grant date it is not probable that the sales target will be achieved. On January 1, 20X7, 80,000 units of Product A have been sold. To further motivate the salespeople, the sales target is lowered to 130,000 units of Product A (the modified sales target). No other terms or conditions of the original award are modified. Entity T lost a major customer for Product A in December 20X6; hence, management continues to believe that the modified sales target is not probable of achievement. Immediately before the modification, total compensation cost expected to be recognized over the 3-year vesting period is $0 or $14.69 multiplied by the number of share options expected to vest (zero). Because no other terms or conditions of the award were modified, the modification does not affect the per-share-option fair value (assumed in this Case to be $8 at the modification date). Furthermore, the modification does not affect the number of share options expected to vest; hence, there is no incremental compensation cost associated with the modification.
55-119 This paragraph illustrates the cumulative compensation cost Entity T should recognize for the modified award based on three potential outcomes:
- Outcome 1 — achievement of the modified sales target. In Outcome 1, all 10,000 share options vest because the salespeople sold at least 130,000 units of Product A. In that outcome, Entity T would recognize cumulative compensation cost of $80,000 (10,000 × $8).
- Outcome 2 — achievement of the original sales target and the modified sales target. In Outcome 2, Entity T would recognize cumulative compensation cost of $80,000 because in a Type IV modification the original vesting condition is generally not relevant (that is, the modified award generally vests at a lower threshold of service or performance).
- Outcome 3 — failure to achieve either sales target. In Outcome 3, no share options vest because the modified sales target is not achieved; in that case, Entity T would recognize cumulative compensation cost of $0.
Share-based payment awards may contain a performance condition that requires an IPO to occur before the awards can vest. Compensation cost for such awards typically is not recognized before the IPO because an IPO generally is not considered probable until it occurs (see Section 3.4.2.1). Before and in contemplation of the occurrence of an IPO, entities may modify the terms and conditions of these types of awards. For example, an award that vests upon an IPO and a specified service period could be modified to reduce the specified service period. Although the modification is made in anticipation of the IPO, at the time of the modification, compensation cost is not recognized because the IPO has not yet occurred (i.e., it is still not probable that the award will vest). However, the effects of the modification are measured on the modification date. Since it is not probable that the original award
and the modified award will vest, the modification is considered a Type IV improbable-to-improbable
modification. As discussed above, when it is not probable as of the modification date that an award will
vest on the basis of its original terms, the original grant-date fair-value-based measure of compensation
cost is disregarded once the modification is made. Instead, in accordance with ASC 718-20-55-108,
any compensation cost recognized will be based on a new fair-value-based measure determined on
the modification date on the basis of the terms of the compensation cost. Once an IPO occurs, the
compensation cost will be recognized on the basis of the modification-date fair-value-based measure.
Many modifications are made before an IPO but are not effective unless the IPO occurs. While the date on which a contingent modification is made is generally the modification date for compensation cost measurement purposes, the accounting consequence may not be recognized until the IPO’s effective date if the modification is contingent on the IPO’s occurrence. For example, an award could be modified to increase the quantity of underlying shares upon a successful IPO. In this circumstance, any additional compensation cost (as determined on the modification date) would not be recognized until the IPO is effective.
In addition, there could be circumstances in which changes associated with an award that are not modifications result in accounting consequences. For example, an entity could grant an equity-classified award with a repurchase feature that causes the award to be liability-classified. If the original terms contain a provision that the repurchase feature will expire upon an IPO, however, the award would be reclassified from liability to equity upon the IPO. See Section 5.9 for further discussion of changes in classification as a result of changes in probable settlement outcomes.
Example 6-12
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. The options
vest only if A’s cumulative net income over the
succeeding four years is greater than $5 million and A
completes an IPO. Entity A believes that it is probable
that the net income performance condition will be met.
However, because an IPO is generally not considered
probable until it occurs (see Section 3.4.2.1),
A does not recognize any compensation cost.
On January 1, 20X4, because its
financial performance has deteriorated, A modifies the
net income performance condition to decrease the
cumulative net income target to $4 million. The
modification does not affect any of the options’ other
terms or conditions. The fair-value-based measure of the
modified options as of the modification date is $12.
Even though A expects the revised net
income target to be met, an IPO has not yet occurred and
is therefore still not considered probable (i.e., the
options are not expected to vest). Accordingly, total
recognized compensation cost for the modified award is
zero (0 options expected to vest × $12 modification-date
fair-value-based measure). As demonstrated in Case D of
Example 14 in ASC 718-20-55-118 and 55-119, since it is
improbable that the options will vest before the
modification, compensation cost is based on the
modification-date fair-value-based measure of the
modified award.
Subsequently, if the modified net income
performance condition ($4 million net income) is met and
an IPO occurs, the options will vest. Accordingly, A
should recognize compensation cost of $12,000 on the
basis of the number of options vested (1,000 options if
there are no forfeitures) and the fair-value-based
measure of the modified options on the date of
modification ($12). See the journal entry below.
Example 6-13
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.
The options vest only if (1) A completes an IPO
(performance condition) and (2) a specified target IRR
to shareholders is achieved (market condition). Both
conditions must be met for the employees to earn the
awards. Compensation cost should not be recognized
unless it is probable that the performance condition
will be met. Because an IPO generally is not considered
probable until it occurs, A does not recognize any
compensation cost.
On January 1, 20X2, A modifies the market condition by lowering the IRR target. On the modification date, the fair-value-based measure of each of the original options is $10, and the fair-value-based measure of each of the modified options is $13. The fair-value-based measure will incorporate the IRR target because a market condition is not a vesting condition. When an award contains a performance condition and it is not probable that the performance condition will be met before a modification, the original grant-date fair-value-based measure of compensation cost is disregarded, and only the modification-date fair-value-based measure is considered. Because an IPO has not yet occurred and is therefore still not considered probable (i.e., the options are not expected to vest), total recognized compensation cost for the modified award is zero (0 options expected to vest × $13 modification-date fair-value-based measure).
Entity A would ultimately recognize compensation cost on the basis of the modification-date fair-value-based measure of the modified award only when it becomes probable that the performance condition will be met (i.e., upon the occurrence of an IPO). On April 13, 20X4, A completes an IPO. Because the performance condition has now been met, A should recognize compensation cost of $13,000 on the basis of the number of options vested (1,000 options if there are no forfeitures) and the fair-value-based measure of the modified options on the date of modification ($13) irrespective of whether the IRR target is achieved. See the journal entry below.
6.3.5 Modifications to Accelerate Vesting of Deep Out-of-the-Money Stock Options
At-the-money stock option awards may become out-of-the-money awards because of declines in the value of the underlying shares. If the underlying shares’ value is severely depressed relative to the exercise price, the awards are considered “deep out-of-the-money.” If deep out-of-the-money stock option awards no longer offer sufficient retention motivation to grantees, entities may contemplate accelerating their vesting.
As indicated in ASC 718-10-55-67, the acceleration of the vesting of a deep out-of-the-money award granted to an employee is not substantive because the explicit service period is replaced with a derived service period (see Section 3.6.3 for a discussion of derived service periods). Accordingly, any remaining unrecognized compensation cost should not be recognized immediately, and an entity should generally continue to recognize such cost over the remaining original requisite service period.
To be an in-the-money award, the stock price of the award must, during the derived service period, increase to a level above the stock price on the grant date. Accordingly, the employee must continue to
work for the entity during the derived service period to receive any benefit from the stock option award because it is customary for awards to have features that limit exercisability upon termination (i.e., the term of the option typically truncates, such as 90 days after termination).
ASC 718 does not provide guidance on determining whether an accelerated stock
option award is deep out-of-the-money. An entity will therefore need to use
judgment and may consider, among other factors, those that affect the value of
the award (e.g., volatility of the underlying stock, exercise price, risk-free
rate) and time it will take for the award to become at-the-money. In addition,
an entity may calculate the derived service period of the modified award and
compare it with the original remaining service period to determine whether the
modification is substantive. If the derived service period approximates or is
longer than the original remaining service period, the modification would most
likely not be substantive. In certain situations, it may be clear that the award
is deep out-of-the-money.
While the guidance in ASC 718-10-55-67 addresses employee awards, it should be
applied by analogy to similar types of nonemployee awards.
Example 6-14
On January 1, 20X1, Entity A granted 100 at-the-money stock options to its
employees, each with a grant-date fair-value-based
measure of $10. The awards vest at the end of the fourth
year of service (cliff vesting) and have an exercise
price of $20. Accordingly, A recognizes compensation
cost ratably over the four-year service period. On
January 1, 20X3, when the stock options are deemed to be
deep out-of-the-money, A modifies the awards to
accelerate their remaining service period. Because the
awards are considered deep out-of-the-money, the
acceleration of their remaining service period is not
substantive. Accordingly, A should not recognize the
remaining unrecognized compensation cost immediately on
January 1, 20X3. Rather, A should continue to recognize
the remaining unrecognized compensation cost over the
original requisite service period. That is, A should
continue recognizing compensation cost as if the
modification never occurred and recognize the remaining
$500 ($10 grant-date fair-value-based measure × 100
awards × half of the original requisite service period)
in compensation cost over the remaining two years of the
original requisite service period (recognizing $250 in
each of 20X3 and 20X4).
6.3.6 Modification of the Employee’s Requisite Service Period
The accounting for the modification of a share-based payment award’s requisite service period is based on whether the modified requisite service period is shorter or longer than the original requisite service period.
6.3.6.1 Modification to Reduce the Employee’s Requisite Service Period of an Award
If an entity modifies the requisite service period of a share-based payment
award and the modified award’s requisite service period is shorter than the original award’s requisite service
period, the entity should recognize compensation cost over the remaining
portion of the modified award’s requisite service period. The
fair-value-based measure of the modified award would most likely be the same
or less than the fair-value-based measure of the original award immediately
before modification because the modification only affects the service period
of the award. Vesting conditions are not directly factored into the
fair-value-based measure of an award. In addition, if the award is a stock
option award, the fair-value-based measure may be less than the
fair-value-based measure of the original award because a shorter vesting
period may result in a shorter expected term, as discussed in Section 6.1. Accordingly, there is no
incremental value conveyed to the holder of the award, and no incremental
compensation cost is recognized in connection with the modification.
However, the entity may consider whether the reduction in the requisite service
period affects the number of awards that are expected to vest. If, as a
result of the modification, the entity expects additional awards to vest,
those awards may be accounted for as an improbable-to-probable
modification.3 For the awards that were originally expected to vest, no incremental
compensation cost is recognized in connection with the modification, as
discussed above. For the additional awards expected to vest as a result of
the modification, the entity will record compensation cost on the basis of
(1) the incremental number of awards that are now expected to vest and (2)
the modification-date fair-value-based measure of the awards over the
remaining portion of the requisite service period of the modified awards.
See Section
6.3.3 for a discussion of improbable-to-probable
modifications.
Example 6-15
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 $20. The options vest at the end of the fourth year of service (cliff vesting). In addition, A has a policy of estimating forfeitures and estimates that 10 percent of the options will be forfeited.
Over the first year of service, A records $4,500 of cumulative compensation
cost, or (1,000 options × 90 percent of options
expected to vest) × $20 grant-date fair-value-based
measure × 25 percent for one of four years of
services rendered. On January 1, 20X2, A modifies
the options to reduce the requisite service period
from four years to three years. The fair-value-based
measure of the modified options as of the
modification date is $12. Because the modification
only affects the service period of the options, and
the service period is shorter, the fair-value-based
measure of the modified options would most likely be
equal to or less than the fair-value-based measure
of the original options immediately before
modification. Accordingly, there is no incremental
value conveyed to the holder of the award.
However, because of the reduced requisite service period, A now expects 95
percent of the options to vest. Accordingly, A will
recognize the remaining unrecognized compensation
cost for the 900 options originally expected to vest
— (1,000 options × 90 percent of options originally
expected to vest) × $20 grant-date fair-value-based
measure – $4,500 amount previously recognized =
$13,500 — over the remainder of the modified
requisite service period (two years). For the 50
options now expected to vest as a result of the
modification, A may recognize $600 of incremental
compensation cost (50 options expected to vest × $12
modification-date fair-value-based measure) over the
remainder of the modified requisite service period
(two years).
6.3.6.2 Modification to Increase the Employee’s Requisite Service Period of an Award
If the requisite service period of a modified award is longer than the requisite service period of the original award and, both before and after the modification, it is probable that the awards will vest (Type I or probable-to-probable modification), an entity may make an accounting policy choice to use either of the following methods (both were discussed by the Statement 123(R) Resource Group at its May 26, 2005, meeting; see Section 6.3.1 for a discussion of probable-to-probable modifications):
- The unrecognized compensation cost remaining from the original award would be recognized over the remaining portion of the requisite service period of the original award. The incremental compensation cost, if any, as a result of the modification would be recognized over the remaining portion of the requisite service period of the modified award. See Method 1 in Example 6-16 below.
- The unrecognized compensation cost remaining from the original award plus the incremental compensation cost, if any, as a result of the modification would be recognized in its entirety over the remaining portion of the requisite service period of the modified award. See Method 2 in Example 6-16. (Note, however, that if an employee is not expected to render service over the new requisite service period but is expected to render service over the original requisite service period, the unrecognized compensation cost remaining from the original award would be recognized over the remaining portion of the original award’s requisite service period.)
Regardless of the method chosen, it must be applied consistently and disclosed in accordance with ASC 235-10 if it is material to the financial statements.
Under either method, if the employee does not remain employed for the original award’s requisite service period, any previously recognized compensation cost should be reversed. However, if the employee remains employed for the original award’s requisite service period but terminates employment before the modified award’s requisite service period, all compensation cost associated with the original award should be recognized. Under Method 1, all compensation cost associated with the original award would already have been recognized. Under Method 2, all compensation cost associated with the original award should be immediately recognized. However, under either method, any previously recognized incremental compensation cost associated with the modified award should be reversed. As a result of a modification, the total recognized compensation cost attributable to an award is generally required to be at least equal to the grant-date fair-value-based measure of the original award if the original service or performance condition is met or is expected to be met as of the modification date.
Example 6-16
Assume the same facts as in Example 6-15, except that on January
1, 20X2, Entity A modifies the options to (1)
reprice them (i.e., lower the exercise price to
equal the market price of A’s shares) and (2)
lengthen the requisite service period from four
years to five years. The fair-value-based measure of
the original options immediately before the
modification is $12, and the fair-value-based
measure of the modified options is $16. For
simplicity, assume that the extension of the service
period does not affect forfeitures (90 percent
expected to vest).
On the modification date, A computes the incremental compensation cost as
$3,600, or ($16 fair-value-based measure of modified
options – $12 fair-value-based measure of original
options immediately before the modification) × 900
options. Accordingly, A will recognize the total
remaining unrecognized compensation cost of $17,100
($13,500 of unrecognized compensation cost from the
original options plus $3,600 in incremental
compensation cost from the modification) by using
one of two acceptable methods:
-
Method 1 — Entity A will recognize the unrecognized compensation cost remaining from the original award of $13,500 over the remaining portion of the requisite service period of the original award (three years). The incremental compensation cost of $3,600 as a result of the modification will be recognized over the remaining portion of the requisite service period of the modified award (four years).
-
Method 2 — Entity A will recognize $17,100 ratably over the remaining portion of the requisite service period of the modified award (four years).
6.3.7 Determining the Unit of Account When Assessing the Type of Modification
A share-based payment award may contain a performance condition
under which a different number of shares vest depending on various outcomes of a
performance target (e.g., an EPS growth percentage). ASC 718-10-25-20 requires
compensation cost to be accrued on the basis of the probable outcome of an award’s
performance conditions; however, ASC 718 prohibits recognition of compensation cost
for a performance condition or conditions whose achievement is not probable. The
interrelationship of the performance targets is a key part of the unit-of-account
assessment. An entity would only accrue compensation cost associated with the number
of awards whose vesting is probable at the end of each reporting period. If a
modification is made to one or more performance targets that results in the vesting
of a different number of awards, an entity should consider whether to apply
modification accounting to the award in tranches (under ASC 718-20-35-2A) on the
basis of each tranche’s probability of vesting immediately before and after the
performance target or targets are modified. The example below illustrates such a
scenario.
Example 6-17
On January 1, 20X1, Entity A grants stock
options to an employee. The stock options (1) include a
performance condition that is based on a three-year
cumulative EBITDA growth target and (2) have a grant-date
fair-value-based measure of $6. The number of
equity-classified stock options that will vest at the end of
the third year of employment (cliff vesting) varies
depending on the EBITDA growth target achieved, as defined
below:
Tranche
|
EBITDA Growth Target
|
Options
|
---|---|---|
1
|
100%
|
1,000
|
2
|
110%
|
1,100
|
3
|
120%
|
1,200
|
During 20X1 and 20X2, A believes that it is
probable that the 100 percent EBITDA growth target will be
met at the end of 20X3 but not probable that the 110 percent
growth target will be met. Accordingly, A recognizes
compensation of $2,0004 in 20X1 and 20X2 on the basis of its conclusion that
Tranche 1 will be the probable outcome.
In early 20X3, A decides to lower the EBITDA growth target
needed for vesting under each tranche to the following:
Tranche
|
EBITDA Growth Target
|
Options
|
---|---|---|
1
|
95%
|
1,000
|
2
|
105%
|
1,100
|
3
|
115%
|
1,200
|
The fair-value-based measure of each option
on the day of modification is $7. On the date of the
modification, A believes that it is (1) probable that the
105 percent EBITDA growth target will be met at the end of
20X3 under the modified terms but (2) not probable that the
110 percent growth target will be met under the original
terms. This represents an improbable-to-probable
modification for the incremental 100 options whose vesting
is now probable on the basis of the modification (1,100
options in total are now expected to vest). During 20X3, A
will accrue compensation cost for the Tranche 1 awards
expected to vest by using the $6 original grant-date
fair-value-based measure because vesting of the Tranche 1
awards was probable before and after the modification and
there is no incremental compensation cost as a result of the
modification (the fair-value-based measure of each option
immediately before and after the modification is $7). For
Tranche 2, A will accrue compensation cost beginning on the
modification date for the 100 incremental options expected
to vest by using the $7 fair value of the options on the day
of the modification ($700 in incremental compensation cost
over the remaining requisite service period).
Vesting of the Tranche 3 awards was
improbable before the modification and continues to be
improbable after it. Since it is not probable that the
original award and the modified award will vest under
Tranche 3, the modification is considered a Type IV
improbable-to-improbable modification. If the 115 percent
EBITDA growth target subsequently become probable, any
compensation cost recognized will be based on the $7
fair-value-based measure for each option determined on the
modification date.
Footnotes
2
ASC 718 requires an entity to
record compensation cost if either the original
performance condition or the modified performance
condition is met. In this case, since the modified
performance target is lower than the original
performance target, the attainment of the modified
target would be sufficient to trigger recognition
of compensation cost.
3
An entity that modifies a group of awards granted to
a number of grantees may instead choose to consider each grantee’s
awards as the unit of account when determining whether the awards
are expected to vest and the type of modification accounting to
apply. When applying this approach, the entity may conclude that
each individual’s awards were expected to vest before the
modification and are accounted for as a probable-to-probable
modification. That is, even if a few grantees were expected to
forfeit the original awards as a result of normal turnover, the
entity may account for the entire modification as a
probable-to-probable modification. However, if an entity’s policy is
to estimate forfeitures when recognizing compensation cost, and the
percentage of all modified awards that are expected to vest
increases (i.e., the entity’s forfeiture rate is reduced),
additional compensation cost will be recognized for those awards on
the basis of their original grant-date fair-value-based measure.
4
Calculated as [($6 × 1,000 options)
÷ by 3 years].
6.4 Modification of Factors Other Than Vesting Conditions
Modifications may be made to an award that do not affect its vesting conditions (i.e., its service or performance conditions). If modification accounting is required for such changes (see Section 6.1 for circumstances in which modification accounting is not required), the same principles apply as those discussed in Section 6.3.
6.4.1 Modification of a Market Condition
The modification of an award’s market condition does not directly affect the probability that the award
will be earned. Unlike a service or a performance condition, a market condition is not a vesting condition
but rather is factored into the award’s fair-value-based measure (see Section 3.5). However, the
modification could indirectly affect the probability that the award will be earned if there is a change in a
derived service period.
The determination of whether an award will vest depends on whether the grantee meets any service
or performance conditions. Accordingly, if the original award is expected to vest at the time of the
modification, incremental compensation cost is computed as the excess of the fair-value-based measure
of the modified award on the date of modification over the fair-value-based measure of the original
award immediately before the modification.
Example 6-18
On January 1, 20X1, Entity A granted 1,000 at-the-money employee stock options, each with a grant-date fair-value-based measure of $5 and a derived service period of five years. The options have an exercise price of $12 and become exercisable only if the market price of A’s shares reaches $20. In addition, A has a policy of estimating forfeitures, and it estimates that 15 percent of the options will be forfeited because the employees will terminate employment before the end of the derived service period.
Over the first year of service, A records $850 of cumulative compensation cost,
or (1,000 options × 85 percent of options expected to
vest) × $5 grant-date fair-value-based measure × 20
percent for one of five years of services rendered. On
January 1, 20X2, because of a significant decline in the
market price of A’s shares, A modifies the options to be
exercisable when the market price of A’s shares reaches
$15. The fair-value-based measure of the original
options immediately before modification is $3, and the
fair-value-based measure of the modified options is $4.
In addition, the derived service period of the modified
options is three years. As a result of the reduction in
the derived service period, A expects additional options
to vest. Accordingly, A revises its forfeiture estimate
from 15 percent to 10 percent and computes the
incremental compensation cost as a result of modifying
the options’ market condition as follows:
The total compensation cost to be recognized over the remaining derived service
period of the modified options (three years) of $4,450
is the unrecognized compensation cost from the original
options of $3,400 — (1,000 options × 85 percent of
options expected to vest) × $5 grant-date
fair-value-based measure – $850 previously recognized —
plus the incremental compensation cost resulting from
the modification of the options’ market condition of
$1,050 (determined above).
6.4.2 Modification of Stock Options During Blackout Periods
In certain instances, grantees (including grantees who are no longer employed or are no longer providing goods or services) may not be able to exercise their stock options because of blackout periods imposed by the entity or others. Blackout periods may be imposed because (among other reasons):
- The terms of an award require such periods (e.g., to restrict the selling of an entity’s securities close to its earnings releases).
- The entity’s registration statements on Form S-8 are temporarily suspended because its filing requirements under the Securities Exchange Act of 1934 are not current.
- An entity’s stock has been delisted.
If grantees have vested options that will expire during a blackout period, sometimes entities will (even though they have no obligation to do so) extend the options’ term to give such grantees the ability to exercise the options after the blackout period is over (or provide other assets in lieu of the options). The extension of the options’ contractual term should be accounted for as a modification. If, at the time of the modification, the original options are not exercisable because of a blackout period and the entity is not obligated to settle the option in cash or other assets, the options have no value to the holders. An entity may wish to seek the opinion of legal counsel in determining whether it is obligated to settle in cash or other assets. In accordance with ASC 718-20-35-3, the incremental compensation cost is the excess of the fair-value-based measure of the modified award on the date of modification over the fair-value-based measure of the original award immediately before the modification. Since the original options’ value is zero, the incremental value would be the fair-value-based measure of the modified options because the entity has, in substance, replaced worthless options with options that the grantees can exercise in the future. Further, because the award is fully vested, the compensation cost would be recognized in full on the date of the modification.
6.5 Equity Restructuring
ASC 718-10 — Glossary
Equity
Restructuring
A
nonreciprocal transaction between an entity and
its shareholders that causes the per-share fair
value of the shares underlying an option or
similar award to change, such as a stock dividend,
stock split, spinoff, rights offering, or
recapitalization through a large, nonrecurring
cash dividend.
ASC 718-20
Equity
Restructuring or Business
Combination
35-6 Exchanges of share
options or other equity instruments or changes to
their terms in conjunction with an equity
restructuring or a business combination are
modifications for purposes of this Subtopic. An
entity shall apply the guidance in paragraph
718-20-35-2A to those exchanges or changes to
determine whether it shall account for the effects
of those modifications. Example 13 (see paragraph
718-20-55-103) provides further guidance on
applying the provisions of this paragraph. See
paragraph 718-10-35-10 for an
exception.
Equity
Restructuring
55-2 In accordance with
paragraph 718-20-35-6, an entity shall apply the
guidance in paragraph 718-20-35-2A to exchanges of
share options or other equity instruments or
changes to their terms in conjunction with an
equity restructuring to determine whether it shall
account for the effects of those modifications as
described in paragraphs 718-20-35-3 through 35-9.
Example 13 (see paragraph 718-20-55-103) provides
additional guidance on accounting for
modifications of awards in the context of equity
restructurings.
6.5.1 Antidilution Provisions
An equity restructuring is a
nonreciprocal transaction between an entity and
its shareholders that causes a change in the
per-share fair value of the shares underlying an
award (e.g., stock dividend, stock split,
spin-off). Exchanges of stock options or other
equity instruments or changes to their terms in
conjunction with an equity restructuring are
modifications. However, the effect of such
modifications depends on whether an adjustment is
made in accordance with an existing
nondiscretionary antidilution provision. A
nondiscretionary provision is clear and measurable
and requires the entity to take action. By
contrast, a discretionary provision may be broad
or subjective, and it allows but does not require
the entity to take action.
If the terms of the original
award do not include an antidilution provision and
an entity subsequently adds an antidilution
provision but does not contemplate an equity
restructuring, the fair-value-based measure of the
award would generally remain the same.
Accordingly, as long as there are no other changes
to the award that would affect vesting or
classification, the entity does not apply
modification accounting. If the entity
contemplates an equity restructuring, however, it
applies modification accounting and may need to
recognize significant incremental compensation
cost.
In addition, upon an equity
restructuring, it is not uncommon for an entity to
make grantees “whole” (in accordance with a
preexisting nondiscretionary antidilution
provision) on an intrinsic-value basis when the
awards are stock options. In certain
circumstances, the fair-value-based measure of
modified stock options could change as a result of
the equity restructuring even if the intrinsic
value remains the same. Under ASC 718-20-35-2A, an
entity compares the intrinsic value before and
after a modification in determining whether to
apply modification accounting only “if such an
alternative measurement method is used”; thus, if
an entity uses a fair-value-based measure to
calculate and recognize compensation cost for its
share-based payment awards, it would still be
required to apply modification accounting when the
fair-value-based measure has changed, even if the
intrinsic value is the same immediately before and
after the modification.
An entity may adjust an award
by making a cash payment to the holder,
particularly in circumstances in which the equity
restructuring is in the form of a large,
nonrecurring cash dividend. Although the
authoritative guidance does not explicitly address
cash payments made in conjunction with an equity
restructuring, transactions such as these are
treated as a modification or a partial settlement
(or a combination of both). See Section
6.10.2.
6.5.1.1 Original Award Contains a Nondiscretionary Antidilution Provision
To determine whether
incremental compensation cost should be recognized, an entity should compare the
fair-value-based measure of the modified award with the fair-value-based measure of the
original award (on the basis of the stated antidilution terms in the award) immediately
before the modification. See below for illustrations of original awards that contain
either a nondiscretionary (Example
6-19) or a discretionary (Example 6-21) antidilution provision. If the award is modified in
accordance with a preexisting nondiscretionary antidilution provision, modification
accounting is not required if the fair-value-based measure, vesting conditions, and
classification are the same immediately before and after the modification. When an
antidilution feature is designed to equalize the fair value of the award as a result of
an equity restructuring, the actual adjustment typically would not affect the award’s
fair-value-based measure immediately before or immediately after the modification
because the change is already contemplated in the award’s fair-value-based measure. The
accounting for a modification of an award with a preexisting nondiscretionary
antidilution provision may result in both (1) a settlement and (2) a modification that
changes the award’s classification to a liability (see Example 6-34).
An entity should carefully
review the terms of its awards to determine
whether an adjustment is required if an equity
restructuring occurs. In certain circumstances
when such an adjustment is required, the entity
may be permitted to choose how to make it (e.g.,
the entity may be allowed to determine how it
adjusts the exercise price or quantity of stock
options). As long as an equitable adjustment is
required by the award, an entity may conclude that
the antidilution provision is nondiscretionary,
even if the entity has some discretion in
determining how to make the adjustment. When it is
not clear that an equitable adjustment is
required, an entity should consider whether the
holder of the award could enforce an antidilution
adjustment. The entity may need to obtain the
opinion of legal counsel to make that
determination.
ASC 718-20
Example
13: Modifications Due to an Equity
Restructuring
55-103 As a reminder,
exchanges of share options or other equity
instruments or changes to their terms in
conjunction with an equity restructuring are
considered modifications for purposes of this
Topic. The following Cases illustrate the guidance
in paragraph 718-20-35-6:
- Original award contains antidilution provisions (Case A).
- Original award does not contain antidilution provisions (Case B).
- Original award does not contain an antidilution provision but is modified on the date of equity restructuring (Case C).
Case A: Original Award Contains
Antidilution Provisions
55-104 In this Case, assume
an award contains antidilution provisions. On May
1 there is an announcement of a future equity
restructuring. On October 12 the equity
restructuring occurs and the terms of the award
are modified in accordance with the antidilution
provisions. In this Case, the modification occurs
on October 12 when the terms of the award are
changed. The fair value of the award is compared
pre- and postmodification on October 12. The
calculation of fair value is necessary to
determine whether there is any incremental value
transferred as a result of the modification, and
if so, that incremental value would be recognized
as additional compensation cost. If there is no
change in fair value, vesting conditions, or the
classification of the award, the entity would not
account for the effect of the modification (see
paragraph 718-20-35-2A).
Example 6-19
Stock Split
When the Original Award Contains a
Nondiscretionary Antidilution Provision
On January 1, 20X1, Entity A
grants 1,000 at-the-money employee stock options
with a grant-date fair-value-based measure of $6
and an exercise price of $10. The options vest at
the end of the third year of service (cliff
vesting) and contain a nondiscretionary
antidilution provision. On July 1, 20X2, A
announces a two-for-one stock split and that a
nondiscretionary antidilution provision will apply
to each of the options. The nondiscretionary
antidilution provision that existed in the
original terms of the options requires an
adjustment to preserve the value of the options
after the stock split. Because the antidilution
provision is not discretionary and already
existed, A is not likely to apply modification
accounting on July 1, 20X2, when A announces the
two-for-one stock split, because modification
accounting is not applied if the fair-value-based
measure of the options immediately before and
after the stock split is the same, and there are
no changes to the vesting conditions or
classification of the options. Accordingly, A
records no incremental compensation
cost.
6.5.1.2 Modification to Add a Nondiscretionary Antidilution Provision in Contemplation of an Equity Restructuring
An adjustment to the terms of
an award to maintain the holder’s value in
response to an equity restructuring may trigger
the recognition of significant compensation cost
if (1) the adjustment is not required under the
existing terms of the award and (2) the provision
that requires an adjustment is added in
contemplation of an equity restructuring. Note
that the addition of a nondiscretionary
antidilution provision to a stock option plan
could result in unintended tax consequences and
could be considered a disqualifying event of an
ISO. An entity should consult with its tax
professional regarding the tax implications of
making changes to its stock option plans.
ASC 718-20
Example
13: Modifications Due to an Equity
Restructuring
Case
B: Original Award Does Not Contain Antidilution
Provisions
55-105 In
this Case, the original award does not contain
antidilution provisions. On May 1 there is an
announcement of a future equity restructuring. On
July 26 the terms of an award are modified to add
antidilution provisions in contemplation of an
equity restructuring. On September 30 the equity
restructuring occurs. In this Case, there are two
modifications to account for. The first
modification occurs on July 26, when the terms of
the award are changed to add antidilution
provisions. There must be a comparison of the fair
value of the award pre- and postmodification on
July 26 in accordance with paragraph 718-20-35-2A
to determine whether the entity should account for
the effects of the modifications as described in
paragraphs 718-20-35-3 through 35-9. The
premodification fair value on July 26 is based on
the award without antidilution provisions taking
into account the effect of the contemplated
restructuring on its value. The postmodification
fair value is based on an award with antidilution
provisions, taking into account the effect of the
contemplated restructuring on its value. Any
incremental value transferred would be recognized
as additional compensation cost. Once the equity
restructuring occurs, there is a second
modification event on September 30 when the terms
of the award are changed in accordance with the
antidilution provisions. A second comparison of
pre- and postmodification fair values is then
required to determine whether the fair value of
the award has changed as a result of the
modification. If there is no change in fair value,
vesting conditions, or the classification of the
award, the entity would not account for the effect
of the modification on September 30 (see paragraph
718-20-35-2A). Changes to the terms of an award in
accordance with its antidilution provisions
typically would not result in additional
compensation cost if the antidilution provisions
were properly structured. If there is a change in
fair value, vesting conditions, or the
classification of the award, the incremental value
transferred, if any, would be recognized as
additional compensation cost.
Case C: Original Award Does Not
Contain an Antidilution Provision but Is Modified
on the Date of Equity Restructuring
55-106 Assume the same facts
as in Case B except the terms of the awards are
modified on the date of the equity restructuring,
September 30. In contrast to Case B in which there
are two separate modifications, there is one
modification that occurs on September 30 and the
fair value is compared pre- and postmodification
to determine whether any incremental value is
transferred as a result of the modification. Any
incremental value transferred would be recognized
as additional compensation cost.
Example 6-20
Stock Split
When a Nondiscretionary Antidilution Provision Is
Added
On January 1,
20X1, Entity A grants 1,000 at-the-money employee
stock options with a grant-date fair-value-based
measure of $6 and an exercise price of $10. The
options vest at the end of the third year of
service (cliff vesting) and do not contain an
antidilution provision. On July 1, 20X2, A
announces a two-for-one stock split and the
addition of a nondiscretionary antidilution
provision to each of the options. The
fair-value-based measure of the options
immediately before the addition of the
antidilution provision is $4, and the
fair-value-based measure immediately afterwards is
$7. On December 31, 20X2, the stock split occurs
and A (1) modifies the exercise price of the
options and (2) issues additional options to the
employee to reflect the effects of the stock
split. The fair-value-based measure of the options
before and after the stock split is the
same.
The addition of the antidilution provision on July 1, 20X2, should be accounted
for as a modification. The $3,000 incremental value, or ($7 – $4) × 1,000
options, conveyed to the holder as a result of adding the nondiscretionary
antidilution provision should be recorded as incremental compensation cost
over the remaining 18-month service period. The premodification
fair-value-based measure is based on the original options without a
nondiscretionary antidilution provision and takes into account the effect of
the contemplated equity restructuring (i.e., the stock split) on its value.
The postmodification fair-value-based measure is based on the modified
options with a nondiscretionary antidilution provision and takes into
account the effect of the contemplated equity restructuring on its
value.
On December 31,
20X2, the reduction in the exercise price of the
options and the issuance of the additional options
as a result of the stock split would not be
subject to modification accounting. Provided that
there are no changes to vesting conditions or the
classification of the options, A does not apply
modification accounting since the fair-value-based
measure of the options before and after the
modification is the same. Changes to the terms of
an award in accordance with its nondiscretionary
antidilution provisions often do not result in
incremental compensation cost if the antidilution
provisions are structured to retain the same
fair-value-based measure of the award.
Example 6-21
Stock Split
When the Original Award Contains Discretionary
Antidilution Provisions
Assume the same facts as in the example above, except that the original terms of
the options contain a discretionary antidilution provision. Under the
provision, A may — but is not required to — adjust the terms of the options
in response to an equity restructuring (e.g., stock split). Because the
antidilution provision is discretionary, the options are treated as though
the provision does not exist. That is, if A were to reduce the exercise
price of the options and issue additional options on December 31, 20X2, it
has in substance “added” a nondiscretionary antidilution provision to the
original terms of the options. As a result of the modification to add a
nondiscretionary antidilution provision to the terms of the options, and to
reduce the exercise price of the options and issue additional options,
incremental value would be conveyed to the holder (as it was in the example
above). Accordingly, A should record incremental compensation cost for the
incremental value conveyed to the holder on December 31, 20X2, over the
remaining 12-month service period.
Alternatively, if A announces on July 1, 20X2, that it will adjust the terms of
the options in response to the stock split, a modification occurs on July 1,
20X2, to effectively add a nondiscretionary antidilution provision to the
options’ terms. The addition of the nondiscretionary antidilution provision
results in incremental value conveyed to the holder. Accordingly, A should
record incremental compensation cost of $3,000 (as determined in the example
above) over the remaining 18-month service period.
6.5.1.3 Modification to Add a Nondiscretionary Antidilution Provision That Is Not in Contemplation of an Equity Restructuring
While adding a
nondiscretionary antidilution provision generally
increases the value of an award, a market
participant would typically not place significant
value on such a provision if an equity
restructuring is not anticipated since it would be
difficult to determine the provision’s effect on
the valuation of the award.
Because a modification to add
a nondiscretionary antidilution provision that is
not made in contemplation of an equity
restructuring would generally result in the same
fair-value-based measure before and after the
modification, modification accounting would not be
applied as long as there are no other changes to
the award.
6.5.2 Spin-Offs
As discussed in Section
6.5.1, a spin-off is considered an
equity restructuring. Accordingly, under ASC
718-20-35-6, “[e]xchanges of share options or
other equity instruments or changes to their terms
in conjunction with an equity restructuring” are
treated as modifications.
In a spin-off, individuals who
were originally employees or vendors of an entity
(the former parent or spinnor) that is spinning
off a consolidated entity (the former subsidiary
or spinnee) may become employees or vendors of the
former subsidiary or remain employees or vendors
of the former parent. Those individuals may
exchange their share-based payment awards for
awards in the former parent, the former
subsidiary, or both. The former parent’s
(spinnor’s) and former subsidiary’s (spinnee’s)
accounting for these share-based payment awards
will ultimately be based on whose employees or
vendors are providing the goods or services to
earn any remaining portions of the awards after
the spin-off.
6.5.2.1 Attribution of Compensation Cost in a Spin-Off
In a spin-off, compensation
cost related to share-based payment awards should be recognized by the entity whose
employees or vendors are providing the goods or services to earn any remaining portions
of the award. For those grantees that will continue to provide goods or services to the
former subsidiary, the former parent does not reverse any compensation cost recorded for
the awards before the spin-off date (i.e., the awards are not forfeited). After the
spin-off, the former parent no longer records compensation cost related to the original
or modified awards issued to employees or vendors of the former subsidiary. The
remaining unrecognized fair-value-based measure of the original awards and the
incremental compensation cost associated with the modified awards, if any, are
recognized by the former subsidiary over the remaining employee requisite service period
or nonemployee’s vesting period. For those grantees that will continue to provide goods
or services to the former parent, the former parent continues to recognize the remaining
unrecognized fair-value-based measure of the original awards and the incremental
compensation cost associated with the modified awards, if any, over the remaining
employee requisite service period or nonemployee’s vesting period.
At its September 1, 2004,
meeting, the FASB reached the following conclusion
about spin-off transactions:
In connection with a spinoff transaction and as a
result of the related modification, employees of
the former parent may receive unvested equity
instruments of the former subsidiary, or employees
of the former subsidiary may retain unvested
equity instruments of the former parent. The Board
decided that, based on the current accounting
model for spinoff transactions, the former parent
and former subsidiary should recognize
compensation cost related to the unvested modified
awards for those employees that provide service to
each respective entity. For example, if an employee of the former
subsidiary retains unvested equity instruments of
the former parent, the former subsidiary would
recognize in its financial statements the
remaining unrecognized compensation cost
pertaining to those instruments. In those cases,
the former parent would recognize no compensation
cost related to its unvested equity instruments
held by those former employees that subsequent to
the spinoff provide services solely to the former
subsidiary. [Emphasis added]
We understand that this
guidance was not included in FASB Statement No.
123(R) because the FASB deleted the example of a
spin-off transaction just before issuing the
standard. However, the rationale for the FASB’s
conclusion above remains appropriate.
6.5.2.2 Classification of Awards in a Spin-Off
Under an exception in FASB Interpretation 44, an entity was not required to
change the accounting method of an award when the
award holder’s status changed from employee to
nonemployee as a direct result of a spin-off. If
an employee was granted a share-based payment
award that was outstanding as of the date of the spin-off, and that employee was then considered a nonemployee as a direct result of the spin-off, a change from the intrinsic value method to the fair value method for the award previously granted was not required under Interpretation 44.
While nullified by FASB Statement 123(R), the guidance in Interpretation
44 remains applicable by analogy since it contains
the only guidance on accounting for share-based
payment awards in a spin-off. For example, ASC 718
does not provide guidance on the classification of
awards that are, after a spin-off, (1) indexed to
the spinnor’s equity (i.e., the former parent’s
equity) and held by employees or vendors of the
spinnee (i.e., the former subsidiary) or (2)
indexed to the spinnee’s equity (i.e., the former
subsidiary’s equity) and held by employees or
vendors of the spinnor (i.e., the former parent).
Accordingly, in a manner similar to the exception
under which an entity is not required to change
its accounting method when there is a change in
the award holder’s status, the spinnee should
account for its awards that are indexed to the
spinnor’s equity in the same manner as the spinnor
(i.e., equity versus liability); that is, by using
the guidance for share-based payment awards as
though the spin-off had not occurred and provided
that no other changes to the award have been made.
Likewise, the spinnor should account for its
awards that are indexed to the spinnee’s equity in
the same manner as the spinnee.
6.5.2.3 Determining the Market Price Before and After a Spin-Off
To determine whether
modification accounting is required and, if so, to
account for a modification in a spin-off, an
entity compares the fair-value-based measure of
the original share-based payment award immediately
before the spin-off with the fair-value-based
measure of the modified share-based payment award
immediately after the spin-off. The
fair-value-based measure of the original award
immediately before the spin-off is determined on
the basis of the assumptions (e.g., stock price,
volatility, expected dividends, risk-free interest
rate) before the spin-off. The fair-value-based
measure of the modified award immediately after
the spin-off is determined on the basis of the
assumptions that exist immediately after the
spin-off.
Depending on the structure of
the share-based payment plan and the spin-off, the
market price of the parent’s shares before and
after the spin-off, as well as the market price of
the spinnee’s shares after the transaction, may
also be relevant.
The market price of the
parent’s shares immediately before the
modification should be based on the closing price
on the date of the spin-off, otherwise known as
the “record date.” Sometimes the parent’s shares
begin trading on an “ex-dividend” basis before the
distribution date, which already excludes the
value of the spinnee’s shares. In these
circumstances, and if the spinnee’s shares are
trading on a “when-issued” basis (e.g., after the
spinnee’s registration statement is declared
effective), to determine the market price of the
parent’s shares immediately before the
modification, an entity would add the
distribution-date (i.e., spin-off date) closing
price of the spinnee’s shares to the
distribution-date closing price of the parent’s
shares, since the parent’s shares incorporate the
reduction in value that is attributable to the
spin-off.
The market price of the
parent’s shares immediately after the modification
is the opening price on the first trading date
after the distribution. However, if the parent’s
shares are traded on an ex-dividend basis and the
spinnee’s shares are traded on a when-issued
basis, the entity uses the price of the parent’s
shares at the time of the spin-off since the
market price will already exclude the closing
price of the spinnee’s shares.
The market price of the
spinnee’s shares immediately after the
modification is the closing price of the spinnee’s
shares on the distribution date as long as the
shares are traded on a when-issued basis.
Otherwise, the entity should use the opening price
of the spinnee’s shares on the first trading date
after the distribution as the market price of the
spinnee’s shares immediately after the
modification.
6.5.3 Accounting for Awards Modified in Conjunction With an Equity Restructuring Held by Individuals No Longer Employed or Providing Goods or Services
Share-based payment awards
that were originally granted to individuals in exchange for goods or services continue to
be accounted for under ASC 718 throughout the awards’ life unless their terms are modified
when a grantee is no longer an employee or a nonemployee has vested in the award and is no
longer providing goods or services. Because changes to an award’s terms in conjunction
with an equity restructuring are treated as a modification, when the individuals are no
longer employed or providing goods or services, the entity would normally be required to
account for (1) the modification in accordance with the guidance in ASC 718 and (2) the
award after the modification under other applicable GAAP. However, if changes to an
award’s terms are made solely to reflect an equity restructuring, ASC 718-10-35-10A does
not require the entity (including the spinnor and spinnee in connection with a spin-off)
to account for the award after the modification under other applicable GAAP if both of the
following conditions are met:
-
There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved, that is, the holder is made whole) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
-
All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.
Example 6-22
Former parent P (spinnor)
modifies awards held by employees of the former
subsidiary (spinnee) as a direct result of a
spin-off. There is no change in the ratio of the
awards’ intrinsic value to their exercise price or
addition of an antidilution provision in
contemplation of the spin-off, and all holders of
the same class of equity instruments are treated
in the same manner. While in accounting for the
awards after their terms have changed P would not
consider changes that reflect the spin-off to be a
modification that causes the awards to be
accounted for under other applicable GAAP, P still
would need to treat the changes to the terms as a
modification in accordance with ASC 718. That is,
P would need to consider whether, as a result of
the changes in the awards’ terms, it would be
required under ASC 718-20-35-2A and 35-3 to apply
modification accounting and recognize any
incremental compensation cost. For example, while
the nonemployees may be made whole if “the ratio
of intrinsic value to the exercise price of the
award[s] is preserved,” the fair-value-based
measure of the modified awards on the date of the
spin-off may be greater than the fair-value-based
measure of the original awards immediately before
the spin-off. If so, for unvested awards, the
former subsidiary would recognize incremental
compensation cost for the excess of the
fair-value-based measure of the modified awards
over the fair-value-based measure of the original
awards over the remaining service
period.
6.6 Business Combination
ASC 718-20
Equity Restructuring or Business Combination
35-6 Exchanges of share options or other equity instruments or changes to their terms in conjunction with an equity restructuring or a business combination are modifications for purposes of this Subtopic. An entity shall apply the guidance in paragraph 718-20-35-2A to those exchanges or changes to determine whether it shall account for the effects of those modifications. Example 13 (see paragraph 718-20-55-103) provides further guidance on applying the provisions of this paragraph. See paragraph 718-10-35-10 for an exception.
An acquiring entity may issue share-based payment awards (referred to in ASC 805
as “replacement awards”) to the acquiree’s employees or vendors to replace their
existing share-based payment awards. Exchanges of share-based payment awards in a
business combination are considered modifications under ASC 718-20-35-6. An acquirer
often issues replacement awards to ensure that the acquiree’s employees or vendors
are in a similar economic position immediately before and after the consummation of
the business combination. The replacement awards may represent consideration
transferred in the business combination (i.e., they may be related to past goods or
services that the grantees provided to the acquiree before the acquisition date),
compensation for future goods or services (i.e., postcombination goods or services)
by the grantees, or both. See Chapter 10 for
further discussion of the accounting treatment of awards that are exchanged in a
business combination.
6.7 Short-Term Inducements
ASC 718-20 — Glossary
Short-Term Inducement
An offer by the entity that would result in modification of an award to which an award holder may subscribe for a limited period of time.
ASC 718-20
Short-Term Inducements
35-5 Except as described in paragraph 718-20-35-2A, a short-term inducement shall be accounted for as a modification of the terms of only the awards of grantees who accept the inducement, and other inducements shall be accounted for as modifications of the terms of all awards subject to them.
The ASC master glossary defines a short-term inducement as an “offer by the
entity that would result in modification of an award to which an award holder may
subscribe for a limited period of time.” Modification accounting applies only to the
awards for which holders accept the offer. While entities must use judgment in
determining what constitutes a limited period, we would generally expect it to be
less than a few months. If an inducement is not “for a limited period of time,” it
is considered a long-term inducement and is accounted for as a modification of all
awards subject to the inducement, even if the inducement is not accepted by the
holder.
The modification date for a short-term inducement is typically the date on which an
award holder accepts the offer (i.e., “opts in”). If award holders opt in on
different dates, the entity would have multiple modification dates. However, if
award holders have the ability to withdraw their acceptance (i.e., “opt out”) before
the end of the offer period, the modification date would be the date on which the
withdrawal right expires. By contrast, the modification date of a long-term
inducement is the date on which the inducement is offered, regardless of how many
award holders accept the offer or when they accept it.
See Section 6.10.2 for a
discussion of short-term offers to settle an equity award for cash or other assets.
Example 6-23
On January 1, 20X1, Entity A grants 1,000 at-the-money employee stock options to each of its 100 employees. The options have a grant-date fair-value-based measure of $3 and an exercise price of $10, and they vest at the end of the third year of service (cliff vesting).
On December 31, 20X1, A offers to all 100 employees the ability to reduce the
exercise price of the stock options to $8 if the employees
are willing to extend the vesting period for an additional
year. The offer is valid for the remaining original service
period of two years. Because the inducement is not
short-term (i.e., it is not offered for a limited period), A
should account for the inducement as a modification of all
100,000 stock options on December 31, 20X1 (i.e., the
modification date), regardless of how many employees accept
the offer.
Example 6-24
Assume the same facts as in the example above, except that the employees have
only one month to accept the offer, and those who opt in do
not have the ability to opt out once they have accepted the
offer. During that one-month period, 60 employees accept the
offer. Entity A would apply modification accounting to only
the 60,000 stock options awarded to employees who accepted
the offer because it has determined that the offer is a
short-term inducement. In addition, the modification date
for each opt-in is the date on which each employee accepts
the offer.
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 6-25
On January 1, 20X1, Entity A grants 1,000 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 6-26
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. 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 6-27
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 6-28
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.
6.9 Modifications Under ASR 268
SEC ASR 268 and ASC 480-10-S99-3A require (with limited exceptions) temporary-equity classification for share-based payment awards with redemption features not solely within the control of the entity (as long as the awards would not otherwise be classified as liabilities). See Section 5.10 for a discussion of classification of awards with redemption features not solely within the control of the entity.
The modification guidance in ASC 718-20 also applies to awards that are accounted for in accordance with ASR 268 and ASC 480-10-S99-3A. In other words, SEC registrants are required to record the incremental fair-value-based measure, if any, of the modified award as compensation cost on the date of modification (for vested awards) or over the remaining service period (for unvested awards). In addition, SEC registrants are required to reclassify the redemption amount to temporary equity on the modification date.
Example 6-29
Accounting for the Modification of an Award With a Contingent Cash-Settlement Feature
On January 1, 20X1, Entity A, an SEC registrant, granted 1,000 at-the-money employee stock options, each with a grant-date fair-value-based measure of $12 and an exercise price of $25. The options vest at the end of the fifth year of service (cliff vesting) and contain a redemption feature permitting the employee to require A to net cash settle the options upon a change in control (the occurrence of which is not probable as of the grant date).
Since the options were granted at-the-money and are not fully vested (i.e., the intrinsic value on the grant date is zero), no amount is initially reclassified as temporary equity. However, because the options contain a redemption feature that is not solely within the control of A, A is required to remeasure the options to their redemption value (i.e., their intrinsic value) in temporary equity once it is considered probable that the change-in-control event (i.e., the contingent redemption feature) will occur (generally when the change-in-control event occurs). Accordingly, for the year ended December 31, 20X1, A (1) recognizes compensation cost on the basis of the grant-date fair-value-based measure of the options and (2) reclassifies no amount as temporary equity. See the journal entry below.
Journal Entry: December 31, 20X1
On January 1, 20X2, A modifies the options to reduce the requisite service period from five years to four years. Because the modification affects only the options’ service period, which is now shorter, the fair-value-based measure of the modified options would most likely be equal to or less than the fair-value-based measure of the original options immediately before modification. Accordingly, there is no incremental value conveyed to the holder of the award; therefore, no incremental compensation cost has to be recorded in connection with this modification. Entity A will recognize the remaining unrecognized compensation cost (1,000 options × $12 grant-date fair-value-based measure – $2,400 amount previously recognized = $9,600) over the remainder of the modified requisite service period (three years).
However, on the modification date, the market price of A’s shares is $27, while the exercise price of the options remained at $25. Because the modification of an award is viewed as the exchange of a new award for an old award, A must again consider the application of the measurement guidance in ASR 268 and ASC 480-10-S99-3A as of the modification date. Therefore, in accordance with ASC 480-10-S99-3A, A will reclassify the redemption amount (i.e., the intrinsic value of the options on the modification date) as temporary equity. Accordingly, in 20X2, A (1) recognizes compensation cost on the basis of the options’ grant-date fair-value-based measure and (2) reclassifies as temporary equity an amount based on the options’ intrinsic value ($2) and the portion of the requisite service rendered. See the journal entries below.
Journal Entry: January 1, 20X2
Journal Entries: December 31, 20X2
Example 6-30
Accounting for the Modification of an Award That Is Puttable by the Employee
On January 1, 20X1, Entity A, an SEC registrant, granted 1,000 at-the-money employee stock options, each with
a grant-date fair-value-based measure of $6 and an exercise price of $15. The options vest at the end of the
fifth year of service (cliff vesting). In addition, the shares underlying the options contain a redemption feature
allowing the employee to require A to repurchase the shares at the then-current fair value six months and one
day after exercise of the options.
Since the options were granted at-the-money and are not fully vested (i.e., the intrinsic value on the grant date is zero), no amount is initially reclassified to temporary equity. However, because the options contain a redemption feature, A is required to remeasure the options to their redemption value (i.e., their intrinsic value) in temporary equity in each reporting period until settlement. The amount recorded in temporary equity is based on the options’ redemption amount and the portion of the requisite service rendered as of each reporting period. On December 31, 20X1, the market price of A’s shares is $18. Accordingly, for the year ended December 31, 20X1, A (1) recognizes compensation cost on the basis of the grant-date fair-value-based measure of the options and (2) reclassifies as temporary equity an amount based on the options’ intrinsic value ($3) and the portion of the requisite service rendered. See the journal entries below.
Journal Entries: December 31, 20X1
On January 1, 20X2, A modifies the options to reduce the requisite service period from five years to four years. Because the modification only affects the service period of the options, and the service period is shorter, the fair-value-based measure of the modified options would most likely be equal to or less than the fair-value-based measure of the original options immediately before modification. Accordingly, there is no incremental value conveyed to the holder of the award; therefore, no incremental compensation cost has to be recorded in connection with this modification. Entity A will recognize the remaining unrecognized compensation cost (1,000 options × $6 grant-date fair-value-based measure – $1,200 amount previously recognized = $4,800) over the remainder of the modified requisite service period (three years).
On the modification date, the market price of A’s shares is $17, while the
exercise price of the options remained at $15. The market
price of A’s shares increases to $19 as of December 31,
20X2. In accordance with ASR 268 and ASC 480-10-S99-3A, A
will reclassify the redemption amount (i.e., the intrinsic
value of the options on the modification date) as temporary
equity. Accordingly, for the year ended December 31, 20X2, A
(1) recognizes compensation cost on the basis of the
grant-date fair-value-based measure of the options and (2)
reclassifies as temporary equity an amount based on the
options’ intrinsic value ($4) and the portion of the
requisite service rendered. See the journal entries
below.
Journal Entries: December 31, 20X2
6.10 Repurchases and Settlements
ASC 718-20
Repurchase or Cancellation
35-7 The amount of cash or other assets transferred (or liabilities incurred) to repurchase an equity award
shall be charged to equity, to the extent that the amount paid does not exceed the fair value of the equity
instruments repurchased at the repurchase date. Any excess of the repurchase price over the fair value of
the instruments repurchased shall be recognized as additional compensation cost. An entity that repurchases
an award for which the promised goods have not been delivered or the service has not been rendered has,
in effect, modified the employee’s requisite service period or nonemployee’s vesting period to the period
for which goods have already been delivered or service already has been rendered, and thus the amount of
compensation cost measured at the grant date but not yet recognized shall be recognized at the repurchase
date.
A settlement is a payment (usually in the form of shares or cash) made to fulfill a share-based payment
award. Stock options are typically settled in shares, while many phantom stock unit plans are settled in
cash. In addition, certain share-based payment plans may give the entity the option to repurchase the
underlying shares in cash, may give the grantee the option to sell them for cash, or do both.
An entity must carefully consider whether any cash-settlement features affect an award’s classification.
Even if an award’s terms do not permit cash settlement, an entity’s past practice of settling or
intending to settle awards in cash before the risks and rewards of share ownership are borne by
grantees (generally six months from the date options are exercised or shares are vested) may indicate
that awards are in-substance liabilities. See Chapter 5 for a detailed discussion of determining the classification of an award.
Because cash settlement is often required under the terms of
liability-classified awards, use of the term
“settlement” in this section generally refers to
the payment made to satisfy an award that is
equity-classified and includes the repurchase of
equity instruments. While the next section
discusses the settlement of share-based payment
awards in cash, the guidance also applies to
settlements in other assets or liabilities.
6.10.1 Cash Settlements
The amount of cash paid to settle an equity-classified award is charged directly to equity as long as that amount is equal to or less than the fair-value-based measure of the award on the settlement date. To the extent that the settlement consideration exceeds the fair-value-based measure of the equity-classified award on the settlement date, that difference is recognized as additional compensation cost.
If an entity settles an unvested award (i.e., an award for which the goods or services have not been provided), the entity has effectively modified the award to accelerate the vesting conditions associated with it. Accordingly, any remaining unrecognized compensation cost is generally recognized immediately on the settlement date.
The example below is based on the same facts as in Example 1 in ASC 718-20-55-4
through 55-9 (see Section
6.1).
ASC 718-20
Example 12: Modifications and Settlements
Case D: Cash Settlement of Nonvested Share Options
55-102 Rather than modify the share option terms, Entity T offers on January 1, 20X6, to settle the original January 1, 20X5, grant of share options for cash. Because the share price decreased from $30 at the grant date to $20 at the date of settlement, the fair value of each share option is $5.36, the same as in Case C. If Entity T pays $5.36 per share option, it would recognize that cash settlement as the repurchase of an outstanding equity instrument and no incremental compensation cost would be recognized. However, the cash settlement of the share options effectively vests them. Therefore, the remaining unrecognized compensation cost of $9.79 per share option would be recognized at the date of settlement.
Example 6-31
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. The options vest at the end of the fourth year of service (cliff vesting). On December 31, 20X2, the market price of A’s stock has declined so dramatically that A wishes to settle the options because they provide little future incentive value to its employees. In this case, the employees may be willing to relinquish the options for an amount less than their then-current fair-value-based measure because payment would be immediate, settlement would not require future service, and the options may not become in-the-money during the expected term. The fair-value-based measure of the options on the settlement date is $3.50, and A settles the options for $2 in cash.
Before settlement, A recorded compensation cost of $4,500 on the basis of the number of options expected to vest (1,000 options, assuming no forfeitures), the grant-date fair-value-based measure of the options ($9), and the amount of services rendered (50 percent for two of four years of services rendered). On the settlement date, A would record the amount of cash paid ($2,000 = 1,000 options × $2 cash paid per option), with a corresponding charge to equity. Simultaneously, A would record the remaining unrecognized compensation cost ($4,500) because the options have fully vested as a result of the settlement. See the journal entries below (recorded on the settlement date).
An entity may make a cash payment to a grantee and concurrently cancel that
grantee’s awards. While the transaction would typically be accounted for as a
settlement, the determination of whether such a payment is a modification,
settlement, or other action is based on the facts and circumstances of each
situation. For example, an entity may enter into a separation agreement with an
employee to terminate employment or terminate an arrangement with a nonemployee
in which the entity (1) will make a termination payment in cash and (2)
separately cancel all of the grantee’s outstanding share-based payment awards.
The entity should account for the separation agreement and cancellation of the
awards as a single transaction. That is, the entity should view the termination
arrangement and related termination payment as the repurchase of all outstanding
awards for cash. Accordingly, as long as the settlement consideration does not
exceed the fair-value-based measure of the equity-classified awards as of the
settlement date, the entity records no additional compensation cost and charges
the amount of cash paid to settle the awards directly to equity. If the
settlement consideration exceeds the fair-value-based measure of the
equity-classified awards as of the settlement date, the entity recognizes the
amount in excess of the fair-value-based measure as additional compensation
cost.
In determining the accounting for the awards that are settled, the entity should consider the vested and unvested awards as follows:
- Vested awards — Since the termination payment for the vested awards is a settlement, the entity should recognize as a charge to equity the amount paid to repurchase the vested awards that is less than or equal to the fair-value-based measure of the vested awards on the repurchase date.
- Unvested awards — Since the grantee will not render the services or deliver the goods to earn the awards, the unvested awards are not expected to vest as of the separation date. Therefore, the entity should reverse any previously recognized compensation cost related to the unvested awards. The termination payment is an improbable-to-probable modification of the unvested awards. (See Sections 6.3 and 6.3.3 for a discussion of improbable-to-probable modifications.) That is, as a result of the termination arrangement, the grantee would not have vested in these awards upon termination of employment or the arrangement with a nonemployee (improbable). The termination payment effectively accelerated the awards’ vesting (i.e., made it probable that the awards would vest upon cash settlement). Accordingly, the total fair-value-based measure of the unvested awards is zero immediately before settlement on the separation date (0 awards expected to vest × fair-value-based measure of the unvested awards as of the date of the separation agreement). To determine the incremental compensation cost resulting from the settlement, the entity would subtract this value (zero) from the cash paid for the unvested awards (i.e., any cash paid in excess of the fair-value-based measure of the vested awards). Therefore, the entity would recognize the amount of cash paid for the unvested awards as compensation cost on the date of the termination arrangement. No amount should be recognized as the repurchase of an equity-classified award.
The decision tree below
addresses cash settlement as part of an employee
separation.
Example 6-32
On January 1, 20X3, Entity A enters into a separation agreement with one of its executives, who also terminates employment on that date:
- In connection with the separation agreement, A agrees to pay $1 million in cash to the executive upon termination of employment.
- The executive concurrently agrees to cancel all outstanding employee options to purchase A’s common stock (both vested and unvested).
- The executive has 10,000 vested employee stock options, each with a grant-date fair-value-based measure of $30 and a fair-value-based measure of $40, on January 1, 20X3.
- The executive has 10,000 unvested employee stock options, each with a grant-date fair-value-based measure of $35 and a fair-value-based measure of $42, on January 1, 20X3. The options were granted on January 1, 20X1, and vest at the end of the fourth year of service (cliff vesting).
In determining the fair-value-based measure of the outstanding options that are settled, A should consider the vested and unvested options as follows:
Vested Options
The termination payment is viewed as a settlement of the vested options. Therefore, A should recognize in equity the amount of cash paid to settle the options up to the fair-value-based measure of the options. See the journal entry below.
To record the repurchase of the vested options on the date of the separation agreement (10,000 options × $40 fair-value-based measure as of the date of the separation agreement).
Unvested Options
Since the executive’s unvested options are no longer expected to vest as of the date of the separation agreement, A should reverse any previously recognized compensation cost associated with these options on the date of the separation agreement. The termination payment is then treated as an improbable-to-probable modification of the unvested options. Accordingly, the total fair-value-based measure of the unvested options is zero immediately before the date of the separation agreement (0 options expected to vest × $42 fair-value-based measure of the unvested options as of the date of the separation agreement). The cash paid for the unvested options is $600,000, which is the total amount of cash paid for the vested and unvested options ($1 million) less the fair-value-based measure of the vested options ($400,000). Therefore, A recognizes the $600,000 settlement of the unvested options as compensation cost on the date of the separation agreement. See the journal entries below.
6.10.2 Cash Settlements Versus Modifications
As discussed in Section 6.7, modification accounting
generally applies to short-term inducements (1) to
which the award holder can subscribe for a limited
period and (2) that are accepted by the award
holder. However, the accounting consequences could
be considerably different depending on whether the
repurchase of an equity-classified share-based
payment award for cash or other assets in the
future constitutes (1) a short-term offer that
is, in substance, a settlement of the equity award
or (2) a modification of the equity award that
changes the award’s classification from equity to
liability followed by a settlement of the now
liability-classified award.
If the repurchase of (or offer to repurchase) the equity award is considered a settlement, the requirements of ASC 718-20-35-7 apply. That is, as long as the settlement consideration (cash, other assets, or liabilities incurred) does not exceed the fair-value-based measure of the equity award as of the settlement date, no additional compensation cost is recorded. The amount of cash, other assets, or liabilities incurred to settle an award is charged directly to equity. To the extent that the settlement consideration exceeds the fair-value-based measure of the equity award on the settlement date, that difference is recognized as additional compensation cost.
Alternatively, if the repurchase of (or offer to repurchase) the equity award is considered a modification that changes the award’s classification from equity to liability followed by a subsequent settlement of the now liability-classified award, an entity may need to recognize additional compensation cost as of the modification date on the basis of the fair-value-based measure of the liability award. That is, upon changing the award’s classification from equity to liability, an entity would adjust the carrying value of the equity award to its then-current fair-value-based measure as a share-based liability. Additional compensation cost would be recorded if the fair-value-based measure of the liability award on the modification date is greater than the original grant-date fair-value-based measure of the equity award. (See Section 6.8.1 for a more detailed discussion of the accounting for a modification that changes an award’s classification from equity to liability.) Because the award is now a share-based liability, the entity would remeasure it at its fair-value-based amount in each reporting period until settlement. (See Chapter 7 for a more detailed discussion of the accounting for liability awards.) In addition, the amount of cumulative compensation cost recognized cannot be less than the original grant-date fair-value-based measure. When the cash is paid to settle the liability award at an amount equal to its fair value, the share-based liability is settled with a corresponding credit to cash.
An entity must determine whether to account for a repurchase transaction in
which it offers to settle the equity award for
cash or other assets (or liabilities incurred) on
some future date as a settlement or a modification
of the equity award. The FASB clarified in FSP FAS
123(R)-6 that its intent was not for an award’s
classification to change from equity to liability
as a result of an offer to repurchase the award
for a limited period. Paragraph 11 of FSP FAS
123(R)-6 states, in part:
The
Board did not intend for a short-term inducement
that is deemed to be a settlement to affect the
classification of the award for the period it
remains outstanding (for example, change the award
from an equity instrument to a liability
instrument). Therefore, an offer (for a limited
time period) to repurchase an award should be
excluded from the definition of a short-term
inducement and should not be accounted for as a
modification pursuant to paragraph 52 of Statement
123(R) [codified in ASC 718-20-35-5].
Entities should use judgment to determine whether an offer to repurchase an
equity award is outstanding for more than a
“limited time period”; that is, whether the
repurchase of the equity award should be accounted
for as (1) a short-term offer that is, in
substance, a settlement of the equity award or (2)
a modification of the equity award followed by the
settlement of a liability award.
The following are among the items an entity
should consider in determining whether an offer to
repurchase an award that has been accepted by the
holder is a modification that changes the award’s
classification from equity to liability:
-
The amount that would be paid to settle the awards continues to be indexed to the grantor’s equity (i.e., the settlement amount is not fixed or determinable).
-
Whether substantive future service is required.
Note that if an entity’s practice or intent is to repurchase (or offer to
repurchase) equity awards, it should evaluate the
substantive terms of all outstanding share-based
payment awards in accordance with ASC
718-10-25-15. An entity’s consistent pattern of
cash settling, or its intent to cash settle,
awards may suggest that its outstanding awards’
substantive terms permit cash settlement and
therefore require liability classification. This
concept was emphasized in paragraph 11 of FSP FAS
123(R)-6, which states, in part:
[I]f an entity has a history of
settling its awards for cash, the entity should
consider whether at the inception of the awards it
has a substantive liability pursuant to paragraph
34 of Statement 123(R) [codified in ASC
718-10-25-15].
Example 6-33
On January 1, 20X1, Entity A granted 1,000 at-the-money employee stock options, each with a grant-date fair-value-based measure of $10. Throughout the options’ life, they are classified as equity. After the options are fully vested, A offers to repurchase them for cash equal to their then-current fair-value-based measure ($12 per option). If the offer to repurchase the options is considered a settlement, because, for example, the options will be settled immediately, the entire $12,000 (1,000 options × $12 fair-value-based measure on the settlement date) will be charged to equity, with the corresponding credit to cash. See the journal entry below.
Alternatively, if the offer to repurchase the options is considered a modification because, for example, the options will be settled in one year for cash on the basis of their fair-value-based measure at that time, the options are first reclassified as a share-based liability, and the difference ($2) between the grant-date fair-value-based measure ($10) and the current fair-value-based measure ($12) is recorded as additional compensation cost. Because the award is now a share-based liability, the entity would remeasure it at its fair-value-based amount in each reporting period until settlement, which is $15 per option one year later (the fair-value-based measure at that time). When the cash is paid to settle the liability award, the share-based liability is settled with a corresponding credit to cash. See the journal entries below.
In some cases, the repurchase of an equity-classified share-based payment award
for cash constitutes both (1) a settlement and (2)
a modification that changes the award’s
classification to a liability. For example, an
entity may modify an award to require cash
settlement but subject only a portion of the cash
payment to vesting, or it may pay a large,
nonrecurring cash dividend to all award holders in
connection with an equity restructuring but, for
unvested awards, subject a portion of the cash
dividend to vesting. The accounting for large,
nonrecurring cash dividends is different from that
in ASC 718 for dividend protected awards (see
Section 3.10) because such dividends
meet the definition of an equity restructuring
(see Section 6.5). Exchanges of stock
options or other equity instruments or changes to
their terms in conjunction with an equity
restructuring are modifications and therefore
subject to the accounting guidance in ASC
718-20-35-2A. Further, a “large, nonrecurring
dividend” is not defined in U.S. GAAP; therefore,
an entity should apply judgment when determining
whether a dividend gives rise to an equity
restructuring transaction and modification
accounting under ASC 718. An entity may wish to
seek the opinion of legal counsel when determining
whether a dividend represents an equity
restructuring that triggers a nondiscretionary
antidilution provision.
In these circumstances, the cash payment should
be allocated to (1) the portion of the awards that
has been settled and (2) the portion of the awards
that has been modified.
Example 6-34
On January 1, 20X1, Entity A granted to an employee 1,000 equity-classified
RSUs, each with a grant-date fair-value-based
measure of $10. The RSUs vest on a graded basis
over four years (25 percent each year on December
31). Entity A has a policy of recognizing
compensation cost on a straight-line basis over
the total requisite service period of four years
and has therefore recognized compensation cost of
$2,500 each year.
On January 1, 20X3, A declares a large,
nonrecurring cash dividend of $5 per share which
meets the definition of an equity restructuring.
The RSUs have (1) a nondiscretionary antidilution
provision that requires an equitable adjustment or
payment in the event of an equity restructuring
(and therefore are subject to the modification
accounting guidance in ASC 718-20-35-2A) and (2) a
fair-value-based measure of $20 per RSU on January
1, 20X3 (the $20 value includes the value of the
$5 dividend), both immediately before and after
the modification. Each RSU is entitled to the cash
dividend, including the unvested RSUs that are
subject to continued vesting on the basis of their
original vesting terms.
One acceptable approach is to separately account for the fully vested RSUs and the unvested RSUs (which have two years of remaining service). Therefore, for 500 of the RSUs that are fully vested, there is a partial cash settlement for 25 percent of the RSUs ($5 dividend per share ÷ $20 fair-value-based measure per RSU on January 1, 20X3). For the 500 unvested RSUs, there is a partial modification from an equity-classified award to a liability-classified award for 25 percent of the RSUs; the remaining 75 percent of the RSUs are deemed not to be settled or modified. The journal entries and related calculations below illustrate this approach to accounting for the partial cash settlement and modification.
6.11 Cancellations
ASC 718-20
Cancellation and Replacement
35-8 Except as described in paragraph 718-20-35-2A,
cancellation of an award accompanied by the concurrent grant of (or offer to
grant) a replacement award or other valuable consideration shall be accounted
for as a modification of the terms of the cancelled award. (The phrase offer
to grant is intended to cover situations in which the service inception
date precedes the grant date.) Therefore, incremental compensation cost shall be
measured as the excess of the fair value of the replacement award or other
valuable consideration over the fair value of the cancelled award at the
cancellation date in accordance with paragraph 718-20-35-3. Thus, the total
compensation cost measured at the date of a cancellation and replacement shall
be the portion of the grant-date fair value of the original award for which the
promised good is expected to be delivered (or has already been delivered) or the
service is expected to be rendered (or has already been rendered) at that date
plus the incremental cost resulting from the cancellation and replacement.
35-9 A cancellation of an award that is not accompanied by the concurrent grant of (or offer to grant) a replacement award or other valuable consideration shall be accounted for as a repurchase for no consideration. Accordingly, any previously unrecognized compensation cost shall be recognized at the cancellation date.
A cancellation may be accompanied by a concurrent grant of (or offer to grant) a
new (or replacement) award. Because the entity is in effect granting (or offering to grant)
an award to replace the canceled award, a cancellation accompanied by a concurrent grant of
(or offer to grant) a replacement award is accounted for in the same manner as a
modification. That is, the entity must record the incremental value, if any, conveyed to the
holder of the award as compensation cost on the cancellation date (for vested awards) or
over the remaining employee requisite service period or nonemployee’s vesting period (for
unvested awards). The incremental compensation cost is the excess of the fair-value-based
measure of the replacement award over the fair-value-based measure of the canceled award on
the cancellation date.
By contrast, a cancellation without a concurrent replacement is viewed as the
settlement of an award for no consideration. As a
result, if an entity (or grantee) cancels an
unvested award without a replacement award, any
remaining unrecognized compensation cost would
generally be recognized immediately on the
cancellation date. Note that a cancellation
differs from a forfeiture. As discussed in
Section 3.4.1, a forfeiture represents
an award for which the employee’s requisite
service is not rendered or the nonemployee’s goods
or services are not delivered (e.g., because of
termination of employment or termination of an
arrangement with a nonemployee). Therefore, an
award that will not vest because of the grantee’s
inability to satisfy a service condition is
accounted for as a forfeiture rather than as a
cancellation.
A cancellation, however, represents an award for which the employee’s requisite service is expected
to be rendered or the nonemployee’s goods or services is expected to be provided but is canceled.
Accordingly, for a forfeiture, an entity reverses any compensation cost that it has previously recognized,
whereas it does not reverse any previously recognized compensation for a cancellation. As noted above,
any remaining unrecognized compensation cost is generally recognized immediately on the cancellation
date.
Example 6-35
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. The options vest at the end of the fourth year of service (cliff vesting). On January 1, 20X4, A cancels the options and concurrently issues replacement options. The service period of the replacement options covers the remaining one-year service period of the canceled options. The fair-value-based measure of the replacement award is $7, and the fair-value-based measure of the canceled award is $4 on the date of cancellation.
During the first three years of service, A records cumulative compensation cost
of $6,750 (1,000 options × $9 grant-date fair-value-based measure × 75% for
three of four years of services rendered). On the cancellation date (i.e., the
modification date), A computes the incremental compensation cost as $3,000, or
($7 fair-value-based measure of replacement options – $4 fair-value-based
measure of canceled options on the date of cancellation) × 1,000 options. The
$3,000 incremental compensation cost is recorded over the remaining year of
service of the replacement options. In addition, A records the remaining $2,250
of compensation cost over the remaining year of service attributable to the
canceled options. Therefore, total compensation cost associated with these
options is $12,000 ($9,000 grant-date fair-value-based measure + $3,000
incremental fair-value-based measure) recorded over four years of required
service for both the canceled and replacement options.
Example 6-36
Assume all the same facts as in the example above, except that Entity A cancels
the original options with no concurrent issuance of (or offer to issue)
replacement options. Six months later, A issues 1,000 new at-the-money employee
stock options, each with a grant-date fair-value-based measure of $12. The
options vest over the remaining six-month service period attributable to the
canceled options.
During the first three years of service, A records cumulative compensation cost of $6,750 (1,000 options × $9 grant-date fair-value-based measure × 75% for three of four years of services rendered). On the cancellation date, the options are treated as though they are fully vested. Accordingly, A records the remaining $2,250 of compensation cost attributable to the canceled options. Therefore, total compensation cost associated with the canceled options is the $9,000 grant-date fair-value-based measure.
For the options issued six months later, A records $12,000 (1,000 options × $12 grant-date fair-value-based measure) of compensation cost over the remaining six-month service period of the options. Therefore, total compensation cost associated with these options is the $12,000 grant-date fair-value-based measure.
Because A did not account for the cancellation of the original options and
issuance of the new options as a cancellation and concurrent replacement (and
therefore did not apply modification accounting), A records total compensation
cost of $21,000 (i.e., $9,000 for the canceled options and $12,000 for the
options issued six months later). By contrast, if A had canceled and replaced
the original options concurrently for options worth $12 per option (and
therefore modification accounting was applied), A would record only total
compensation cost of $17,000, which is equal to the grant-date fair-value-based
measure of the canceled options ($9,000) and the incremental value conveyed to
the holders of the replacement options ($8,000), or ($12 fair-value-based
measure of replacement options – $4 fair-value-based measure of canceled options
on the date of cancellation) × 1,000 options.
Example 6-37
Assume all the same facts as
in Example 6-35,
except that on January 1, 20X4, Entity A’s stock price is significantly less
than the strike price, and the options are out-of-the-money. In addition, the
grantee (an executive-level officer) voluntarily agrees to cancel all 1,000
stock options because they are not material to the executive’s overall
compensation and she would like the shares to be used to grant new employee
awards under A’s stock incentive plan (rather than modifying the existing award
to adjust the options’ strike price).
The “return” of the options is voluntary; it is
not caused by the employee’s inability to satisfy
the service condition and vest in the awards
(i.e., employment was not terminated, and it is
assumed that the requisite services would have
otherwise been rendered over the vesting period).
Therefore, the return of the unvested options is
treated as a cancellation rather than a
forfeiture. As a result, the remaining
unrecognized compensation cost of $2,250
(remaining 25 percent of compensation cost that
would have been recognized in 20X4) is recognized
upon cancellation of the options, and the
previously recorded compensation cost of $6,750 is
not reversed.
6.12 Modifications That Change the Scope of Awards
An entity may modify or settle a liability to a grantee that is not subject to the provisions of ASC 718 by issuing awards that are subject to ASC 718 (e.g., stock options are granted in place of a cash-based profit-sharing arrangement). If a liability that was not initially within the scope of ASC 718 is modified or settled through the issuance of a new instrument that is within the scope of ASC 718, the entity should account for the transaction, as well as the new award, under ASC 718.
Example 6-38
On January 1, 20X1, Entity A entered into a long-term incentive agreement with its CFO. The earliest date on which the CFO would be entitled to receive payment under the agreement is 10 years from the date of the agreement (January 1, 20Y1). Entity A accounts for the plan in accordance with ASC 710-10-25-9 and recognizes the cost of the agreement in a systematic and rational manner over this 10-year period.
On January 1, 20X6, A and the CFO agree to terminate the agreement in exchange for A’s granting the CFO options to purchase A’s common stock. The number of stock options that will be granted is determined on the basis of the value of the long-term incentive agreement on the date of the exchange.
The value of the long-term incentive agreement on January 1, 20X6, was determined to be $2 million. The number of stock options to be issued to the CFO on that date was based on the fair-value-based measure of each stock option, determined by using an appropriate pricing model, and the $2 million value of the agreement. The stock options will vest after the CFO’s fifth year of service (cliff vesting). As of January 1, 20X6, A had recorded cumulative compensation cost and an accrued liability of $1 million associated with the long-term incentive agreement because 50 percent (for 5 of 10 years of services rendered) of the required service period had been rendered.
Although the accounting for the original agreement was not within the scope of ASC 718, such guidance is relevant in the determination of the cost of the share-based payment awards (whether newly granted or as a replacement of a prior compensation arrangement).
Therefore, A should reclassify the $1 million accrued liability as equity (APIC) and should record the difference between the $2 million aggregate fair-value-based measure of the stock options and the $1 million of cumulative compensation cost previously recognized in connection with the long-term incentive agreement ($1 million) as compensation cost over the remaining five-year service period of the stock options. See the journal entries below.
6.13 Modifications When a Holder Is No Longer an Employee, a Nonemployee Is No Longer Providing Goods or Services, or a Grantee Is No Longer a Customer
ASC 718-10
Awards May Become Subject to Other Guidance
35-9 Paragraphs 718-10-35-10
through 35-14 are intended to apply to those instruments
issued in share-based payment transactions with employees
and nonemployees accounted for under this Topic, and to
instruments exchanged in a business combination for
share-based payment awards of the acquired business that
were originally granted to grantees of the acquired business
and are outstanding as of the date of the business
combination.
35-9A Paragraph superseded by
Accounting Standards Update No. 2020-06.
35-10 A freestanding financial
instrument or a convertible security issued to a grantee
that is subject to initial recognition and measurement
guidance within this Topic shall continue to be subject to
the recognition and measurement provisions of this Topic
throughout the life of the instrument, unless its terms are
modified after any of the following:
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- A grantee vests in the award and is no longer providing goods or services.
- A grantee vests in the award and is no longer a customer.
- A grantee is no longer an employee.
35-10A Only for
purposes of paragraph 718-10-35-10, a modification does not
include a change to the terms of an award if that change is
made solely to reflect an equity restructuring provided that
both of the following conditions are met:
- There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved, that is, the holder is made whole) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
- All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.
35-11 Other modifications of
that instrument that take place after a grantee vests in the
award and is no longer providing goods or services, is no
longer a customer, or is no longer an employee should be
subject to the modification guidance in paragraph
718-10-35-14. Following modification, recognition and
measurement of the instrument shall be determined through
reference to other applicable GAAP.
35-12 Once the classification of an instrument is determined, the recognition and measurement provisions of this Topic shall be applied until the instrument ceases to be subject to the requirements discussed in paragraph 718-10-35-10. Topic 480 or other applicable GAAP, such as Topic 815, applies to a freestanding financial instrument that was issued under a share-based payment arrangement but that is no longer subject to this Topic. This guidance is not intended to suggest that all freestanding financial instruments shall be accounted for as liabilities pursuant to Topic 480, but rather that freestanding financial instruments issued in share-based payment transactions may become subject to that Topic or other applicable GAAP depending on their substantive characteristics and when certain criteria are met.
35-13 Paragraph superseded by Accounting Standards Update No. 2016-09.
35-14 An entity may modify (including cancel and replace) or settle a fully vested, freestanding financial instrument after it becomes subject to Topic 480 or other applicable GAAP. Such a modification or settlement shall be accounted for under the provisions of this Topic unless it applies equally to all financial instruments of the same class regardless of the holder of the financial instrument. Following the modification, the instrument continues to be accounted for under that Topic or other applicable GAAP. A modification or settlement of a class of financial instrument that is designed exclusively for and held only by grantees (or their beneficiaries) may stem from the employment or vendor relationship depending on the terms of the modification or settlement. Thus, such a modification or settlement may be subject to the requirements of this Topic. See paragraph 718-10-35-10 for a discussion of changes to awards made solely to reflect an equity restructuring.
ASC 718-10-35-10 indicates that a share-based payment award that is subject to
ASC 718 does not become subject to other applicable GAAP unless the award is
modified when the individual is no longer an employee or, for nonemployee awards,
the award is vested and the individual is no longer providing goods or services or,
for customers, the award is vested and the grantee is no longer a customer.
Modifications made to an award when the holder is no longer an employee should be
accounted for under ASC 718-10-35-11, which refers to ASC 718-10-35-14. If the
modification or a settlement does not apply equally to all financial instruments of
the same class regardless of whether the holder is (or was) an employee, a
nonemployee providing goods or services, or a customer, the above sections on
modifications and settlements apply, and any incremental fair-value-based measure is
recognized as compensation cost. After the modification, the award will become
subject to other applicable GAAP (e.g., ASC 815 and ASC 480). Note that once the
award becomes subject to other applicable GAAP, ASC 718’s guidance on classification
(including the exceptions to liability classification) no longer applies. See
Section 5.8 for
further discussion of the accounting for awards that become subject to other
guidance.
However, in accordance with ASC 718-10-35-10A, if the terms of an award are
modified solely to reflect an equity restructuring, the award is not subject to
other applicable GAAP as long as both of the following conditions are met:
-
There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved, that is, the holder is made whole) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
-
All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.
Chapter 7 — Liability-Classified Awards
Chapter 7 — Liability-Classified Awards
This chapter discusses the accounting for share-based payment awards for which
liability classification is required under ASC 718. Unlike
equity-classified awards, liability-classified awards must be
remeasured at the end of each reporting period until settlement. By
contrast, equity-classified awards are measured at their
fair-value-based amount (or, for nonpublic entities, at a calculated
value if a fair-value-based measure is not reasonably estimable) on
the grant date (i.e., the award’s fair-value-based measure is fixed
on the grant date). In addition, because the measurement date for
liability-classified awards is the settlement date, the related
income tax effects are remeasured at the end of each reporting
period until settlement.
7.1 Fair-Value-Based Measurement
ASC 718-10
55-9 The fair value measurement
objective for liabilities incurred in a share-based payment
transaction is the same as for equity instruments. However,
awards classified as liabilities are subsequently remeasured
to their fair values (or a portion thereof until the
promised good has been delivered or the service has been
rendered) at the end of each reporting period until the
liability is settled.
ASC 718-30
Measurement Objective and Measurement Date
Public Entity
30-1 At the grant date, the measurement objective for liabilities incurred under share-based compensation arrangements is the same as the measurement objective for equity instruments awarded to grantees as described in paragraph 718-10-30-6. However, the measurement date for liability instruments is the date of settlement.
Nonpublic Entity
30-2 A nonpublic entity shall
make a policy decision of whether to measure all of its
liabilities incurred under share-based payment arrangements
(for employee and nonemployee awards) issued in exchange for
distinct goods or services at fair value or at intrinsic
value. However, a nonpublic entity shall initially and
subsequently measure awards determined to be consideration
payable to a customer (as described in paragraph
606-10-32-25) at fair value.
Measurement
35-1 The fair value of liabilities incurred in share-based payment transactions shall be remeasured at the end of each reporting period through settlement.
35-2 Changes in the fair value
(or intrinsic value for a nonpublic entity that elects that
method) of a liability incurred under a share-based payment
arrangement issued in exchange for goods or services that
occur during the employee’s requisite service period or the
nonemployee’s vesting period shall be recognized as
compensation cost over that period. The percentage of the
fair value (or intrinsic value) that is accrued as
compensation cost at the end of each period shall equal the
percentage of the requisite service that has been rendered
for an employee award or the percentage that would have been
recognized had the grantor paid cash for the goods or
services instead of paying with a nonemployee award at that
date. Changes in the fair value (or intrinsic value) of a
liability issued in exchange for goods or services that
occur after the end of the employee’s requisite service
period or the nonemployee’s vesting period are compensation
cost of the period in which the changes occur. Any
difference between the amount for which a liability award
issued in exchange for goods or services is settled and its
fair value at the settlement date as estimated in accordance
with the provisions of this Subtopic is an adjustment of
compensation cost in the period of settlement. Example 1
(see paragraph 718-30-55-1) provides an illustration of
accounting for a liability award issued in exchange for
service from the grant date through its settlement.
Public Entity
35-3 A public entity shall measure a liability award under a share-based payment arrangement based on the award’s fair value remeasured at each reporting date until the date of settlement. Compensation cost for each period until settlement shall be based on the change (or a portion of the change, depending on the percentage of the requisite service that has been rendered for an employee award or the percentage that would have been recognized had the grantor paid cash for the goods or services instead of paying with a nonemployee award at the reporting date) in the fair value of the instrument for each reporting period. Example 1 (see paragraph 718-30-55-1) provides an illustration of accounting for an instrument classified as a liability using the fair-value-based method.
Nonpublic Entity
35-4
Regardless of the measurement method
initially selected under paragraph 718-10-30-20, a nonpublic
entity shall remeasure its liabilities under share-based
payment arrangements at each reporting date until the date
of settlement. The fair-value-based method is preferable for
purposes of justifying a change in accounting principle
under Topic 250. Example 1 (see paragraph 718-30-55-1)
provides an illustration of accounting for an instrument
classified as a liability using the fair-value-based method.
Example 2 (see paragraph 718-30-55-12) provides an
illustration of accounting for an instrument classified as a
liability using the intrinsic value method. A nonpublic
entity shall subsequently measure awards determined to be
consideration payable to a customer (as described in
paragraph 606-10-32-25) at fair value.
The measurement objective for liability-classified awards is the same as that
for equity-classified awards. (See Chapter 4 for a detailed discussion of how the fair-value-based
measure of share-based payment award is determined.) For public entities,
liability-classified awards must be measured at their fair-value-based amount, which
is the same measurement method required for equity-classified awards. However, since
the measurement date for liability-classified awards is the date of settlement
rather than the grant date for equity-classified awards, liability-classified awards
are remeasured at their fair-value-based amount at the end of each reporting period
until settlement. As discussed in Section 4.13.3 and
Section 7.3, nonpublic entities can make a policy decision to elect,
as an alternative to a fair-value-based measure, to measure liability-classified
awards issued in exchange for goods or services at intrinsic value.
If a nonpublic entity elects to measure its liability-classified awards issued
in exchange for goods or services at intrinsic value, those awards must still be
remeasured at the end of each reporting period until settlement. However, the use of
the intrinsic-value method reduces the burden of calculating a fair-value-based
measure for options and similar instruments at the end of each reporting period. For
example, if an entity grants SARs that it classifies as a liability and calculates
by using a fair-value-based measurement, it will be required to use a valuation
technique such as an option pricing model and update the assumptions at the end of
each reporting period. See Section
4.9 for a more detailed discussion of selecting a valuation
technique.
7.2 Recognition
As indicated in Section
7.1, the fair-value-based measure (or intrinsic value for a nonpublic
entity that elects that method for awards issued in exchange for goods or services)
of a share-based payment award that is classified as a liability is remeasured at
the end of each reporting period until settlement. Therefore, for all
liability-classified awards, the settlement amount will ultimately be the total
amount of compensation cost recognized. The changes in the fair-value-based measure
(or intrinsic value) are recognized as compensation cost (with a corresponding
increase or decrease in the share-based liability) either immediately or over the
employee’s remaining requisite service period or nonemployee’s vesting period,
depending on the vested status of the award. For unvested awards, the percentage of
the fair-value-based measure (or intrinsic value) that is recognized as compensation
cost at the end of each period is based on (1) the percentage of the requisite
service that has been rendered (for employee awards) or (2) the percentage that
would have been recognized had the grantor paid cash for the goods or services
instead of paying with a share-based payment award as of that date (for nonemployee
awards).
7.2.1 Cash-Settled SARs
The example in ASC 718-30 below illustrates the accounting for a cash-settled
SAR associated with an award that is recognized on the basis of its
fair-value-based measure. The example also illustrates how the classification of
a share-based payment award affects the accounting for income taxes.
ASC 718-30
Illustrations
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.
55-3 Paragraph 718-30-35-4 permits a nonpublic entity to measure share-based payment liabilities at either fair value (or, in some cases, calculated value) or intrinsic value. If a nonpublic entity elects to measure those liabilities at fair value, the accounting demonstrated in this Example would be applicable. Paragraph 718-30-35-3 requires that share-based compensation liabilities be recognized at fair value or a portion thereof (depending on the percentage of requisite service rendered at the reporting date) and be remeasured at each reporting date through the date of settlement; consequently, compensation cost recognized during each year of the three-year vesting period (as well as during each year thereafter through the date of settlement) will vary based on changes in the award’s fair value. As of December 31, 20X5, the assumed fair value is $10 per stock appreciation right; hence, the fair value of the award is $8,214,060 (821,406 × $10). The share-based compensation liability as of December 31, 20X5, is $2,738,020 ($8,214,060 ÷ 3) to account for the portion of the award related to the service rendered in 20X5 (1 year of the 3-year requisite service period). For convenience, this Example assumes that journal entries to account for the award are performed at year-end. The journal entries for 20X5 are as follows.
55-4 As of December 31, 20X6, the fair value is assumed to be $25 per stock appreciation right; hence, the 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 service has been provided for 2 years of the 3-year requisite service period. Compensation cost recognized for the award in 20X6 is $10,952,080 ($13,690,100 – $2,738,020). Entity T recognizes the following journal entries for 20X6.
55-5 As of December 31, 20X7, the fair value is assumed to be $20 per stock appreciation right; hence, the award’s fair value is $16,428,120 (821,406 × $20), and the corresponding liability at that date is $16,428,120 ($16,428,120 × 1) because the award is fully vested. Compensation cost recognized for the liability award in 20X7 is $2,738,020 ($16,428,120 – $13,690,100). Entity T recognizes the following journal entries for 20X7.
55-6 The share-based liability award is as follows.
55-7 For simplicity, this Example assumes that all of the stock appreciation rights are exercised on the same day, that the liability award’s fair value is $20 per stock appreciation right, and that Entity T has already recognized its income tax expense for the year without regard to the effects of the exercise of the employee stock appreciation rights. In other words, current tax expense and current taxes payable were recognized based on taxable income and deductions before consideration of additional deductions from exercise of the stock appreciation rights. The amount credited to cash for the exercise of the stock appreciation rights is equal to the share-based compensation liability of $16,428,120.
55-8 At exercise the journal entry is as follows.
55-9 The cash paid to the
employees on the date of exercise is deductible for tax
purposes. The tax benefit is $5,749,842 ($16,428,120 ×
.35).
55-10 At exercise the journal entry is as follows.
55-11 If the stock appreciation rights had expired worthless, the share-based compensation liability account and deferred tax asset account would have been adjusted to zero through the income statement as the award’s fair value decreased.
Since a liability-classified SAR is remeasured at the end of each reporting
period until settlement, the settlement amount and ultimate amount of
compensation cost recognized will generally be equal to the award’s intrinsic
value, even if recognized on the basis of its fair-value-based measure. This is
because upon settlement, there is no remaining time value. Therefore, the
ultimate amount of compensation cost recognized for a cash-settled SAR will be
the same regardless of whether a nonpublic entity elects to measure its
liability-classified awards issued in exchange for goods or services on the
basis of their fair-value-based measure or intrinsic value. (See Section 7.3 for a
discussion of the intrinsic-value practical expedient available for nonpublic
entities.) In addition, as noted in ASC 718-30-55-11, if a cash-settled SAR is
worthless at expiration, the ultimate amount of compensation cost recognized
will be zero. By contrast, an equity-classified stock option or SAR will be
recognized at its grant-date fair-value-based measure, and compensation cost
cannot be reversed if the award is worthless at expiration as long as the
vesting conditions are met (i.e., the good is delivered or the service is
rendered).
7.2.2 Liability-Classified Awards With Market Conditions
As discussed in Section 3.5, the effect of a market condition is reflected in the fair-value-based measure of an award. If an award with a market condition is classified as equity, and the good is delivered or the service is rendered, compensation cost is recognized regardless of whether the market condition is satisfied. However, the same is not true for a liability-classified award that is earned only if a market condition is satisfied. Because liability-classified awards are remeasured at the end of each reporting period until settlement, the final compensation cost will be zero even if the good is delivered or the service is rendered since the market condition has not been satisfied and therefore the award has not been earned.
7.3 Intrinsic-Value Practical Expedient for Nonpublic Entities
ASC 718-30
Nonpublic Entity
30-2 A nonpublic entity shall
make a policy decision of whether to measure all of its
liabilities incurred under share-based payment arrangements
(for employee and nonemployee awards) issued in exchange for
distinct goods or services at fair value or at intrinsic
value. However, a nonpublic entity shall initially and
subsequently measure awards determined to be consideration
payable to a customer (as described in paragraph
606-10-32-25) at fair value.
Nonpublic Entity
35-4 Regardless of the
measurement method initially selected under paragraph
718-10-30-20, a nonpublic entity shall remeasure its
liabilities under share-based payment arrangements at each
reporting date until the date of settlement. The
fair-value-based method is preferable for purposes of
justifying a change in accounting principle under Topic 250.
Example 1 (see paragraph 718-30-55-1) provides an
illustration of accounting for an instrument classified as a
liability using the fair-value-based method. Example 2 (see
paragraph 718-30-55-12) provides an illustration of
accounting for an instrument classified as a liability using
the intrinsic value method. A nonpublic entity shall
subsequently measure awards determined to be consideration
payable to a customer (as described in paragraph
606-10-32-25) at fair value.
As noted in Section
7.1, nonpublic entities can elect, as a policy decision, to measure
liability-classified awards issued in exchange for goods or services at intrinsic
value instead of a fair-value-based measure (or at a calculated value if a
fair-value-based measure is not reasonably estimable) as of the end of each
reporting period until the awards are settled. To justify a change in accounting
principle under ASC 250, it is preferable for a nonpublic entity to use the
fair-value-based method (see Section 4.13.4 for a discussion of how to record the effects of an
entity’s change from nonpublic to public entity). Therefore, a nonpublic entity that
has elected to measure its liability-classified awards at a fair-value-based amount
(or calculated value) would not be permitted to subsequently change to the
intrinsic-value method.
The example in ASC 718-30 below illustrates the use of the intrinsic-value method for measuring liability-classified awards, which is available to nonpublic entities.
ASC 718-30
Example 2: Award Granted by a Nonpublic Entity That Elects the Intrinsic Value Method
55-12 This Example illustrates the guidance in paragraphs 718-30-35-4 and 718-740-25-2 through 25-4.
55-12A This Example (see paragraphs 718-30-55-13 through 55-20) 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, a nonpublic entity can make the accounting policy election in paragraph 718-30-30-2 to change its measurement of all liability-classified nonemployee awards from fair value to intrinsic value and remeasure those awards each reporting period as illustrated in this Example. Therefore, the guidance in this Example may serve as implementation guidance for similar liability-classified nonemployee awards.
55-12B Compensation cost attribution for awards to nonemployees may be the same or different for liability-classified 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.
55-13 On January 1, 20X6, Entity W, a nonpublic entity that has chosen the accounting policy of using the intrinsic value method of accounting for share-based payments that are classified as liabilities in accordance with paragraphs 718-30-30-2 and 718-30-35-4, grants 100 cash-settled stock appreciation rights with a 5-year life to each of its 100 employees. Each stock appreciation right entitles the holder to receive an amount in cash equal to the increase in value of 1 share of Entity W’s stock over $7. The awards cliff-vest at the end of three years of service (an explicit and requisite service period of three years). For simplicity, the Example assumes that no forfeitures occur during the vesting period and does not reflect the accounting for income tax consequences of the awards.
55-14 Because of Entity W’s accounting policy decision to use intrinsic value, all of its share-based payments that are classified as liabilities are recognized at intrinsic value (or a portion thereof, depending on the percentage of requisite service that has been rendered) at each reporting date through the date of settlement; consequently, the compensation cost recognized in each year of the three-year requisite service period will vary based on changes in the liability award’s intrinsic value. As of December 31, 20X6, Entity W stock is valued at $10 per share; hence, the intrinsic value is $3 per stock appreciation right ($10 – $7), and the intrinsic value of the award is $30,000 (10,000 × $3). The compensation cost to be recognized for 20X6 is $10,000 ($30,000 ÷ 3), which corresponds to the service provided in 20X6 (1 year of the 3-year service period). For convenience, this Example assumes that journal entries to account for the award are performed at year-end. The journal entry for 20X6 is as follows.
55-15 As of December 31, 20X7, Entity W stock is valued at $8 per share; hence, the intrinsic value is $1 per stock appreciation right ($8 – $7), and the intrinsic value of the award is $10,000 (10,000 × $1). The decrease in the intrinsic value of the award is $20,000 ($10,000 – $30,000). Because services for 2 years of the 3-year service period have been rendered, Entity W must recognize cumulative compensation cost for two-thirds of the intrinsic value of the award, or $6,667 ($10,000 × 2/3); however, Entity W recognized compensation cost of $10,000 in 20X5. Thus, Entity W must recognize an entry in 20X7 to reduce cumulative compensation cost to $6,667.
55-16 As of December 31, 20X8, Entity W stock is valued at $15 per share; hence, the intrinsic value is $8 per stock appreciation right ($15 – $7), and the intrinsic value of the award is $80,000 (10,000 × $8). The cumulative compensation cost recognized as of December 31, 20X8, is $80,000 because the award is fully vested. The journal entry for 20X8 is as follows.
55-17 The share-based liability award at intrinsic value is as follows.
55-18 For simplicity, this Example assumes that all of the stock appreciation rights are settled on the day that they vest, December 31, 20X8, when the share price is $15 and the intrinsic value is $8 per share. The cash paid to settle the stock appreciation rights is equal to the share-based compensation liability of $80,000.
55-19 At exercise the journal entry is as follows.
55-20 If the stock appreciation rights had not been settled, Entity W would continue to remeasure those remaining awards at intrinsic value at each reporting date through the date they are exercised or otherwise settled.
7.4 Modifications
ASC 718-30
Modification of an Award
35-5 A modification of a
liability award is accounted for as the exchange of the
original award for a new award. However, because liability
awards are remeasured at their fair value (or intrinsic
value for a nonpublic entity that elects that method) at
each reporting date, no special guidance is necessary in
accounting for a modification of a liability award that
remains a liability after the modification (see Example 15,
Case C [paragraph 718-20-55-135] for what happens when the
modification causes the award to no longer be a
liability).
As discussed in Chapter
6, a modification is considered an exchange of an original award for
a new award. This principle also applies to liability-classified awards that are
modified. Since liability-classified awards are remeasured at the end of each
reporting period until settlement, an entity accounts for a modification by
measuring the modified award at its fair-value-based amount (or intrinsic value for
a nonpublic entity that has elected that method for awards issued in exchange for
goods or services) on the modification date. If the award is unvested, the entity
determines the cumulative compensation cost to be recorded by calculating the
award’s fair-value-based measure (or intrinsic value) and multiplying this amount by
the percentage of the requisite service that has been rendered for an employee award
or the percentage that would have been recognized had the grantor paid cash for the
goods or services instead of paying with a share-based payment award on the
modification date. The entity then compares (1) the cumulative compensation cost to
be recorded for the modified award and (2) the cumulative compensation cost
recognized for the original award and records the difference as either an increase
or decrease in compensation cost. The implementation example in ASC 718-20 below
illustrates the accounting for the modification of a liability-classified award that
remains a liability after the modification and is based on the facts as described in
ASC 718-30-55-1 through 55-11 (see Section 7.2.1).1
ASC 718-20
Example 16: Modifications Regarding an Award’s
Classification
Case D: Liability to Liability Modification (Cash-Settled to Cash-Settled Stock Appreciation Rights)
55-139 This Case is based on the facts given in Example 1 (see paragraph 718-30-55-1). Entity T grants stock appreciation rights to its employees. The fair value of the award on January 1, 20X5, is $12,066,454 (821,406 × $14.69).
55-140 On December 31, 20X5, the fair value of each stock appreciation right is assumed to be $5; therefore, the fair value of the award is $4,107,030 (821,406 × $5). The share-based compensation liability at December 31, 20X5, is $1,369,010 ($4,107,030 ÷ 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 to recognize compensation cost for 20X5 are as follows.
55-141 On January 1, 20X6, Entity T reprices the stock appreciation rights, giving each holder the right to receive an amount in cash equal to the increase in value of 1 share of Entity T stock over $10. The modification affects no other terms or conditions of the stock appreciation rights and does not change the number of stock appreciation rights expected to vest. The fair value of each stock appreciation right based on its modified terms is $12. The incremental compensation cost is calculated per the method in Example 12 (see paragraph 718-20-55-93).
55-142 Entity T also could determine the incremental value of the modified stock appreciation right award by multiplying the fair value of the modified stock appreciation right award by the portion of the award that is earned and subtracting the cumulative recognized compensation cost [($9,856,872 ÷ 3) – $1,369,010 = $1,916,614]. As a result, Entity T would record the following journal entries at the date of the modification.
55-143 Entity T would continue to remeasure the liability award at each reporting date until the award’s settlement.
Footnotes
1
See ASC 718-20-55-122A through 55-122C for considerations
related to the application of Example 16 to nonemployee awards.
Chapter 8 — Employee Stock Purchase Plans
Chapter 8 — Employee Stock Purchase Plans
8.1 Scope
ASC 718-50
General
05-1 This Subtopic provides guidance to entities that use employee share purchase plans. The entity must first determine whether the plan is compensatory or noncompensatory. This is determined by the terms of the plan (see paragraphs 718-50-25-1 through 25-2). A plan with an option feature, for example a look-back feature, is considered compensatory. For a compensatory plan the calculation of the amount of the compensation is important (see Section 718-50-55).
Overall Guidance
15-1 This Subtopic has its own discrete scope, which is separate and distinct from the pervasive scope for this Topic as outlined in Section 718-10-15.
An ESPP is a plan that gives employees the ability to purchase an entity’s shares, typically at a discount. Generally, employees contribute to the ESPP through payroll deductions over a period between the enrollment date and purchase date (referred to as the purchase period). The accumulated payroll withholdings are then used to purchase the entity’s shares on behalf of the participating employees.
The guidance on share-based payment transactions with ESPPs is contained in ASC 718-50 and is separate and distinct from the general requirements in ASC 718, as outlined in ASC 718-10-15.
An ESPP may be considered compensatory or noncompensatory. The distinction is
significant because it affects whether an entity recognizes compensation cost for
the ESPP. To qualify as a noncompensatory plan and, therefore, not give rise to the
recognition of compensation cost, an ESPP must meet certain criteria, which are
discussed in Section
8.2. However, many plans are compensatory because the discount
offered to employees exceeds the limits permissible under ASC 718.
8.2 Noncompensatory Plans
ASC 718-50
General
25-1 An employee share purchase plan that satisfies all of the following criteria does not give rise to recognizable compensation cost (that is, the plan is noncompensatory):
- The plan satisfies either of the following conditions:
- The terms of the plan are no more favorable than those available to all holders of the same class of shares. Note that a transaction subject to an employee share purchase plan that involves a class of equity shares designed exclusively for and held only by current or former employees or their beneficiaries may be compensatory depending on the terms of the arrangement.
- Any purchase discount from the market price does not exceed the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering. A purchase discount of 5 percent or less from the market price shall be considered to comply with this condition without further justification. A purchase discount greater than 5 percent that cannot be justified under this condition results in compensation cost for the entire amount of the discount. Note that an entity that justifies a purchase discount in excess of 5 percent shall reassess at least annually, and no later than the first share purchase offer during the fiscal year, whether it can continue to justify that discount pursuant to this paragraph.
- Substantially all employees that meet limited employment qualifications may participate on an equitable basis.
- The plan incorporates no option features, other than the following:
- Employees are permitted a short period of time — not exceeding 31 days — after the purchase price has been fixed to enroll in the plan.
- The purchase price is based solely on the market price of the shares at the date of purchase, and employees are permitted to cancel participation before the purchase date and obtain a refund of amounts previously paid (such as those paid by payroll withholdings).
25-2 A plan provision that establishes the purchase price as an amount based on the lesser of the equity share’s market price at date of grant or its market price at date of purchase, commonly called a look-back plan, is an example of an option feature that causes the plan to be compensatory. Similarly, a plan in which the purchase price is based on the share’s market price at date of grant and that permits a participating employee to cancel participation before the purchase date and obtain a refund of amounts previously paid contains an option feature that causes the plan to be compensatory. Section 718-50-55 provides guidance on determining whether an employee share purchase plan satisfies the criteria necessary to be considered noncompensatory.
Unless it meets all three conditions in ASC 718-50-25-1, an ESPP is compensatory and therefore gives rise to the recognition of compensation cost.
8.2.1 First Condition in ASC 718-50-25-1
Under ASC 718-50-25-1(a), an ESPP must satisfy either of the following criteria:
- “The terms of the plan are no more favorable than those available to all holders of the same class of shares.”Meeting this criterion is uncommon because ESPPs often offer terms for the purchase of shares that are more favorable than the terms available to all shareholders. To prevent an entity from creating a separate class of shares solely to satisfy this condition, ASC 718-50-25-1(a)(1) contains an anti-abuse provision, which states that “a transaction subject to an employee share purchase plan that involves a class of equity shares designed exclusively for and held only by current or former employees or their beneficiaries may be compensatory depending on the terms of the arrangement.”
- A purchase discount, if it is greater than 5 percent, does not exceed the per-share amount of share issuance costs that would be incurred to raise a significant amount of capital through a public offering.A purchase discount of 5 percent or less from the market price of the entity’s shares is a safe harbor and does not result in a compensatory ESPP. Many IRC Section 423 plans, however, offer a purchase discount of 15 percent from the market price of the entity’s shares. If an entity can justify that the discount (e.g., the 15 percent discount permitted under IRC Section 423) is equivalent to the share issuance costs that the entity would have incurred to raise a significant amount of capital in a public offering, the ESPP may be considered noncompensatory (provided that the plan meets the remaining conditions discussed below). AICPA Technical Q&As Section 4110.01 provides guidance on what amounts should be considered for inclusion in the share issuance cost. It states, in part:Such costs should be limited to the direct cost of issuing the security. Thus, there should be no allocation of officers’ salaries, and care should be taken that legal and accounting fees do not include any fees that would have been incurred in the absence of such issuance.In addition, the entity must continue to justify the appropriateness of the discount percentage (if greater than 5 percent) at least annually and no later than when it makes the first share purchase offer during the fiscal year. If the entity is no longer able to justify a discount in excess of 5 percent, subsequent grants using that discount rate would be considered compensatory (unless the “terms of the plan are no more favorable than those available to all holders of the same class of shares” and the other conditions in ASC 718-50-25-1 are satisfied). The inability to justify a discount on a current offering would not affect the noncompensatory nature of previous offerings. That is, an entity would not record compensation cost for purchase offers made before the entity is unable to justify a discount in excess of 5 percent.
The application of the condition in ASC
718-50-25-1(a) is illustrated in the following implementation guidance:
ASC 718-50
55-35 Another criterion is that the terms are no more favorable than those available to all holders of the same class of shares. For example, Entity A offers all full-time employees and all nonemployee shareholders the right to purchase $10,000 of its common stock at a 5 percent discount from its market price at the date of purchase, which occurs in 1 month. The arrangement is not compensatory because its terms are no more favorable than those available to all holders of the same class of shares. In contrast, assume Entity B has a dividend reinvestment program that permits shareholders of its common stock the ability to reinvest dividends by purchasing shares of its common stock at a 10 percent discount from its market price on the date that dividends are distributed and Entity B offers all full-time employees the right to purchase annually up to $10,000 of its common stock at a 10 percent discount from its market price on the date of purchase. Entity B’s common stock is widely held; hence, many shareholders will not receive dividends totaling at least $10,000 during the annual period. Assuming that the 10 percent discount cannot be justified as the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering, the arrangement is compensatory because the number of shares available to shareholders at a discount is based on the quantity of shares held and the amounts of dividends declared. Whereas, the number of shares available to employees at a discount is not dependent on shares held or declared dividends; therefore, the terms of the employee share purchase plan are more favorable than the terms available to all holders of the same class of shares. Consequently, the entire 10 percent discount to employees is compensatory. If, on the other hand, the 10 percent discount can be justified as the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering, then the entire 10 percent discount to employees is not compensatory. If an entity justifies a purchase discount in excess of 5 percent, it would be required to reassess that discount at least annually and no later than the first share purchase offer during the fiscal year. If upon reassessment that discount is not deemed justifiable, subsequent grants using that discount would be compensatory.
In the example in ASC 718-50-55-35 above, B offers its shareholders the ability to participate in a dividend reinvestment program (DRIP) and offers its employees a 10 percent discount on purchases of its common stock up to $10,000. Because the shareholders are not likely to receive dividends totaling $10,000, their participation in the DRIP will not be the same as that of employees in the ESPP. That is, while the terms of the ESPP (for employees) and the DRIP (for all other shareholders) are similar (i.e., B’s shares may be purchased at a 10 percent discount from the market price), employees can participate in the ESPP by contributing up to $10,000, whereas all other shareholders can participate in the DRIP by contributing only up to the amount of dividends they receive, which may not total $10,000. Accordingly, the terms available to employees under the ESPP may be more favorable.
The ESPP may still be noncompensatory with respect to the discounted shares
offered to employees if B can justify that the
discount does not exceed the share issuance costs
that the entity would have incurred to raise a
significant amount of capital in a public market
(assuming the plan meets the remaining conditions
in ASC 718-50-25-1). However, as discussed above,
the entity must continue to assess the discount
percentage at least annually, and no later than
the first ESPP offer during the fiscal year, to
justify continued use of the discount percentage
on subsequent offerings.
Example 8-1
On January 1, 20X1, Entity A establishes an ESPP that permits employees to purchase A’s shares at a 7 percent discount. Entity A can justify that the 7 percent discount is not greater than the costs A would have incurred in a significant offering of A’s shares in a public market. Therefore, the ESPP is not considered compensatory (provided that all the other criteria in ASC 718-50-25-1 also have been met).
On July 1, 20X1, A makes a second offering under its ESPP, also with a 7 percent discount. Entity A is not required to reassess the 7 percent discount used in the second ESPP offering in 20X1. As long as all the other criteria in ASC 718-50-25-1 continue to be met, the plan is not considered compensatory.
On January 1, 20X2, A makes a third offering under its ESPP and again offers a 7 percent discount. In accordance with ASC 718-50-25-1(a)(2), A would have to justify that the 7 percent discount remains appropriate for this offering. If, for this offering, A can no longer justify the 7 percent discount, the plan is considered compensatory (unless the “terms of the plan are no more favorable than those available to all holders of the same class of shares” and the other conditions in ASC 718-50-25-1 have been met). Entity A’s inability to justify the discount on the current offering would not affect the noncompensatory nature of prior offerings. That is, A would record no compensation cost for purchase offers made before A is unable to justify the discount (i.e., for the January 1, 20X1, and the July 1, 20X1, offerings). Further, for the third offering, A must include the entire amount of the discount (i.e., 7 percent) in determining the amount of compensation cost over the requisite service period, not just the discount in excess of 5 percent.
8.2.2 Second Condition in ASC 718-50-25-1
Under ASC 718-50-25-1(b), the ESPP must allow
substantially all employees that meet limited employment qualifications to
participate on an equitable basis. ASC 718-50-55-34 provides examples of limited
employment qualifications as follows:
ASC 718-50
Example 2: Limitations for Noncompensatory Treatment
55-34 Paragraph 718-50-25-1 stipulates the criteria that an employee share purchase plan must satisfy to be considered noncompensatory. One of those criteria specifies that substantially all employees that meet limited employment qualifications may participate on an equitable basis. Examples of limited employment qualifications might include customary employment of greater than 20 hours per week or completion of at least 6 months of service.
While an entity will assess whether it has satisfied this condition on the basis
of its specific facts and circumstances, the
underlying principle is that the ESPP should be
nondiscriminatory. For example, participation
could be limited to employees in a specific
country and be considered nondiscriminatory.
However, if participation is limited to executives
(i.e., nonexecutives are not eligible to
participate) the ESPP would not meet this
condition.
8.2.3 Third Condition in ASC 718-50-25-1
Under ASC 718-50-25-1(c), an entity assesses whether the ESPP incorporates option features and, if so, whether they cause the plan to become compensatory. Except in the following two circumstances, an option feature renders a plan compensatory:
- The option feature gives an employee “a short period of time — not exceeding 31 days — after the purchase price has been fixed to enroll in the plan.” However, an ESPP with such a feature may have an additional option feature that renders it compensatory. For example, an ESPP would be compensatory if (1) the purchase price is set on the date the employee begins to participate in the plan and is having money withheld to pay for the shares but (2) the plan allows the employee to cancel participation after enrollment and receive a refund of the amount previously withheld from the employee’s pay. This is because the employee begins to benefit from, or be adversely affected by, subsequent changes in the entity’s share price once the purchase price is set. Allowing cancellation of participation after enrollment would give the employee benefits similar to those of a stock option.
- The “purchase price is based solely on the market price of the [entity’s] shares at the date of purchase, and employees are permitted to cancel participation before the purchase date and obtain a refund of amounts previously paid” (emphasis added). Unlike a scenario in which the employee can cancel participation in the plan after the purchase price has been set (and therefore after beginning to benefit from, or be adversely affected by, subsequent changes in the entity’s share price), such an option feature does not give the employee benefits similar to those of a stock option because the employee can only cancel participation before the purchase price is set.
Note that many existing ESPPs include a look-back feature that allows the
purchase price to be set at the lower of (1) the
market price of the entity’s shares on the date
the employee begins participating in the plan and
is having money withheld to pay for the shares or
(2) the market price of the shares on the purchase
date. A look-back feature is considered an option
feature that results in a compensatory plan. See
discussion in Section 8.9.
8.3 Grant Date
Compensation cost for equity-classified ESPP awards is measured on
the grant date. The definition in ASC 718-50 of “grant date” for ESPPs is the same
as that for other forms of share-based payment awards under ASC 718. For a grant
date to be established, all 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.
-
All necessary approvals have been obtained.
-
The recipient must meet the definition of an employee.
Generally, the employee’s enrollment and selection of withholdings
(i.e., enrollment period) for ESPPs is completed before the start of the purchase
period. Therefore, the grant date would typically be when the employee has committed
to enrolling in the plan since this is when there would be a mutual understanding of
the arrangement. (See Section
3.2 for more information about determining the grant date.)
For some ESPPs that have a look-back feature (see Section
8.9), the final exercise price may be based on the share price at the
end of the purchase period. However, ASC 718-10-55-83 notes that while the ultimate
exercise price in an award with a look-back feature is not known on the grant date,
such price cannot be greater than the share price at the start of the purchase
period. In this case, the relationship between the exercise price and the current
share price provides a sufficient basis for understanding both the compensatory and
equity relationship established by the award. Provided that all other conditions for
establishing a grant date have been met, the grant date would be established at the
beginning of the purchase period because that is when the employee begins to benefit
from subsequent changes in the price of the shares.
Under the terms of some ESPPs, an employee may be entitled to
purchase a specified dollar amount of an entity’s stock on a future date (e.g., in
one year) at an established discount from the market price of the entity’s stock on
that future date (i.e., a variable number of shares for a fixed monetary amount). In
addition, the ESPP’s terms may not include a look-back feature. That is, the
purchase price would not be the lower of the purchase-date price or the
enrollment-date price of the entity’s stock. Although the liability would be based
on a fixed amount, we do not believe that the ability to benefit from, or be
adversely affected by, subsequent changes in the employer’s stock price would be
necessary to establish a grant date. Thus, the grant date is the beginning of the
purchase period (i.e., the start of the enrollment period through the date on which
the shares are purchased).
8.4 Requisite Service Period
ASC 718-50
25-3 The requisite service period for any compensation cost resulting from an employee share purchase plan is the period over which the employee participates in the plan and pays for the shares.
As with any other share-based payment award, if an ESPP is deemed to be
compensatory, compensation cost is recognized over the requisite service period. The
service inception date is the date on which the requisite service period begins and
is usually the grant date, although there may be circumstances in which the service
inception date precedes the grant date. Given the guidance in ASC 718-50-25-3, the
requisite service period, and therefore the period over which compensation cost is
recognized for an ESPP, will typically be the purchase period, which may begin
before or after the grant date (i.e., the service inception date may not be the
grant date).
If an ESPP contains multiple purchase periods, the award in effect has a graded vesting schedule. Accordingly, an entity would record compensation cost in accordance with its policy on the treatment of awards with only service conditions that have a graded vesting schedule. For such awards, ASC 718-10-35-8 allows entities to elect, as a policy decision, to recognize compensation cost 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 requisite service period for the entire award (that is, over the requisite service period of the last separately vesting portion of the award).” (See Section 3.6.5 for examples illustrating both methods.) An entity should consistently apply the method it elects for recognizing compensation cost for awards with only a service condition that have a graded vesting schedule.
Note that an entity’s ability to make a policy election regarding how to recognize compensation cost (i.e., on an accelerated or straight-line basis) is not affected by the technique it uses to value an ESPP award or whether the technique may directly or indirectly result in the valuation of each portion of a graded vesting award as an individual award. See Section 4.10 for a discussion of the interaction between valuation techniques and the graded vesting attribution methods.
The examples below illustrate how to determine the requisite service period for different types of ESPPs.
Example 8-2
Recognizing Compensation Cost for an ESPP Over a Single Purchase Period
Entity A offers an ESPP to all eligible employees. To participate in the offering for the following year, A’s employees must enroll by December 15, 20X1. On that date, all the terms of the ESPP (including the purchase price) are determined, and a grant date is established in accordance with ASC 718. The purchase period for all employees enrolled in the ESPP, which is the period in which actual payroll withholdings are made, is January 1, 20X2, through June 30, 20X2. In accordance with ASC 718-50-25-3, the requisite service period, and therefore the period over which compensation cost will be recognized, is January 1, 20X2, through June 30, 20X2, even though a grant date was established as of December 15, 20X1.
Example 8-3
Recognizing Compensation Cost for an ESPP With a Single Look-Back Feature Over Multiple Purchase Periods
Assume the same facts as in the example above, except that Entity A gives its
employees a two-year offering period in which to purchase
its shares on June 30, 20X2; December 31, 20X2; June 30,
20X3; and December 31, 20X3. The purchase price of A’s
shares is based on a look-back feature that is tied to the
lesser of A’s share price on January 1, 20X2, or its share
price on the purchase date. Because the grant date cannot be
established until all terms of the ESPP are determined
(i.e., the purchase price is not determined until January 1,
20X2), the grant date is January 1, 20X2.
Because the ESPP has multiple 6-month purchase periods, each with a look-back
feature tied to A’s share price at the beginning of the
offering period (i.e., January 1, 20X2, or the grant date),
the award in effect has a graded vesting schedule. In
addition, because each 6-month purchase period has the same
grant date (i.e., January 1, 20X2), there are four separate
tranches that have, respectively, a 6-month, 12-month,
18-month, and 24-month requisite service period.
Accordingly, A would recognize compensation cost on the
basis of its established policy for recognizing compensation
cost for graded vesting awards with only a service
condition. That is, A would recognize compensation cost for
this ESPP on either (1) an accelerated basis as though each
portion of the award for each separate requisite service
period was, in substance, a separate award or (2) a
straight-line basis over all purchase periods from January
1, 20X2, through December 31, 20X3.
Example 8-4
Recognizing Compensation Cost for an ESPP With Multiple Look-Back Features Over Multiple Purchase Periods
Assume the same facts as in Example 8-2,
except that Entity A establishes a two-year offering period
in which its employees can purchase its shares on the
following dates: June 30, 20X2; December 31, 20X2; June 30,
20X3; and December 31, 20X3. For each six-month purchase
period, the purchase price of A’s shares is based on a
look-back feature that is tied to the lesser of A’s share
price at the beginning of each purchase period (i.e.,
January 1, 20X2; July 1, 20X2; January 1, 20X3; and July 1,
20X3) or its share price on each date of purchase.
Because the ESPP has multiple six-month purchase periods that have a look-back feature tied to A’s share price at the beginning of each purchase period, each purchase period is, in effect, a separate award whose grant date is at the beginning of each purchase period. Accordingly, A would measure and recognize compensation cost separately and sequentially for each of the four six-month purchase periods.
Under the terms of some ESPPs, an employee may be entitled to purchase a
specified dollar amount of an entity’s stock on a
future date at an established discount from the
market price of the entity’s stock on that future
date (i.e., a variable number of shares for a
fixed monetary amount). That is, the purchase
price would not be the lower of the purchase-date
price or the enrollment-date price of the entity’s
stock.
Since the terms of the ESPP require the employee to purchase a specific dollar
amount of the employer’s stock on the purchase
date, the amount of compensation cost is fixed and
known on the service inception date (see
Section 8.3
for information about determining the grant date).
That compensation cost is recognized over the
requisite service period, which is the period over
which the employee participates in the plan and
has money withheld to pay for the shares on the
purchase date.
Example 8-5
On January 1, 20X1, an employee enrolls in an ESPP. Under the plan, the employee
elects to have an aggregate amount of $850
withheld from pay over the next six months (i.e.,
until June 30, 20X1). The $850 will be used to
purchase a variable number of shares of the
employer’s stock at a 15 percent discount from
their market price on June 30, 20X1. In accordance
with ASC 718-50-25-3, the service inception date
is January 1, 20X1 (the beginning of the purchase
period), and the requisite service period is the
six-month period from January 1, 20X1 (the service
inception date, which is also the grant date),
through June 30, 20X1 (the purchase date).
Accordingly, compensation cost of $150 — ($850
withheld from the employee’s pay ÷ 85% discounted
market price of the employer’s shares) – $850
withheld from the employee’s pay — is recognized
over the period from the service inception date
(enrollment date of January 1, 20X1) to the
purchase date of June 30, 20X1. Because the plan’s
terms specify that the employee purchases a
variable number of shares worth a fixed monetary
amount, the amount of the benefit conveyed to the
employee is known on the grant date (i.e., it is
based on the discount from the market price of the
entity’s shares and the amount of cash the
employee elects to withhold to purchase the
entity’s shares) and is unaffected by the number
of the entity’s shares ultimately purchased.
Further, if on June 30, 20X1 (the purchase date), the entity’s stock is worth $2
per share, the employee would purchase 500 of the entity’s
shares — $850 withheld from the employee’s pay ÷ ($2 market
price of the entity’s shares × 85% discounted market price
of the entity’s shares) — for $850, resulting in a discount
of $150 from the market value of the entity’s shares.
Alternatively, if on June 30, 20X1, the entity’s shares are
worth $4 per share, the employee would purchase 250 of the
entity’s shares — $850 withheld from the employee’s pay ÷
($4 market price of the entity’s shares × 85% discounted
market price of the entity’s shares) — for $850, still
resulting in a discount of $150 from the market value of the
entity’s shares.
8.5 Forfeitures
For all employee awards, ASC 718 allows an entity to make an entity-wide
accounting policy election to either (1) estimate forfeitures when share-based
payment awards are granted (and to update its estimate if information becomes
available indicating that actual forfeitures will differ from previous estimates) or
(2) account for forfeitures when they occur.
To comply with IRC Section 423, ESPPs typically have shorter requisite service periods than other share-based payment awards (i.e., a six- or twelve-month purchase period is common). Nevertheless, an entity must apply its entity-wide forfeiture accounting policy election to ESPPs. If an entity elects to estimate forfeitures, it must do so when it recognizes compensation cost for ESPPs (and must update its estimate if it receives new information indicating that actual forfeitures will differ from previous estimates). When employee turnover is limited, an entity may conclude that it is appropriate to use a minimal forfeiture estimate in determining compensation cost associated with an ESPP. See Section 3.4.1.1 for a discussion of information that an entity may use in estimating forfeitures. See also the examples in Sections 3.4.1.1 and 3.4.1.2 of how to account for forfeitures under either accounting policy election.
Note that when an employee elects to completely withdraw from an ESPP, the
withdrawal should be accounted for as a
cancellation rather than as a forfeiture.
Accordingly, any unrecognized compensation cost
should be recognized immediately for the canceled
awards. See Section 8.7 for
a discussion of the accounting for increases and
decreases in an employee’s withholdings (including
a complete withdrawal).
8.6 Measurement
ASC 718-50
General
30-1 Paragraph 718-10-30-6 states that the objective of the fair value measurement method is to estimate the fair value of the equity instruments, based on the share price and other measurement assumptions at the grant date, that are issued in exchange for providing goods or rendering services. Estimating the fair value of equity instruments at the grant date, which are issued in exchange for employee services, also applies to the fair value measurements associated with grants under a compensatory employee share purchase plan and is the basis for the approach described in Example 1, Case A (see paragraph 718-50-55-10).
Look-Back Plans
30-2 Many employee share purchase plans with a look-back option have features in addition to or different from those of the plan described in Example 1, Case A (see paragraph 718-50-55-10). For example, some plans contain multiple purchase periods, others contain reset mechanisms, and still others allow changes in the withholding amounts or percentages after the grant date (see Example 1, Cases B through E [see paragraphs 718-50-55-22 through 55-33]).
30-3 In some circumstances, applying the measurement approaches described in this Subtopic at the grant date may not be practicable for certain types of employee share purchase plans. Paragraph 718-20-35-1 provides guidance on the measurement requirements if it is not possible to reasonably estimate fair value at the grant date.
Under a compensatory ESPP, the measurement objective is the same as that
described in ASC 718-10, which is to estimate the fair-value-based measure of the
equity instruments on the grant date. Chapter 4 of this Roadmap discusses the
measurement objective outlined in ASC 718-10 in detail. In addition, see Section 8.9 for examples of
the measurement of plans with look-back features.
8.7 Changes in Employee Withholdings
ASC 718-50
General
35-1 Changes in total employee withholdings during a purchase period that occur solely as a result of salary increases, commissions, or bonus payments are not plan modifications if they do not represent changes to the terms of the award that was offered by the employer and initially agreed to by the employee at the grant (or measurement) date. Under those circumstances, the only incremental compensation cost is that which results from the additional shares that may be purchased with the additional amounts withheld (using the fair value calculated at the grant date). For example, an employee may elect to participate in the plan on the grant date by requesting that 5 percent of the employee’s annual salary be withheld for future purchases of stock. If the employee receives an increase in salary during the term of the award, the base salary on which the 5 percent withholding amount is applied will increase, thus increasing the total amount withheld for future share purchases. That increase in withholdings as a result of the salary increase is not considered a plan modification and thus only increases the total compensation cost associated with the award by the grant date fair value associated with the incremental number of shares that may be purchased with the additional withholdings during the period. The incremental number of shares that may be purchased is calculated by dividing the incremental amount withheld by the exercise price as of the grant date (for example, 85 percent of the grant date stock price).
35-2 Any decreases in the withholding amounts (or percentages) shall be disregarded for purposes of recognizing compensation cost unless the employee services that were valued at the grant date will no longer be provided to the employer due to a termination. However, no compensation cost shall be recognized for awards that an employee forfeits because of failure to satisfy a service requirement for vesting. The accounting for decreases in withholdings is consistent with the requirement in paragraph 718-10-35-3 that the total amount of compensation cost that must be recognized for an award 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).
8.7.1 Increase in Withholdings
The accounting for an increase in an employee’s withholding in connection with an ESPP depends on whether the increase results from a rise in (1) the employee’s compensation (i.e., an increase in the total dollar amount of the withholdings, but not the percentage) or (2) the percentage of the employee’s compensation to be withheld.
In accordance with ASC 718-50-35-1, an increase in an employee’s withholding solely as a result of an increase in an employee’s compensation (i.e., salary, commission, or bonus) is not accounted for as a modification of the award (provided that no other changes to the terms of the ESPP have been made). Incremental compensation cost results only from the additional shares that will be purchased with the additional amounts withheld (under the fair-value-based measure calculated as of the grant date). In other words, the increase in the withholding amount does not change the grant-date fair-value-based measure per share of the award. Rather, it changes the quantity of shares that will be purchased in connection with the total award.
By contrast, as indicated in ASC 718-50-55-29, an increase in the percentage of
the employee’s compensation to be withheld is accounted for
as a modification of the award even though it is not a change to the
ESPP’s terms. Therefore, total recognized compensation cost attributable to the
award is (1) the grant-date fair-value-based measure of the original award for
which the required service has been provided (i.e., the number of awards that
have been earned) or is expected to be provided and (2) the incremental
compensation cost conveyed to the holder of the award as a result of the
modification. The incremental compensation cost is the excess of the
fair-value-based measure of the modified award on the date of modification over
the fair-value-based measure of the original award immediately before the
modification. See Section
8.9.4 for an example of how modification accounting is applied in
the determination of incremental compensation cost resulting from an increase in
the percentage of an employee’s withheld compensation.
8.7.2 Decrease in Withholdings
If, before the purchase date, an employee elects to irrevocably withdraw from an ESPP and receive a complete refund of all amounts withheld from his or her pay, the withdrawal should be accounted for as a cancellation if the employee continues employment with the entity. The employee has, in essence, canceled the award associated with that offering. That is, the employee does not have the ability to purchase the entity’s shares under the ESPP since the withdrawal is irrevocable. In accordance with ASC 718-20-35-9, a cancellation of an award that is not accompanied by the concurrent grant of (or offer to grant) a replacement award or other valuable consideration is accounted for as a repurchase for no consideration. Accordingly, any unrecognized compensation cost should be recognized immediately for the canceled awards.
The period over which compensation cost is recognized is different for complete withdrawals than it is for partial withdrawals. Under a partial withdrawal, employees decrease the amount of future payroll withholdings during a purchase period. A decrease in the amount of future payroll withholdings will result in the employee’s purchase of fewer of the entity’s shares on the purchase date. Since such decreases are disregarded under ASC 718-50-35-2, compensation cost continues to be recognized over the requisite service period on the basis of the entire grant-date fair-value-based measure of the award unless the award is forfeited. Decreases in the amount of future payroll withholdings are the equivalent of a failure of the employee to exercise a stock option that has been earned (i.e., vested). Compensation cost can be reversed only when the employee forfeits the award (i.e., the employee fails to provide the requisite service).
8.8 Classification
If the employee is entitled to purchase a variable number of shares
for a fixed monetary amount, the award would be classified as a share-based
liability (in accordance with ASC 718-10-25-7 and ASC 480) and recorded at its
fair-value-based measure in each reporting period until settlement (i.e., the
purchase date). Upon settlement, the award would be reclassified as equity.
By contrast, if an ESPP contains option features such as a look-back
option, the award would not be precluded from equity classification (in accordance
with ASC 718-10-25-7 and ASC 480) because the employee is entitled to purchase a
variable number of shares for a value that is not fixed on the grant date (i.e., the
employee is subject to the risks and rewards of equity ownership).
In addition, the cash withheld from employees’ salaries during the purchase period
would be recorded as a liability on the entity’s books until the cash is either used
to purchase shares or returned to the employee in accordance with the terms of the
ESPP award. Such cash withheld from employees’ salaries is considered an advance
payment of the exercise price of the ESPP award, which is not treated as a
substantive purchase of stock.
Example 8-6
Assume same facts as in Example
8-5. Because the award entitles the employee
to purchase a variable number of the entity’s shares for a
fixed dollar amount, a share-based liability is recorded as
the offsetting entry to compensation cost. In addition, the
$850 withheld over the next six months would be recorded as
a liability on the entity’s books until the cash is used to
purchase shares or returned to the employee (depending on
the terms of the award).
8.9 Look-Back Plans
The guidance in this section applies to common types of ESPPs that have
look-back features. The examples in the guidance illustrate how entities value ESPPs
with look-back features and separate the award into components to estimate the
fair-value-based measure (see Sections 8.9.1 through 8.9.5). For example, an ESPP that allows
employees to purchase stock at a discount from the lesser of the market price on the
enrollment date or the purchase date would be valued as two components: (1) a
restricted stock award equal in value to the purchase discount and (2) an
at-the-money stock option equal to the discounted purchase price.
ASC 718-50
Variations on Basic Look-Back Plans
55-2 The following are some of the more common types of employee share purchase plans with a look-back option that currently exist and the features that differentiate each type:
- Type A plan — Maximum number of shares. This type of plan permits an employee to have withheld a fixed amount of dollars from the employee’s salary (or a stated percentage of the employee’s salary) over a one-year period to purchase stock. At the end of the one-year period, the employee may purchase stock at 85 percent of the lower of the grant date stock price or the exercise date stock price. If the exercise date stock price is lower than the grant date stock price, the employee may not purchase additional shares (that is, the maximum number of shares that may be purchased by an employee is established at the grant date based on the stock price at that date and the employee’s elected withholdings); any excess cash is refunded to the employee. This is the basic type of employee share purchase plan shown in Example 1, Case A [see paragraph 718-50-55-10]).
- Type B plan — Variable number of shares. This type of plan is the same as the Type A plan except that the employee may purchase as many shares as the full amount of the employee’s withholdings will permit, regardless of whether the exercise date stock price is lower than the grant date stock price (see Example 1, Case B [paragraph 718-50-55-22]).
- Type C plan — Multiple purchase periods. This type of plan permits an employee to have withheld a fixed amount of dollars from the employee’s salary (or a stated percentage of the employee’s salary) over a two-year period to purchase stock. At the end of each six-month period, the employee may purchase stock at 85 percent of the lower of the grant date stock price or the exercise date stock price based on the amount of dollars withheld during that period (see Example 1, Case C [paragraph 718-50-55-26]).
- Type D plan — Multiple purchase periods with a reset mechanism. This type of plan is the same as the Type C plan except that the plan contains a reset feature if the market price of the stock at the end of any six-month purchase period is lower than the stock price at the original grant date. In that case, the plan resets so that during the next purchase period an employee may purchase stock at 85 percent of the lower of the stock price at either the beginning of the purchase period (rather than the original grant date price) or the exercise date (see Example 1, Case D [paragraph 718-50-55-28]).
- Type E plan — Multiple purchase periods with a rollover mechanism. This type of plan is the same as the Type C plan except that the plan contains a rollover feature if the market price of the stock at the end of any six-month purchase period is lower than the stock price at the original grant date. In that case, the plan is immediately cancelled after that purchase date, and a new two-year plan is established using the then-current stock price as the base purchase price (see Example 1, Case D [paragraph 718-50-55-28]).
- Type F plan — Multiple purchase periods with semifixed withholdings. This type of plan is the same as the Type C plan except that the amount (or percentage) that the employee may elect to have withheld is not fixed and may be changed (increased or decreased) at the employee’s election immediately after each six-month purchase date for purposes of all future withholdings under the plan (see Example 1, Case D [paragraph 718-50-55-28]).
- Type G plan — Single purchase period with variable withholdings. This type of plan permits an employee to have withheld an amount of dollars from the employee’s salary (or a stated percentage of the employee’s salary) over a one-year period to purchase stock. That amount (or percentage) is not fixed and may be changed (increased or decreased) at the employee’s election at any time during the term of the plan for purposes of all future withholdings under the plan. At the end of the one-year period, the employee may purchase stock at 85 percent of the lower of the grant date stock price or the exercise date stock price (see Example 1, Case D [paragraph 718-50-55-28]).
- Type H plan — Multiple purchase periods with variable withholdings. This type of plan combines the characteristics of the Type C and Type G plans in that there are multiple purchase periods over the term of the plan and an employee is permitted to change (increase or decrease) withholding amounts (or percentages) at any time during the term of the plan for purposes of all future withholdings under the plan (see Example 1, Case D [paragraph 718-50-55-28]).
- Type I plan — Single purchase period with variable withholdings and cash infusions. This type of plan is the same as the Type G plan except that an employee is permitted to remit catch-up amounts to the entity when (and if) the employee increases withholding amounts (or percentages). The objective of the cash infusion feature is to permit an employee to increase withholding amounts (or percentages) during the term of the plan and remit an amount to the entity such that, on the exercise date, it appears that the employee had participated at the new higher amount (or percentage) during the entire term of the plan (see Example 1, Case E [paragraph 718-50-55-32]).
55-3 The distinguishing characteristic between the Type A plan and the Type B plan is whether the maximum number of shares that an employee is permitted to purchase is fixed at the grant date based on the stock price at that date and the expected withholdings. Each of the remaining plans described above (Type C through Type I plans) incorporates the features of either a Type A plan or a Type B plan. The above descriptions are intended to be representative of the types of features commonly found in many existing plans. The accounting guidance in this Subtopic shall be applied to all plans with characteristics similar to those described above.
55-4 The measurement approach described in Example 1, Case A (see paragraph 718-50-55-10) was developed to illustrate how the fair value of an award under a basic type of employee share purchase plan with a look-back option could be determined at the grant date by focusing on the substance of the arrangement and valuing separately each feature of the award. Although that general technique of valuing an award as the sum of the values of its separate components applies to all types of employee share purchase plans with a look-back option, the fundamental components of an award may differ from plan to plan thus affecting the individual calculations. For example, the measurement approach described in that Case assumes that the maximum number of shares that an employee may purchase is fixed at the grant date based on the grant date stock price and the employee’s elected withholdings (that is, the Type A plan described in paragraph 718-50-55-2). That approach needs to be modified to appropriately determine the fair value of awards under the other types of plans described in that paragraph, including a Type B plan, that do not fix the number of shares that an employee is permitted to purchase.
55-5 Although many employee share purchase plans with a look-back option initially limit the maximum number of shares of stock that the employee is permitted to purchase under the plan (Type A plans), other employee share purchase plans (Type B plans) do not fix the number of shares that the employee is permitted to purchase if the exercise date stock price is lower than the grant date stock price. In effect, an employee share purchase plan that does not fix the number of shares that may be purchased has guaranteed that the employee can always receive the value associated with at least 15 percent of the stock price at the grant date (the employee can receive much more than 15 percent of the grant date value of the stock if the stock appreciates during the look-back period). That provision provides the employee with the equivalent of a put option on 15 percent of the shares with an exercise price equal to the stock price at the grant date. In contrast, an employee who participates in a Type A plan is only guaranteed 15 percent of the lower of the stock price as of the grant date or the exercise date, which is the equivalent of a call option on 85 percent of the shares (as described more fully in paragraph 718-50-55-16). A participant in a Type B plan receives the equivalent of both a put option and a call option.
Illustrations
Example 1: Look-Back Plans
55-6 The following Cases illustrate the guidance in paragraphs 718-50-30-1 through 30-2.
55-7 The following Cases illustrate the fundamental differences between different types of look back plans:
- Basic look-back plans (Case A)
- Look-back plan variable versus maximum number of shares (Case B)
- Look-back plan with multiple purchase periods (Case C)
- Look-back plans with reset or rollover mechanisms (Case D)
- Look-back plans with retroactive cash infusion election (Case E).
55-8 The assumptions used for the numerical calculations in Cases B–E are not intended to be the same as those in Case A. Rather, they are independent and designed to illustrate how the component measurement approach in Case A would be modified to reflect various features of employee stock purchase plans.
55-9 This Example does not take into consideration the effect of interest forgone by the employee on the fair value of an award for which the exercise price is paid over time (for instance, through payroll withholdings). Awards for which part or all of the exercise price is paid before the exercise date are less valuable than awards for which the exercise price is paid at the exercise date, and it is appropriate to recognize that difference in applying the guidance in this Subtopic. However, for simplicity, the effect of forgone interest is not reflected in the fair value calculations in this Example.
8.9.1 Basic Look-Back Plans
ASC 718-50
Case A: Basic Look-Back Plans
55-10 Some entities offer share options to employees under Section 423 of the U.S. Internal Revenue Code, which provides that employees will not be immediately taxed on the difference between the market price of the stock and a discounted purchase price if several requirements are met. One requirement is that the exercise price may not be less than the smaller of either:
- 85 percent of the stock’s market price when the share option is granted
- 85 percent of the price at exercise.
55-11 A share option that provides the employee the choice of either option above may not have a term in excess of 27 months. Share options that provide for the more favorable of two (or more) exercise prices are referred to as look-back share options. A look-back share option with a 15 percent discount from the market price at either grant or exercise is worth more than a fixed share option to purchase stock at 85 percent of the current market price because the holder of the look-back share option is assured a benefit. If the share price rises, the holder benefits to the same extent as if the exercise price was fixed at the grant date. If the share price falls, the holder still receives the benefit of purchasing the stock at a 15 percent discount from its price at the date of exercise. An employee share purchase plan offering share options with a look-back feature would be compensatory because the look-back feature is an option feature (see paragraph 718-50-25-1).
55-12 For example, on January
1, 20X5, when its share price is $30, Entity A offers
its employees the opportunity to sign up for a payroll
deduction to purchase its stock at either 85 percent of
the share’s current price or 85 percent of the price at
the end of the year when the share options expire,
whichever is lower. The exercise price of the share
options is the lesser of $25.50 ($30 × .85) or 85
percent of the share price at the end of the year when
the share options expire.
55-13 The look-back share option can be valued as a combination position. (This Case presents one of several existing valuation techniques for estimating the fair value of a look-back option. In accordance with this Topic, an entity shall use a valuation technique that reflects the substantive characteristics of the instrument being granted in the estimate of fair value.) In this situation, the components are as follows:
- 0.15 of a share of nonvested stock
- 0.85 of a 1-year share option held with an exercise price of $30.
55-14 Supporting analysis for the two components is discussed below.
55-15 Beginning with the
first component, a share option with an exercise price
that equals 85 percent of the value of the stock at the
exercise date will always be worth 15 percent (100% –
85%) of the share price upon exercise. For a stock that
pays no dividends, that share option is the equivalent
of 15 percent of a share of the stock. The holder of the
look-back share option will receive at least the
equivalent of 0.15 of a share of stock upon exercise,
regardless of the share price at that date. For example,
if the share price falls to $20, the exercise price of
the share option will be $17 ($20 × .85), and the holder
will benefit by $3 ($20 – $17), which is the same as
receiving 0.15 of a share of stock for each share
option.
55-16 If the share price upon
exercise is more than $30, the holder of the look-back
share option receives a benefit that is worth more than
15 percent of a share of stock. At prices of $30 or
more, the holder receives a benefit for the difference
between the share price upon exercise and $25.50 — the
exercise price of the share option (.85 × $30). If the
share price is $40, the holder benefits by $14.50 ($40 –
$25.50). However, the holder cannot receive both the
$14.50 value of a share option with an exercise price of
$25.50 and 0.15 of a share of stock. In effect, the
holder gives up 0.15 of a share of stock worth $4.50
($30 × .15) if the share price is above $30 at exercise.
The result is the same as if the exercise price of the
share option was $30 ($25.50 + $4.50) and the holder of
the look-back share option held 85 percent of a 1-year
share option with an exercise price of $30 in addition
to 0.15 of a share of stock that will be received if the
share price is $30 or less upon exercise.
55-17 An option-pricing model can be used to value the 1-year share option on 0.85 of a share of stock represented by the second component. Thus, assuming that the fair value of a share option on one share of Entity A’s stock on the grant date is $4, the compensation cost for the look-back option at the grant date is as follows.
55-18 For a look-back option on a dividend-paying share, both the value of the nonvested stock component and the value of the share option component would be adjusted to reflect the effect of the dividends that the employee does not receive during the life of the share option. The present value of the dividends expected to be paid on the stock during the life of the share option (one year in this Case) would be deducted from the value of a share that receives dividends. One way to accomplish that is to base the value calculation on shares of stock rather than dollars by assuming that the dividends are reinvested in the stock.
55-19 For example, if Entity A pays a quarterly dividend of 0.625 percent (2.5% ÷ 4) of the current share price, 1 share of stock would grow to 1.0252 (the future value of 1 using a return of 0.625 percent for 4 periods) shares at the end of the year if all dividends are reinvested. Therefore, the present value of 1 share of stock to be received in 1 year is only 0.9754 of a share today (again applying conventional compound interest formulas compounded quarterly) if the holder does not receive the dividends paid during the year.
55-20 The value of the share option component is easier to compute; the appropriate dividend assumption is used in an option-pricing model in estimating the value of a share option on a whole share of stock. Thus, assuming the fair value of the share option is $3.60, the compensation cost for the look-back share option if Entity A pays quarterly dividends at the annual rate of 2.5 percent is as follows.
55-21 The first component, which is worth $4.39 at the grant date, is the minimum amount of benefits to the holder regardless of the price of the stock at the exercise date. The second component, worth $3.06 at the grant date, represents the additional benefit to the holder if the share price is above $30 at the exercise date.
8.9.2 Variable Versus Maximum Number of Shares
ASC 718-50
Case B: Look-Back Plan Variable Versus Maximum Number of Shares
55-22 On January 1, 20X0, when its stock price is $50, Entity A offers its employees the opportunity to sign up for a payroll deduction to purchase its stock at the lower of either 85 percent of the stock’s current price or 85 percent of the stock price at the end of the year when the options expire. Thus, the exercise price of the options is the lesser of $42.50 ($50 × 85 percent) or 85 percent of the stock price at the end of the year when the option is exercised. Two employees each agree to have $4,250 withheld from their salaries; however, Employee A is not allowed to purchase any more shares than the $4,250 would buy on the grant date (that is, 100 shares [$4,250/$42.50]) and Employee B is permitted to buy as many shares as the $4,250 will permit under the terms of the plan. In both cases, the 15 percent purchase price discount at the grant date is worth $750 (100 shares × $50 × 15 percent). Depending on the stock price at the end of the year, the value of the 15 percent discount for each employee is as follows.
55-23 As illustrated above, both awards provide the same value to the employee if the stock price at the exercise date has increased (or remained unchanged) from the grant date stock price. However, the award under the Type B plan is more valuable to the employee if the stock price at the exercise date has decreased from the grant date stock price because it guarantees that the employee always will receive at least 15 percent of the stock price at the grant date, whereas the award under the Type A plan only guarantees that the employee will receive 15 percent of the ultimate (lower) stock purchase price.
55-24 Using the component measurement approach described in Case A as the base, the additional feature associated with a Type B plan that shall be included in the fair value calculation is 15 percent of a put option on the employer’s stock (valued by use of a standard option-pricing model, using the same measurement assumptions that were used to value the 85 percent of a call option). If the plan in that Case had the provisions of a Type B plan (that is, a plan that does not fix the number of shares that may be purchased), the fair value of the award would be calculated at the grant date as follows.
With the
same values the fair value of the Type A employee share
purchase plan award described in Case A is determined as
follows:
55-25 In Cases B through E, total compensation cost would be measured at the grant date based on the number of shares that can be purchased using the estimated total withholdings and market price of the stock as of the grant date, and not based on the potentially greater number of shares that may ultimately be purchased if the market price declines. In other words, assume that on January 1, 20X0, Employee A elects to have $850 withheld from his pay for the year to purchase stock. Total compensation cost for the Type B plan award to Employee A would be $291 ($14.57 × 20 grant-date-based shares [$850/$42.50]). For purposes of determining the number of shares on which to measure compensation cost, the stock price as of the grant date less the discount, or $50 × 85 percent in this case, is used.
8.9.3 Multiple Purchase Periods
ASC 718-50
Case C: Look-Back Plan With Multiple Purchase Periods
55-26 In substance, an employee share purchase plan with multiple purchase periods (a Type C plan) is a series of linked awards, similar in nature to how some view a graded vesting stock option plan. Accordingly, the fair value of an award under an employee share purchase plan with multiple purchase periods shall be determined at the grant date in the same manner as an award under a graded vesting stock option plan. Under the graded vesting approach, awards under a two-year plan with purchase periods at the end of each year would be valued as having two separate option tranches both starting on the initial grant date (using the Case A approach if the plan has the characteristics of a Type A plan or using the Case B approach if the plan has the characteristics of a Type B plan) but with different lives of 12 and 24 months, respectively. All other measurement assumptions would need to be consistent with the separate lives of each tranche.
55-27 For example, if the plan in Case A was a two-year Type C plan with purchase periods at the end of each year, the fair value of each tranche of the award would be calculated at the grant date as follows.
8.9.4 Reset or Rollover Mechanisms
ASC 718-50
Case D: Look-Back Plans With Reset or Rollover Mechanisms
55-28 The basic measurement approach described in Case C for a Type C plan also should be used to value awards under employee share purchase plans with multiple purchase periods that incorporate reset or rollover mechanisms (that is, Type D and Type E plans). The fair value of those awards initially can be determined at the grant date using the graded vesting measurement approach. However, at the date that the reset or rollover mechanism becomes effective, the terms of the award have been modified (the exercise price has been decreased and, for a grant under a Type E plan, the term of the award has been extended), which, in substance, is similar to an exchange of the original award for a new award with different terms. Share-based payment modification accounting (see paragraphs 718-20-35-3 through 35-9) shall be applied at the date that the reset or rollover mechanism becomes effective to determine the amount of any incremental fair value associated with the modified grant.
55-29 Likewise, although not a change to the terms of the employee share purchase plan, an election by an employee to increase withholding amounts (or percentages) for future services (Type F through Type H plans) is a modification of the terms of the award to that employee, which, in substance, is similar to an exchange of the original award for a new award with different terms. Accordingly, the fair value of an award under an employee share purchase plan with variable withholdings shall be determined at the grant date (using the Type A, Type B, or Type C measurement approach, as applicable) based on the estimated amounts (or percentages) that a participating employee initially elects to withhold under the terms of the plan. After the grant date (except as noted in paragraph 718-50-35-1), any increases in withholding amounts (or percentages) for future services shall be accounted for as a plan modification in accordance with the guidance in paragraph 718-20-35-3.
55-30 To illustrate, if the plan described in Case C allowed an employee to elect to change withholdings at the end of the first year, modification accounting would be applied at the date the employee elected to increase withholdings to determine the amount, if any, of incremental compensation cost. Assume that on January 1, 20X0, Employee A initially elected to have $850 per year withheld from his pay for each purchase period. However, at the end of Year 1 when the stock price is $60 (and assume that no other factors have changed), Employee A elects to have a total of $1,275 withheld for the second purchase period. At that date, $1,275 is equivalent to 30 shares eligible for purchase at the end of the second year ($1,275/$42.50). At the date Employee A elects to increase withholdings, modification accounting shall be applied to determine the amount of any incremental fair value associated with the modified award as follows.
55-31 The incremental value is determined based on the fair value measurements at the date of the modification using the then-current stock price. To simplify the illustration, the fair value at the modification date is based on the same assumptions about volatility, the risk-free interest rate, and expected dividend yield as at the grant date.
8.9.5 Retroactive Cash Infusion Election
ASC 718-50
Case E: Look-Back Plans With Retroactive Cash Infusion Election
55-32 As with all employee share purchase plans, the objective of the measurement process for employee share purchase plans with a look-back option is to reasonably measure the fair value of the award at the grant date. Unlike Type F through Type H plans, which permit an employee to increase withholding amounts (or percentages) only prospectively, the Type I plan permits an employee to make a retroactive election to increase withholdings. Under a Type I plan, an employee may elect not to participate (or to participate at a minimal level) in the plan until just before the exercise date, thus making it difficult to determine when there truly is a mutual understanding of the terms of the award, and thus the date at which the grant occurs. For example, assume that the Type A employee share purchase plan in Case A permits an employee to remit catch-up amounts (up to a maximum aggregate withholding of 15 percent of annual salary) to Entity A at any time during the term of the plan. On January 1, 20X0, Employee A elects to participate in the plan by having $100 (0.04 percent) of her $250,000 salary withheld monthly from her pay over the year. On December 20, 20X0, when the stock price is $65, Employee A elects to remit a check to Entity A for $36,300, which, together with the $1,200 withheld during the year, represents 15 percent of her salary.
55-33 In that situation, December 20, 20X0 is the date at which Entity A and Employee A have a mutual understanding of the terms of the award in exchange for the services already rendered and Entity A becomes contingently obligated to issue equity instruments to Employee A upon the fulfillment of vesting requirements. The fair value of the entire award to Employee A is therefore measured as of December 20, 20X0.
Chapter 9 — Nonemployee Awards
Chapter 9 — Nonemployee Awards
9.1 Overview
ASC 718-10
General
05-1 The Compensation — Stock
Compensation Topic provides guidance on share-based payment
transactions. This Topic includes the following
Subtopics:
-
Overall
-
Awards Classified as Equity
-
Awards Classified as Liabilities
-
Employee Stock Ownership Plans
-
Employee Stock Purchase Plans
-
Income Taxes.
05-2 This Topic provides guidance
for employee and nonemployee share-based payment
transactions.
05-3 This Subtopic provides general
guidance related to share-based payment arrangements. This
Subtopic and Subtopics 718-20 and 718-30 are interrelated
and the required guidance may be located in either this
Subtopic or one of the other Subtopics. In general, material
that relates to both equity and liability instruments is
included in this Subtopic, while material more specifically
related to either equity or liability instruments is
included in their respective Subtopics. Guidance referencing
grantees is intended to be applicable to recipients of both
employee and nonemployee awards, and guidance referencing
employees or nonemployees is only applicable to those
specific types of awards.
General
10-1 The objective of accounting
for transactions under share-based payment arrangements is
to recognize in the financial statements the goods or
services received in exchange for equity instruments granted
or liabilities incurred and the related cost to the entity
as those goods or services are received. This Topic uses the
terms compensation and payment in their
broadest senses to refer to the consideration paid for goods
or services or the consideration paid to a customer.
10-2 This Topic requires that the
cost resulting from all share-based payment transactions be
recognized in the financial statements. This Topic
establishes fair value as the measurement objective in
accounting for share-based payment arrangements and requires
all entities to apply a fair-value-based measurement method
in accounting for share-based payment transactions except
for equity instruments held by employee stock ownership
plans.
The objectives of accounting for share-based payment arrangements are the same for nonemployees
as they are for employees, and therefore the guidance on nonemployee and employee awards is largely
aligned. However, there are some significant differences, two of which are as follows:
- Attribution — Any cost associated with nonemployee awards is recognized under other applicable accounting guidance as though the grantor paid cash. That is, ASC 718 does not prescribe the period(s) or the manner (i.e., capitalize or expense) in which nonemployee share-based payments will be recognized. Rather, an entity should recognize an asset or expense (or reverse a previously recognized cost) in the same period(s) and in the same manner as though the entity had paid cash for the goods or services. By contrast, any compensation cost associated with employee awards is generally recognized on a ratable basis over the requisite service period (or over multiple requisite service periods).
- Contractual term — Nonemployee awards of stock options and similar instruments are measured by using the expected term, but the contractual term may be elected as the expected term on an award-by-award basis. By contrast, all employee awards of stock options and similar instruments are measured by using an estimate of the expected term.
9.2 Scope
ASC 718-10
Entities
15-2 The guidance in the
Compensation — Stock Compensation Topic applies to all
entities that enter into share-based payment
transactions.
Transactions
15-3 The guidance in the
Compensation—Stock Compensation Topic applies to all
share-based payment transactions in which a grantor acquires
goods or services to be used or consumed in the grantor’s
own operations or provides consideration payable to a
customer by issuing (or offering to issue) its shares, share
options, or other equity instruments or by incurring
liabilities to an employee or a nonemployee that meet either
of the following conditions:
-
The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award of share-based compensation may be indexed to both the price of an entity’s shares and something else that is neither the price of the entity’s shares nor a market, performance, or service condition.)
-
The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.
15-3A Paragraphs 323-10-25-3
through 25-5 provide guidance on accounting for share-based
compensation granted by an investor to employees or
nonemployees of an equity method investee that provide goods
or services to the investee that are used or consumed in the
investee’s operations.
15-4 Share-based payments awarded
to a grantee by a related party or other holder of an
economic interest in the entity as compensation for goods or
services provided to the reporting entity are share-based
payment transactions to be accounted for under this Topic
unless the transfer is clearly for a purpose other than
compensation for goods or services to the reporting entity.
The substance of such a transaction is that the economic
interest holder makes a capital contribution to the
reporting entity, and that entity makes a share-based
payment to the grantee in exchange for services rendered or
goods received. An example of a situation in which such a
transfer is not compensation is a transfer to settle an
obligation of the economic interest holder to the grantee
that is unrelated to goods or services to be used or
consumed in a grantor’s own operations.
15-5 The guidance in this Topic
does not apply to transactions involving share-based payment
awards granted to a lender or an investor that provides
financing to the issuer. However, see paragraphs
815-40-35-14 through 35-15, 815-40-35-18, 815-40-55-49, and
815-40-55-52 for guidance on an issuer’s accounting for
modifications or exchanges of written call options to
compensate grantees.
-
Subparagraph superseded by Accounting Standards Update No. 2018-07.
-
Subparagraph superseded by Accounting Standards Update No. 2019-08.
-
Subparagraph superseded by Accounting Standards Update No. 2019-08.
15-5A
Share-based payment awards granted to a customer shall be
measured and classified in accordance with the guidance in
this Topic (see paragraph 606-10-32-25A) and reflected as a
reduction of the transaction price and, therefore, of
revenue in accordance with paragraph 606-10-32-25 unless the
consideration is in exchange for a distinct good or service.
If share-based payment awards are granted to a customer as
payment for a distinct good or service from the customer,
then an entity shall apply the guidance in paragraph
606-10-32-26.
ASC 718 applies to all share-based payment arrangements related to the acquisition of goods and
services from employees and nonemployees. Therefore, most of the guidance in ASC 718 on employee
share-based payments, including most of its requirements related to classification and measurement,
applies to nonemployee share-based payment arrangements. However, it is still important to determine
whether the counterparty (i.e., the grantee) is an employee or a nonemployee since there are certain
differences in the respective guidance (see Section 9.1).
Entities are required to apply ASC 718 to measure and classify
share-based payments issued as consideration payable to a customer under ASC 606.
However, ASC 606 addresses the recognition of share-based sales incentives (e.g., as
a reduction of revenue). For information about accounting for share-based payments
issued as sales incentives, see Section 9.2.1 and Chapter 14.
ASC 718 does not address the accounting for share-based payments received by a
vendor (grantee) from a customer (grantor). Such payments are subject to ASC 606,
which addresses share-based payments received by a vendor in a contract with a
customer. Under ASC 606, share-based payments (i.e., noncash consideration) received
by a vendor (grantee) from a customer (grantor) are measured at their fair value at
contract inception. For more information, see Chapter 6 of Deloitte’s Roadmap Revenue
Recognition.
ASC 718 also does not apply to equity instruments issued to a lender or investor
that provides financing to the issuer. In paragraph BC21 of ASU 2018-07, the FASB clarified that ASC 718
applies to “instruments granted for goods or services used or consumed in a
grantor’s own operations and does not apply to instruments granted essentially to
provide financing to the issuer.” The Board included this anti-abuse measure to
prevent entities from structuring a share-based payment transaction as a means of
raising capital and accounting for it under ASC 718 (particularly its classification
guidance).
9.2.1 Sales Incentives to Customers
ASC 718-10
15-5A Share-based payment
awards granted to a customer shall be measured and
classified in accordance with the guidance in this Topic
(see paragraph 606-10-32-25A) and reflected as a
reduction of the transaction price and, therefore, of
revenue in accordance with paragraph 606-10-32-25 unless
the consideration is in exchange for a distinct good or
service. If share-based payment awards are granted to a
customer as payment for a distinct good or service from
the customer, then an entity shall apply the guidance in
paragraph 606-10-32-26.
ASC 606-10
32-25 Consideration payable to
a customer includes:
- Cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer)
- Credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer)
- Equity instruments (liability or equity classified) granted in conjunction with selling goods or services (for example, shares, share options, or other equity instruments).
An entity shall account for consideration payable to a
customer as a reduction of the transaction price and,
therefore, of revenue unless the payment to the customer
is in exchange for a distinct good or service (as
described in paragraphs 606-10-25-18 through 25-22) that
the customer transfers to the entity. If the
consideration payable to a customer includes a variable
amount, an entity shall estimate the transaction price
(including assessing whether the estimate of variable
consideration is constrained) in accordance with
paragraphs 606-10-32-5 through 32-13.
ASC 718 applies to the measurement and classification of share-based payment
awards issued as consideration payable to a customer. If such consideration is
not in exchange for a distinct good or service, ASC 606 requires that the
consideration be reflected as a reduction of the transaction price. However, ASC
606-10-32-26 states, in part, that “[i]f consideration payable to a customer is
a payment for a distinct good or service from the customer, then an entity shall
account for the purchase of the good or service in the same way that it accounts
for other purchases from suppliers.”
9.3 Recognition
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).
25-2B 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.
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.
35-1A A grantor shall recognize the
goods acquired or services received in a share-based payment
transaction with nonemployees when it obtains the goods or
as services are received. A grantor may need to recognize an
asset before it actually receives goods or services if it
first exchanges a share-based payment for an enforceable
right to receive those goods or services. Nevertheless, the
goods or services themselves are not recognized before they
are received.
35-1B If fully vested,
nonforfeitable equity instruments are granted at the date
the grantor and nonemployee enter into an agreement for
goods or services (no specific performance is required by
the nonemployee to retain those equity instruments), then,
because of the elimination of any obligation on the part of
the nonemployee to earn the equity instruments, a grantor
shall recognize the equity instruments when they are granted
(in most cases, when the agreement is entered into). Whether
the corresponding cost is an immediate expense or a prepaid
asset (or whether the debit should be characterized as
contra-equity under the requirements of paragraph
718-10-45-3) depends on the specific facts and
circumstances.
35-1C An entity may grant fully
vested, nonforfeitable equity instruments that are
exercisable by the nonemployee only after a specified period
of time if the terms of the agreement provide for earlier
exercisability if the nonemployee achieves specified
performance conditions. Any measured cost of the transaction
shall be recognized in the same period(s) and in the same
manner as if the entity had paid cash for the goods or
services instead of paying with, or using, the share-based
payment awards.
35-1E A recognized asset or expense
shall not be reversed if a stock option that the nonemployee
has the right to exercise expires unexercised.
35-1F A grantor shall recognize
either a corresponding increase in equity or a liability,
depending on whether the instruments granted satisfy the
equity or liability classification criteria established in
paragraphs 718-10-25-6 through 25-19A. As the goods or
services are disposed of or consumed, the grantor shall
recognize the related cost. For example, when inventory is
sold, the cost is recognized in the income statement as cost
of goods sold, and as services are consumed, the cost
usually is recognized in determining net income of that
period, for example, as expenses incurred for services. In
some circumstances, the cost of services (or goods) 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.
As in the case of a share-based payment arrangement with an employee, a
share-based payment arrangement with a nonemployee is an exchange between the
issuing entity and the grantee providing the goods or services. An entity typically
recognizes the effect of that exchange in the balance sheet and income statement as
the goods or services are received. The entity may either (1) recognize the cost as
an expense as the goods or services are received or (2) capitalize the cost as part
of an asset and later recognize it as an expense. For example, if the cost
associated with an award is included in the cost of acquiring or producing
inventory, the cost arising from the award is capitalized, and the capitalized cost
is later recognized as cost of goods sold. As discussed in Section 9.1, any cost associated with nonemployee
awards is recognized under other applicable accounting guidance as though the
grantor paid cash. The term “nonemployee’s vesting period” as used throughout ASC
718 and this publication is intended to represent the recognition of compensation
cost for a nonemployee award 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 the
share-based payment award.
The credit in the balance sheet is based on the award’s classification. If the
award is classified as equity, the corresponding credit is recorded in equity —
typically as paid-in capital. The measurement date for equity-classified awards is
generally the grant date (see Section 3.2 for further discussion of the determination of the grant
date). If an award is classified as a liability, the corresponding credit is
recorded as a share-based liability. Liability-classified awards are remeasured as
of each reporting date until settlement. See Section 9.5 and Chapter 5 for discussions of the
classification of awards and Chapter 7 for a discussion of the accounting for
liability-classified awards.
Example 9-1
On January 1, 20X1, Entity A enters into an
arrangement with an advertising company that provides
marketing services for the next two years in exchange for
1,000 equity-classified warrants. The warrants vest at the
end of two years (i.e., when the marketing services are
complete). Assume that the grant date is January 1, 20X1,
and the marketing services are provided ratably over the
two-year period.
The fair-value-based measure of the warrants
on January 1, 20X1, is $10. The following journal entries
illustrate the recognition under ASC 718:
Journal Entry: December
31, 20X1
Journal Entry: December
31, 20X2
9.3.1 Attribution of Cost
9.3.1.1 Recognition as if Cash Were Paid
For share-based payment arrangements with employees, compensation cost is
generally recognized ratably over the requisite service period (or ratably
over multiple requisite service periods; see Section 3.6). Because of the nature of
nonemployee awards, ratable recognition over a service period may not
necessarily be appropriate. Any cost recognized for nonemployee share-based
payments should be recognized under other applicable accounting guidance as
though the grantor paid cash. That is, ASC 718 does not prescribe the
period(s) or the manner (i.e., capitalize or expense) in which nonemployee
share-based payments will be recognized. Rather, an entity should recognize
an asset or expense (or reverse a previously recognized cost) in the same
period(s) and in the same manner as though the entity had paid cash for the
goods or services. Accordingly, an entity recognizes the cost of nonemployee
awards during the nonemployee’s vesting period “when it obtains the goods or
as services are received.”
An entity must use judgment in determining the attribution of costs since they may not be tied directly to nonemployee vesting conditions. The entity could grant awards to a vendor that provides services ratably but for which vesting is tied solely to the level of performance. For instance, a vendor could provide services associated with a call center ratably over time, but vesting of the awards could be tied to the resolution of issues within a certain period. Similarly, awards could be provided to a nonemployee for goods, but vesting may not be tied to the delivery of goods (e.g., a nonemployee award issued for goods may vest if less than 1 percent of all goods delivered over a specified period are defective).
9.3.1.2 Graded Vesting Awards
As discussed in Section
3.6.5, ASC 718-10-35-8 requires an entity to elect, as its
accounting policy, one of the following ways to recognize compensation cost
for employee awards that have graded vesting schedules and only contain
service conditions (i.e., no performance or market conditions):
-
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).
The policy election is limited to employee awards. Other than as described in
Section 9.3, ASC 718 does not
provide explicit guidance on the period(s) or manner of cost recognition for
nonemployee awards and consequently does not include a similar policy
election for graded vesting nonemployee awards.
9.3.2 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.
While most nonemployee awards are issued in exchange for services, there may be
instances in which such awards are issued for goods. Accordingly, the definition
of “vest” in ASC 718 incorporates vesting conditions tied to the delivery of
goods (in addition to services) and uses the term “nonemployee’s vesting period”
rather than “requisite service period” to describe the period during which the
cost associated with nonemployee awards is recognized (i.e., as the goods or
services are provided).
Under ASC 718, service and performance conditions are vesting conditions, while market conditions are
incorporated into the fair-value-based measurement of share-based payments.
9.3.2.1 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.
The definition of service condition incorporates characteristics of nonemployee awards by stating that such a condition can be satisfied if “a nonemployee deliver[s] goods or render[s] services to the grantor over a vesting period.”
ASC 718-10
35-1D The total amount of
compensation cost recognized for share-based payment
awards to nonemployees shall be based on the number
of instruments for which a good has been delivered
or a service has been rendered. 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 nonemployee
share-based payment awards, including share-based
payment awards granted to customers, to do either of
the following:
-
Estimate the number of forfeitures expected to occur. The entity shall base initial accruals of compensation cost on the estimated number of nonemployee share-based payment awards for which a good is expected to be delivered or a 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 estimates shall be recognized in compensation cost in the period of the change.
-
Recognize the effect of forfeitures in compensation cost when they occur. Previously recognized compensation cost for a nonemployee share-based payment award shall be reversed in the period that the award is forfeited.
In a manner similar to its guidance on employee awards with certain conditions
(see Section
3.4), ASC 718 allows an entity to make an entity-wide policy
election for all nonemployee awards (including share-based payments issued
as sales incentives to customers; see Section
14.4) to either (1) estimate forfeitures or (2) recognize
forfeitures when they occur. The policy election is independent of the
entity’s policy election for employee awards. If the entity elects to
estimate forfeitures, it should recognize the cost of nonemployee awards on
the basis of its estimate of awards for which the goods are expected to be
delivered or the service is expected to be rendered, and the entity should
revise its estimate as appropriate.
An entity’s forfeiture policy is associated solely with service conditions. The
entity must assess the probability of achieving any performance conditions
and may not make a policy election for performance conditions. However, as
noted above, unlike employee service conditions, nonemployee vesting
conditions might not be tied to the provision of service for a specific
period. An entity will need to use judgment to determine whether its
forfeiture policy applies to certain nonemployee vesting conditions, because
it may not be obvious whether such conditions are service or performance
conditions. See Section 9.3.2.2 for a
discussion of determining whether a nonemployee vesting condition is a
service condition or performance condition.
In addition, an entity may consider the nature and volume of awards granted to nonemployees when
assessing which forfeiture accounting policy to elect. The number of nonemployee award grantees may
not be significant relative to that of employee award grantees (which often consist of large employee
pools). Consequently, there may be insufficient historical forfeiture data, which may make it difficult for
an entity to estimate how many nonemployee awards will be forfeited. In such circumstances, an entity
that elects to estimate forfeitures might conclude that each nonemployee will fulfill its contract and that
no awards are estimated to be forfeited. However, an entity may reasonably estimate forfeitures on the
basis of historical forfeiture data if the volume of nonemployee providers is large and the nonemployees
share similar characteristics. For example, an entity may grant awards to employees of a third-party
management advisory company that vest if the grantees provide advisory services for a specified period.
In this situation, the entity may be able to use historical forfeiture data to estimate forfeitures if the
grantees perform a function that is similar to that of the entity’s employees.
9.3.2.2 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).
The definition of a performance condition incorporates characteristics of
nonemployee awards since it states that the performance target might pertain
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).” An entity is required to recognize any cost on the basis
of the probable outcome of performance conditions.
Example 9-2
On January 1, 20X1, Entity C enters
into a contract with an advertising company that
provides marketing services in exchange for a cash
fee. The marketing services are completed on
December 31, 20X1. The cost associated with the cash
fee is recognized as the marketing services are
performed. In addition, if C achieves $100 million
in sales over a one-year period after the services
are provided (January 1, 20X2, through December 31,
20X2), the advertising company will receive 100
equity-classified warrants. Entity C concludes that
it is probable that it will achieve $100
million in sales for the one-year period, and it
achieves that sales target on December 31, 20X2.
Under ASC 718, C recognizes the
grant-date fair-value-based measure of the warrants
since achievement of the sales target (performance
condition) is probable. In addition, C would
generally recognize the cost as the marketing
services are performed.
The
fair-value-based measure of the warrants on January
1, 20X1, is $10. The following journal entry
illustrates the recognition under ASC 718:
Journal Entry: December 31, 20X1
Because the vesting conditions of nonemployee awards might not be similar to those of employee
awards (e.g., employment for a specified period), an entity must apply judgment in determining whether
a nonemployee vesting condition is a service condition or performance condition. For example,
vesting conditions for certain nonemployee awards may be tied to specific tasks and activities (e.g.,
promoting the entity’s products at a defined number of events) rather than to the provision of service
for a specified period. In such circumstances, those specific tasks and activities may represent service
conditions instead of performance conditions. To meet the definition of a performance condition,
the vesting requirement must be related to the grantor’s operations or activities, not the grantee’s.
Therefore, certain tasks and activities that a nonemployee must perform (e.g., quality-control services
that include an assessment of a minimum number of locations each year) to vest in awards may be
characterized as service conditions because they are not solely related to the grantor’s own operations
or activities.
Example 9-3
Entity B grants 100 warrants to a distributor that is not a customer (i.e., it is a vendor). The warrants will vest as long as the distributor provides B’s products at 20 of its locations for two years. In addition, if the distributor generates $100 million in sales for B during that two-year period, an additional 100 warrants will vest. While the maintenance of B’s products at 20 of the distributor’s locations and the generation of $100 million in sales for B are both related to the distributor’s performance, B would need to assess whether each vesting condition is a service or performance condition. B may reasonably conclude that maintaining its products at 20 of the distributor’s locations is a service condition and that achieving $100 million in sales to earn additional warrants is a performance condition. While achievement of $100 million in sales for B is associated with the distributor’s service and performance, such performance is related solely to B’s own operations. By contrast, maintaining B’s products at 20 of the distributor’s locations may not be related solely to B’s own operations and may therefore be treated as a service condition.
9.4 Measurement
ASC 718-10
General
10-2 This Topic requires that the
cost resulting from all share-based payment transactions be
recognized in the financial statements. This Topic
establishes fair value as the measurement objective in
accounting for share-based payment arrangements and requires
all entities to apply a fair-value-based measurement method
in accounting for share-based payment transactions except
for equity instruments held by employee stock ownership
plans.
Fair-Value-Based
30-2 A share-based payment
transaction shall be measured based on the fair value (or in
certain situations specified in this Topic, a calculated
value or intrinsic value) of the equity instruments
issued.
30-3 An entity shall account for
the compensation cost from share-based payment transactions
in accordance with the fair-value-based method set forth in
this Topic. That is, the cost of goods obtained or services
received in exchange for awards of share-based compensation
generally shall be measured based on the grant-date fair
value of the equity instruments issued or on the fair value
of the liabilities incurred. The cost of goods obtained or
services received by an entity as consideration for equity
instruments issued or liabilities incurred in share-based
compensation transactions shall be measured based on the
fair value of the equity instruments issued or the
liabilities settled. The portion of the fair value of an
instrument attributed to goods obtained or services received
is net of any amount that a grantee pays (or becomes
obligated to pay) for that instrument when it is granted.
For example, if a grantee pays $5 at the grant date for an
option with a grant-date fair value of $50, the amount
attributed to goods or services provided by the grantee is
$45. An entity shall apply the guidance in paragraph
606-10-32-26 when determining the portion of the fair value
of an equity instrument attributed to goods obtained or
services received from a customer.
Measurement Objective —
Fair Value at Grant Date
30-6 The measurement objective for
equity instruments awarded to grantees is to estimate the
fair value at the grant date of the equity instruments that
the entity is obligated to issue when grantees have
delivered the good or rendered the service and satisfied any
other conditions necessary to earn the right to benefit from
the instruments (for example, to exercise share options).
That estimate is based on the share price and other
pertinent factors, such as expected volatility, at the grant
date.
30-7 The fair value of an equity
share option or similar instrument shall be measured based
on the observable market price of an option with the same or
similar terms and conditions, if one is available (see
paragraph 718-10-55-10).
30-8 Such market prices for equity
share options and similar instruments granted in share-based
payment transactions are frequently not available; however,
they may become so in the future.
30-9 As such, the fair value of an
equity share option or similar instrument shall be estimated
using a valuation technique such as an option-pricing model.
For this purpose, a similar instrument is one whose fair
value differs from its intrinsic value, that is, an
instrument that has time value. For example, a share
appreciation right that requires net settlement in equity
shares has time value; an equity share does not. Paragraphs
718-10-55-4 through 55-47 provide additional guidance on
estimating the fair value of equity instruments, including
the factors to be taken into account in estimating the fair
value of equity share options or similar instruments as
described in paragraphs 718-10-55-21 through 55-22.
In a manner similar to employee awards, nonemployee awards are recognized on the basis of their fair-value-based measure (and in certain circumstances, nonpublic entities are permitted to use calculated
value or intrinsic value; see discussions in Sections 9.4.2.2 and 9.4.2.3).
9.4.1 Contractual Term Versus Expected Term
ASC 718-10
Vesting Versus
Nontransferability
30-10 To satisfy the
measurement objective in paragraph 718-10-30-6, the
restrictions and conditions inherent in equity
instruments awarded are treated differently depending on
whether they continue in effect after the requisite
service period or the nonemployee’s vesting period. A
restriction that continues in effect after an entity has
issued awards, 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 equity 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).
30-10A On an award-by-award
basis, an entity may elect to use the contractual term
as the expected term when estimating the fair value of a
nonemployee award to satisfy the measurement objective
in paragraph 718-10-30-6. Otherwise, an entity shall
apply the guidance in this Topic in estimating the
expected term of a nonemployee award, which may result
in a term less than the contractual term of the
award.
As discussed in Section
4.9.2.2, an entity measures employee stock options under ASC 718
by using an expected term that takes into account the effects of employees’
expected exercise and postvesting employment termination behavior. ASC
718-10-55-29 states that the expected term is used because employee stock
options differ from transferable or tradable options “in that employees cannot
sell (or hedge) their share options — they can only exercise them; because of
this, employees generally exercise their options before the end of the options’
contractual term.” However, determining an expected term for nonemployee awards
could be challenging because entities may not have sufficient historical data
related to the early exercise behavior of nonemployees, particularly if
nonemployee awards are not frequently granted. In addition, nonemployee stock
option awards may not be exercised before the end of the contractual term if
they do not contain certain features typically found in employee stock option
awards (e.g., nontransferability, nonhedgeability, and truncation of the
contractual term because of postvesting termination).
Accordingly, ASC 718 allows an entity to elect on an award-by-award basis to use the contractual term as the expected term for nonemployee awards. If an entity elects not to use the contractual term for a particular award, the entity estimates the expected term. However, a nonpublic entity can make an accounting policy election to apply a practical expedient to estimate the expected term for awards that meet the conditions in ASC 718-10-30-20B (see discussion in Section 9.4.2.1).
9.4.2 Practical Expedients for Nonpublic Entities
Under ASC 718, nonpublic entities may apply the same practical expedients to nonemployee awards
that they apply to employee awards.
9.4.2.1 Expected Term
ASC 718-10
Vesting
Versus Nontransferability
30-10B When a nonpublic
entity chooses to measure a nonemployee share-based
payment award by estimating its expected term and
applies the practical expedient in paragraph
718-10-30-20A, it must apply the practical expedient
to all nonemployee awards that meet the conditions
in paragraph 718-10-30-20B. However, a nonpublic
entity may still elect, on an award-by-award basis,
to use the contractual term as the expected term as
described in paragraph 718-10-30-10A.
30-20A For an award that
meets the conditions in paragraph 718-10-30-20B, a
nonpublic entity may make an entity-wide accounting
policy election to estimate the expected term using
the following practical expedient:
-
If vesting is only dependent upon a service condition, a nonpublic entity shall estimate the expected term as the midpoint between the employee’s requisite service period or the nonemployee’s vesting period and the contractual term of the award.
-
If vesting is dependent upon satisfying a performance condition, a nonpublic entity first would determine whether the performance condition is probable of being achieved.
-
If the nonpublic entity concludes that the performance condition is probable of being achieved, the nonpublic entity shall estimate the expected term as the midpoint between the employee’s requisite service period (a nonpublic entity shall consider the guidance in paragraphs 718-10-55-69 through 55-79 when determining the requisite service period of the award) or the nonemployee’s vesting period and the contractual term.
- If the nonpublic entity
concludes that the performance condition is not
probable of being achieved, the nonpublic entity
shall estimate the expected term as either:i. The contractual term if the service period is implied (that is, the requisite service period or the nonemployee’s vesting period is not explicitly stated but inferred based on the achievement of the performance condition at some undetermined point in the future)ii. The midpoint between the employee’s requisite service period or the nonemployee’s vesting period and the contractual term if the requisite service period is stated explicitly.
-
Paragraph 718-10-55-50A provides
implementation guidance on the practical
expedient.
30-10A On an award-by-award
basis, an entity may elect to use the contractual
term as the expected term when estimating the fair
value of a nonemployee award to satisfy the
measurement objective in paragraph 718-10-30-6.
Otherwise, an entity shall apply the guidance in
this Topic in estimating the expected term of a
nonemployee award, which may result in a term less
than the contractual term of the award.
30-20B A nonpublic entity
that elects to apply the practical expedient in
paragraph 718-10-30-20A shall apply the practical
expedient to a share option or similar award that
has all of the following characteristics:
-
The share option or similar award is granted at the money.
-
The grantee has only a limited time to exercise the award (typically 30–90 days) if the grantee no longer provides goods, terminates service after vesting, or ceases to be a customer.
-
The grantee can only exercise the award. The grantee cannot sell or hedge the award.
-
The award does not include a market condition.
A nonpublic entity that elects to
apply the practical expedient in paragraph
718-10-30-20A may always elect to use the
contractual term as the expected term when
estimating the fair value of a nonemployee award as
described in paragraph 718-10-30-10A. However, a
nonpublic entity must apply the practical expedient
in paragraph 718-10-30-20A for all nonemployee
awards that have all the characteristics listed in
this paragraph if that nonpublic entity does not
elect to use the contractual term as the expected
term and that nonpublic entity elects the accounting
policy election to apply the practical expedient in
paragraph 718-10-30-20A.
Selecting or Estimating the Expected
Term
55-29A Paragraph
718-10-30-10A states that, on an award-by-award
basis, an entity may elect to use the contractual
term as the expected term when estimating the fair
value of a nonemployee award to satisfy the
measurement objective in paragraph 718-10-30-6.
Otherwise, an entity shall apply the guidance in
this Topic in estimating the expected term of a
nonemployee award, which may result in a term less
than the contractual term of the award. If an entity
does not elect to use the contractual term as the
expected term, similar considerations discussed in
paragraph 718-10-55-29, such as the inability to
sell or hedge a nonemployee award, apply when
estimating its expected term.
As discussed in Section
9.4.1, an entity may make an award-by-award election to use
the contractual term as the expected term. If the contractual term is not
used and a nonpublic entity instead estimates the expected term, the entity
may elect to estimate the expected term by using a practical expedient for
nonemployee awards that meet the conditions in ASC 718-10-30-20B. The
practical expedient is an entity-wide accounting policy election that must
be consistently applied to both employee and nonemployee awards. In
addition, if elected, the practical expedient must be applied to all
nonemployee awards that meet the conditions in ASC 718-10-30-20B and for
which the entity did not first elect to use the contractual term as the
expected term. Under the practical expedient, the expected term is generally
estimated as the midpoint between the nonemployee’s vesting period and the
contractual term of the award. However, the midpoint is not used if an award
has an implicit vesting period and a performance condition and it is not
probable that the performance condition will be met. In this circumstance,
the expected term is the contractual term.
See Section 4.9.2.2.3 for further discussion of the expected-term practical expedient.
Example 9-4
Entity D enters into a contract with an advertising company that provides marketing services in exchange
for warrants. In accordance with the terms of the award, the number of warrants earned will depend on the
market price of D’s common shares when the marketing services are completed. For this award, D elects not
to use the contractual term as the expected term. In addition, D has made an entity-wide accounting policy
election to use the practical expedient to estimate the expected term for awards that meet the required
conditions. Therefore, D reviews the guidance in ASC 718-10-30-20B to determine whether it should use the
practical expedient to estimate the expected term. Because the warrants include a market condition, the
practical expedient cannot be applied, and D must estimate the expected term.
9.4.2.2 Calculated Value
ASC 718-10
30-19A Similar to employee
equity share options and similar instruments, a
nonpublic entity may not be able to reasonably
estimate the fair value of nonemployee awards
because it is not practicable for the nonpublic
entity to estimate the expected volatility of its
share price. In that situation, the nonpublic entity
shall account for nonemployee equity share options
and similar instruments on the basis of a value
calculated using the historical volatility of an
appropriate industry sector index instead of the
expected volatility of the nonpublic entity’s share
price (the calculated value) in accordance with
paragraph 718-10-30-20. A nonpublic entity’s use of
calculated value shall be consistent between
employee share-based payment transactions and
nonemployee share-based payment transactions.
30-20 A nonpublic entity may
not be able to reasonably estimate the fair value of
its equity share options and similar instruments
because it is not practicable for it to estimate the
expected volatility of its share price. In that
situation, the entity shall account for its equity
share options and similar instruments based on a
value calculated using the historical volatility of
an appropriate industry sector index instead of the
expected volatility of the entity’s share price (the
calculated value). Throughout the remainder of this
Topic, provisions that apply to accounting for share
options and similar instruments at fair value also
apply to calculated value. Paragraphs 718-10-55-51
through 55-58 and Example 9 (see paragraph
718-20-55-76) provide additional guidance on
applying the calculated value method to equity share
options and similar instruments granted by a
nonpublic entity.
Under ASC 718, a nonpublic entity is required to use calculated value to measure its stock options
and similar instruments granted to employees if it is unable to reasonably estimate the fair value of
such awards because it is not practicable for it to estimate the expected volatility of its stock price. This
practical expedient also applies to nonemployee awards and needs to be consistently applied to both
employee and nonemployee awards. See Section 4.13.2 for further discussion of calculated value.
9.4.2.3 Intrinsic Value
ASC 718-30
30-2 A nonpublic entity shall
make a policy decision of whether to measure all of
its liabilities incurred under share-based payment
arrangements (for employee and nonemployee awards)
issued in exchange for distinct goods or services at
fair value or at intrinsic value. However, a
nonpublic entity shall initially and subsequently
measure awards determined to be consideration
payable to a customer (as described in paragraph
606-10-32-25) at fair value.
Under ASC 718, the accounting policy election permitting nonpublic entities to
measure all liability-classified share-based payment awards at intrinsic
value instead of a fair-value-based measure applies to both employee awards
and nonemployee awards, with the exception of measuring liability-classified
share-based payments issued as sales incentives to customers (see Chapter 14 for additional information about
sales incentives to customers). This practical expedient must be
consistently applied to both employee and nonemployee awards.
9.4.2.4 Current Price Input for Equity Classified Awards
Nonpublic entities may use, as a practical expedient, “the
reasonable application of a reasonable valuation method” to determine the
current price input of equity-classified share-based payment awards issued
to both employees and nonemployees. See Section 4.13.1.3 for further
discussion of the use of this practical expedient.
9.5 Classification
ASC 718-10
35-9 Paragraphs 718-10-35-10
through 35-14 are intended to apply to those instruments
issued in share-based payment transactions with employees
and nonemployees accounted for under this Topic, and to
instruments exchanged in a business combination for
share-based payment awards of the acquired business that
were originally granted to grantees of the acquired business
and are outstanding as of the date of the business
combination.
35-9A
Paragraph superseded by Accounting Standards Update No.
2020-06.
35-10 A freestanding financial
instrument or a convertible security issued to a grantee
that is subject to initial recognition and measurement
guidance within this Topic shall continue to be subject to
the recognition and measurement provisions of this Topic
throughout the life of the instrument, unless its terms are
modified after any of the following:
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- A grantee vests in the award and is no longer providing goods or services.
- A grantee vests in the award and is no longer a customer.
- A grantee is no longer an employee.
35-10A Only for
purposes of paragraph 718-10-35-10, a modification does not
include a change to the terms of an award if that change is
made solely to reflect an equity restructuring provided that
both of the following conditions are met:
- There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved, that is, the holder is made whole) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
- All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.
35-11 Other modifications of that
instrument that take place after a grantee vests in the
award and is no longer providing goods or services, is no
longer a customer, or is no longer an employee should be
subject to the modification guidance in paragraph
718-10-35-14. Following modification, recognition and
measurement of the instrument shall be determined through
reference to other applicable GAAP.
35-12 Once the classification of an
instrument is determined, the recognition and measurement
provisions of this Topic shall be applied until the
instrument ceases to be subject to the requirements
discussed in paragraph 718-10-35-10. Topic 480 or other
applicable GAAP, such as Topic 815, applies to a
freestanding financial instrument that was issued under a
share-based payment arrangement but that is no longer
subject to this Topic. This guidance is not intended to
suggest that all freestanding financial instruments shall be
accounted for as liabilities pursuant to Topic 480, but
rather that freestanding financial instruments issued in
share-based payment transactions may become subject to that
Topic or other applicable GAAP depending on their
substantive characteristics and when certain criteria are
met.
35-14 An entity may modify
(including cancel and replace) or settle a fully vested,
freestanding financial instrument after it becomes subject
to Topic 480 or other applicable GAAP. Such a modification
or settlement shall be accounted for under the provisions of
this Topic unless it applies equally to all financial
instruments of the same class regardless of the holder of
the financial instrument. Following the modification, the
instrument continues to be accounted for under that Topic or
other applicable GAAP. A modification or settlement of a
class of financial instrument that is designed exclusively
for and held only by grantees (or their beneficiaries) may
stem from the employment or vendor relationship depending on
the terms of the modification or settlement. Thus, such a
modification or settlement may be subject to the
requirements of this Topic. See paragraph 718-10-35-10 for a
discussion of changes to awards made solely to reflect an
equity restructuring.
The guidance in ASC 718 on the classification of employee share-based payment awards also applies
to nonemployee awards. Therefore, nonemployee awards will generally remain within the scope of ASC
718 unless they are modified after the awards vest and the nonemployee is no longer providing goods
and services (except under an equity restructuring that meets certain criteria). See Chapter 5 for a
discussion of the guidance on the classification of share-based payment awards.
Changing Lanes
In August 2020, the FASB issued ASU 2020-06,
which simplifies the accounting for certain financial instruments with
characteristics of liabilities and equity, including convertible instruments
and contracts on an entity’s own equity. Most of the guidance in that ASU
does not apply to this Roadmap. However, the ASU removes from U.S. GAAP the
guidance on a nonemployee award that is granted in the form of a convertible
instrument described in ASC 718-10-35-9A. Therefore, upon adoption of the
ASU, nonemployee awards in the form of a convertible instrument that are
issued after the date of adoption (or that are outstanding as of (1) the
adoption date under a modified retrospective basis or (2) the beginning of
the earliest period presented under a retrospective basis) will generally
remain within the scope of ASC 718 unless the awards are modified after the
awards vest and the nonemployee is no longer providing goods and services
(except under an equity restructuring that meets certain criteria).
See Deloitte’s August 5, 2020, Heads
Up for additional information about changes required
under the ASU, including its effective dates.
For additional discussion of the issuer’s accounting for
convertible debt after the adoption of ASU 2020-06, see Deloitte’s Roadmap
Issuer’s
Accounting for Debt.
9.6 Nonemployee Awards Exchanged in a Business Combination
ASC 805-30
55-9A The portion of a nonemployee
replacement award attributable to precombination vesting is
based on the fair-value-based measure of the acquiree award
multiplied by the percentage that would have been recognized
had the grantor paid cash for the goods or services instead
of paying with a nonemployee award. For this calculation,
the percentage that would have been recognized is the lower
of:
-
The percentage that would have been recognized calculated on the basis of the original vesting requirements of the nonemployee award
-
The percentage that would have been recognized calculated on the basis of the effective vesting requirements. Effective vesting requirements are equal to the services or goods provided before the acquisition date plus any additional postcombination services or goods required by the replacement award.
55-10 The portion of a nonvested
replacement award (for employee and nonemployee)
attributable to postcombination vesting, and therefore
recognized as compensation cost in the postcombination
financial statements, equals the total fair-value-based
measure of the replacement award less the amount attributed
to precombination vesting. Therefore, the acquirer
attributes any excess of the fair-value-based measure of the
replacement award over the fair value of the acquiree award
to postcombination vesting and recognizes that excess as
compensation cost in the postcombination financial
statements.
55-11 Regardless of the accounting
policy elected in accordance with paragraph 718-10-35-1D or
718-10-35-3, the portion of a nonvested replacement award
included in consideration transferred shall reflect the
acquirer’s estimate of the number of replacement awards for
which the service is expected to be rendered or the goods
are expected to be delivered (that is, an acquirer that has
elected an accounting policy to recognize forfeitures as
they occur in accordance with paragraph 718-10-35-1D or
718-10-35-3 should estimate the number of replacement awards
for which the service is expected to be rendered or the
goods are expected to be delivered when determining the
portion of a nonvested replacement award included in
consideration transferred). For example, if the
fair-value-based measure of the portion of a replacement
award attributed to precombination vesting is $100 and the
acquirer expects that the service will be rendered for only
95 percent of the instruments awarded, the amount included
in consideration transferred in the business combination is
$95. Changes in the number of replacement awards for which
the service is expected to be rendered or the goods are
expected to be delivered are reflected in compensation cost
for the periods in which the changes or forfeitures occur —
not as adjustments to the consideration transferred in the
business combination. If an acquirer’s accounting policy is
to account for forfeitures as they occur, the amount
excluded from consideration transferred (because the service
is not expected to be rendered or the goods are not expected
to be delivered) should be attributed to the postcombination
vesting and recognized in compensation cost over the
employee’s requisite service period or the nonemployee’s
vesting period. Recognition of compensation cost for
nonemployees should consider the recognition guidance
provided in paragraph 718-10-25-2C. That is, recognition of
the fair value of the nonemployee share-based payment award
should be recognized 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 awards.
When nonemployee awards are exchanged in a business combination, it is important for an entity
to determine what portion of the replacement awards is attributed to “precombination vesting” (and
therefore included in the consideration transferred) and what portion is attributed to “postcombination
vesting” (and therefore recognized in the postcombination period). Unlike the computation of ratably
recognized employee awards, the computation of the portion of the replacement awards attributed to
the consideration transferred and the portion attributed to the postcombination period is based on the
percentage of the cost of the awards that would have been recognized in each period if the grantor had
paid cash. Below are examples from ASC 805 illustrating how an acquirer that has provided replacement
awards to nonemployees of an acquiree would attribute such replacement awards to precombination
vesting and postcombination vesting.
ASC 805-30
Example 3: Acquirer
Replacement of Nonemployee Awards
55-25 The following Cases
illustrate the guidance referred to in paragraph 805-30-55-6
for replacement awards that the acquirer was obligated to
issue and the attribution guidance for a nonemployee
replacement award to precombination and postcombination
vesting referenced in paragraph 805-30-55-9A.
55-26 In these Cases, the acquiring
entity is referred to as Acquirer and the acquiree is
referred to as Target:
-
Awards that require no postcombination vesting that are exchanged for acquiree awards for which grantees:
-
Have met the vesting condition as of the acquisition date (Case A)
-
Have not met the vesting condition as of the acquisition date (Case D).
-
-
Awards that require postcombination vesting that are exchanged for acquiree awards for which grantees:
-
Have met the vesting condition as of the acquisition date (Case B)
-
Have not met the vesting condition as of the acquisition date (Case C).
-
55-27 The Cases assume the
following:
-
All awards are classified as equity.
-
The only vesting condition included in the awards, if any, involves the delivery of engines.
-
Target and Acquirer typically pay cash as each engine is delivered to their suppliers.
Case A: No Required Postcombination Vesting
and the Vesting Condition for Acquiree Awards Has Been Met
as of Acquisition Date
55-28 Acquirer issues replacement
awards of $110 (fair-value-based measure) at the acquisition
date for Target awards of $100 (fair-value-based measure) at
the acquisition date. No postcombination vesting is required
for the replacement awards, and Target’s grantee has
delivered all the engines necessary for the acquiree awards
as of the acquisition date.
55-29 The amount attributable to
precombination vesting is the fair-value-based measure of
Target’s awards ($100) at the acquisition date; that amount
is included in the consideration transferred in the business
combination. The amount attributable to postcombination
vesting is $10, which is the difference between the total
value of the replacement awards ($110) and the portion
attributable to precombination vesting ($100). Because no
postcombination vesting is required for the replacement
awards, Acquirer immediately recognizes $10 as compensation
cost in its postcombination financial statements.
Case B: Postcombination Vesting Required and
the Vesting Condition for Acquiree Awards Has Been Met as of
Acquisition Date
55-30 Acquirer exchanges
replacement awards that require the delivery of another 10
engines postcombination for share-based payment awards of
Target for which the grantee had met the necessary vesting
condition to deliver 40 engines before the business
combination. The fair-value-based measure of both awards is
$100 at the acquisition date. Even though the grantee
already had met the vesting condition for the acquiree’s
award, Acquirer attributes a portion of the replacement
award to postcombination compensation cost in accordance
with paragraphs 805-30-30-12 through 30-13 because the
replacement awards require the delivery of an additional 10
engines.
55-31 The portion attributable to
precombination vesting equals the fair-value-based measure
of the acquiree award ($100) multiplied by the percentage
that would have been recognized for the award. The
percentage that would have been recognized is the lower of
the calculation on the basis of the original vesting
requirements and the percentage that would have been
recognized on the basis of the effective vesting
requirements as described in paragraph 805-30-55-9A. The
percentage that would have been recognized on the basis of
the original vesting requirements equals 100 percent, which
is calculated as 40 engines delivered divided by 40 engines
required to be delivered. The percentage that would have
been recognized on the basis of the effective vesting
requirements equals 80 percent, which is calculated as 40
engines delivered divided by 50 engines (the sum of 40
engines delivered plus 10 engines required postcombination).
Thus, $80 ($100 × 80%) is attributed to the precombination
vesting period and therefore is included in the
consideration transferred in the business combination. The
remaining $20 is attributed to the postcombination vesting
period and therefore is recognized as compensation cost in
Acquirer’s postcombination financial statements in
accordance with Topic 718.
Case C: Postcombination Vesting Required and
the Vesting Condition for Acquiree Awards Has Not Been Met
as of Acquisition Date
55-32 Acquirer exchanges
replacement awards that require the delivery of 10 engines
postcombination for share-based payment awards of Target for
which the grantee had not met the necessary vesting
condition to deliver 40 engines before the business
combination. The fair-value-based measure of both awards is
$100 at the acquisition date. As of the acquisition date,
Target grantee has delivered 20 engines, and Target grantee
would have been required to deliver an additional 20 engines
after the acquisition date for its awards to vest.
Accordingly, only a portion of Target’s awards is
attributable to precombination vesting.
55-33 The portion attributable to
precombination vesting equals the fair-value-based measure
of the acquiree award ($100) multiplied by the percentage
that would have been recognized on the award. The percentage
that would have been recognized is the lower of the
percentage that would have been recognized on the basis of
the original vesting requirements and the percentage that
would have been recognized on the basis of the effective
vesting requirements as described in paragraph 805-30-55-9A.
The percentage that would have been recognized on the basis
of the original vesting requirements equals 50 percent,
which is calculated as 20 engines delivered divided by 40
engines required to be delivered. The percentage that would
have been recognized on the basis of the effective vesting
requirements equals 66.67 percent, which is calculated as 20
engines delivered divided by 30 engines (the sum of 20
engines delivered plus 10 engines required postcombination).
Thus, $50 ($100 × 50%) is attributed to precombination
vesting and therefore is included in the consideration
transferred in the business combination. The remaining $50
is attributed to the postcombination vesting and therefore
is recognized as compensation cost in Acquirer’s
postcombination financial statements in accordance with
Topic 718.
Case D: No Postcombination Vesting Required
and the Vesting Condition for Acquiree Awards Has Not Been
Met as of Acquisition Date
55-34 Assume the same facts as in
Case C, except that Acquirer exchanges replacement awards
that require no postcombination vesting for share-based
payment awards of Target for which the grantee had not met
the necessary vesting condition to deliver 40 engines before
the business combination. The terms of the replaced Target
awards did not eliminate the vesting condition upon a change
in control. (If the Target awards had included a provision
that eliminated the vesting condition upon a change in
control, the guidance in Case A [see paragraph 805-30-55-28]
would apply.) The fair-value-based measure of both awards is
$100.
55-35 The portion attributable to
precombination vesting equals the fair-value-based measure
of the acquiree award ($100) multiplied by the percentage
that would have been recognized on the award. The percentage
that would have been recognized is the lower of the
percentage that would have been recognized on the basis of
the original vesting requirements and the percentage that
would have been recognized on the basis of the effective
vesting requirements as described in paragraph 805-30-55-9A.
The percentage that would have been recognized on the basis
of the original vesting requirements equals 50 percent,
which is calculated as 20 engines delivered divided by 40
engines required to be delivered. The percentage that would
have been recognized on the basis of the effective vesting
requirements equals 100 percent, which is calculated as 20
engines delivered divided by 20 engines (the sum of 20
engines delivered plus zero engines required
postcombination). Thus, $50 ($100 × 50%) is attributed to
the precombination vesting and is therefore included in the
consideration transferred in the business combination. The
remaining $50 is attributed to the postcombination vesting.
Because no postcombination vesting is required to vest in
the replacement award, Acquirer recognizes the entire $50
immediately as compensation cost in the postcombination
financial statements.
9.7 Presentation
ASC 718-10
35-1B If fully vested,
nonforfeitable equity instruments are granted at the date
the grantor and nonemployee enter into an agreement for
goods or services (no specific performance is required by
the nonemployee to retain those equity instruments), then,
because of the elimination of any obligation on the part of
the nonemployee to earn the equity instruments, a grantor
shall recognize the equity instruments when they are granted
(in most cases, when the agreement is entered into). Whether
the corresponding cost is an immediate expense or a prepaid
asset (or whether the debit should be characterized as
contra-equity under the requirements of paragraph
718-10-45-3) depends on the specific facts and
circumstances.
45-3 As discussed in paragraph
718-10-35-1B, a grantor may conclude that an asset (other
than a note or a receivable) has been received in return for
fully vested, nonforfeitable, nonemployee share-based
payment awards that are issued at the date the grantor and
nonemployee enter into an agreement for goods or services
(and no specific performance is required by the nonemployee
to retain those equity instruments). Such an asset shall not
be displayed as contra-equity by the grantor of the award.
The transferability (or lack thereof) of the awards shall
not affect the balance sheet display of the asset. This
guidance is limited to transactions in which awards are
transferred to nonemployees in exchange for goods or
services.
If an entity receives a recourse note for the issuance of a share-based payment
award, that note would generally be presented as contra-equity (see Section 12.1.1). However, if
an entity receives an asset that is not a note or a receivable from a nonemployee
supplier or service provider (e.g., an asset received in return for fully vested,
nonforfeitable equity instruments), that asset should not be presented as
contra-equity.
In addition, in an SEC staff announcement regarding ASC 505-50, the
staff indicated that unvested, forfeitable instruments should be treated as unissued
for accounting purposes until the future services are received. Although the SEC
staff rescinded that announcement at the March 24, 2022, EITF meeting as a result of
the FASB’s issuance of ASU 2018-07, we believe that the underlying principle remains
applicable for unvested, forfeitable instruments issued for goods and services.
9.8 Disclosures
There are no specific or incremental disclosure requirements for nonemployee share-based payment arrangements because the disclosures in ASC 718 apply equally to employee and nonemployee awards. Under ASC 718-10-50-2(g), separate disclosures for nonemployee awards would be required “to the extent that the differences in the characteristics of the awards make separate disclosure important to an understanding of the entity’s use of share-based compensation.” See Chapter 13 for additional guidance on disclosures about share-based payment awards.
9.9 Nonemployees of an Equity Method Investee
ASC 323-10
Stock-Based Compensation
Granted to Employees and Nonemployees of an Equity
Method Investee
25-3 Paragraphs 323-10-25-4 through
25-6 provide guidance on accounting for share-based payment
awards granted by an investor to employees or nonemployees
of an equity method investee that provide goods or services
to the investee that are used or consumed in the investee’s
operations when no proportionate funding by the other
investors occurs and the investor does not receive any
increase in the investor’s relative ownership percentage of
the investee. That guidance assumes that the investor’s
grant of share-based payment awards to employees or
nonemployees of the equity method investee was not agreed to
in connection with the investor’s acquisition of an interest
in the investee. That guidance applies to share-based
payment awards granted to employees or nonemployees of an
investee by an investor based on that investor’s stock (that
is, stock of the investor or other equity instruments
indexed to, and potentially settled in, stock of the
investor).
25-4 In the circumstances described
in paragraph 323-10-25-3, a contributing investor shall
expense the cost of share-based payment awards granted to
employees and nonemployees of an equity method investee as
incurred (that is, in the same period the costs are
recognized by the investee) to the extent that the
investor’s claim on the investee’s book value has not been
increased.
25-5 In the circumstances described
in paragraph 323-10-25-3, other equity method investors in
an investee (that is, noncontributing investors) shall
recognize income equal to the amount that their interest in
the investee’s net book value has increased (that is, their
percentage share of the contributed capital recognized by
the investee) as a result of the disproportionate funding of
the compensation costs. Further, those other equity method
investors shall recognize their percentage share of earnings
or losses in the investee (inclusive of any expense
recognized by the investee for the share-based compensation
funded on its behalf).
25-6 Example 2 (see paragraph
323-10-55-19) illustrates the application of this guidance
for share-based compensation granted to employees of an
equity method investee.
Share-Based Compensation
Granted to Employees and Nonemployees of an Equity
Method Investee
30-3 Share-based compensation cost
recognized in accordance with paragraph 323-10-25-4 shall be
measured initially at fair value in accordance with Topic
718. Example 2 (see paragraph 323-10-55-19) illustrates the
application of this guidance.
Example 2:
Share-Based Compensation Granted to Employees of an
Equity Method Investee
55-19 This Example illustrates the
guidance in paragraphs 323-10-25-3 and 323-10-30-3 for
share-based compensation by an investor granted to employees
of an equity method investee. This Example is equally
applicable to share-based awards granted by an investor to
nonemployees that provide goods or services to an equity
method investee that are used or consumed in the investee’s
operations.
55-20 Entity A owns a 40 percent
interest in Entity B and accounts for its investment under
the equity method. On January 1, 20X1, Entity A grants
10,000 stock options (in the stock of Entity A) to employees
of Entity B. The stock options cliff-vest in three years. If
an employee of Entity B fails to vest in a stock option, the
option is returned to Entity A (that is, Entity B does not
retain the underlying stock). The owners of the remaining 60
percent interest in Entity B have not shared in the funding
of the stock options granted to employees of Entity B on any
basis and Entity A was not obligated to grant the stock
options under any preexisting agreement with Entity B or the
other investors. Entity B will capitalize the share-based
compensation costs recognized over the first year of the
three-year vesting period as part of the cost of an
internally constructed fixed asset (the internally
constructed fixed asset will be completed on December 31,
20X1).
55-21 Before granting the stock
options, Entity A’s investment balance is $800,000, and the
book value of Entity B’s net assets equals $2,000,000.
Entity B will not begin depreciating the internally
constructed fixed asset until it is complete and ready for
its intended use and, therefore, no related depreciation
expense (or compensation expense relating to the stock
options) will be recognized between January 1, 20X1, and
December 31, 20X1. For the years ending December 31, 20X2,
and December 31, 20X3, Entity B will recognize depreciation
expense (on the internally constructed fixed asset) and
compensation expense (for the cost of the stock options
relating to Years 2 and 3 of the vesting period). After
recognizing those expenses, Entity B has net income of
$200,000 for the fiscal years ending December 31, 20X1,
December 31, 20X2, and December 31, 20X3.
55-22 Entity C also owns a 40
percent interest in Entity B. On January 1, 20X1, before
granting the stock options, Entity C’s investment balance is
$800,000.
55-23 Assume that the fair value of
the stock options granted by Entity A to employees of Entity
B is $120,000 on January 1, 20X1. Under Topic 718, the fair
value of share-based compensation should be measured at the
grant date. This Example assumes that the stock options
issued are classified as equity and ignores the effect of
forfeitures.
55-24 Entity A would make the
following journal entries.
55-25 A rollforward of Entity B’s
net assets and a reconciliation to Entity A’s and Entity C’s
ending investment accounts follows.
55-26 A summary of the calculation
of share-based compensation cost by year follows.
ASC 323 provides guidance on share-based payment awards that are issued by an equity method investor to employees and nonemployee goods or service providers of an equity method investee and are indexed to, or settled in, the equity of the investor.
Chapter 10 — Business Combinations
Chapter 10 — Business Combinations
In a business combination, share-based payment awards held by grantees of the
acquiree are often exchanged for share-based payment awards of the acquirer. ASC 805
refers to the new awards as “replacement awards.” The acquirer must analyze the
terms of both the preexisting and the replacement awards to determine what portion
of the replacement awards is related to precombination vesting (i.e., past goods or
services) and therefore part of the consideration transferred in the business
combination. The portion of replacement awards that is related to postcombination
vesting (i.e., future goods or services) should be recognized as compensation cost
in the postcombination period.
10.1 Replacement of Acquiree Awards
ASC 718-20
Equity Restructuring or Business Combination
35-6 Exchanges of share options or other equity instruments or changes to their terms in conjunction with an
equity restructuring or a business combination are modifications for purposes of this Subtopic. An entity shall
apply the guidance in paragraph 718-20-35-2A to those exchanges or changes to determine whether it shall
account for the effects of those modifications. Example 13 (see paragraph 718-20-55-103) provides further
guidance on applying the provisions of this paragraph. See paragraph 718-10-35-10 for an exception.
ASC 805-30
Acquirer Share-Based Payment Awards Exchanged for Awards
Held by the Acquiree’s Grantees
30-9 An acquirer may exchange
its share-based payment awards for awards held by grantees
of the acquiree. This Topic refers to such awards as
replacement awards. Exchanges of share options or other
share-based payment awards in conjunction with a business
combination are modifications of share-based payment awards
in accordance with Topic 718. If the acquirer is obligated
to replace the acquiree awards, either all or a portion of
the fair-value-based measure of the acquirer’s replacement
awards shall be included in measuring the consideration
transferred in the business combination. The acquirer is
obligated to replace the acquiree awards if the acquiree or
its grantees have the ability to enforce replacement. For
example, for purposes of applying this requirement, the
acquirer is obligated to replace the acquiree’s awards if
replacement is required by any of the following:
-
The terms of the acquisition agreement
-
The terms of the acquiree’s awards
-
Applicable laws or regulations.
Exchanges of share-based payment awards in a business combination are considered
modifications under ASC 718. An acquirer must assess whether the replacement awards
are part of the consideration transferred, are recognized as compensation cost in
the postcombination financial statements, or are a combination of both in accordance
with ASC 805. Before it can make its determination, the acquirer must assess whether
it is “obligated” to replace the acquiree’s awards. If it is obligated to replace
the awards, the acquirer must include all or a portion of the fair-value-based
measure1 of the replacement awards in its measurement of the consideration transferred
in the business combination. The portion not included in the measurement of
consideration transferred is included in postcombination compensation cost.
ASC 805-30-30-9 notes that the acquirer is obligated to replace the acquiree’s
share-based payment awards “if the acquiree or its grantees have the ability to
enforce replacement.” It further indicates that the acquirer is obligated to replace
the awards if replacement is required by (1) the terms of the acquisition agreement,
(2) the terms of the acquiree’s awards, or (3) applicable laws or regulations. It is
not uncommon for the terms of the acquiree’s awards to be silent or give the
acquiree discretion regarding the awards’ treatment upon a business combination. If
an obligation to replace the acquiree’s awards is based on the terms of the
acquisition agreement, acquirers should carefully consider the awards’ preexisting
terms to determine the portion of the fair-value-based-measure to include in the
consideration transferred and in postcombination compensation cost. In addition,
acquirers may wish to consult with legal counsel for assistance in assessing the
terms of award agreements and their requirements under applicable laws and
regulations.
Accordingly, an entity should consider the original terms of the acquiree’s awards
(as well as applicable laws or regulations) and whether the acquirer was obligated
to issue replacement awards in the event of a change in control. While some awards
may contractually expire upon a change in control (see Section 10.10), it is more common for the terms of the acquiree’s
awards to be silent on the matter or give the acquiree discretion regarding the
awards’ treatment upon a change in control event such as a business combination. In
these circumstances, if the acquiree’s awards are replaced under the terms of the
acquisition agreement, an entity generally accounts for the replacement awards as if
the replacement obligation exists. Acquirers may wish to consult with legal counsel
for assistance in assessing the terms of award agreements and their requirements
under applicable laws and regulations.
See Section 10.2 for additional
information about allocating replacement awards between consideration transferred
and postcombination compensation cost.
In addition, Section 10.9
discusses situations in which the acquiree’s share-based payment awards are not
modified but remain outstanding after the business combination. For guidance that
applies when the acquiree’s share-based payment awards expire as a result of the
business combination, see Section 10.10.
Footnotes
1
While the term “fair-value-based measure” is used in this
chapter, ASC 718 permits the use of a calculated value or an intrinsic value
in specified circumstances. Accordingly, the guidance in this chapter also
applies in situations in which a calculated or an intrinsic value is
used.
10.2 Allocating Replacement Awards Between Consideration Transferred and Postcombination Compensation Cost
ASC 805-30
30-11 To determine the portion
of a replacement award that is part of the consideration
transferred for the acquiree, the acquirer shall measure
both the replacement awards granted by the acquirer and the
acquiree awards as of the acquisition date in accordance
with Topic 718. The portion of the fair-value-based measure
of the replacement award that is part of the consideration
transferred in exchange for the acquiree equals the portion
of the acquiree award that is attributable to precombination
vesting.
30-12 The acquirer shall
attribute a portion of a replacement award to
postcombination vesting if it requires postcombination
vesting, regardless of whether grantees had rendered all of
the service or delivered all of the goods required in
exchange for their acquiree awards before the acquisition
date. The portion of a nonvested replacement award
attributable to postcombination vesting equals the total
fair-value-based measure of the replacement award less the
amount attributed to precombination vesting. Therefore, the
acquirer shall attribute any excess of the fair-value-based
measure of the replacement award over the fair value of the
acquiree award to postcombination vesting.
30-13 Paragraphs 805-30-55-6
through 55-13, 805-740-25-10 through 25-11, 805-740-45-5
through 45-6, and Example 2 (see paragraph 805-30-55-17)
provide additional guidance and illustrations on
distinguishing between the portion of a replacement award
that is attributable to precombination vesting, which the
acquirer includes in the consideration transferred in the
business combination, and the portion that is attributed to
postcombination vesting, which the acquirer recognizes as
compensation cost in its postcombination financial
statements.
Replacement Share-Based Payment Awards
35-3 Topic 718 provides
guidance on subsequent measurement and accounting for the
portion of replacement share-based payment awards issued by
an acquirer that is attributable to future goods or
services.
Acquirer Share-Based Payment Awards Exchanged for Awards
Held by the Grantees of the Acquiree
55-6 If the acquirer is obligated to replace the acquiree’s share-based payment awards, paragraph 805-30-30-9 requires the acquirer to include either all or a portion of the fair-value-based measure of the replacement awards in the consideration transferred in the business combination. Paragraphs 805-30-55-7 through 55-13, 805-740-25-10 through 25-11, 805-740-45-5 through 45-6, and Example 2 (see paragraph 805-30-55-17) provide additional guidance on and illustrate how to determine the portion of an award to include in consideration transferred in a business combination and the portion to recognize as compensation cost in the acquirer’s postcombination financial statements.
55-7 To determine the portion
of a replacement award that is part of the consideration
exchanged for the acquiree and the portion that is
compensation for postcombination vesting, the acquirer first
measures both the replacement awards and the acquiree awards
as of the acquisition date in accordance with the
requirements of Topic 718. In most situations, those
requirements result in use of the fair-value-based
measurement method, but that Topic permits use of the
calculated value method or the intrinsic value method in
specified circumstances. This discussion focuses on the
fair-value-based method, but the guidance in paragraphs
805-30-30-9 through 30-13 and the additional guidance cited
in the preceding paragraph also apply in situations in which
Topic 718 permits use of either the calculated value method
or the intrinsic value method for both the acquiree awards
and the replacement awards.
55-8 The portion of an employee
replacement award attributable to precombination vesting is
the fair-value-based measure of the acquiree award
multiplied by the ratio of the precombination employee’s
service period to the greater of the total service period or
the original service period of the acquiree award. (Example
2, Cases C and D [see paragraphs 805-30-55-21 through 55-24]
illustrate that calculation.) The total service period is
the sum of the following amounts:
-
The part of the employee’s requisite service period for the acquiree award that was completed before the acquisition date
-
The postcombination employee’s requisite service period, if any, for the replacement award.
55-9 The employee’s requisite
service period includes explicit, implicit, and derived
service periods during which employees are required to
provide service in exchange for the award (consistent with
the requirements of Topic 718).
55-9A The
portion of a nonemployee replacement award attributable to
precombination vesting is based on the fair-value-based
measure of the acquiree award multiplied by the percentage
that would have been recognized had the grantor paid cash
for the goods or services instead of paying with a
nonemployee award. For this calculation, the percentage that
would have been recognized is the lower of:
- The percentage that would have been recognized calculated on the basis of the original vesting requirements of the nonemployee award
- The percentage that would have been recognized calculated on the basis of the effective vesting requirements. Effective vesting requirements are equal to the services or goods provided before the acquisition date plus any additional postcombination services or goods required by the replacement award.
55-10 The portion of a
nonvested replacement award (for employee and nonemployee)
attributable to postcombination vesting, and therefore
recognized as compensation cost in the postcombination
financial statements, equals the total fair-value-based
measure of the replacement award less the amount attributed
to precombination vesting. Therefore, the acquirer
attributes any excess of the fair-value-based measure of the
replacement award over the fair value of the acquiree award
to postcombination vesting and recognizes that excess as
compensation cost in the postcombination financial
statements.
55-13 The same requirements for
determining the portions of a replacement award attributable
to precombination and postcombination vesting apply
regardless of whether a replacement award is classified as a
liability or an equity instrument in accordance with the
provisions of paragraphs 718-10-25-6 through 25-19A. All
changes in the fair-value-based measure of awards classified
as liabilities after the acquisition date and the related
income tax effects are recognized in the acquirer's
postcombination financial statements in the period(s) in
which the changes occur.
Illustrations
Example 2: Acquirer Replacement of Employee
Awards
55-17 The following Cases
illustrate the guidance referred to in paragraph 805-30-55-6
for replacement awards that the acquirer was obligated to
issue. The Cases assume that all awards are classified as
equity and that the awards have only an explicit service
period. As discussed in paragraphs 805-30-55-8 through 55-9,
the acquirer also must take any implicit or derived
employee’s service periods into account in determining the
employee’s requisite service period for a replacement award.
In these Cases, the acquiring entity is referred to as
Acquirer and the acquiree is referred to as Target:
-
Awards that require no postcombination vesting that are exchanged for acquiree awards for which employees:
-
Have rendered the required service as of the acquisition date (Case A)
-
Have not rendered all of the required service as of the acquisition date (Case D).
-
-
Awards that require postcombination vesting that are exchanged for acquiree awards for which employees:
-
Have rendered the required service as of the acquisition date (Case B)
-
Have not rendered all of the required service as of the acquisition date (Case C).
-
Case A: No Required Postcombination Vesting, All Requisite Service for Acquiree
Awards Rendered as of Acquisition Date
55-18 Acquirer issues
replacement awards of $110 (fair-value-based measure) at the
acquisition date for Target awards of $100 (fair-value-based
measure) at the acquisition date. No postcombination vesting
is required for the replacement awards, and Target's
employees had rendered all of the required service for the
acquiree awards as of the acquisition date.
55-19 The amount attributable
to precombination vesting is the fair-value-based measure of
Target’s awards ($100) at the acquisition date; that amount
is included in the consideration transferred in the business
combination. The amount attributable to postcombination
vesting is $10, which is the difference between the total
value of the replacement awards ($110) and the portion
attributable to precombination vesting ($100). Because no
postcombination vesting is required for the replacement
awards, Acquirer immediately recognizes $10 as compensation
cost in its postcombination financial statements.
Case B: Postcombination Vesting Required, All Requisite Service for Acquiree
Awards Rendered as of Acquisition Date
55-20 Acquirer
exchanges replacement awards that require one year of
postcombination vesting for share-based payment awards of
Target for which employees had completed the requisite
service period before the business combination. The
fair-value-based measure of both awards is $100 at the
acquisition date. When originally granted, Target's awards
had a requisite service period of four years. As of the
acquisition date, the Target employees holding unexercised
awards had rendered a total of seven years of service since
the grant date. Even though Target employees had already
rendered all of the requisite service, Acquirer attributes a
portion of the replacement award to postcombination
compensation cost in accordance with paragraphs 805-30-30-12
through 30-13 because the replacement awards require one
year of postcombination vesting. The total service period is
five years — the requisite service period for the original
acquiree award completed before the acquisition date (four
years) plus the requisite service period for the replacement
award (one year). The portion attributable to precombination
vesting equals the fair-value-based measure of the acquiree
award ($100) multiplied by the ratio of the precombination
vesting period (4 years) to the total vesting period (5
years). Thus, $80 ($100 × 4 ÷ 5 years) is attributed to the
precombination vesting period and therefore included in the
consideration transferred in the business combination. The
remaining $20 is attributed to the postcombination vesting
period and therefore is recognized as compensation cost in
Acquirer’s postcombination financial statements in
accordance with Topic 718.
Case C: Postcombination Vesting Required, All Requisite Service for Acquiree
Awards Not Rendered as of Acquisition Date
55-21 Acquirer exchanges
replacement awards that require one year of postcombination
vesting for share-based payment awards of Target for which
employees had not yet rendered all of the required services
as of the acquisition date. The fair-value-based measure of
both awards is $100 at the acquisition date. When originally
granted, the awards of Target had a requisite service period
of four years. As of the acquisition date, the Target
employees had rendered two years’ service, and they would
have been required to render two additional years of service
after the acquisition date for their awards to vest.
Accordingly, only a portion of Target’s awards is
attributable to precombination vesting.
55-22 The replacement awards
require only one year of postcombination vesting. Because
employees have already rendered two years of service, the
total requisite service period is three years. The portion
attributable to precombination vesting equals the
fair-value-based measure of the acquiree award ($100)
multiplied by the ratio of the precombination vesting period
(2 years) to the greater of the total service period (3
years) or the original service period of Target’s award (4
years). Thus, $50 ($100 × 2 ÷ 4 years) is attributable to
precombination vesting and therefore included in the
consideration transferred for the acquiree. The remaining
$50 is attributable to postcombination vesting and therefore
recognized as compensation cost in Acquirer’s
postcombination financial statements in accordance with
Topic 718.
Case D: No Required Postcombination Vesting, All Requisite Service for Acquiree
Awards Not Rendered as of Acquisition Date
55-23 Assume the same facts as
in Case C, except that Acquirer exchanges replacement awards
that require no postcombination vesting for share-based
payment awards of Target for which employees had not yet
rendered all of the requisite service as of the acquisition
date. The terms of the replaced Target awards did not
eliminate any remaining requisite service period upon a
change in control. (If the Target awards had included a
provision that eliminated any remaining requisite service
period upon a change in control, the guidance in Case A
would apply.) The fair-value-based measure of both awards is
$100. Because employees have already rendered two years of
service and the replacement awards do not require any
postcombination vesting, the total service period is two
years.
55-24 The portion of the
fair-value-based measure of the replacement awards
attributable to precombination vesting equals the
fair-value-based measure of the acquiree award ($100)
multiplied by the ratio of the precombination vesting period
(2 years) to the greater of the total service period (2
years) or the original service period of Target’s award (4
years). Thus, $50 ($100 × 2 ÷ 4 years) is attributable to
precombination vesting and therefore included in the
consideration transferred for the acquiree. The remaining
$50 is attributable to postcombination vesting. Because no
postcombination vesting is required to vest in the
replacement award, Acquirer recognizes the entire $50
immediately as compensation cost in the postcombination
financial statements.
Example 3: Acquirer Replacement of Nonemployee
Awards
55-25 The
following Cases illustrate the guidance referred to in
paragraph 805-30-55-6 for replacement awards that the
acquirer was obligated to issue and the attribution guidance
for a nonemployee replacement award to precombination and
postcombination vesting referenced in paragraph
805-30-55-9A.
55-26 In these
Cases, the acquiring entity is referred to as Acquirer and
the acquiree is referred to as Target:
- Awards that require no
postcombination vesting that are exchanged for
acquiree awards for which grantees:
- Have met the vesting condition as of the acquisition date (Case A)
- Have not met the vesting condition as of the acquisition date (Case D).
- Awards that require postcombination
vesting that are exchanged for acquiree awards for
which grantees:
- Have met the vesting condition as of the acquisition date (Case B)
- Have not met the vesting condition as of the acquisition date (Case C).
55-27 The Cases
assume the following:
- All awards are classified as equity.
- The only vesting condition included in the awards, if any, involves the delivery of engines.
- Target and Acquirer typically pay cash as each engine is delivered to their suppliers.
Case A: No Required Postcombination Vesting and the Vesting
Condition for Acquiree Awards Has Been Met as of Acquisition
Date
55-28 Acquirer
issues replacement awards of $110 (fair-value-based measure)
at the acquisition date for Target awards of $100
(fair-value-based measure) at the acquisition date. No
postcombination vesting is required for the replacement
awards, and Target’s grantee has delivered all the engines
necessary for the acquiree awards as of the acquisition
date.
55-29 The
amount attributable to precombination vesting is the
fair-value-based measure of Target’s awards ($100) at the
acquisition date; that amount is included in the
consideration transferred in the business combination. The
amount attributable to postcombination vesting is $10, which
is the difference between the total value of the replacement
awards ($110) and the portion attributable to precombination
vesting ($100). Because no postcombination vesting is
required for the replacement awards, Acquirer immediately
recognizes $10 as compensation cost in its postcombination
financial statements.
Case B: Postcombination Vesting Required and the Vesting
Condition for Acquiree Awards Has Been Met as of Acquisition
Date
55-30 Acquirer
exchanges replacement awards that require the delivery of
another 10 engines postcombination for share-based payment
awards of Target for which the grantee had met the necessary
vesting condition to deliver 40 engines before the business
combination. The fair-value-based measure of both awards is
$100 at the acquisition date. Even though the grantee
already had met the vesting condition for the acquiree’s
award, Acquirer attributes a portion of the replacement
award to postcombination compensation cost in accordance
with paragraphs 805-30-30-12 through 30-13 because the
replacement awards require the delivery of an additional 10
engines.
55-31 The
portion attributable to precombination vesting equals the
fair-value-based measure of the acquiree award ($100)
multiplied by the percentage that would have been recognized
for the award. The percentage that would have been
recognized is the lower of the calculation on the basis of
the original vesting requirements and the percentage that
would have been recognized on the basis of the effective
vesting requirements as described in paragraph 805-30-55-9A.
The percentage that would have been recognized on the basis
of the original vesting requirements equals 100 percent,
which is calculated as 40 engines delivered divided by 40
engines required to be delivered. The percentage that would
have been recognized on the basis of the effective vesting
requirements equals 80 percent, which is calculated as 40
engines delivered divided by 50 engines (the sum of 40
engines delivered plus 10 engines required postcombination).
Thus, $80 ($100 × 80%) is attributed to the precombination
vesting period and therefore is included in the
consideration transferred in the business combination. The
remaining $20 is attributed to the postcombination vesting
period and therefore is recognized as compensation cost in
Acquirer’s postcombination financial statements in
accordance with Topic 718.
Case C: Postcombination Vesting Required and the Vesting
Condition for Acquiree Awards Has Not Been Met as of
Acquisition Date
55-32 Acquirer
exchanges replacement awards that require the delivery of 10
engines postcombination for share-based payment awards of
Target for which the grantee had not met the necessary
vesting condition to deliver 40 engines before the business
combination. The fair-value-based measure of both awards is
$100 at the acquisition date. As of the acquisition date,
Target grantee has delivered 20 engines, and Target grantee
would have been required to deliver an additional 20 engines
after the acquisition date for its awards to vest.
Accordingly, only a portion of Target’s awards is
attributable to precombination vesting.
55-33 The
portion attributable to precombination vesting equals the
fair-value-based measure of the acquiree award ($100)
multiplied by the percentage that would have been recognized
on the award. The percentage that would have been recognized
is the lower of the percentage that would have been
recognized on the basis of the original vesting requirements
and the percentage that would have been recognized on the
basis of the effective vesting requirements as described in
paragraph 805-30-55-9A. The percentage that would have been
recognized on the basis of the original vesting requirements
equals 50 percent, which is calculated as 20 engines
delivered divided by 40 engines required to be delivered.
The percentage that would have been recognized on the basis
of the effective vesting requirements equals 66.67 percent,
which is calculated as 20 engines delivered divided by 30
engines (the sum of 20 engines delivered plus 10 engines
required postcombination). Thus, $50 ($100 × 50%) is
attributed to precombination vesting and therefore is
included in the consideration transferred in the business
combination. The remaining $50 is attributed to the
postcombination vesting and therefore is recognized as
compensation cost in Acquirer’s postcombination financial
statements in accordance with Topic 718.
Case D: No Postcombination Vesting Required and the Vesting
Condition for Acquiree Awards Has Not Been Met as of
Acquisition Date
55-34 Assume
the same facts as in Case C, except that Acquirer exchanges
replacement awards that require no postcombination vesting
for share-based payment awards of Target for which the
grantee had not met the necessary vesting condition to
deliver 40 engines before the business combination. The
terms of the replaced Target awards did not eliminate the
vesting condition upon a change in control. (If the Target
awards had included a provision that eliminated the vesting
condition upon a change in control, the guidance in Case A
[see paragraph 805-30-55-28] would apply.) The
fair-value-based measure of both awards is $100.
55-35 The portion attributable to
precombination vesting equals the fair-value-based measure of
the acquiree award ($100) multiplied by the percentage that
would have been recognized on the award. The percentage that
would have been recognized is the lower of the percentage that
would have been recognized on the basis of the original vesting
requirements and the percentage that would have been recognized
on the basis of the effective vesting requirements as described
in paragraph 805-30-55-9A. The percentage that would have been
recognized on the basis of the original vesting requirements
equals 50 percent, which is calculated as 20 engines delivered
divided by 40 engines required to be delivered. The percentage
that would have been recognized on the basis of the effective
vesting requirements equals 100 percent, which is calculated as
20 engines delivered divided by 20 engines (the sum of 20
engines delivered plus zero engines required postcombination).
Thus, $50 ($100 × 50%) is attributed to the precombination
vesting and is therefore included in the consideration
transferred in the business combination. The remaining $50 is
attributed to the postcombination vesting. Because no
postcombination vesting is required to vest in the replacement
award, Acquirer recognizes the entire $50 immediately as
compensation cost in the postcombination financial
statements.
Replacement share-based payment awards issued by the acquirer may represent
consideration transferred in the business combination if the award is related to
precombination vesting (past goods or services provided), postcombination
compensation cost for future vesting (future goods or services provided), or
both.
Entities should carefully analyze any modifications to or replacements of
acquiree awards to determine whether they are part of, or separate from, the
business combination. ASC 805-10-25-20 states, in part, that the “acquirer shall
recognize as part of applying the acquisition method only the consideration
transferred for the acquiree and the assets acquired and liabilities assumed in the
exchange for the acquiree. Separate transactions shall be accounted for in
accordance with the relevant [GAAP].” In addition, ASC 805-10-25-21 states, in part,
that a “transaction entered into by or on behalf of the acquirer or primarily for
the benefit of the acquirer or the combined entity, rather than primarily for the
benefit of the acquiree (or its former owners) before the combination, is likely to
be a separate transaction.”
Further, ASC 805-10-55-18 provides three factors for entities to consider in
determining whether the transaction is part of a business combination or should be
accounted for separately (these factors are not mutually exclusive or individually
conclusive).
ASC 805-10
55-18
Paragraphs 805-10-25-20 through 25-22 establish the
requirements to identify amounts that are not part of the
business combination. The acquirer should consider the
following factors, which are neither mutually exclusive nor
individually conclusive, to determine whether a transaction
is part of the exchange for the acquiree or whether the
transaction is separate from the business combination:
- The reasons for the transaction. Understanding the reasons why the parties to the combination (the acquirer, the acquiree, and their owners, directors, managers, and their agents) entered into a particular transaction or arrangement may provide insight into whether it is part of the consideration transferred and the assets acquired or liabilities assumed. For example, if a transaction is arranged primarily for the benefit of the acquirer or the combined entity rather than primarily for the benefit of the acquiree or its former owners before the combination, that portion of the transaction price paid (and any related assets or liabilities) is less likely to be part of the exchange for the acquiree. Accordingly, the acquirer would account for that portion separately from the business combination.
- Who initiated the transaction. Understanding who initiated the transaction may also provide insight into whether it is part of the exchange for the acquiree. For example, a transaction or other event that is initiated by the acquirer may be entered into for the purpose of providing future economic benefits to the acquirer or combined entity with little or no benefit received by the acquiree or its former owners before the combination. On the other hand, a transaction or arrangement initiated by the acquiree or its former owners is less likely to be for the benefit of the acquirer or the combined entity and more likely to be part of the business combination transaction.
- The timing of the transaction. The timing of the transaction may also provide insight into whether it is part of the exchange for the acquiree. For example, a transaction between the acquirer and the acquiree that takes place during the negotiations of the terms of a business combination may have been entered into in contemplation of the business combination to provide future economic benefits to the acquirer or the combined entity. If so, the acquiree or its former owners before the business combination are likely to receive little or no benefit from the transaction except for benefits they receive as part of the combined entity.
Further, understanding the business purpose of a modification will help an
acquirer assess which party benefits from the modification. The acquirer should
particularly consider terms that accelerate vesting upon a change in control (see
Section 10.4), cash
settlement upon a change in control (see Section 10.5), and other compensation
arrangements affected by a change in control (see Section 10.7).
10.2.1 Allocation Steps
The diagram below illustrates the steps in an entity’s determination of the
amount to recognize as consideration transferred in a business combination and
as postcombination compensation cost. Sections 10.2.1.1 through 10.2.1.3 discuss
the steps in detail. If the acquirer is not obligated to replace the acquiree’s
awards, and replacement awards are issued, generally the entire replacement
award is accounted for as postcombination compensation cost (see Section 10.1).
10.2.1.1 Considerations Related to Step 1
The acquirer must determine the fair-value-based measure of both the acquirer’s replacement awards and the acquiree’s replaced awards as of the acquisition date, in accordance with the guidance in ASC 718.
ASC 805 requires acquirers to use the guidance in ASC 820, with limited
exceptions, to measure the consideration transferred, the assets acquired,
and any liabilities assumed in a business combination at their
acquisition-date fair values. One of the exceptions is share-based payment
awards, which are measured by using the guidance in ASC 718. Unlike a fair
value measure, a fair-value-based measure under ASC 718 excludes certain
considerations such as vesting conditions (i.e., service or performance
conditions). However, a market condition is directly factored into the
fair-value-based measure of an award and should be taken into consideration
in the calculation of the fair value-based measure of the acquiree’s
replaced awards and the acquirer’s replacement awards. See Section 4.1 for
additional discussion of the fair-value-based measure method prescribed in
ASC 718.
In certain circumstances, ASC 718 also permits the use of a calculated value and
an intrinsic value. Those measurement methods are discussed in Sections 4.13.2 and
4.13.3. If
either is used, the acquirer’s replacement awards and the acquiree’s
replaced awards are measured on such a basis.
10.2.1.2 Considerations Related to Step 2
If there is an excess of the fair-value-based measure of the acquirer’s
replacement awards over the fair-value-based measure of the acquiree’s
replaced awards as of the acquisition date, incremental value is recognized
as compensation cost in the acquirer’s postcombination financial statements
in accordance with ASC 805-30-30-12. Such cost is recognized over the period
from the acquisition date through the end of the employee’s requisite
service period or nonemployee’s vesting period of the replacement awards. If
there is no postcombination vesting requirement, all of the excess is
generally recognized immediately in the postcombination financial statements
(i.e., on day 1). This is illustrated in Case A of Example 2 in ASC
805-30-55-18 and 55-19, which addresses employees, and Case A of Example 3
in ASC 805-30-55-28 and 55-29, which addresses nonemployees.
10.2.1.3 Considerations Related to Step 3
10.2.1.3.1 Allocation to Precombination Vesting
The portion of the replacement share-based
payment awards that is attributable to precombination vesting, and
therefore included in the consideration transferred, is calculated as
follows:
The practical effect of requiring the use of the greater
of the total vesting period or the original vesting period of the
acquiree’s replaced awards is that an acquirer will always reflect at
least the proportion of the compensation cost in the postcombination
financial statements, as it would have under the original terms of the
award. In a scenario in which the acquirer accelerates vesting, this
“greater of” calculation is consistent with the accounting for an
acceleration of vesting that is determined to primarily benefit the
acquirer, as described in Section 10.4.1. An acquirer’s
decision to immediately accelerate vesting of replacement awards does
not decrease its proportion of compensation expense in the
postcombination financial statements but merely accelerates the timing
of recognition. This is illustrated in Case D of Example 2 in ASC
805-30-55-23 and 55-24, which addresses employee awards, and Case D of Example
3 in ASC 805-30-55-34 and 55-35, which addresses nonemployee awards.
The total vesting period
is calculated as follows:
For employee awards, the requisite service period (i.e., the vesting
period) may be explicit, implicit, or derived and will depend on the
terms of the share-based payment awards (see Section 3.6 for additional
information). For nonemployee awards, the vesting period is calculated
on the basis of the percentage that would have been recognized had the
grantor paid cash for the goods or services instead of paying with a
nonemployee award.
If the acquirer decides to extend the vesting period rather than accelerate
vesting, use of the “greater of” calculation would result in a greater
share of the compensation cost attributed to the post-combination period
and is consistent with the increase in grantee services to be provided
to the acquirer. For acquiree awards that were fully vested before the
acquisition date and that were replaced by new awards for which an
additional future vesting period is required, the total vesting period
is the sum of the vesting period of the acquiree-replaced awards and the
vesting period of the replacement awards. It excludes the period from
the precombination vesting date of the acquiree-replaced awards to the
acquisition date. This is illustrated in Case B of Example 2 in ASC
805-30-55-20, which addresses employee awards, and Case B of Example
3 in ASC 805-30-55-30 and 55-31, which addresses nonemployee awards.
The examples below illustrate how to determine the total service period for
employee awards.
Example 10-1
Determining the Total Service Period of a Replacement Award When the Replaced Award Is Fully Vested
An employee is awarded 100 options on Entity B’s common stock that became fully vested on June 30, 20X1. A three-year service period was originally associated with this award, but the options have not been exercised yet. On January 1, 20X2, Entity A acquires B in a transaction accounted for as a business combination and is obligated to replace the employee’s options. As part of the acquisition, A is obligated to replace B’s fully vested options with A’s new options that require an additional three years of service.
The total service period of the replacement award is six years, which is the sum of the service period of B’s original award (the replaced award) plus the service period of A’s new award (the replacement award). The total service period does not include the period from the original vesting date (i.e., June 30, 20X1) to the acquisition date (i.e., January 1, 20X2).
Example 10-2
Determining the Total Service Period of Replacement Awards When the Service Period Is the Same as That for the Replaced Awards
On January 1, 20X1, Entity B grants 100 share-based payment awards to an employee that vest at the end of the fourth year of service (cliff vesting). On January 1, 20X3, Entity A acquires B in a transaction accounted for as a business combination and is obligated to replace the employee’s awards with 100 new awards that have the same service terms as B’s original award (i.e., the replacement awards will vest at the end of two additional years).
The total service period of the replacement awards is four years, which is equal to the service period of B’s original awards. In the calculation of the portion attributable to precombination service, the precombination service period is two years (January 1, 20X1, to January 1, 20X3).
See Section 9.6 for an example of
how to determine the total vesting period for nonemployee awards.
10.2.1.3.2 Allocation to Postcombination Vesting
The portion of the replacement awards
attributable to postcombination vesting, and therefore included in
postcombination compensation cost, is calculated as follows:
The example below illustrates how to allocate the replacement awards between
consideration transferred and postcombination compensation cost for an
employee award.
Example 10-3
Allocation of Consideration
On January 1, 20X1, Entity B grants 100 share-based payment awards to an employee that vest at the end of the third year of service (cliff vesting).
On January 1, 20X2, Entity A acquires B in a transaction accounted for as a business combination and is obligated to replace the employee’s awards with 100 new awards that have the same service terms as B’s original awards (i.e., the replacement awards will vest at the end of two additional years). On January 1, 20X2, the fair-value-based measure of both A’s replacement awards and B’s replaced awards is $10 per award.
The total fair-value-based measure of the replacement awards as of the acquisition date is $1,000 (100 awards × $10 fair-value-based measure), of which $333 (one of three years) is attributable to precombination service and $667 (two of three years) is attributable to postcombination service. The $333 is included in the consideration transferred, and the $667 is recognized as compensation cost by A as the service is rendered by the employee (i.e., from January 1, 20X2, to December 31, 20X3). Note that the grant-date fair-value-based measure assigned to the awards issued by B is not relevant as of the acquisition date.
See Section 9.6 for an example of
how to allocate the replacement awards between consideration transferred
and postcombination compensation cost for a nonemployee award.
10.2.2 Forfeitures
ASC 805-30
55-11 Regardless of the
accounting policy elected in accordance with paragraph
718-10-35-1D or 718-10-35-3, the portion of a nonvested
replacement award included in consideration transferred
shall reflect the acquirer’s estimate of the number of
replacement awards for which the service is expected to
be rendered or the goods are expected to be delivered
(that is, an acquirer that has elected an accounting
policy to recognize forfeitures as they occur in
accordance with paragraph 718-10-35-1D or 718-10-35-3
should estimate the number of replacement awards for
which the service is expected to be rendered or the
goods are expected to be delivered when determining the
portion of a nonvested replacement award included in
consideration transferred). For example, if the
fair-value-based measure of the portion of a replacement
award attributed to precombination vesting is $100 and
the acquirer expects that the service will be rendered
for only 95 percent of the instruments awarded, the
amount included in consideration transferred in the
business combination is $95. Changes in the number of
replacement awards for which the service is expected to
be rendered or the goods are expected to be delivered
are reflected in compensation cost for the periods in
which the changes or forfeitures occur — not as
adjustments to the consideration transferred in the
business combination. If an acquirer’s accounting policy
is to account for forfeitures as they occur, the amount
excluded from consideration transferred (because the
service is not expected to be rendered or the goods are
not expected to be delivered) should be attributed to
the postcombination vesting and recognized in
compensation cost over the employee’s requisite service
period or the nonemployee’s vesting period. Recognition
of compensation cost for nonemployees should consider
the recognition guidance provided in paragraph
718-10-25-2C. That is, recognition of the fair value of
the nonemployee share-based payment award should be
recognized 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 awards.
ASC 718 allows an entity to make an entity-wide accounting policy election to either (1) estimate forfeitures when the awards are granted and update its estimate when information becomes available indicating that actual forfeitures will differ from previous estimates or (2) account for forfeitures when they occur. See Section 3.4.1 for examples illustrating how to account for forfeitures under either accounting policy election.
ASC 718 permits an entity to make an entity-wide policy election
for all nonemployee awards to either (1) estimate forfeitures or (2) recognize
forfeitures when they occur. This policy election can be different from the
entity’s policy election for employee awards.
Regardless of the accounting policy elected for forfeitures, ASC 805-30-55-11
requires that the portion of the fair-value-based measure of the replacement
share-based payment awards included in consideration transferred (i.e., the
amount attributable to precombination vesting) reflect the acquirer’s forfeiture
estimate as of the acquisition date. If the acquirer’s accounting policy is to
account for forfeitures when they occur, the amount that is excluded from
consideration transferred on the basis of the acquirer’s estimate of forfeitures
as of the acquisition date should be attributed to postcombination vesting and
recognized in compensation cost over the employee’s requisite service period or
nonemployee’s vesting period. Changes in the forfeiture estimate or actual
forfeitures (i.e., an increase or decrease in the number of awards expected to
vest or awards that actually vest) are recorded in postcombination compensation
cost and not as adjustments to the consideration transferred in the business
combination. There is diversity in practice regarding how such changes should be
reflected in the financial statements (see Section 10.3).
10.2.3 Employee Awards With a Graded Vesting Schedule
ASC 805-30
55-12 Similarly, the effects
of other events, such as modifications or the ultimate
outcome of awards with performance conditions, that
occur after the acquisition date are accounted for in
accordance with Topic 718 in determining compensation
cost for the period in which an event occurs. If the
replacement award for an employee award has a graded
vesting schedule, the acquirer shall recognize the
related compensation cost in accordance with its policy
election for other awards with graded vesting in
accordance with paragraph 718-10-35-8.
Graded vesting awards are awards that are split into multiple tranches, each of
which legally and separately vests as service is provided. For example, an
entity may grant an employee 100 share-based payment awards, 25 of which legally
vest at the end of each of the four years of service provided. Under ASC
718-10-35-8, the entity can make an accounting policy election about whether to
recognize compensation cost for its employee awards with
only service conditions that have 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
requisite service period for the entire award (i.e., over the requisite service
period of the last separately vesting portion of the award).2 An acquiree may have made an accounting policy election regarding the
recognition of the compensation cost for an award with a graded vesting schedule
(i.e., as a single award or as in-substance multiple awards) that is different
from the election made by the acquirer. Regardless of how the acquiree elected
to account for its replaced share-based payment awards with a graded vesting
schedule, the acquirer applies its existing accounting policy election for
similar awards with a graded vesting schedule to recognize compensation cost for
the replacement awards.
This guidance is also important in the determination of the portion of the
fair-value-based measure of the replacement award that is attributable to (1)
precombination service and therefore included in consideration transferred and
(2) postcombination service and therefore included in postcombination
compensation cost. The acquirer should determine its attribution of compensation
cost on the basis of its accounting policy election (see Section 3.6.5 for further discussion of
attribution methods for awards with graded vesting). If it has elected to treat
an award with a graded vesting schedule as a single award, the determination of
the total service period and the original service period will be based on a
single award (e.g., a single award with four years of required service).
Conversely, if it has elected to treat an award with a graded vesting schedule
as, in substance, multiple awards, the determination of the total service period
and the original service period will be based on each tranche of the award as
though the award is, in substance, multiple awards (e.g., four separate awards
with required service of one, two, three, and four years, respectively). The
examples below illustrate this guidance.
Note that if the accounting policy elections of the acquiree and the acquirer
differ, on a combined basis (i.e., in the acquiree’s financial statements and
the acquirer’s financial statements) compensation cost (1) may not be recorded
in either the acquiree’s precombination financial statements or the acquirer’s
postcombination financial statements or (2) may be recorded in both the
acquiree’s precombination financial statements and the acquirer’s
postcombination financial statements. This concept is illustrated in Example 10-5.
Example 10-4
Replacement Awards With Graded Vesting
On January 1, 20X1, Entity B grants 1,000 employee share-based payment awards.
The awards vest in 25 percent increments each year over
the next four years (i.e., a graded vesting schedule)
and have only a service condition. On December 31, 20X3,
Entity A acquired B in a transaction accounted for as a
business combination and is obligated to replace B’s
awards with new awards that have the same terms and
conditions. (Section 10.1
discusses how to determine when an acquirer is obligated
to exchange an acquiree’s awards.) Both A and B have
chosen, as their policy election, to recognize
compensation cost on a straight-line basis over the
requisite service period for the entire award (i.e., as
though the award is a single award).
The fair-value-based measure of both awards (i.e., the replaced awards and the replacement awards) is $10 per award as of the acquisition date. The portion of the fair-value-based amount of the replacement award attributable to (1) precombination service and therefore included in consideration transferred is $7,500 ($10 fair-value-based measure of the replaced award × 1,000 awards × 75% for three of four years of services rendered) and (2) postcombination service and therefore included in postcombination compensation cost is $2,500 ($10 fair-value-based measure of the replacement award × 1,000 awards × 25% for one of four years of services rendered).
Example 10-5
Replacement Awards With Graded Vesting When the Policy Elected by the Acquirer to Recognize Compensation Cost Is Different From the Policy Elected by the Acquiree
Assume the same facts as in the example above, except that the acquirer has
elected, as a policy decision, to recognize compensation
cost over the requisite service period for each
separately vesting portion of the award (i.e., as though
the award is, in substance, multiple awards). The
acquirer has also made a policy election to value such
share-based payment awards as a single award. The table
below summarizes the attribution of the fair-value-based
amount of the replaced awards ($10,000 = 1,000 awards ×
$10 fair-value-based measure of the replaced award) over
each of the first three years of service and the related
amount attributable to precombination service and
therefore included in consideration transferred.
The portion of the fair-value-based amount of the replacement awards attributable to (1) precombination service and therefore included in consideration transferred is $9,375 (even though the acquiree would have only recognized $7,500 in compensation cost because of the difference in policies) and (2) postcombination service and therefore included in postcombination compensation cost is $625.
Footnotes
2
Note that regardless of an entity’s policy decision
regarding the recognition of compensation cost, it may elect to value
the awards as (1) a single award or (2) in-substance multiple awards.
That is, even though each portion of the awards may directly or
indirectly be treated by certain valuation techniques as individual
awards, the entity is able to make a policy decision to recognize
compensation cost as (1) a single award or (2) in-substance multiple
awards.
10.3 Changes Reflected in Postcombination Compensation Cost
ASC 805-30
Replacement Share-Based Payment Awards
35-3 Topic 718 provides
guidance on subsequent measurement and accounting for the
portion of replacement share-based payment awards issued by
an acquirer that is attributable to future goods or
services.
55-12 Similarly, the effects of
other events, such as modifications or the ultimate outcome
of awards with performance conditions, that occur after the
acquisition date are accounted for in accordance with Topic
718 in determining compensation cost for the period in which
an event occurs. If the replacement award for an employee
award has a graded vesting schedule, the acquirer shall
recognize the related compensation cost in accordance with
its policy election for other awards with graded vesting in
accordance with paragraph 718-10-35-8.
55-13 The same requirements
for determining the portions of a replacement
award attributable to precombination and
postcombination vesting apply regardless of
whether a replacement award is classified as a
liability or an equity instrument in accordance
with the provisions of paragraphs 718-10-25-6
through 25-19A. All changes in the
fair-value-based measure of awards classified as
liabilities after the acquisition date and the
related income tax effects are recognized in the
acquirer’s postcombination financial statements in
the period(s) in which the changes occur.
10.3.1 Changes in Forfeiture Estimates or Actual Forfeitures in the Postcombination Period
ASC 805-30-55-11 (see Section 10.2.2)
requires an acquirer to reflect changes in (1) the
acquirer’s forfeiture estimate (if the acquirer’s accounting
policy is to estimate forfeitures) or (2) actual forfeitures
(if the acquirer’s accounting policy is to account for
forfeitures when they occur) in the postcombination period
in compensation cost for the period in which the changes
occur. If the acquirer’s accounting policy is to account for
forfeitures when they occur, it should attribute to
postcombination vesting, and recognize in compensation cost
over the employee’s requisite service period or the
nonemployee’s vesting period, the amount excluded from
consideration transferred (i.e., attributable to
precombination vesting) on the basis of the acquirer’s
estimate of forfeitures as of the acquisition date. However,
views differ on how the acquirer should reflect changes in
its forfeiture estimate or actual forfeitures (i.e., a
decrease in the number of awards expected to vest or awards
that actually vest) in postcombination compensation
cost.
The following are two acceptable views on accounting for circumstances in which
the forfeiture estimate or actual forfeitures have increased
since the acquisition-date forfeiture estimate (in the event
of a decrease, only View B would apply):
-
View A — An increase in an acquirer’s forfeiture estimate or actual forfeitures (i.e., a decrease in the number of awards expected to vest or that actually vest) should result in the reversal of compensation cost associated with the acquisition-date fair-value-based measure of the awards not expected to vest or that do not actually vest that was solely attributed to postcombination vesting as of the acquisition date.
-
View B — An increase in the acquirer’s forfeiture estimate or actual forfeitures (i.e., a decrease in the number of awards expected to vest or that actually vest) should result in the reversal of compensation cost associated with the acquisition-date fair-value-based measure of the awards not expected to vest or that do not actually vest, regardless of whether that measure was attributed to precombination or postcombination vesting as of the acquisition date. This reversal of compensation cost may exceed the amounts previously recognized as compensation cost in the acquirer’s postcombination financial statements. View B is consistent with the guidance in ASC 805-30-55-13, which states that the acquirer must recognize, in its postcombination financial statements, “[a]ll changes in the fair-value-based measure of awards classified as liabilities after the acquisition date . . . in the period(s) in which the changes occur.”
An acquirer may elect either view as an accounting policy.
Regardless of the view selected, however, the acquirer must recognize in the
current-period income tax provision the reversal of the
corresponding deferred tax asset (DTA) related to the
acquisition-date fair-value-based measure attributed to both
precombination and postcombination vesting. ASC 805-740
provides specific income tax accounting guidance on
replacement awards. For a discussion of this guidance, see
Section 10.7
of Deloitte’s Roadmap Income
Taxes.
The examples below illustrate the accounting for an increase in
the acquirer’s forfeiture estimate or actual forfeitures
under View A and View B. In the examples, it is assumed that
the acquirer recognizes a DTA in purchase accounting in
accordance with the guidance in ASC 805-740 and (for the
portion of the award that vests postcombination) ASC
718-740.
Example 10-6
View A — Entity Elects to Estimate Forfeitures
On January 1, 20X1, Entity D grants employees 100 nonqualified (tax-deductible)
stock options that vest at the end of the fifth
year of service (cliff vesting). On December 31,
20X4, Entity C acquires D in a transaction
accounted for as a business combination and is
obligated to replace the employees’ awards with
100 replacement awards that have the same service
terms as D’s original awards (i.e., the
replacement awards will vest at the end of one
additional year of service). The fair-value-based
measure of each award on the acquisition date is
$10. Accordingly, the fair-value-based measure of
both C’s awards (the replacement awards) and D’s
awards (the replaced awards) is $1,000 as of the
acquisition date. Entity C attributes $800 of the
acquisition-date fair-value-based measure of the
replacement awards to precombination service and
the remaining $200 to postcombination service. The
$200 attributed to the postcombination service is
recognized as postcombination compensation cost
over the replacement awards’ remaining one-year
service period. On the acquisition date, C
estimates that 25 percent of the replacement
awards granted will be forfeited. Entity C’s
applicable tax rate is 25 percent and its policy
is to estimate forfeitures.
Journal
Entries: December 31, 20X4, Acquisition
Date
Journal Entries: Quarter Ended
March 31, 20X5
Journal
Entries: Quarter Ended June 30, 20X5
During the third quarter, C goes through a
restructuring, and many of D’s former employees
terminate their employment before their
replacement awards vest. Accordingly, C changes
its forfeiture estimate for the replacement awards
from 25 percent to 80 percent.
Journal
Entries: Quarter Ended September 30,
20X5
There were no additional changes to the
forfeiture estimate in the fourth quarter;
therefore, 20 of the 100 replacement awards
vested.
Journal
Entries: Quarter Ended December 31,
20X5
Example 10-7
View B — Entity Elects to Estimate Forfeitures
Assume the same facts as in the example above. Under View B, there is no
difference in the accounting as of the acquisition
date and for the first two quarters of service in
the postcombination period (i.e., the journal
entries are the same). However, Entity C’s
accounting in the third quarter for the change in
forfeiture estimate will differ from that under
View A.
Because C’s forfeiture estimate has increased to 80 percent in the third
quarter, only $200 of the $1,000 acquisition-date
fair-value-based measure of the replacement awards
should be allocated between the precombination and
postcombination service periods. Accordingly, C
recognizes an adjustment in postcombination
compensation cost for the sum of (1) the amount of
the acquisition-date fair-value-based measure of
the replacement awards that was originally
included in consideration transferred but that is
associated with replacement awards of $440 that
are no longer expected to vest — ($800
acquisition-date fair-value-based measure
allocated to precombination service × 20% revised
awards expected to vest) – $600 previously
recognized as consideration transferred — and (2)
the amount of the acquisition-date
fair-value-based measure of the replacement awards
that was originally included in postcombination
compensation cost but that is associated with
replacement awards of $45 that are no longer
expected to vest: ($200 acquisition-date
fair-value-based measure allocated to
postcombination service × 20% revised awards
expected to vest × 75% service rendered) – $75
previously recognized as compensation cost.
With respect to the income tax adjustments, the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in consideration transferred would be recorded in the income tax provision along with the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in postcombination compensation cost.
Journal
Entries: Quarter Ended September 30,
20X5
As in the example above, there were no additional changes to the forfeiture
estimate in the fourth quarter; therefore, 20 of
the 100 originally issued awards vested.
Journal
Entries: Quarter Ended December 31,
20X5
Example 10-8
View A — Entity Elects to Account for Forfeitures as They Occur
Assume the same facts as in Example 10-6, except that Entity C
elects to account for forfeitures as they occur,
and all forfeitures (80 awards) occur in the
quarter ended September 30, 20X5. Entity C is
still required to estimate the number of awards
that will vest in calculating the portion of the
fair-value-based measure of the replacement awards
included in consideration transferred (i.e.,
attributable to precombination service). In
addition, in a manner consistent with its
accounting policy election, C recognizes
compensation cost of $200 for the portion of all
outstanding awards attributable to postcombination
service. However, C is also required to include
the amount ($200) excluded from consideration
transferred (on the basis of C’s estimate of
forfeitures as of the acquisition date) as
compensation cost attributed to postcombination
service ($800 acquisition-date fair-value-based
measure initially allocated to precombination
service × 25% awards not expected to vest).
There is no difference in the accounting as of the acquisition date (i.e., the journal entries are the same) because C is still required to estimate forfeitures to determine the portion of the acquisition-date fair-value-based measure of the replacement awards attributed to precombination service.
Journal
Entries: Quarter Ended March 31, 20X5
Journal
Entries: Quarter Ended June 30, 20X5
Since C’s accounting policy is to account for forfeitures as they occur, and it
was required to recognize as compensation cost the
amount excluded from consideration transferred
related to its estimate of forfeitures as of the
acquisition date, it also makes an adjustment to
recognize an increase in actual forfeitures
related to the amount it would have recognized as
consideration transferred if the acquisition-date
estimate of forfeitures were equal to actual
forfeitures. Because C’s actual forfeitures are 80
percent in the third quarter, it should allocate
only $200 of the $1,000 acquisition-date
fair-value-based measure of the replacement awards
between the precombination and postcombination
service periods. Accordingly, C recognizes an
adjustment in postcombination compensation cost
for the sum of (1) the amount of the
acquisition-date fair-value-based measure of the
replacement awards that was initially allocated to
precombination service and is associated with
replacement awards of $540 that are forfeited —
($800 acquisition-date fair-value-based measure
initially allocated to precombination service ×
20% of awards outstanding) – $600 previously
recognized as consideration transferred – $100
previously recognized as compensation cost for the
amount excluded from consideration transferred —
and (2) the amount of the acquisition-date
fair-value-based measure of the replacement awards
that was originally included in postcombination
compensation cost but that is associated with
replacement awards of $70 that are now forfeited:
($200 acquisition-date fair-value-based measure
allocated to postcombination service × 20% of
awards outstanding × 75% service rendered) – $100
previously recognized as compensation cost.
However, under View A, the adjustment is limited
to the $100 previously recognized as compensation
cost (based on the amount excluded from
consideration transferred related to A’s estimate
of forfeitures at the acquisition date). In
addition, an adjustment related to the DTA
previously recorded in purchase accounting
(attributable to precombination service) is
recognized because actual forfeitures during the
third quarter exceeded the amount of forfeitures
estimated as of the acquisition date.
Journal
Entries: Quarter Ended September 30,
20X5
Because all the forfeitures occurred in the third quarter, there are no additional adjustments, and 20 of the 100 replacement awards vested.
Journal
Entries: Quarter Ended December 31,
20X5
Example 10-9
View B — Entity Elects to Account for Forfeitures as They Occur
Assume the same facts as in the previous example. Under View B, there is no
difference in the accounting as of the acquisition
date and for the first two quarters of service in
the postcombination period (i.e., the journal
entries are the same). However, Entity C’s
accounting in the third quarter for the change in
actual forfeitures will differ from the accounting
under View A because the adjustment is not limited
to the amount previously recognized as
compensation cost.
Journal
Entries: Quarter Ended September 30,
20X5
As in the previous example, because all the forfeitures occurred in the third
quarter, there are no additional adjustments, and
20 of the 100 replacement awards vested.
Journal
Entries: Quarter Ended December 31,
20X5
10.3.2 Changes in the Probability of Meeting a Performance Condition in the Postcombination Period
ASC 805-30-55-12 states that the effects of the ultimate outcome of awards with performance conditions that occur after the acquisition date should be accounted for in accordance with ASC 718 in the period that the event occurs. However, views differ on how an acquirer should reflect a change in the expected outcome of a performance condition that results in a decrease in the number of awards expected to vest (e.g., a performance condition that was deemed probable as of the acquisition date that is subsequently considered improbable) in postcombination compensation cost.
The following are two acceptable views on accounting for circumstances in which
the achievement of a performance condition is deemed
probable as of the acquisition date and is subsequently
considered improbable:
-
View A — A change in the expected outcome of a performance condition from probable to improbable should result in the reversal of compensation cost associated with the acquisition-date fair-value-based measure that was solely attributed to postcombination vesting as of the acquisition date.
-
View B — A change in the expected outcome of a performance condition from probable to improbable should result in the reversal of compensation cost associated with the acquisition-date fair-value-based measure of all awards not expected to vest, regardless of whether that acquisition-date fair-value-based measure was attributed to precombination or postcombination vesting as of the acquisition date. This reversal of compensation cost may exceed the amounts previously recognized as compensation cost in the acquirer’s postcombination financial statements. As discussed previously, View B is consistent with the guidance in ASC 805-30-55-13, under which the acquirer must recognize in its postcombination financial statements “[a]ll changes in the fair-value-based measure of awards classified as liabilities after the acquisition date . . . in the period(s) in which the changes occur.”
An acquirer may elect either view as an accounting policy.
Regardless of the view selected, the acquirer must recognize in
the current-period income tax provision the reversal of the
corresponding DTA related to the acquisition-date
fair-value-based measure attributed to both precombination
and postcombination vesting. ASC 805-740 provides specific
income tax accounting guidance on replacement awards. For a
discussion of this guidance, see Section 10.7 of Deloitte’s Roadmap
Income
Taxes.
If the achievement of a performance condition is deemed
improbable as of the acquisition date for either the
acquiree’s awards or the acquirer’s replacement awards, no
amount is recognized as either precombination or
postcombination services. However, if the performance
conditions subsequently become probable for the replacement
awards, an approach similar to View B would apply. For
example, if the performance condition changes from
improbable to probable for the replacement awards, the
acquirer would recognize compensation cost in the
postcombination financial statements on the basis of the
acquisition-date fair-value-based measure of the replacement
awards. No adjustments would be made to the consideration
transferred in the business combination.
The examples below illustrate the accounting for a change in the expected
outcome of a performance condition from probable to
improbable under View A and View B. In the examples, it is
assumed that the acquirer recognizes a DTA in purchase
accounting in accordance with the guidance in ASC 805-740
and (for the portion of the award that vests
postcombination) ASC 718-740.
Example 10-10
View A
On January 1, 20X1, Entity D grants employees 100 nonqualified (tax-deductible) stock options that vest only if D’s cumulative net income over the succeeding five years is greater than $5 million. On the grant date, it is deemed probable that the performance condition will be met. Accordingly, D begins to recognize compensation cost on a straight-line basis over the five-year service period.
On December 31, 20X4, Entity C acquires D in a transaction accounted for as a business combination and is obligated to replace the employees’ awards with 100 new awards that have the same terms as D’s original awards (i.e., the replacement awards will vest at the end of one additional year of service if the performance condition is met). The fair-value-based measure of each award on the acquisition date is $10. Accordingly, the fair-value-based measure of both C’s awards (the replacement awards) and D’s awards (the replaced awards) is $1,000 as of the acquisition date.
Entity C attributes $800 of the acquisition-date fair-value-based measure of the
replacement awards to precombination service and
the remaining $200 to postcombination service. The
$200 attributed to the postcombination service is
recognized as postcombination compensation cost
over the replacement awards’ remaining one-year
service period. On the acquisition date, it is
still probable that the performance condition will
be met. Assume that C’s applicable tax rate is 25
percent.
Journal
Entries: December 31, 20X4, Acquisition
Date
Journal
Entries: Quarter Ended March 31, 20X5
Journal
Entries: Quarter Ended June 30, 20X5
During the third quarter, C loses one of its largest customers and no longer believes that meeting the performance condition is probable.
Journal
Entries: Quarter Ended September 30,
20X5
Entity C ultimately did not meet the performance condition. Therefore, none of the awards vested, and no additional journal entries were necessary.
Example 10-11
View B
Assume all the same facts as in the example above. Under View B, there is no
difference in the accounting as of the acquisition
date and for the first two quarters of service in
the postcombination period (i.e., the journal
entries are the same). However, Entity C’s
accounting in the third quarter for the change in
the expected outcome of the performance condition
from probable to improbable will differ from its
accounting under View A.
Because C has now determined that meeting the performance condition is no longer probable, it recognizes an adjustment to postcombination compensation cost for the sum of (1) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in consideration transferred but that is associated with replacement awards of $800 that are no longer expected to vest and (2) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in postcombination compensation cost but that is associated with replacement awards of $100 that are no longer expected to vest ($200 acquisition-date fair-value-based measure allocated to postcombination service × 50% of service rendered).
With respect to the income tax adjustments, the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in consideration transferred would be recorded in the income tax provision along with the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in postcombination compensation cost.
Journal
Entries: Quarter Ended September 30,
20X5
As in the example above, C ultimately did not meet the performance condition.
Therefore, none of the awards vested, and no
additional journal entries were necessary.
10.4 Acceleration of Vesting Upon a Change in Control
In some cases, the vesting of an acquiree’s share-based payment awards is
accelerated upon a change in control of the
acquiree. The accounting for the accelerated
vesting of an award upon a change in control
depends on which party initiated the acceleration
as well as on whether the acceleration is a
preexisting provision in the terms of the
acquiree’s awards.
10.4.1 Acquirer Accelerates Vesting
An acquirer’s decision to immediately vest or reduce the future vesting period
of awards held by grantees of the acquiree does
not affect the portion of the fair-value-based
measure of the replacement awards that is
attributable to postcombination vesting and
therefore included in postcombination compensation
cost; rather, it affects the timing of the
recognition of postcombination compensation cost.
This is because the allocation of compensation
expense to precombination and postcombination
periods is based on the greater of (1) the
total vesting period or (2) the original vesting
period of the replaced awards (see Section 10.2.1.3).
Therefore, in instances in which the acquirer
accelerates vesting, the allocation will still be
based on the original vesting period of the
replaced awards. For example, if the acquirer
decides to immediately vest the replacement
awards, the portion of the fair-value-based
measure of the awards attributable to
postcombination vesting would be immediately
recognized as compensation cost in the acquirer’s
postcombination financial statements. The amount
of the compensation cost would not be
affected.
Example 10-12
Acquirer Accelerates Vesting Upon the Acquisition Date
On January 1, 20X1, Entity B issues 100 share-based payment awards to an employee that vest at the end of the third year of service (cliff vesting). On January 1, 20X2, Entity A acquires B in a transaction accounted for as a business combination and is obligated to replace the employee’s awards with 100 new awards that have the same service terms as B’s original awards. On January 1, 20X2, the fair-value-based measure of both A’s replacement awards and B’s replaced awards is $10 per award. Entity A then immediately vests all of the outstanding replacement awards on the date of the business combination.
The total fair-value-based measure of the replacement awards as of the acquisition date is $1,000 (100 awards × $10 fair-value-based measure), of which $333 (one of three years) is attributable to precombination service and $667 (two of three years) is attributable to postcombination service. The $333 is included in the consideration transferred, and the $667 is recognized as compensation cost by A in the postcombination financial statements immediately upon the business combination.
If the fair-value-based measure of the replacement awards had been greater than the acquisition-date fair-value-based measure of B’s replaced awards, any excess would have been recognized immediately as compensation cost in A’s postcombination financial statements.
10.4.2 Acceleration of Vesting Included in the Original Terms of the Awards
If share-based payment awards of the acquiree become immediately vested on the
acquisition date because of a preexisting
provision in the awards’ terms that accelerates
their vesting (commonly referred to as a
“change-in-control” provision), the portion of the
replacement awards that is attributable to
precombination vesting, and therefore included in
consideration transferred, would be affected. As
noted in Section 10.2,
the portion of the replacement awards attributable
to precombination vesting is the acquisition-date
fair-value-based measure of the replaced awards
multiplied by the ratio of the precombination
vesting period to the greater of the (1) total
vesting period or (2) original vesting period of
the replaced awards. Since (1) all of the goods or
services have been provided in the precombination
period, (2) there is no requirement for future
vesting, and (3) the original vesting period is
complete, the entire
fair-value-based measure of the replaced awards would be
attributable to precombination vesting and
therefore included in consideration transferred.
If the fair-value-based measure of the replacement
awards is the same as that of the replaced awards,
there is no postcombination compensation cost
recognized. If, however, the fair-value-based
measure of the replacement awards is greater than
that of the replaced awards, the excess is
recognized as postcombination compensation
cost.
Note that there is diversity in practice related to the acquiree’s recognition
of the remaining unrecognized compensation cost. One view is that any remaining
unrecognized compensation cost associated with the original grant-date
fair-value-based measure of the awards should be recognized in the acquiree’s
precombination financial statements. Alternatively, the compensation cost may be
presented in neither the acquiree’s precombination financial statements nor the
combined entity’s postcombination financial statements (i.e., it is recognized
on the “black line”). See Section A.16.1 of Deloitte’s Roadmap Business Combinations for
information about the presentation of certain acquiree expenses triggered by the
consummation of a business combination.
Example 10-13
Acceleration of Vesting Included in the Original Terms of the Award
Assume the same facts as in Example 10-12, except that the
original terms of Entity B’s awards included a
preexisting provision that accelerates their
vesting upon B’s acquisition. Since (1) all of the
service has been rendered in the precombination
period, (2) there is no requirement for future
vesting, and (3) the original vesting period is
complete, the entire $1,000 would be attributable
to precombination service and therefore included
in consideration transferred.
10.4.3 Modification to the Original Terms of the Awards to Add a Change-in-Control Provision in Contemplation of a Business Combination
In some instances, share-based payment awards are modified to add a change-in-control provision in contemplation of a business combination. A modification could also result from the decision to exercise a discretionary change-in-control provision that was part of the original terms of the award (or was added in contemplation of the business combination). Such modifications may be initiated by the acquiree or requested by the acquirer. As discussed in Section 10.2, entities should carefully analyze a modification to determine whether it is part of, or separate from, the business combination. A transaction that is entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer or the combined entity is likely to be a separate transaction.
Under ASC 805-10-55-18, factors for entities to consider in determining whether
a transaction primarily benefits the acquirer or the acquiree include the reason
for the transaction, which party initiated it, and when it occurred.
Understanding the business purpose of a modification will help an acquirer
assess which party benefits from it. It is generally presumed that the acquirer
benefits when an award’s original terms are modified to (1) add a
change-in-control provision during the negotiation of a business combination
with the acquirer or (2) exercise a discretionary change-in-control provision.
On the other hand, the acquirer is generally not presumed to benefit if an
acquiree, before entering into negotiations with the acquirer, modifies the
award’s original terms as part of actively exploring exit strategies. Given the
high degree of judgment involved in these determinations, discussion with
accounting advisers is encouraged.
When a modification to accelerate the vesting of awards upon a change in control
is determined to be primarily for the benefit of the acquirer, the modification
is accounted for in accordance with ASC 718 (i.e., compensation cost is
recognized over the remaining portion of the modified requisite service period;
see Section 6.3.6.1 for a discussion of
modifications that reduce the requisite service period of an award). The
acceleration of vesting upon the consummation of the business combination would
be considered a transaction that is separate from the business combination and
would be accounted for as though the acquirer had decided to accelerate the
vesting of the replacement awards immediately upon the acquisition. That is, the
acquirer’s decision to accelerate the vesting of the awards would affect the
timing of the recognition of postcombination compensation cost — any remaining
unrecognized compensation cost associated with the modified awards would not be
recognized as compensation cost in the acquiree’s precombination financial
statements; instead, it would be recognized as compensation cost immediately in
the postcombination financial statements (i.e., on day 1). The acceleration of
vesting would not affect the determination of the portion of the awards that is
attributable to (1) precombination vesting and therefore included in the
consideration transferred and (2) postcombination vesting and therefore included
in postcombination compensation cost.
Example 10-14
Modification to Add a Change-in-Control Provision
Assume the same facts as in Example 10-12, except that to retain the
employee until at least the acquisition date, Entity B
modified the employee’s existing awards during the
negotiations of the business combination so that they
automatically vest upon a change in control. It was also
determined that the modification was made to benefit
Entity A as it was initiated and discussed between the
parties as part of the negotiations. The modification is
therefore, in substance, the acceleration of the vesting
of the awards by the acquirer and is accounted for as a
transaction that is separate from the business
combination.
This accounting treatment is the same as that in Example 10-12; that is, one-third of
the awards are attributable to precombination
service and two-thirds are attributable to
postcombination service (which is immediately
recognized). As indicated above, acceleration of
the vesting of awards by the acquirer does not
affect the portion of the fair-value-based measure
of the replacement awards that is attributable to
postcombination service and therefore included in
postcombination compensation cost (i.e., the
$667); rather, it affects the timing of the
recognition of postcombination compensation cost
(i.e., immediate).
Example 10-15
Modification as a Result of Exercising a Discretionary Change-in-Control Provision
Assume the same facts as in Example 10-12, except that the original
awards included a discretionary change-in-control
provision that allowed Entity B to elect whether upon a
change in control the awards would (1) be replaced or
(2) vest in full (i.e., accelerated vesting). Entity B
elected to accelerate vesting and further determined
that exercise of the discretionary provision benefitted
A because it was initiated and discussed between the
parties as part of the negotiations.
As in Example 10-12 and the example
above, the modification is, in substance, the
acceleration of the vesting of the awards by the
acquirer and is accounted for as a transaction
that is separate from the business combination.
The amount attributable to (1) precombination
service (i.e., included in consideration
transferred) and (2) postcombination service
(i.e., recognized as postcombination compensation
cost by the acquirer) is determined in a manner
consistent with that described in Example 10-12 and the
example above.
10.5 Cash Settlement Upon a Change in Control
In some business combinations, acquirers may, upon a change in control, cash
settle share-based payment awards instead of either accelerating the awards’ vesting
provisions or replacing the awards. Like vesting provisions that are accelerated
upon a change in control (see Section 10.4), cash settlement provisions should be analyzed
carefully in the determination of whether they are part of, or separate from, the
business combination. ASC 805-10-25-20 states, in part, that the “acquirer shall
recognize as part of applying the acquisition method only the consideration
transferred for the acquiree and the assets acquired and liabilities assumed in the
exchange for the acquiree. Separate transactions shall be accounted for in
accordance with the relevant [GAAP].” In addition, ASC 805-10-25-21 states, in part,
that a “transaction entered into by or on behalf of the acquirer or primarily for
the benefit of the acquirer or the combined entity, rather than primarily for the
benefit of the acquiree (or its former owners) before the combination, is likely to
be a separate transaction.” As noted in Section 10.2, ASC 805-10-55-18 also provides
three factors to help entities determine whether the transaction primarily benefits
the acquirer or the acquiree (i.e., “[t]he reasons for the transaction,” “[w]ho
initiated the transaction,” and “[t]he timing of the transaction”).
10.5.1 Acquirer Cash Settles the Acquiree’s Awards (Cash-Settlement Provision Is Not Included in the Original Terms of the Award)
If there is no preexisting change-in-control cash settlement provision in the
original terms of awards (but the acquirer is obligated to issue replacement
awards) and the acquirer decides to cash settle the acquiree’s awards, the cash
settlement is treated in the same manner as if the acquirer was required to
replace the awards with share-based payment awards of the acquirer.
An acquirer’s decision to cash settle the acquiree’s share-based
payment awards does not affect the portion of the fair-value-based measure of
the replacement awards (i.e., cash) that is attributable to postcombination
vesting and therefore included in postcombination compensation cost; rather, it
affects the timing of the recognition of postcombination compensation cost
(i.e., if the acquiree’s awards were previously unvested, the cash settlement
would effectively accelerate vesting in such a manner that postcombination
compensation cost would be recognized immediately). Further, cash settlement
does not affect the classification of the acquiree’s replaced awards because
there was no preexisting change-in-control cash settlement provision in the
original awards’ terms.
10.5.1.1 Fully Vested Awards That Are Cash Settled Upon a Change in Control
Rather than issuing replacement shares, an acquirer may
choose to settle the acquiree’s awards with cash or a promissory note. If
awards are fully vested as of the acquisition date, the fair value of the
settlement amount should be included in consideration transferred unless it
exceeds the fair-value-based measure of the settled acquiree awards. If the
fair value of the settlement amount exceeds the fair-value-based measure of
the settled acquiree awards, the excess would be immediately recognized as
compensation cost in the acquirer’s postcombination financial
statements.
10.5.1.2 Partially Vested Awards That Are Cash Settled Upon a Change in Control
If awards are partially vested as of the acquisition date,
the acquirer has effectively accelerated the vesting of the unvested portion
of the award and settled the entire award. The amount of the
fair-value-based measure of the acquiree’s replaced award attributable to
precombination vesting and therefore included in consideration transferred
is based on the ratio of precombination vesting to the original vesting
period of the acquiree’s replaced award (see Section 10.2.1.3.1). The amount
recognized as compensation cost in the postcombination financial statements
represents (1) any excess of the cash settlement over the fair-value-based
measure of the vested replaced awards plus (2) the portion of the
fair-value-based measure attributable to the postcombination period.
10.5.2 Cash-Settlement Provision Is Included in the Original Terms of the Award
In some circumstances, an acquiree’s share-based payment awards must be cash
settled as a result of a change in control because of a preexisting provision in
the awards’ original terms.
In such a case, as long as all other criteria for equity classification have
been met, the awards would be classified as equity until it becomes probable
that the change in control will occur (i.e., when it is probable that the awards
will be cash settled). A change in control is generally not
considered probable until the event has occurred (i.e., when the
business combination has been consummated). See Section 5.4.2 for more information about the classification of
share-based payment awards with contingent cash settlement features.
Contemporaneously with the closing of the business combination (when it is
probable that the awards will be cash settled), the awards will become a
share-based liability. As a result of the change in the probable settlement
outcome, an entity would account for the awards in accordance with ASC
718-10-35-15; that is, the entity would account for them in a manner similar to
a modification from equity awards to liability awards (see Section 6.8.1 for a
discussion and examples of the accounting for the modification of awards whose
classification changes from equity to liability). Because the awards are
liability-classified in the acquiree’s financial statements at the time of the
acquisition (i.e., the cash settlement triggers a modification from equity to
liability in the acquiree’s financial statements upon the acquisition), the
awards would be accounted for as an assumed liability by the acquirer in the
business combination rather than as consideration transferred. See Section 10.7.1 for more
information about determining whether amounts should be accounted for as
consideration transferred or an assumed liability in the acquirer’s acquisition
accounting.
There is diversity in practice related to the acquiree’s
recognition of the associated compensation cost resulting from the modification.
One acceptable view is that all of the acquiree’s acquisition expenses, even
those that are contingent on a change in control, should be recognized in the
period in which they were incurred (i.e., in the acquiree’s precombination
financial statements). Another acceptable view is that the compensation costs
should not be recognized in the acquiree’s financial statements but instead
recognized on the “black line.”
10.5.2.1 Fully Vested Awards That Are Cash Settled Upon a Change in Control
If awards are fully vested as of the acquisition date and include a cash
settlement provision in their original terms, the acquirer assumes and
recognizes a share-based liability (because it is now probable that the
awards will be cash settled) for their fair-value-based measure on the
acquisition date. If the fair-value-based measure of the share-based
liability is greater than the original grant-date fair-value-based measure
of the equity awards, the difference is recognized as additional
compensation cost in the acquiree’s precombination financial statements or
on the “black line.” Conversely, if the fair-value-based measure of the
share-based liability is less than or equal to the original grant-date
fair-value-based measure of the equity awards, the offsetting amount is
recorded to APIC in the acquiree’s precombination financial statements.
Example 10-16
Fully Vested Unexercised Options That Are Cash Settled Upon
a Change in Control
On January 1, 20X1, Entity B issues 1,000 options to its employees, each with a
grant-date fair-value-based measure of $5, that vest
at the end of the third year of service (cliff
vesting). Under a preexisting provision in the
original terms of the option award, cash settlement
is required in the event of a change in control.
Because a change in control is generally not
considered probable until it occurs, B classifies
the options as equity (as long as all other criteria
for equity classification are met).
On January 1, 20X5, Entity A acquires B in a transaction accounted for as a
business combination. On January 1, 20X5, the
fair-value-based measure of B’s options is $6 per
option.
Contemporaneously with the closing of the business combination, B (1)
reclassifies the amount currently residing in APIC
as a share-based liability (i.e., $5,000, or 1,000
options × $5 grant-date fair-value-based measure ×
100% of service rendered) and (2) records the excess
$1,000, or ($6 acquisition-date fair-value-based
measure – $5 grant-date fair-value-based measure) ×
1,000 options × 100% of service rendered, as
additional compensation cost in the acquiree’s
precombination financial statements or on the “black
line” (if the acquiree elects to apply pushdown
accounting) to record the share-based liability at
its fair-value-based measure, with a corresponding
adjustment to the share-based liability. Entity A
accounts for the share-based liability as an assumed
liability in the business combination rather than as
consideration transferred.
10.5.2.2 Partially Vested Awards That Are Cash Settled Upon a Change in Control
If awards are partially vested as of the acquisition date, a preexisting cash
settlement provision may immediately cause them to be vested because such
provision accelerates vesting for any remaining unvested awards.
Accordingly, any unrecognized compensation cost associated with the original
equity awards is recognized as compensation cost in the acquiree’s
precombination financial statements or on the “black line.” Since the awards
are now fully vested, if the fair-value-based measure of the acquiree’s
awards as of the acquisition date is greater than the awards’ original
grant-date fair-value-based measure, the difference is recognized as
additional compensation cost in the acquiree’s precombination financial
statements or on the “black line.” Conversely, if the fair-value-based
measure is less than the awards’ original grant-date fair-value-based
measure, the offsetting amount is recorded to APIC in the acquiree’s
precombination financial statements. In addition, the acquirer accounts for
the share-based liability as an assumed liability in the business
combination at an amount equal to the awards’ fair-value-based measure on
the acquisition date (i.e., generally for the amount of cash that it would
expect to settle the acquiree’s awards).
Example 10-17
Partially Vested Options That Are Cash Settled Upon a Change
in Control
Assume the same facts as in Example 10-16, except that the options
granted by Entity B vest at the end of the fifth
year of service (cliff vesting) and cash settlement
is required even if the awards are unvested.
Contemporaneously with the closing of the business combination, B (1) recognizes
$1,000 (1,000 options × $5 grant-date
fair-value-based measure × 1 of 5 years of service
remaining) for the remaining unrecognized
compensation cost associated with the original
equity options because the cash settlement provision
immediately vests the remaining unvested options;
(2) reclassifies the amount now residing in APIC as
a share-based liability (i.e., $5,000, or 1,000
options × $5 grant-date fair-value-based measure ×
100% of service rendered); and (3) records the
excess $1,000, or ($6 acquisition-date
fair-value-based measure – $5 grant-date
fair-value-based measure) × 1,000 options × 100% of
service rendered, as additional compensation cost in
the acquiree’s precombination financial statements
or on the “black line” (if the acquiree elects to
apply pushdown accounting) to record the share-based
liability at its fair-value-based measure, with a
corresponding adjustment to the share-based
liability.
10.6 Arrangements for Contingent Payments to Employees or Selling Shareholders
During negotiations of a business combination, an acquirer may agree to make a
payment at some point in the future to one or more selling
shareholders or to acquiree employees who become employees of the
combined entity (or otherwise provide goods or services to the
combined entity) after the acquisition date. For example, a payment
to a selling shareholder may be contingent on whether the following
continue to be employed at the combined entity after the
acquisition: the selling shareholder, a different selling
shareholder, or a nonshareholder employee. See Section 6.2.3 of Deloitte’s
Roadmap Business
Combinations for additional guidance.
There may also be circumstances in which one or more of the selling
shareholders decide to share some of the proceeds that they are
entitled to receive with one or more of the acquiree’s
nonshareholder employees. Payments made by selling shareholders to
such nonshareholder employees that become employees of the acquirer
should be carefully evaluated under SAB Topic 5.T (which refers to
ASC 718-10-15-4, included in Section 2.5), which
discusses payments made by economic interest holders (e.g., selling
shareholders) on behalf of an entity. Also see Section
6.2.5 of Deloitte’s Roadmap Business Combinations for
more information. Acquirers must evaluate conditional future
payments (i.e., payments that include conditions other than the
passage of time) to former shareholders of the acquiree and to
individuals who become employees of the combined entity (or
otherwise provide goods or services to the combined entity) to
determine whether such payments represent (1) consideration
transferred (i.e., contingent consideration) or (2) compensation
cost that is separate from the business combination.
See Deloitte’s Roadmap Business
Combinations for additional guidance
on contingent consideration.
10.7 Compensation Arrangements
An acquiree in a business combination may have agreements in place to provide
specified employees with additional compensation
predicated upon a change in control of the
acquiree. Such arrangements could have been
established either before or after the
negotiations began for the business combination.
When determining whether the acquirer should
account for these arrangements as part of the
business combination or separately as
compensation, entities must use judgment and
consider the specific facts and circumstances as
discussed below and in Section 10.2. However, if a business
combination results in additional compensation
arrangements payable to the acquirer’s employees,
these payments are always accounted for as
compensation costs in the acquirer’s financial
statements.
10.7.1 Arrangements to Pay an Acquiree’s Employee Upon a Change in Control
Arrangements may be established with the objective of retaining one or more of
the acquiree’s employees until the acquisition
date and possibly for a defined period thereafter.
Such arrangements — often referred to in practice
as “stay bonuses,” “change in control payments,”
or “golden parachutes” — may also provide
additional compensation for performance related to
the business combination or compensate employees
who are terminated after the combination.
Arrangements to pay an
acquiree’s employees upon a change in control must
be assessed to determine whether they should be
accounted for as part of or separately from the
business combination. In assessing the substance
of an arrangement, an entity should consider the
factors listed in ASC 805-10-55-18 (i.e., “[t]he
reasons for the transaction,” “[w]ho initiated the
transaction,” and “[t]he timing of the
transaction”; see Section 10.2 for
discussion) to determine whether the arrangement
should be accounted for as part of, or separately
from, the business combination. See Section
10.4.3 for more information about
making that determination. Arrangements to pay an
acquiree’s employees upon a change in control that
are determined to be separate from the business
combination represent compensation cost of the
acquirer. If no future service is required, the
acquirer should recognize compensation cost on the
acquisition date. There may also be circumstances
in which a payment needs to be allocated between
the portion attributable to precombination
services and postcombination compensation
cost.
ASC 805-10-55-34 through 55-36 provide an example of a contingent payment to an
acquiree’s employee:
ASC 805-10
Example 4: Arrangement for Contingent Payment to an Employee
55-34 This Example illustrates the guidance in paragraphs 805-10-55-24 through 55-25 relating to contingent payments to employees in a business combination. Target hired a candidate as its new chief executive officer under a 10-year contract. The contract required Target to pay the candidate $5 million if Target is acquired before the contract expires. Acquirer acquires Target eight years later. The chief executive officer was still employed at the acquisition date and will receive the additional payment under the existing contract.
55-35 In this Example, Target entered into the employment agreement before the negotiations of the combination began, and the purpose of the agreement was to obtain the services of the chief executive officer. Thus, there is no evidence that the agreement was arranged primarily to provide benefits to Acquirer or the combined entity. Therefore, the liability to pay $5 million is included in the application of the acquisition method.
55-36 In other circumstances, Target might enter into a similar agreement with the chief executive officer at the suggestion of Acquirer during the negotiations for the business combination. If so, the primary purpose of the agreement might be to provide severance pay to the chief executive officer, and the agreement may primarily benefit Acquirer or the combined entity rather than Target or its former owners. In that situation, Acquirer accounts for the liability to pay the chief executive officer in its postcombination financial statements separately from application of the acquisition method.
In accounting for the acquisition, the acquirer will need to assess whether to
recognize amounts that have been determined to be
part of the business combination as part of the
consideration transferred or as a liability
assumed.
If the acquirer issues cash, other assets, or its equity instruments to settle
the acquiree’s awards that were equity-classified
in the acquiree’s precombination financial
statements, the portion determined to be part of
the business combination represents consideration
transferred since the acquiree’s employees were
owners of (or increased their ownership in) the
acquiree as a result of the arrangement.
By contrast, if the acquirer issues cash, other assets, or its equity
instruments to settle a bonus arrangement (e.g.,
stay bonus) with the acquiree’s employees or to
settle the acquiree’s awards that were
liability-classified in the acquiree’s
precombination financial statements, the portion
determined to be part of the business combination
would be treated in the acquisition accounting as
a liability assumed.
If arrangements to pay an acquiree’s employees upon a change in control are
settled in cash or in other assets after the
acquisition date rather than at the closing of the
business combination, the acquirer would need to
recognize a liability in its acquisition
accounting for the portion determined to be part
of the business combination. In the acquisition
accounting, the nature of that liability as either
consideration transferred or a liability assumed
should be determined on the basis of the analysis
described above.
10.7.2 Dual- or Double-Trigger Arrangements
An employment agreement entered into before negotiations began for the business
combination may include terms that require a
payment or accelerate vesting upon (1) a change in
control and (2) a second defined event or
“trigger,” which is why such provisions are
commonly called “dual trigger” or “double trigger”
arrangements. The second defined event is
generally the separation of the employee from the
acquirer and might be limited to involuntary
terminations or might also include resignation of
the employee in specified conditions (sometimes
referred to as “good reasons”) such as:
-
A demotion or significant reduction in the employee’s duties or responsibilities after the acquisition date.
-
A significant reduction in the employee’s salary or compensation after the acquisition date.
-
The relocation of the employee’s job site beyond a specified radius after the acquisition date.
The objective of such employment agreements, which are typically entered into before negotiations have begun for a business combination, is generally to obtain the employee’s services. While the three factors in ASC 805-10-55-18 (i.e., “[t]he reasons for the transaction,” “[w]ho initiated the transaction,” and “[t]he timing of the transaction”) might indicate that the payments should be accounted for as part of the business combination, such arrangements are generally accounted for separately from the business combination. This is because the decision to effect the second trigger (i.e., the employee’s involuntary termination or voluntary termination for “good reason”) is under the control of the acquirer and is therefore presumed to be made primarily for the acquirer’s benefit (e.g., to reduce cost by eliminating the unneeded employee).
Example 10-18
Dual- or Double-Trigger Arrangement Involving the Termination of Employment
Company A acquires Company B in a transaction accounted for as a business combination. Company B has an existing employment agreement with its CEO that was put in place before negotiations began for the combination. Under the agreement, all of the CEO’s unvested awards will fully vest upon (1) a change in the control of B and (2) the involuntary termination of the CEO’s employment within one year after the acquisition date.
Before the closing, A determines that it will not offer employment to the CEO
after the combination has been completed. Thus,
both conditions are triggered, and the vesting of
the CEO’s unvested awards is accelerated upon the
closing of the acquisition.
The decision not to employ B’s former CEO was under A’s control and was made for
A’s benefit (i.e., to reduce costs). Therefore, A
should recognize the compensation cost related to
the accelerated vesting of the unvested awards in
its postcombination financial statements and not
as part of the business combination.
Example 10-19
Dual- or Double-Trigger Arrangement in Which Employee Resigns for “Good Reason”
As in the example above, Company A acquires Company B in a transaction accounted
for as a business combination, and B has an
existing employment agreement with its CEO.
However, in this example, the agreement provides
that all of the CEO’s unvested awards will fully
vest upon (1) a change in the control of B
and (2) either the involuntary termination
of the CEO or the voluntary departure of the CEO
for “good reason” within one year after the
acquisition date. The agreement specifies that a
significant reduction in job responsibilities
would be a good reason. After the acquisition
date, B’s CEO will not assume the role of CEO of
the combined entity but instead will be assigned a
position with reduced responsibilities. In
response, B’s CEO will resign upon the change in
control.
The decision to reduce the responsibilities of B’s former CEO after the acquisition date is within A’s control. Therefore, A should recognize the compensation cost related to the accelerated vesting of the awards in its postcombination financial statements and not as part of the business combination.
10.7.3 Arrangements to Reallocate Forfeited Awards or Amounts to Remaining Shareholders/Employees
An acquirer may issue share-based payment awards to a group of shareholders of
the acquiree, all of whom become employees of the
combined entity with such awards subject to
vesting based on continued employment. The awards
may be placed in a trust by the acquirer on the
acquisition date. Such arrangements are sometimes
referred to as “last man standing” arrangements
because any forfeited awards must be reallocated
to the remaining participants in the group. Some
arrangements may not specify what happens if none
of the participants are still employed by the
acquirer at the end of the term; however, since
these arrangements typically encompass many
employees, it would be unlikely that none remain.
Other arrangements may specify that the amounts
revert to the acquiree’s former shareholders if
none of the participants are still employed at the
end of the term.
In his remarks at the 2000 AICPA Conference on Current SEC Developments, then SEC OCA Professional Accounting Fellow R. Scott Blackley provided the following example of such an arrangement:
For illustration, consider an example business combination where a company acquires another enterprise, XYZ Company, for cash and stock. All of the shareholders of XYZ Company are also employees. The acquiring company expects and desires to have the employee shareholders of XYZ Company continue as employees of the combined companies. Accordingly, of the shares issued to the shareholders of XYZ Company, a portion is held in an irrevocable trust, subject to a three year vesting requirement (“forfeiture shares”).
The forfeiture provision requires that if, prior to vesting, a shareholder resigns from employment or is terminated for cause, the shares held in the trust allocable to the employee shareholder be forfeited. Additionally, any shares actually forfeited are reallocated to the remaining employee shareholders based on their remaining ownership interests such that all of the forfeiture shares in the trust will ultimately be issued.
Mr. Blackley said that in this scenario, the SEC staff concluded that “the forfeiture shares must be accounted for as a compensation arrangement.” He noted that the staff placed “significant weight” on the shares’ vesting on the basis of continued employment even though the amount of consideration was fixed because it would not be returned to the acquirer under any circumstances. Although Mr. Blackley made these remarks before FASB Statement 141(R), as
codified in ASC 805, was issued, we believe that they remain relevant.
Therefore, in an arrangement in which share-based payment awards are issued to a group of shareholders of the acquiree, all of whom become employees of the combined entity on the basis of a requirement to continue employment, the forfeiture and subsequent redistribution of the awards are accounted for as (1) the forfeiture of the original award and (2) the grant of a new award. That is, the acquirer would reverse any compensation previously recognized for the forfeited award (on the basis of the original grant-date fair-value-based measure) and then recognize compensation for the new award (on the basis of the fair-value-based measure on the date the award is redistributed) over the remaining requisite service period.
Example 10-20
Arrangement to Reallocate Forfeited Awards to Remaining Shareholders/Employees
On January 1, 20X1, Company A acquires Company B and, as part of the acquisition agreement, grants each of B’s 10 shareholders/employees 100 new share-based payment awards that vest at the end of five years of service (cliff vesting). The grant-date fair-value-based measure of each award as of the acquisition date is $10.
The terms of the award state that if employment is terminated before the end of five years (i.e., the vesting date), the employee’s awards are forfeited and redistributed among the remaining employees within the group.
The total grant-date fair-value-based measure of the awards as of the acquisition date is $10,000 (10 employees × 100 awards × $10 grant-date fair-value-based measure), which A recognizes in the postcombination financial statements as compensation cost over the five-year service period ($2,000 per year). On December 31, 20X3, two employees in the group terminate their employment and forfeit their awards, which are then redistributed to the eight remaining group members. The fair-value-based measure of each redistributed (i.e., new) award is $12 on the date the awards are redistributed.
On December 31, 20X3, A should reverse $1,200 of previously recognized
compensation cost (2 employees × 100 awards × $10
grant-date fair-value-based measure × 60% for 3
out of 5 years of services rendered) corresponding
to the forfeited awards. Company A should continue
to recognize $1,600 in annual compensation cost (8
employees × 100 awards × $10 grant-date fair value
÷ 5 years) over each of the remaining two years of
service for the original awards provided to the
remaining employees. In addition, A should
recognize $1,200 in additional annual compensation
cost (200 awards × $12 grant-date fair-value-based
measure ÷ 2 years of remaining service) over each
of the remaining two years of service for the
redistributed awards.
In some cases, payments to the shareholders/employees may be made in cash rather than forfeitable shares. We do not believe that the form of the payment affects the conclusion that such arrangements are based on continued employment and therefore should be accounted for as compensation and not as part of the exchange for the acquiree.
10.8 Tax Effects of Replacement Awards Issued in a Business Combination
See Chapter 11 of
Deloitte’s Roadmap Income Taxes for guidance on the
accounting for the tax effects of replacement awards issued in a
business combination. In addition, see Section 10.3 of this
Roadmap for a discussion and examples of the accounting for the tax
effects of replacement awards issued in a business combination.
10.9 Acquiree Awards Remain Outstanding
In some cases, the acquirer is not required to replace the
acquiree’s share-based payment awards and they remain outstanding after the
acquisition. For example, if the acquiree becomes a subsidiary of the acquirer, the
share-based payment awards that were issued by the acquiree before the business
combination might remain outstanding after the business combination. In that case,
assuming that they qualify for equity classification, we believe that those awards
represent a noncontrolling interest in the subsidiary in the parent’s consolidated
financial statements. While the guidance in ASC 805-30-30-1(a)(2) states that any
noncontrolling interests should be measured and recognized at fair value, we believe
that unvested share-based payment awards should be measured in the same manner as
replacement awards; that is, a fair-value-based measure is used in accordance with
ASC 718.
While ASC 805 does not address awards that have postcombination vesting requirements,
we believe that the acquirer should apply the replacement award guidance by analogy
and determine the portion of the acquisition-date fair-value-based measure of the
acquiree award that is attributable to precombination vesting and recognize that
amount as noncontrolling interest (as opposed to consideration transferred). The
portion related to postcombination vesting should be recognized as compensation cost
in the postcombination financial statements. See Section
10.2 for more information about determining that allocation.
10.10 Acquiree Awards That Expire as a Result of the Business Combination
ASC 805-30
30-10 In situations in which
acquiree awards would expire as a consequence of a business
combination and the acquirer replaces those awards even
though it is not obligated to do so, all of the
fair-value-based measure of the replacement awards shall be
recognized as compensation cost in the postcombination
financial statements. That is, none of the fair-value-based
measure of those awards shall be included in measuring the
consideration transferred in the business combination.
In accordance with ASC 805-30-30-10, if an acquiree’s share-based
payment awards will expire as a result of a business combination under the terms of
the original award but the acquirer issues replacement awards even though it is not
obligated to do so, “all of the fair-value-based measure of the replacement awards
shall be recognized as compensation cost in the postcombination financial
statements. That is, none of the fair-value-based measure of those awards shall be
included in measuring the consideration transferred in the business combination.”
In most cases, however, an acquirer is obligated to replace the
acquiree’s awards or they remain outstanding after the acquisition.
Chapter 11 — Income Tax Accounting
Chapter 11 — Income Tax Accounting
ASC 718-740 discusses the accounting for income taxes associated with
share-based payment awards. ASC 718-740-25-2
states, in part, that the “cumulative amount of
compensation cost recognized for [awards] that
ordinarily would result in a future tax deduction
under existing tax law [is] considered to be a
deductible temporary difference in applying [ASC
740].” Accordingly, entities recognize DTAs and
related tax benefits on the basis of cumulative
compensation cost recorded for awards that
ordinarily would result in future tax deductions.
This guidance applies irrespective of whether an
award is classified as equity or a liability. If
the cost of an award that will ordinarily result
in a deduction for tax purposes is capitalized
(e.g., as part of inventory or a fixed asset), the
capitalized cost also becomes part of the tax
basis of the asset.
For awards that would not ordinarily result in future tax deductions, the
cumulative amount of compensation cost recognized
in the financial statements would be treated as a
permanent difference and would be an item (or part
of an item) that reconciles the entity’s statutory
tax rate to its effective tax rate. For public
entities, disclosure of this reconciliation is
required by ASC 740-10-50-12. Any capitalized cost
of an award that would not ordinarily
result in a future deduction would not be
treated as part of the tax basis of the asset.
The DTA associated with share-based payment awards (apart from any required
valuation allowance) is computed by applying the applicable tax rate to the
cumulative amount of compensation cost recognized in the financial statements (i.e.,
the gross temporary difference) and, for equity-classified awards, is not
subsequently affected by changes in the entity’s stock price. An entity should not
remeasure or write off the DTA as a result of a change in its stock price. For
example, even if an entity’s stock price has declined so significantly that a stock
option award’s exercise is unlikely to occur or that the intrinsic value on the
exercise date will most likely be less than the cumulative compensation cost
recognized in the financial statements, the DTA is not adjusted. However, for
share-based payment awards classified as liabilities, the measurement of the DTA
does implicitly take into account the entity’s current stock price since liability
awards are remeasured at the end of each reporting period. The DTA resulting from
compensation cost on liability awards would change as the fair-value-based measure
of the awards changes.
The cumulative amount of compensation cost recognized in the financial
statements may be greater or less than the amount
of actual tax deductions for share-based payment
awards (e.g., the tax deduction determined when a
restricted stock award vests or when a stock
option award is exercised). Differences in such
amounts are referred to as excess tax benefits
(when the amount of the deduction exceeds the
compensation cost recognized in the financial
statements) and tax deficiencies (when the amount
of the deduction is less than the compensation
cost recognized in the financial statements). In
accordance with ASC 718-740-35-2, the excess tax
benefits and tax deficiencies are recognized as
decreases or increases to current tax expense or
benefit in the period the excess tax benefit or
tax deficiency arises (i.e., the period in which
the tax deduction arises or the period in which an
option’s expiration occurs). This results in a
permanent difference between the amount of
cumulative compensation for financial reporting
purposes and the deduction taken for income tax
purposes and has an impact on an entity’s
effective tax rate in the period in which the
excess or deficiency arises.
For additional information about the accounting for income taxes associated with
share-based payment awards, see Chapter 10 of
Deloitte’s Roadmap Income
Taxes.
Chapter 12 — Presentation
Chapter 12 — Presentation
This chapter discusses presentation matters related to the statement of financial position, statement of operations, statement of cash flows, and EPS.
12.1 Statement of Financial Position
12.1.1 Receivables
ASC 505-10
Receivables for Issuance of Equity
45-2 An entity may receive a note, rather than cash, as a contribution to its equity. The transaction may be a sale of capital stock or a contribution to paid-in capital. Reporting the note as an asset is generally not appropriate, except in very limited circumstances in which there is substantial evidence of ability and intent to pay within a reasonably short period of time, for example, as discussed for public entities in paragraph 210-10-S99-1 (paragraphs 27 through 29), which requires a deduction of the receivable from equity. However, such notes may be recorded as an asset if collected in cash before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25).
SEC Staff Accounting Bulletins
SAB Topic 4.E, Receivables
From Sale of Stock [Reproduced in ASC
310-10-S99-2]
Facts:
Capital stock is sometimes issued to officers or
other employees before the cash payment is
received.
Question: How should the receivables from the
officers or other employees be presented in the
balance sheet?
Interpretive Response: The
amount recorded as a receivable should be
presented in the balance sheet as a deduction from
stockholders’ equity. This is generally consistent
with Rule 5-02.30 of Regulation S-X which states
that accounts or notes receivable arising from
transactions involving the registrant’s capital
stock should be presented as deductions from
stockholders’ equity and not as assets.
It should be noted generally
that all amounts receivable from officers and
directors resulting from sales of stock or from
other transactions (other than expense advances or
sales on normal trade terms) should be separately
stated in the balance sheet irrespective of
whether such amounts may be shown as assets or are
required to be reported as deductions from
stockholders’ equity.
The staff will not suggest
that a receivable from an officer or director be
deducted from stockholders’ equity if the
receivable was paid in cash prior to the
publication of the financial statements and the
payment date is stated in a note to the financial
statements. However, the staff would consider the
subsequent return of such cash payment to the
officer or director to be part of a scheme or plan
to evade the registration or reporting
requirements of the securities laws.
Generally, receivables that result from the issuance of shares classified as permanent or mezzanine equity should be presented as a reduction of each respective class of stock (i.e., contra-equity). That is, receivables that result from the issuance of shares classified as permanent equity generally should be presented as a reduction of permanent equity in accordance with ASC 505-10-45-2. Similarly, receivables that result from the issuance of shares classified as mezzanine equity should be presented as a reduction of mezzanine equity.
SAB Topic 4.E (reproduced in ASC 310-10-S99-2) generally requires entities to classify any outstanding receivables from officers or other employees related to the issuance of stock to officers or other employees as a deduction from stockholders’ equity rather than as an asset.
Asset classification of such receivables may be appropriate only when the receivable is fully repaid in cash before the financial statements are issued. The date of payment must be disclosed in the notes to the financial statements. SAB Topic 4.E cautions, however, that the SEC staff would consider any subsequent return of cash to the officer or employee as potentially representing an effort “to evade the registration or reporting requirements of the securities laws.” Further, receivables of this nature must be disclosed separately regardless of whether they are classified as an asset or as a deduction from equity. Entities preparing to file a registration statement with the SEC should be particularly cognizant of the potential legal ramifications associated with loans to employees and should consult with their legal counsel to address any issues well before their public offering.
In addition, an entity that allows an employee to finance the purchase of shares should consider whether recourse or nonrecourse notes have been tendered. Nonrecourse notes are not recognized because such a financing is accounted for, in substance, as stock options. See Section 3.11.
12.1.2 Deferred Tax Assets
As discussed in Section 4.12.2, NQSOs are options that do not qualify for treatment as ISOs or ESPPs under the provisions of IRC Sections 421 through 424. NQSOs give employers more flexibility than ISOs.
In accordance with ASC 740-10-45-4, an entity must classify the DTA as
noncurrent on the balance sheet.
See Chapter 10 of Deloitte’s Roadmap
Income Taxes for a discussion
of the income tax effects of share-based
payments.
12.1.3 Capitalization of Inventory
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 managements 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.
If compensation cost associated with share-based payment awards is part of the cost of inventory, an entity should initially capitalize it as inventory and later recognize it in the income statement when the inventory is consumed. However, the SEC staff has indicated that it may be reasonable for an entity instead to adjust the period-end inventory balance for compensation cost through a period-end adjustment and not incorporate the cost in its inventory costing system.
12.1.4 Fully Vested Nonemployee Awards
ASC 718-10
Classification of Assets Other Than a Note or a Receivable for Nonemployee Awards
45-3 As discussed in paragraph 718-10-35-1B, a grantor may conclude that an asset (other than a note or a receivable) has been received in return for fully vested, nonforfeitable, nonemployee share-based payment awards that are issued at the date the grantor and nonemployee enter into an agreement for goods or services (and no specific performance is required by the nonemployee to retain those equity instruments). Such an asset shall not be displayed as contra-equity by the grantor of the award. The transferability (or lack thereof) of the awards shall not affect the balance sheet display of the asset. This guidance is limited to transactions in which awards are transferred to nonemployees in exchange for goods or services.
For additional information about the classification of assets, other than a note
or a receivable, that are received in exchange for fully vested, nonforfeitable
equity instruments, see Section 9.7.
12.1.5 Presentation of Awards With Repurchase Features That Function as Vesting Conditions
As discussed in Section
3.4.3, repurchase features included in
a share-based payment award may at times function
in substance as vesting conditions. For example, a
stock option or similar instrument may be “early
exercised” and include such repurchase features.
An early exercise of a stock option or similar
instrument 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 the stock
option is generally not considered substantive for
accounting purposes given the repurchase features
included in such awards. However, the shares
issued to a grantee upon an early exercise of a
stock option or similar instrument may be
considered legally outstanding common stock. In
accordance with SEC Regulation S-X, Rule 5-02(29),
SEC registrants are required to disclose the
number of common shares outstanding on the balance
sheet. If the shares are deemed to be legally
outstanding, the number of shares disclosed as
outstanding on the balance sheet may differ from
the number of shares outstanding for accounting
purposes. Entities should consider whether
disclosing this difference is necessary on the
basis of their facts and circumstances. These
considerations also apply to restricted stock or
nonvested shares with repurchase features that
function as vesting conditions.
12.2 Statement of Operations
ASC 718 requires compensation cost from share-based payment awards to be (1) recorded in net income, (2) either expensed or capitalized (and subsequently expensed) in an entity’s financial statements, and (3) classified appropriately as either equity or a liability in accordance with the classification criteria in ASC 718 (see Chapter 5). However, ASC 718 provides little guidance on how compensation cost associated with share-based payment awards should be presented in the statement of operations.
12.2.1 Classification of Compensation Expense
SEC Staff Accounting Bulletins
SAB Topic 14.F, Classification of
Compensation Expense Associated With Share-Based Payment
Arrangements
Facts: Company
G utilizes both cash and share-based payment
arrangements to compensate its employees and nonemployee
service providers. Company G would like to emphasize in
its income statement the amount of its compensation that
did not involve a cash outlay.
Question: How
should Company G present in its income statement the
non-cash nature of its expense related to share-based
payment arrangements?
Interpretive
Response: The staff believes Company G should
present the expense related to share-based payment
arrangements in the same line or lines as cash
compensation paid to the same employees or
nonemployees.84 The staff believes a
company could consider disclosing the amount of expense
related to share-based payment arrangements included in
specific line items in the financial statements.
Disclosure of this information might be appropriate in a
parenthetical note to the appropriate income statement
line items, on the cash flow statement, in the footnotes
to the financial statements, or within MD&A.
______________________________
84 FASB ASC Topic 718 does
not identify a specific line item in the income
statement for presentation of the expense related to
share-based payment arrangements, with the exception of
the guidance in ASC 718-10-15-5A on share-based payment
awards granted to a customer.
The SEC staff believes that compensation expense related to share-based payment arrangements (e.g., cost of sales, R&D, selling and administrative expenses) should be presented within the appropriate line items on the face of the statement of operations and not separately within a single share-based compensation line item. That is, presentation in the statement of operations should not be governed by the form of consideration paid (e.g., cash or share-based payment). The staff believes that instead, an entity could consider disclosing the amount of expense related to share-based payment arrangements presented within specific line items in the financial statements. Disclosure of this information might be appropriate in a parenthetical note to the appropriate income statement line items, in the cash flow statement, in the footnotes to the financial statements, or in MD&A.
The following is an example of an acceptable
disclosure of share-based compensation expense presented within specific line
items:
12.2.2 Share-Based Payment Awards Granted to Employees and Nonemployees of an Equity Method Investee
ASC 323-10
Stock-Based Compensation Granted to Employees and Nonemployees of an Equity Method Investee
25-3 Paragraphs 323-10-25-4
through 25-6 provide guidance on accounting for
share-based payment awards granted by an investor to
employees or nonemployees of an equity method investee
that provide goods or services to the investee that are
used or consumed in the investee’s operations when no
proportionate funding by the other investors occurs and
the investor does not receive any increase in the
investor’s relative ownership percentage of the
investee. That guidance assumes that the investor’s
grant of share-based payment awards to employees or
nonemployees of the equity method investee was not
agreed to in connection with the investor’s acquisition
of an interest in the investee. That guidance applies to
share-based payment awards granted to employees or
nonemployees of an investee by an investor based on that
investor's stock (that is, stock of the investor or
other equity instruments indexed to, and potentially
settled in, stock of the investor).
25-4 In
the circumstances described in paragraph 323-10-25-3, a
contributing investor shall expense the cost of
share-based payment awards granted to employees and
nonemployees of an equity method investee as incurred
(that is, in the same period the costs are recognized by
the investee) to the extent that the investor’s claim on
the investee’s book value has not been increased.
25-5 In the circumstances
described in paragraph 323-10-25-3, other equity method
investors in an investee (that is, noncontributing
investors) shall recognize income equal to the amount
that their interest in the investee’s net book value has
increased (that is, their percentage share of the
contributed capital recognized by the investee) as a
result of the disproportionate funding of the
compensation costs. Further, those other equity method
investors shall recognize their percentage share of
earnings or losses in the investee (inclusive of any
expense recognized by the investee for the share-based
compensation funded on its behalf).
SEC Observer Comment: Accounting by an Investor for Stock-Based Compensation Granted to Employees of an Equity Method Investee
S99-4 The following is the
text of SEC Observer Comment: Accounting by an Investor
for Stock-Based Compensation Granted to Employees of an
Equity Method Investee.
Paragraph
323-10-25-3 provides guidance on the accounting by an
investor for stock-based compensation based on the
investor’s stock granted to employees of an equity
method investee. Investors that are SEC registrants
should classify any income or expense resulting from
application of this guidance in the same income
statement caption as the equity in earnings (or losses)
of the investee.
ASC 323 provides guidance on share-based payment awards granted by an investor to employees and nonemployees of an equity method investee. Generally, investors of the equity method investee (both the contributing investor and noncontributing investors) classify any income or expense associated with the awards in the same caption as the equity in earnings of the investee.
12.2.3 Nonemployee Awards Issued in Exchange for Goods or Services
The SEC staff has reviewed a number of cases in which entities have issued share-based payment awards (e.g., warrants, shares, or convertible instruments) to suppliers, service providers, customers, or partners. The staff has generally held as follows:
- When share-based payment awards are issued to customers or potential customers in arrangements in which the awards will not vest or become exercisable without purchases by the recipient, the related cost must be reported as a sales discount — in other words, as a reduction of revenue.
- When awards are issued to suppliers or potential suppliers and they will not vest or become exercisable unless the recipient provides goods or services to the issuer, the cost of the award should be reported as a cost of the related goods or services.
- Separate line items in the statement of operations should not be presented for the apparent purpose of emphasizing that a portion of the sales discounts or expenses did not involve a cash outlay. This requirement is consistent with the guidance in SAB Topic 14.F (see Section 12.2.1).
- Awards that do not require any performance from the counterparty are related to past transactions and should therefore be classified appropriately (e.g., as cost of sales or reduction of revenue and not as marketing or nonoperating expenses).
12.2.4 Payroll Taxes
ASC 718-10
25-23 Payroll taxes, even though directly related to the appreciation on stock options, are operating expenses and shall be reflected as such in the statement of operations.
Employer payroll taxes incurred as a result of share-based payment transactions
should be reflected as operating expenses.
12.3 Statement of Cash Flows
Because the receipt of goods or services in exchange for a share-based payment award is a noncash item, the award is not presented as a direct cash outflow in the statement of cash flows. However, under the indirect method, an entity would present the compensation cost recognized in net income as a reconciling item in arriving at cash flows from operations.
In addition, an entity presents other effects of share-based payment awards as follows:
- Any cash paid by a grantee (e.g., the exercise price of a stock option) to the entity for an award is classified as a cash inflow from financing activities.
- Any cash paid to settle an equity-classified award that does not exceed the fair-value-based measure of the award on the repurchase date is classified as a cash outflow for financing activities. The amount paid in excess of the fair-value-based measure of the award on the repurchase date is recognized as compensation cost and classified as a cash outflow for operating activities.
- Any cash paid to settle a liability-classified award represents compensation and is classified as a cash outflow for operating activities. An entity may enter into an agreement to repurchase (or offer to repurchase) an equity-classified award for cash. Depending on the facts and circumstances, the agreement to repurchase (or offer to repurchase) may be accounted for as either (1) a settlement of the equity-classified award as discussed in the previous bullet point or (2) a modification of the equity-classified award that changes the award’s classification from equity to liability, followed by a settlement of the now liability-classified award.
- Regardless of whether an entity meets an employee’s statutory tax withholding requirement through either a net settlement feature or a repurchase of shares, the entity must account for the withholding as, in substance, two transactions in the statement of cash flows. First, the gross issuance of shares is presented as a financing activity (any cash received from the employee is classified as a cash inflow from financing activities, and if no cash is received, the gross issuance of shares is presented as a noncash financing activity). Second, the entity is deemed to have repurchased a portion of the shares. While the employee does not receive cash directly, the entity has, in substance, repurchased shares from the employee and remitted the cash consideration to the tax authority on the employee’s behalf. Because the cash payment is related to a repurchase of stock, it is classified as a cash outflow for financing activities.
- Any income tax benefit received for an award is classified as operating activities in the same manner as other cash flows related to income taxes.
For additional information about classifying the effects of share-based payment
awards in the statement of cash flows, see Section 7.3 of Deloitte’s Roadmap Statement of Cash
Flows.
12.4 Earnings per Share
ASC 718-10
Earnings per Share
45-1 Topic 260 requires that equity share options, nonvested shares, and similar equity instruments granted under share-based payment transactions be treated as potential common shares in computing diluted earnings per share (EPS). Diluted EPS shall be based on the actual number of options or shares granted and not yet forfeited regardless of the entity’s accounting policy for forfeitures in accordance with paragraphs 718-10-35-1D and 718-10-35-3, unless doing so would be antidilutive. If vesting in or the ability to exercise (or retain) an award is contingent on a performance or market condition, such as the level of future earnings, the shares or share options shall be treated as contingently issuable shares in accordance with paragraphs 260-10-45-48 through 45-57. If equity share options or other equity instruments are outstanding for only part of a period, the shares issuable shall be weighted to reflect the portion of the period during which the equity instruments are outstanding.
45-2 Paragraphs 260-10-45-29 through 45-34 and Example 8 (see
paragraph 260-10-55-68) provide guidance on applying the treasury stock method for equity
instruments granted in share-based payment transactions in determining diluted EPS.
In calculating EPS, an entity should consider how a share-based payment award
may affect (1) income available to common shareholders (i.e., the numerator
in the EPS calculation) and (2) the weighted-average number of common shares
or dilutive potential common shares (i.e., the denominator in the EPS
calculation). Because an entity recognizes the fair-value-based measure of
an award as compensation cost (or as a reduction of revenue) in arriving at
the entity’s income available to common shareholders, awards granted in
return for goods or services or as a sales incentive to a customer will
typically affect the EPS numerator.
12.4.1 Basic EPS
ASC 260-10
Computation of Basic EPS
45-10 Basic EPS shall be computed by dividing income available to common stockholders (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. Shares issued during the period and shares reacquired during the period shall be weighted for the portion of the period that they were outstanding. See Example 1 (paragraph 260-10-55-38) for an illustration of this guidance.
During the requisite service period or nonemployee’s vesting period, share-based
payment awards do not affect the calculation of basic EPS (other than
the effect of compensation cost as a reduction of income available to
common shareholders) unless such awards are participating securities.
An entity must apply the two-class method when calculating basic and
diluted EPS for such awards (see Section 12.4.3).
Once the good has been delivered, the service has been rendered, or the revenue
related to the sales incentive has been recognized, vested awards that
are considered outstanding common shares affect the denominator in the
calculation of basic EPS. That is, such awards will be included in the
weighted-average number of common shares from the date on which they
become vested outstanding common shares. If the awards do not become
outstanding common shares during the period and are not considered
participating securities, they generally are not included in the
calculation of basic EPS. However, contingently issuable shares should
be included in the denominator of basic EPS when there are no
circumstances in which those shares would not be issued.
Connecting the Dots
Employee awards of shares that vest when the
grantee becomes eligible for retirement must be considered
outstanding shares in the denominator of basic EPS as of
the date on which the grantee is eligible to retire and
retain the shares. This is because, once the employee is
eligible to retire, there are no conditions that must be
met for the common stock to be issued. Such shares are not
considered contingently issuable shares since an agreement
that requires an entity to issue common shares only after
the mere passage of time is not considered a contingently
issuable share arrangement. In other words, no remaining
service period is associated with the issuance of the
shares since the holder can retire at any time and receive
the shares.
Share-based payment awards often contain clawback features. See Section 3.9 for a discussion of such features. Because clawback features are protective provisions, ASC 718 requires that the effect of a clawback feature be accounted for only when the contingent event that triggers the clawback occurs. In a manner consistent with this guidance, vested common shares issued in a share-based payment transaction should be considered outstanding shares in the calculation of basic EPS from the date vesting is complete. It would not be appropriate to exclude such common shares from the denominator of the calculation of basic EPS on the basis of the guidance in ASC 260 on contingently issuable (returnable) shares. This conclusion is consistent with paragraph 92 of the Background Information and Basis for Conclusions of FASB Statement 128, which indicates that vested shares for which the consideration has been received should be included in the calculation of basic EPS. It is also consistent with informal discussions with the FASB staff.
12.4.2 Diluted EPS
ASC 260-10
Computation of Diluted EPS
45-16 The computation of
diluted EPS is similar to the computation of basic
EPS except that the denominator is increased to
include the number of additional common shares
that would have been outstanding if the dilutive
potential common shares had been issued. In
computing the dilutive effect of convertible
securities, the numerator is adjusted in
accordance with the guidance in paragraph
260-10-45-40. Adjustments also may be necessary
for certain contracts that provide the issuer or
holder with a choice between settlement methods.
See Example 1 (paragraph 260-10-55-38) for an
illustration of this guidance.
No Antidilution
45-17 The computation of diluted EPS shall not assume conversion, exercise, or contingent issuance of securities that would have an antidilutive effect on EPS. Shares issued on actual conversion, exercise, or satisfaction of certain conditions for which the underlying potential common shares were antidilutive shall be included in the computation as outstanding common shares from the date of conversion, exercise, or satisfaction of those conditions, respectively. In determining whether potential common shares are dilutive or antidilutive, each issue or series of issues of potential common shares shall be considered separately rather than in the aggregate.
45-18 Convertible securities
may be dilutive on their own but antidilutive when
included with other potential common shares in
computing diluted EPS. To reflect maximum
potential dilution, each issue or series of issues
of potential common shares shall be considered in
sequence from the most dilutive to the least
dilutive. That is, dilutive potential common
shares with the lowest earnings per incremental
share shall be included in diluted EPS before
those with a higher earnings per incremental
share. Example 4 (see paragraph 260-10-55-57)
illustrates that provision. Options and warrants
generally will be included first because use of
the treasury stock method does not affect the
numerator of the computation. An entity that
reports a discontinued operation in a period shall
use income from continuing operations (adjusted
for preferred dividends as described in paragraph
260-10-45-11) as the control number in determining
whether those potential common shares are dilutive
or antidilutive. That is, the same number of
potential common shares used in computing the
diluted per-share amount for income from
continuing operations shall be used in computing
all other reported diluted per-share amounts even
if those amounts will be antidilutive to their
respective basic per-share amounts. (See paragraph
260-10-45-3.) The control number excludes income
from continuing operations attributable to the
noncontrolling interest in a subsidiary in
accordance with paragraph 260-10-45-11A. Example
14 (see paragraph 260-10-55-90) provides an
illustration of this guidance.
45-19 Including potential common shares in the denominator of a diluted per-share computation for continuing operations always will result in an antidilutive per-share amount when an entity has a loss from continuing operations or a loss from continuing operations available to common stockholders (that is, after any preferred dividend deductions). Although including those potential common shares in the other diluted per-share computations may be dilutive to their comparable basic per-share amounts, no potential common shares shall be included in the computation of any diluted per-share amount when a loss from continuing operations exists, even if the entity reports net income.
45-20 The control number for determining whether including potential common shares in the diluted EPS computation would be antidilutive should be income from continuing operations (or a similar line item above net income if it appears on the income statement). As a result, if there is a loss from continuing operations, diluted EPS would be computed in the same manner as basic EPS is computed, even if an entity has net income after adjusting for a discontinued operation. Similarly, if an entity has income from continuing operations but its preferred dividend adjustment made in computing income available to common stockholders in accordance with paragraph 260-10-45-11 results in a loss from continuing operations available to common stockholders, diluted EPS would be computed in the same manner as basic EPS.
Conversion Rate or Exercise Price
45-21A
Changes in an entity’s share price may affect the
exercise price of a financial instrument or the
number of shares that would be used to settle the
financial instrument. For example, when the
principal of a convertible debt instrument is
required to be settled in cash but the conversion
premium is required to (or may) be settled in
shares, the number of shares to be included in the
diluted EPS denominator is affected by the
entity’s share price. In applying both the
treasury stock method and the if-converted method
of calculating diluted EPS, the average market
price shall be used for purposes of calculating
the denominator for diluted EPS when the number of
shares that may be issued is variable, except for
contingently issuable shares within the scope of
the guidance in paragraphs 260-10-45-48 through
45-57. See paragraphs 260-10-55-4 through 55-5 for
implementation guidance on determining an average
market price.
While share-based payment awards do not affect the calculation of basic EPS
(other than the effect of compensation cost as a reduction of income
available to common shareholders) during the requisite service period
or nonemployee’s vesting period (unless the award is a participating
security), an entity generally includes them in the denominator when
calculating diluted EPS if the effect is dilutive on the basis of the
antidilution sequencing requirements of ASC 260. Further, awards
(e.g., stock options or warrants) that do not become outstanding
common shares when the good is delivered or the service is rendered,
and that are not considered participating securities, are not included
in the calculation of basic EPS but may be included in the denominator
of diluted EPS before they are settled (e.g., are exercised, are
canceled, or expire).
An entity may change the terms or conditions of a
share-based payment award. ASC 718-20-35-3 states, in part, that
“[e]xcept as described in paragraph 718-20-35-2A, a modification of
the terms or conditions of an equity award shall be treated as an
exchange of the original award for a new award.” ASC 718-30-35-5
contains similar guidance for liability-classified awards and states,
in part, that “[a] modification of a liability award is accounted for
as the exchange of the original award for a new award.” In accordance
with this guidance, a modification of a share-based payment award that
is not subject to the exception in ASC 718-20-35-2A is treated as a
cancellation of the existing award and the issuance of a new award. In
a manner consistent with the guidance in ASC 718, an entity should
treat the original and modified awards as two separate awards in
calculating diluted EPS. Thus, when the treasury stock method applies
to a modified share-based payment award, an entity would perform the
following two treasury stock method calculations:
-
Calculations based on the terms of the award and the average market price of the entity’s common stock for the period during the financial reporting period before the modification (weighted, as appropriate, for the period).
-
Calculations based on the terms of the award and the average market price of the entity’s common stock for the period during the financial reporting period after the modification (weighted, as appropriate, for the period).
The sum of these two calculations will equal the incremental common
shares that are included in the calculation of diluted EPS for the
period.
ASC 718-20-35-2A addresses situations in which an entity modifies a
share-based payment award but is not required to apply modification
accounting. Entities will need to consider the specific facts and
circumstances associated with such types of modifications to determine
whether they should be treated as a single award or two separate
awards in the calculation of diluted EPS in the period that includes
the change to the terms or conditions of the award.
12.4.2.1 Treasury Stock Method
ASC 260-10
Options, Warrants, and Their Equivalents and the Treasury Stock Method
45-22 The dilutive effect of outstanding call options and warrants (and their equivalents) issued by the reporting entity shall be reflected in diluted EPS by application of the treasury stock method unless the provisions of paragraphs 260-10-45-35 through 45-36 and 260-10-55-8 through 55-11 require that another method be applied. Equivalents of options and warrants include nonvested stock granted under a share-based payment arrangement, stock purchase contracts, and partially paid stock subscriptions (see paragraph 260-10-55-23). Antidilutive contracts, such as purchased put options and purchased call options, shall be excluded from diluted EPS.
45-23 Under the treasury
stock method:
- Exercise of options and warrants shall be assumed at the beginning of the period (or at time of issuance, if later) and common shares shall be assumed to be issued.
- The proceeds from exercise shall be assumed to be used to purchase common stock at the average market price during the period. (See paragraphs 260-10-45-29 and 260-10-55-4 through 55-5.)
- The incremental shares (the difference between the number of shares assumed issued and the number of shares assumed purchased) shall be included in the denominator of the diluted EPS computation.
Example 15 (see paragraph
260-10-55-92) provides an illustration of this
guidance. See paragraph 260-10-45-21A if the
exercise price of a financial instrument or the
number of shares that would be used to settle the
financial instrument is variable.
45-24 Paragraph not used.
45-25 Options and warrants will have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the exercise price of the options or warrants (they are in the money). Previously reported EPS data shall not be retroactively adjusted as a result of changes in market prices of common stock.
45-26 Dilutive options or warrants that are issued during a period or that expire or are cancelled during a period shall be included in the denominator of diluted EPS for the period that they were outstanding. Likewise, dilutive options or warrants exercised during the period shall be included in the denominator for the period prior to actual exercise. The common shares issued upon exercise of options or warrants shall be included in the denominator for the period after the exercise date. Consequently, incremental shares assumed issued shall be weighted for the period the options or warrants were outstanding, and common shares actually issued shall be weighted for the period the shares were outstanding.
45-27 Paragraphs 260-10-55-3 through 55-11 provide additional guidance on the application of the treasury stock method.
Share-Based Payment Arrangements
45-28 The provisions in
paragraphs 260-10-45-28A through 45-31 apply to
share-based awards issued to grantees under a
share-based payment arrangement in exchange for
goods and services or as consideration payable to
a customer.
45-28A Awards of share options and nonvested shares (as defined in Topic 718) to be issued to a grantee under a share-based payment arrangement are considered options for purposes of computing diluted EPS. Such share-based awards shall be considered to be outstanding as of the grant date for purposes of computing diluted EPS even though their exercise may be contingent upon vesting. Those share-based awards are included in the diluted EPS computation even if the grantee may not receive (or be able to sell) the stock until some future date. Accordingly, all shares to be issued shall be included in computing diluted EPS if the effect is dilutive. The dilutive effect of share-based payment arrangements shall be computed using the treasury stock method. If the equity share options or other equity instruments are outstanding for only part of a period, the shares issuable shall be weighted to reflect the portion of the period during which the equity instruments were outstanding. See Example 8 (paragraph 260-10-55-68).
45-28B In applying the treasury stock method, all dilutive potential common shares, regardless of whether they are exercisable, are treated as if they had been exercised. The treasury stock method assumes that the proceeds upon exercise are used to repurchase the entity’s stock, reducing the number of shares to be added to outstanding common stock in computing EPS.
An entity generally includes the dilutive effect of share-based payment awards
(e.g., restricted stock, stock options) in the denominator of
the calculation of diluted EPS by applying the treasury stock
method, under which it is assumed that any service condition
will be met. When applying the treasury stock method to a stock
option, the entity assumes that two hypothetical transactions
have occurred. The first is the hypothetical exercise of the
award (or, for a restricted stock award, the hypothetical
vesting of the award); the second is the hypothetical repurchase
of shares at the average market price during the period by using
the assumed proceeds that will be generated from the
hypothetical exercise of the award (or, for a restricted stock
award, the hypothetical vesting for the award). The incremental
shares that would be hypothetically issued are the number of
shares assumed to be issued upon exercise of the award (or, for
a restricted stock award, the vesting of the award) in excess of
the number of shares assumed to be repurchased with the assumed
proceeds. The incremental shares are included in the number of
diluted potential common shares as a component of the
denominator in the calculation of diluted EPS.
While the treasury stock method applies to both vested and unvested stock
options, it is used for such awards only when the average market
price of the entity’s common stock during the period exceeds the
exercise price of the awards (i.e., the award is in-the-money)
on an award-by-award basis. Thus, an entity needs to perform a
separate treasury stock method calculation for each individual
in-the-money award. An entity would perform the same calculation
for awards that are granted on the same day with the same terms
and conditions (the awards would presumably have the same
grant-date fair-value-based measure). Out-of-the-money awards
are considered antidilutive and excluded from the denominator in
the calculation of diluted EPS. The determination of whether an
award is in-the-money or out-of-the-money is made on an
individual-award basis.
12.4.2.1.1 Assumed Proceeds
ASC 260-10
45-29 In applying the treasury stock method described in
paragraph 260-10-45-23, the assumed proceeds shall be the sum of both of the following:
-
The amount, if any, the grantee must pay upon exercise.
-
The amount of cost attributed to share-based payment awards (within the scope of Topic 718 on stock compensation) not yet recognized. This amount includes share-based payment awards that are not contingent upon satisfying certain conditions as described in paragraph 260-10-45-32 and contingently issuable shares that have been determined to be included in the computation of diluted EPS as described in paragraphs 260-10-45-48 through 45-57.
-
Subparagraph superseded by Accounting Standards Update No. 2016-09.
45-29A Under paragraphs 718-10-35-1D and 718-10-35-3, the effect of forfeitures is taken into account by recognizing compensation cost for those instruments for which the employee’s requisite service has been rendered or the nonemployee’s vesting conditions have been met and no compensation cost shall be recognized for instruments that grantees forfeit because a service or performance condition is not satisfied. See Example 8 (paragraph 260-10-55-68) for an illustration of this guidance.
When determining the amount of assumed proceeds that a share-based payment award
will generate, an entity aggregates (1) the exercise price
of the award, if any, and (2) the average amount of
compensation cost attributed to share-based payment awards
not yet recognized.1 Because there is no exercise price for restricted
stock awards, the entity includes in the assumed proceeds
only the average amount of unrecognized compensation cost
attributed to future goods or services not yet
recognized.
12.4.2.1.2 Period Outstanding
An entity must take into account the amount of time a share-based payment award
was outstanding during the reporting period. If an award
was outstanding for the entire reporting period, the
incremental shares determined under the treasury stock
method are included in the calculation of diluted EPS for
the entire reporting period. By contrast, if an award was
exercised (or, for a restricted stock award, becomes
vested) or forfeited during the reporting period, the
incremental shares are included only for the period in
which the award was outstanding when the treasury stock
method is applied. Once the award is exercised (or, for a
restricted stock award, becomes vested), the shares issued
are considered outstanding common shares and are included
in the weighted-average number of common shares
outstanding (i.e., the denominator in the calculation of
basic and diluted EPS).
12.4.2.1.3 Quarter-to-Date Versus Year-to-Date Calculations
ASC 260-10
Applying the Treasury Stock Method:
Year-to-Date Computations
55-3 The number of
incremental shares included in quarterly diluted
EPS shall be computed using the average market
prices during the three months included in the
reporting period. For year-to-date diluted EPS,
the number of incremental shares to be included in
the denominator shall be determined by computing a
year-to-date weighted average of the number of
incremental shares included in each quarterly
diluted EPS computation. Example 1 (see paragraph
260-10-55-38) provides an illustration of that
provision.
55-3A Computation of year-to-date diluted EPS when an entity has a year-to-date loss from continuing operations including one or more quarters with income from continuing operations and when in-the-money options or warrants were not included in one or more quarterly diluted EPS computations because there was a loss from continuing operations in those quarters is as follows. In computing year-to-date diluted EPS, year-to-date income (or loss) from continuing operations shall be the basis for determining whether or not dilutive potential common shares not included in one or more quarterly computations of diluted EPS shall be included in the year-to-date computation.
55-3B Therefore:
- When there is a year-to-date loss, potential common shares should never be included in the computation of diluted EPS, because to do so would be antidilutive.
- When there is year-to-date income, if in-the-money options or warrants were excluded from one or more quarterly diluted EPS computations because the effect was antidilutive (there was a loss from continuing operations in those periods), then those options or warrants should be included in the diluted EPS denominator (on a weighted-average basis) in the year-to-date computation as long as the effect is not antidilutive. Similarly, contingent shares that were excluded from a quarterly computation solely because there was a loss from continuing operations should be included in the year-to-date computation unless the effect is antidilutive.
Example 12 (see paragraph 260-10-55-85) illustrates this guidance.
When applying the treasury stock method to a quarterly period, an entity should
use the average market price for the period to determine
the number of incremental shares to include in the
denominator of the calculation of diluted EPS. That is,
the entity calculates the number of incremental shares for
the quarterly period as though that period is a discrete
period. By contrast, in the denominator of the calculation
of diluted EPS for the year-to-date period, an entity
includes a weighted-average number of incremental shares
for each of the quarterly periods. The average market
price for the year-to-date period is not used as though
the year-to-date period was a separate discrete period.
Example 1 in ASC 260-10-55-38 through 55-50 and Example 12
in ASC 260-10-55-85 through 55-87 illustrate
quarter-to-date and year-to-date EPS calculations.
12.4.2.1.4 Forfeitures
ASC 718 allows an entity to make an entity-wide accounting policy election to
either (1) estimate the number of awards that are expected
to vest or (2) account for forfeitures when they occur.
The entity’s election will affect the amount of
compensation cost included in income available to common
shareholders (the numerator in the calculation of diluted
EPS). However, regardless of the entity’s policy election,
the denominator in the calculation of diluted EPS is based
on the actual number of awards
outstanding (i.e., the number of awards is reduced only
for actual forfeitures) in a given reporting period
provided that the effect is dilutive. Once an entity has
determined the number of outstanding awards that will have
a dilutive effect on the calculation of diluted EPS, the
entity then uses the treasury stock method to determine
the number of incremental shares to include in the
denominator of the calculation of diluted EPS.
For example, an entity that elects to estimate forfeitures may determine that
only 90 percent of the share-based payment awards issued
to grantees are expected to eventually vest even though
none have actually been forfeited yet. Accordingly, only
90 percent of the awards’ fair-value-based measure is
recognized as compensation cost over the requisite service
period or nonemployee’s vesting period. However, when
determining the number of incremental shares to include in
the denominator of the calculation of diluted EPS, an
entity must assume that all
outstanding dilutive awards that contain only a service
condition will vest or become exercisable. Therefore, when
calculating diluted EPS, the entity must (1) determine the
number of all outstanding awards that are dilutive and (2)
apply the treasury stock method.
When the treasury stock method is applied, the assumed proceeds are also
calculated on the basis of the actual number of all outstanding dilutive awards
regardless of the entity’s forfeiture policy election or
whether certain of those awards are not expected to
eventually vest. The amount of average unrecognized cost
is therefore based on the total number of outstanding
dilutive awards at the beginning of the period and at the
end of the period.
12.4.2.1.5 Treasury Stock Method Examples
The examples below illustrate the application of the treasury stock method to
share-based payment awards in the calculation of diluted
EPS.
ASC 260-10
Example 8: Application of the Treasury Stock Method to a Share-Based Payment Arrangement
55-68 This Example illustrates the guidance in paragraph 260-10-45-28A for the application of the treasury stock method when share options are forfeited.
55-69 Entity A adopted a share option plan on January 1, 20X7, and granted 900,000 at-the-money share options with an exercise price of $30. All share options vest at the end of three years (cliff vesting). Entity A’s accounting policy is to estimate the number of forfeitures expected to occur in accordance with paragraph 718-10-35-1D or 718-10-35-3. At the grant date, Entity A assumes an annual forfeiture rate of 3 percent and therefore expects to receive the service for 821,406 [900,000 × (.97 to the third power)] share options. On January 1, 20X7, the fair value of each share option granted is $14.69. Grantees forfeited 15,000 stock options ratably during 20X7.
55-69A The average stock price during 20X7 is $44. Net income for the period is $97,385,602. For the year ended December 31, 20X7, there are 25,000,000 weighted-average common shares outstanding. This guidance also applies if the service inception date precedes the grant date.
55-70 The following table illustrates computation of basic and diluted EPS for the year ended December 31, 20X7.
Example 12-1
Employee Stock Options — No Exercises or
Forfeitures During the Period
Assume the following about Entity A:
-
Entity A has net income of $5 million, as well as 1 million common shares outstanding, for the entire year ended December 31, 20X2.
-
As of December 31, 20X2, A also has 100,000 employee stock options outstanding. All the stock options were granted on January 1, 20X1, and vest solely on the basis of a two-year service condition. On December 31, 20X1, 50,000 stock options vested. The remaining 50,000 stock options vest on December 31, 20X2. All options are still outstanding on December 31, 20X2 (i.e., none have been exercised).
-
All the stock options have an exercise price of $10 per option and a grant-date fair-value-based measure of $2 per option.
-
Entity A recognizes compensation cost for these stock options on a straight-line basis over the service period from January 1, 20X1, to December 31, 20X2.
-
The average market price of A’s common stock for the year ended December 31, 20X2, was $15 per share.
Note that in the above calculation of diluted EPS, year-to-date amounts are used
for simplicity. ASC 260-10-55-3 states, in part,
“For year-to-date diluted EPS, the number of
incremental shares to be included in the
denominator shall be determined by computing a
year-to-date weighted average of the number of
incremental shares included in each quarterly
diluted EPS computation.” For example, assume that
when applying the treasury stock method, A
determined that it must include 10,000 and 15,000
incremental shares in the denominator of the
calculation of diluted EPS for its first and
second quarter, respectively. When calculating the
number of incremental shares to include in the
denominator for the year-to-date six-month period,
A would assign equal weight to the 10,000 and
15,000 incremental shares. Therefore, 12,500
incremental shares [(10,000 + 15,000) ÷ 2] are
included in the denominator of the calculation of
diluted EPS for the year-to-date six-month
period.
The example below illustrates the application of the treasury stock method to
stock option awards when a portion of the awards was
exercised during the period. Once the awards are
exercised, the shares issued are considered outstanding
common shares and are included in the weighted-average
number of common shares outstanding (i.e., the denominator
in the calculation of basic EPS).
Example 12-2
Employee Stock Options — Exercises During
the Period
Assume the same facts as in Example 12-1, except that the 50,000 employee stock options that vested on December 31, 20X1, were exercised on June 30, 20X2.
Entity A calculates diluted EPS as follows:
As noted in Example 12-1, the above
calculation of diluted EPS is a simplified annual
calculation that does not take into account
interim calculations of diluted EPS as required by
ASC 260-10-55-3. The above calculation is further
simplified because of how exercises during the
period are factored into the calculation. In the
above example, the “weighting” effect on
incremental common shares for stock options
exercised during the period is factored into the
calculation by weighting the number of stock
options outstanding during the entire period
(i.e., one treasury stock method calculation is
performed to calculate the diluted impact of all
stock options). A more precise way to factor in
stock options exercised during the period is to
perform two calculations under the treasury stock
method — one for stock options that were
outstanding for the entire period and one for
stock options that were exercised during the
period. Under this approach, the “weighting”
effect on incremental common shares for stock
options exercised during the period is captured by
multiplying the incremental common shares by a
factor (i.e., percentage) that is determined on
the basis of the period during which the options
were outstanding.
While the more precise calculation may yield
results that do not differ from those under the
simplified approach, an entity should consider its
specific facts and circumstances in determining
when a simplified approach is appropriate. In some
circumstances, a simplified approach could result
in exclusion of the dilutive effect of awards that
were not outstanding during the entire period
because of a difference between the average stock
price during the entire reporting period and the
average stock price during the period in which the
awards were outstanding.
The example below illustrates the application of the treasury stock method to
stock option awards when there is a forfeiture during the
period.
Example 12-3
Employee Stock Options — Forfeitures During
the Period
Assume the following:
- Entity A has net income of $1 million for the quarter ended March 31, 20X1, as well as 100,000 common shares outstanding for the entire period from January 1, 20X1, to March 31, 20X1.
- On January 1, 20X1, A granted 10,000 employee stock options to 10 employees (1,000 stock options each).
- All the stock options have an exercise price of $5 per option and a grant-date fair-value-based measure of $1 per option, and they cliff vest after two years of service.
- The average market price of A’s common stock for the three-month period ended March 31, 20X1, was $6.50 per share.
- Entity A has a policy of estimating forfeitures, and it estimates that 8,000 of the stock options will eventually vest. It therefore has accrued compensation cost on the basis of this forfeiture estimate.
- On February 1, 20X1, an employee terminates and forfeits 1,000 stock options.
Entity A calculates the number of incremental shares to include in the
denominator of the calculation of diluted EPS
under the treasury stock method, as well as
diluted EPS (for the three-month period ended
March 31, 20X1), as follows:
Note that A must base the calculation of diluted EPS on the actual number of
awards outstanding (i.e., actual forfeitures) in a
given reporting period rather than on its estimate
of the number of awards expected to forfeit. In
addition, note that the above calculation is
simplified because of how forfeitures during the
period are factored into the calculation. In the
above example, the “weighting” effect on
incremental common shares for stock options
forfeited during the period is factored into the
calculation by weighting the number of stock
options outstanding during the entire period
(i.e., one treasury stock method calculation is
performed to calculate the diluted impact of all
stock options). A more precise way to factor in
stock options forfeited during the period is to
perform two calculations under the treasury stock
method — one for stock options that were
outstanding for the entire period and one for
stock options that were forfeited during the
period. Under this approach, the “weighting”
effect on incremental common shares for stock
options forfeited during the period is captured by
multiplying the incremental common shares by a
factor (i.e., percentage) that is determined on
the basis of the period during which the options
were outstanding.
While the more precise calculation may yield
results that do not differ significantly from
those under the simplified approach, an entity
should consider its specific facts and
circumstances in determining when a simplified
approach is appropriate. In some circumstances, a
simplified approach could result in exclusion of
the dilutive effect of awards that were not
outstanding during the entire period because of a
difference between the average stock price during
the entire reporting period and the average stock
price during the period in which the awards were
outstanding.
12.4.2.2 Service Conditions
ASC 260-10
Treatment of Contingently Issuable Shares in
Weighted-Average Shares Outstanding
45-12C
Contractual agreements (usually associated with
purchase business combinations) sometimes provide
for the issuance of additional common shares
contingent upon certain conditions being met.
Consistent with the objective that basic EPS
should represent a measure of the performance of
an entity over a specific reporting period,
contingently issuable shares should be included in
basic EPS only when there is no circumstance under
which those shares would not be issued and basic
EPS should not be restated for changed
circumstances.
45-13 Shares issuable for little or no cash consideration upon the satisfaction of certain conditions (contingently issuable shares) shall be considered outstanding common shares and included in the computation of basic EPS as of the date that all necessary conditions have been satisfied (in essence, when issuance of the shares is no longer contingent). Outstanding common shares that are contingently returnable (that is, subject to recall) shall be treated in the same manner as contingently issuable shares. Thus, contingently issuable shares include shares that meet any of the following criteria:
- They will be issued in the future upon the satisfaction of specified conditions.
- They have been placed in escrow and all or part must be returned if specified conditions are not met.
- They have been issued but the holder must return all or part if specified conditions are not met.
Share-Based Payment Arrangements
45-32 Fixed grantee stock options (fixed awards) and nonvested stock (including restricted stock) shall be included in the computation of diluted EPS based on the provisions for options and warrants in paragraphs 260-10-45-22 through 45-27. Even though their issuance may be contingent upon vesting, they shall not be considered to be contingently issuable shares (see Section 815-15-55 and paragraph 260-10-45-48). However, because issuance of performance-based stock options (and performance-based nonvested stock) is contingent upon satisfying conditions in addition to the mere passage of time, those options and nonvested stock shall be considered to be contingently issuable shares in the computation of diluted EPS. A distinction shall be made only between time-related contingencies and contingencies requiring specific achievement.
Generally, an entity will use the treasury stock method to determine the number
of common shares related to share-based payment awards with only
a service condition (i.e., no performance or market condition)
to include in the denominator of the calculation of diluted EPS
provided that the awards are dilutive. (See Section
12.4.2.1.5 for examples illustrating the
application of the treasury stock method to share-based payment
awards.)
A restricted stock award is not included in the
denominator of the calculation of basic EPS during the award’s
requisite service period or before the nonemployee award has
vested, even if the shares of stock have been legally issued.
Such shares are considered contingently returnable shares as
described in ASC 260-10-45-13. For example, if the grantee does
not deliver the good or render the service, the shares are
returned to the entity. Once the vesting conditions have been
satisfied, the shares are considered outstanding common shares
and therefore are included in the weighted-average number of
common shares outstanding (i.e., the denominator in the
calculation of basic EPS).
In addition, an unexercised stock option award is not
included in the denominator of the calculation of basic EPS even
if the award is vested. That is, even if an award’s vesting
conditions have been satisfied, an unexercised stock option
(containing an exercise price that is not nominal) is not an
outstanding common share until it is exercised.
However, an award that contains a right to nonforfeitable dividends or dividend
equivalents that participate in undistributed earnings with
common stock is a participating security even before the award’s
vesting conditions are satisfied (i.e., during the vesting
period). Therefore, the issuer is required to apply the
two-class method discussed in Section 12.4.3 when
calculating basic and diluted EPS. When calculating diluted EPS
for unvested awards that are considered participating
securities, an entity must determine which is more dilutive to
apply, the treasury stock method or the two-class method.
In the calculation of diluted EPS, unvested awards and unexercised stock option
awards that vest solely on the basis of a service condition are
included in the denominator of the calculation of diluted EPS
during their requisite service period (or before the nonemployee
award has vested) or during the period the options are
unexercised under the treasury stock method. (See Section
12.4.2.1 for a discussion of the application of
the treasury stock method to share-based payment awards.)
12.4.2.3 Performance and Market Conditions
ASC 260-10
45-31 Awards with a market condition, a performance condition, or any combination thereof (as defined in Topic 718) shall be included in diluted EPS pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-57.
45-32 Fixed grantee stock options (fixed awards) and nonvested stock (including restricted stock) shall be included in the computation of diluted EPS based on the provisions for options and warrants in paragraphs 260-10-45-22 through 45-27. Even though their issuance may be contingent upon vesting, they shall not be considered to be contingently issuable shares (see Section 815-15-55 and paragraph 260-10-45-48). However, because issuance of performance-based stock options (and performance-based nonvested stock) is contingent upon satisfying conditions in addition to the mere passage of time, those options and nonvested stock shall be considered to be contingently issuable shares in the computation of diluted EPS. A distinction shall be made only between time-related contingencies and contingencies requiring specific achievement.
Contingently Issuable Shares
45-48 Shares whose issuance is contingent upon the satisfaction of certain conditions shall be considered outstanding and included in the computation of diluted EPS as follows:
- If all necessary conditions have been satisfied by the end of the period (the events have occurred), those shares shall be included as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later).
- If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive. Those contingently issuable shares shall be included in the denominator of diluted EPS as of the beginning of the period (or as of the date of the contingent stock agreement, if later).
45-49 For year-to-date computations, contingent shares shall be included on a weighted-average basis. That is, contingent shares shall be weighted for the interim periods in which they were included in the computation of diluted EPS.
45-50 Paragraphs 260-10-45-51 through 45-54 provide general guidelines that shall be applied in determining the EPS impact of different types of contingencies that may be included in contingent stock agreements.
45-55 Contingently issuable potential common shares (other than those covered by a contingent stock agreement, such as contingently issuable convertible securities) shall be included in diluted EPS as follows:
- An entity shall determine whether the potential common shares may be assumed to be issuable based on the conditions specified for their issuance pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-54.
- If those potential common shares should be reflected in diluted EPS, an entity shall determine their impact on the computation of diluted EPS by following the provisions for options and warrants in paragraphs 260-10-45-22 through 45-37, the provisions for convertible securities in paragraphs 260-10-45-40 through 45-42, and the provisions for contracts that may be settled in stock or cash in paragraph 260-10-45-45, as appropriate.
For share-based payment awards with a performance or market condition, an entity
must first apply the guidance on contingently issuable shares in
ASC 260-10-45-48 through 45-55 to determine whether the awards
should be included in the calculation of diluted EPS for the
reporting period. That is, the entity needs to determine the
number of shares, if any, that would be issuable at the end of
the reporting period if the end of the reporting period were the
end of the contingency period. Once the entity has determined
that the award should be included in the calculation of diluted
EPS for the reporting period, the entity must use the treasury
stock method to determine the number of incremental shares to
include in the denominator of the calculation of diluted
EPS.
An entity may be recording compensation cost for an award that only contains a
performance or market condition because the entity believes that
it is probable that the award will vest (performance condition)
or, for example, that the employee will remain employed for the
derived service period (market condition). However, in such
cases, the incremental shares that would be included in the
denominator of the calculation of diluted EPS would be excluded
if the performance or market condition (i.e., the contingency)
has not been achieved as of the end of that particular reporting
period, under an assumption that the end of the reporting period
is the end of the contingency period.
12.4.2.3.1 Performance-Based Awards
ASC 260-10
45-51 If attainment or maintenance of a specified amount of earnings is the condition and if that amount has been attained, the additional shares shall be considered to be outstanding for the purpose of computing diluted EPS if the effect is dilutive. The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive. Because the amount of earnings may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied. Example 3 (see paragraph 260-10-55-53) illustrates that provision.
45-54 If the contingency is based on a condition other than earnings or market price (for example, opening a certain number of retail stores), the contingent shares shall be included in the computation of diluted EPS based on the assumption that the current status of the condition will remain unchanged until the end of the contingency period. Example 3 (see paragraph 260-10-55-53) illustrates that provision.
Assume that a stock award legally vests only if an entity’s cumulative net
income at the end of the third annual reporting period
exceeds $10 million. At the end of each reporting period,
the entity assesses whether cumulative net income has
exceeded $10 million as if that reporting date were the
end of the third annual reporting period. If the
performance condition has been met at the end of a
reporting period, the entity includes the award in the
calculation of diluted EPS. To determine the number of
incremental shares of stock to include in the denominator
of the calculation of diluted EPS, the entity applies the
treasury stock method if the effect is dilutive on the
basis of the antidilution sequencing requirements of ASC
260.
However, if the entity’s cumulative net income has not exceeded $10 million at
the end of the reporting period, the entity does not
include the award in the calculation of diluted EPS even
if it is recording compensation cost because it believes
that it is probable that the award will vest (i.e., it is
probable that the performance target will be achieved).
The entity excludes the award from the calculation of
diluted EPS because the performance condition (i.e., the
contingency) has not been met as of the end of that
reporting period.
Example 12-4
Calculating Diluted EPS When Vesting of
Stock Options Is Contingent on Future
Earnings
Assume the following:
- Entity A has net income of $12 million and $5 million for the year and quarter ended December 31, 20X1, respectively, as well as 5 million common shares outstanding for the quarter ended December 31, 20X1.
- On January 1, 20X1, A granted 1 million employee stock options. The stock options vest on December 31, 20X2, if the recipients remain employed and A’s cumulative net income for the two-year period ended December 31, 20X2, equals or exceeds $10 million.
- As of December 31, 20X1, all the stock options remain outstanding.
- The stock options have an exercise price of $10 per option and a grant-date fair-value-based measure of $2 per option.
- The average market price of A’s common stock for the year ended December 31, 20X1, was $15 per share.
If the end of the reporting period (December 31, 20X1) is considered the end of
the contingency period, the performance target is
deemed to be achieved. As a result, A includes the
employee stock options in the calculation of
diluted EPS for the quarter ended December 31,
20X1. To determine the number of incremental
shares to include in the calculation’s
denominator, A must then apply the treasury stock
method if the effect is dilutive.
Entity A calculates diluted EPS under the treasury stock method for the
quarterly period ended December 31, 20X1, as
follows:
Alternatively, assume that A had generated net income of less than $10 million for the year ended
December 31, 20X1. In that case, A excludes the employee stock
options from the calculation of diluted EPS
because the contingency is not deemed to have been
met as of the end of the reporting period.
Therefore, A is not required to determine the
number of incremental shares to include in the
denominator of the calculation of diluted EPS
under the treasury stock method. However, if A
believes that it is probable that the performance
target will be attained by the end of the
performance period (December 31, 20X2), A
recognizes compensation cost over the requisite
service period for the number of awards expected
to vest.
There may be other circumstances in which an entity issues performance-based
awards for which performance is calculated on the basis of
an average metric over several periods. When calculating
whether contingently issuable shares for such awards
should be included in the calculation of diluted EPS, an
entity applies ASC 260-10-45-51 and ASC 260-10-45-54,
which require the entity to assume that the current status
of the condition (e.g., the current amount of earnings)
will remain unchanged until the end of the contingency
period. In addition, footnote (f) to Example 3 in ASC
260-10-55-56 states, in part, that “[p]rojecting future
earnings levels and including the related contingent
shares are not permitted.” While footnote (f) to Example 3
is associated with the calculation of diluted EPS for an
interim period, we believe that it is appropriate to apply
the guidance to both interim and annual periods. Because
the guidance precludes the projection of future earnings
levels, earnings (or any other metric) in future periods
would be presumed to be zero. See further discussion in
Section 4.5.2.3 of Deloitte’s Roadmap
Earnings per Share. See also
the example below.
Example 12-5
Calculating Diluted EPS for an Award That
Vests on the Basis of Average Metrics
On January 1, 20X1, Entity A granted 1 million performance-based RSUs to a group
of its key employees. The RSUs cliff vest on December 31, 20X3, if the recipients
remain employed and A achieves two performance metrics during the three-year period
from January 20X1 to December 20X3: (1) a three-year average revenue growth rate of at
least 10 percent and (2) a three-year average operating margin of at least 6
percent.
The number of contingently issuable shares that
are included in the calculation of diluted EPS is
determined on the basis of the three-year averages
of both the revenue growth rate and operating
margins, which are calculated as follows: (1) the
actual revenue growth rate and operating margin
attained to date and (2) an assumption of zero
revenue growth rate and zero operating margin for
any remaining periods.
Entity A determines the number of shares to include in the calculation of diluted EPS by using the following
assumptions:
December 31, 20X1
No shares are included in the calculation of diluted EPS because:
- The three-year average revenue growth rate of 4 percent [(12% for 20X1 + 0% for 20X2 + 0% for 20X3) ÷ 3 years] is below 10 percent.
- The three-year average operating margin of 2 percent [(6% for 20X1 + 0% for 20X2 + 0% for 20X3) ÷ 3 years] is below 6 percent.
December 31, 20X2
No shares are included in the calculation of diluted EPS because:
- The three-year average revenue growth rate of 7 percent [(12% for 20X1 + 9% for 20X2 + 0% for 20X3) ÷ 3 years] is below 10 percent.
- The three-year average operating margin of 4 percent [(6% for 20X1 + 6% for 20X2 + 0% for 20X3) ÷ 3 years] is below 6 percent.
December 31, 20X3
The 1 million shares are included in the calculation of diluted EPS because:
- The three-year average revenue growth rate of 11 percent [(12% for 20X1 + 9% for 20X2 + 12% for 20X3) ÷ 3 years] is above 10 percent.
- The three-year average operating margin of 7 percent [(6% for 20X1 + 6% for 20X2 + 9% for 20X3) ÷ 3 years] is above 6 percent.
As noted in Example 12-1, in the above example, year-to-date amounts are used for simplicity.
12.4.2.3.2 Market-Based Awards
ASC 260-10
45-52 The number of shares contingently issuable may depend on the market price of the stock at a future date. In that case, computations of diluted EPS shall reflect the number of shares that would be issued based on the current market price at the end of the period being reported on if the effect is dilutive. If the condition is based on an average of market prices over some period of time, the average for that period shall be used. Because the market price may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied.
45-53 In some cases, the number of shares contingently issuable may depend on both future earnings and future prices of the shares. In that case, the determination of the number of shares included in diluted EPS shall be based on both conditions, that is, earnings to date and current market price — as they exist at the end of each reporting period. If both conditions are not met at the end of the reporting period, no contingently issuable shares shall be included in diluted EPS.
Assume that an award legally vests only if the entity’s share price increases by
more than 20 percent after the grant date. At the end of
each reporting period, the entity would assess whether its
share price has, in fact, increased by more than 20
percent after the grant date. If, at the end of a
reporting period, the market condition has been met, the
entity includes the award in the calculation of diluted
EPS. To determine the number of incremental shares to
include in the denominator of the calculation of diluted
EPS, the entity applies the treasury stock method if the
effect is dilutive on the basis of the antidilution
sequencing requirements of ASC 260.
However, if the entity’s share price has not increased by more than 20 percent
at the end of the reporting period, the award is not
included in the calculation of diluted EPS even if the
entity is recording compensation cost because it believes
that, for example, the employee will remain employed for
the derived service period. The award is excluded because
the market condition (i.e., the contingency) has not been
met as of the end of that reporting period. Moreover, if
an employee does remain employed for the derived service
period, the employee is deemed to have earned (i.e.,
vested in) the award. In this circumstance, the entity
will not reverse any previously recognized compensation
cost even if the market condition is never satisfied. If
the market condition is never satisfied, the shares
issuable under the award will never become issued and
outstanding. Therefore, the shares will never be included
in the weighted-average number of common shares (i.e., the
denominator in the calculation of basic and diluted
EPS).
12.4.3 Participating Securities and the Two-Class Method
ASC 260-10
Participating Securities and the Two-Class Method
45-59A The capital structures of some entities include:
a. Securities that may participate in dividends with common stocks according to a predetermined formula (for example, two for one) with, at times, an upper limit on the extent of participation (for example, up to, but not beyond, a specified amount per share)
b. A class of common stock with different dividend rates from those of another class of common stock but without prior or senior rights.
45-60 The two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise would have been available to common shareholders but does not require the presentation of basic and diluted EPS for securities other than common stock. The presentation of basic and diluted EPS for a participating security other than common stock is not precluded.
45-60A All securities that meet the definition of a participating security, irrespective of whether the securities are convertible, nonconvertible, or potential common stock securities, shall be included in the computation of basic EPS using the two-class method.
45-60B Under the two-class method:
- Income from continuing operations (or net income) shall be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends (or interest on participating income bonds) that must be paid for the current period (for example, unpaid cumulative dividends). Dividends declared in the current period do not include dividends declared in respect of prior-year unpaid cumulative dividends. Preferred dividends that are cumulative only if earned are deducted only to the extent that they are earned.
- The remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. The total earnings allocated to each security shall be determined by adding together the amount allocated for dividends and the amount allocated for a participation feature.
- The total earnings allocated to each security shall be divided by the number of outstanding shares of the security to which the earnings are allocated to determine the EPS for the security.
- Basic and diluted EPS data shall be presented for each class of common stock.
For the diluted EPS computation, outstanding common shares shall include all potential common shares assumed issued. Example 6 (see paragraph 260-10-55-62) illustrates the two-class method.
45-61 Fully vested
share-based compensation subject to the provisions
of Topic 718, including fully vested options and
fully vested stock, that contain a right to
receive dividends declared on the common stock of
the issuer, are subject to the guidance in
paragraph 260-10-45-60A.
45-61A Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method under the requirements of paragraph 260-10-45-60A.
45-62 Dividends or dividend equivalents transferred to the holder of a convertible security in the form of a reduction to the conversion price or an increase in the conversion ratio of the security do not represent participation rights. This guidance applies similarly to other contracts (securities) to issue an entity’s common stock if these contracts (securities) provide for an adjustment to the exercise price that is tied to the declaration of dividends by the issuer. The scope of the guidance in this paragraph excludes forward contracts to issue an entity’s own equity shares.
45-63 In a forward contract to issue an entity’s own equity shares, a provision that reduces the contract price per share when dividends are declared on the issuing entity’s common stock represents a participation right. Such a provision constitutes a participation right because it results in a noncontingent transfer of value to the holder of the forward contract for dividends declared during the forward contract period. That is, the forward contract holder has a right to participate in the undistributed earnings of the issuing entity because a dividend declaration by the issuing entity results in a transfer of value to the holder of the forward contract through a reduction in the forward purchase price per share. Because that value transfer is not contingent — as opposed to a similar reduction in the exercise price of an option or warrant — the forward contract is a participating security, regardless of whether, during the period the contract is outstanding, a dividend is declared.
45-64 Paragraph superseded by
Accounting Standards Update No. 2020-06.
45-65 Undistributed earnings for a period shall be allocated to a participating security based on the contractual participation rights of the security to share in those current earnings as if all of the earnings for the period had been distributed. If the terms of the participating security do not specify objectively determinable, nondiscretionary participation rights, then undistributed earnings would not be allocated based on arbitrary assumptions. For example, if an entity could avoid distribution of earnings to a participating security, even if all of the earnings for the year were distributed, then no allocation of that period’s earnings to the participating security would be made. Paragraphs 260-10-55-24 through 55-31 provide additional guidance on participating securities and undistributed earnings.
45-66 Under the two-class method the remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. This allocation is required despite its pro forma nature and that it may not reflect the economic probabilities of actual distributions to the participating security holders.
45-67 An entity would allocate losses to a nonconvertible participating security in periods of net loss if, based on the contractual terms of the participating security, the security had not only the right to participate in the earnings of the issuer, but also a contractual obligation to share in the losses of the issuing entity on a basis that was objectively determinable. Determination of whether a participating security holder has an obligation to share in the losses of the issuing entity in a given period shall be made on a period-by-period basis, based on the contractual rights and obligations of the participating security. The holder of a participating security would have a contractual obligation to share in the losses of the issuing entity if either of the following conditions is present:
- The holder is obligated to fund the losses of the issuing entity (that is, the holder is obligated to transfer assets to the issuer in excess of the holder’s initial investment in the participating security without any corresponding increase in the holder’s investment interest).
- The contractual principal or mandatory redemption amount of the participating security is reduced as a result of losses incurred by the issuing entity.
45-68 A convertible participating security should be included in the computation of basic EPS in periods of net loss if, based on its contractual terms, the convertible participating security has the contractual obligation to share in the losses of the issuing entity on a basis that is objectively determinable. The guidance in this paragraph also applies to the inclusion of convertible participating securities in basic EPS, irrespective of the differences that may exist between convertible and nonconvertible securities. That is, an entity should not automatically exclude a convertible participating security from the computation of basic EPS if an entity has a net loss from continuing operations. Determination of whether a participating security holder has an obligation to share in the losses of the issuing entity in a given period shall be made on a period-by-period basis, based on the contractual rights and obligations of the participating security.
45-68A Paragraph not used.
45-68B Paragraph 718-10-55-45 requires that nonrefundable dividends or dividend equivalents paid on awards for which the requisite service is not (or is not expected to be) rendered be recognized as additional compensation cost and that dividends or dividend equivalents paid on awards for which the requisite service is (or is expected to be) rendered be charged to retained earnings. As a result, an entity shall not include dividends or dividend equivalents that are accounted for as compensation cost in the earnings allocation in computing EPS. To do so would include the dividend as a reduction of earnings available to common shareholders from both compensation cost and distributed earnings. Undistributed earnings shall be allocated to all share-based payment awards outstanding during the period, including those for which the requisite service is not expected to be rendered (or is not rendered because of forfeiture during the period, if an entity elects to account for forfeitures when they occur in accordance with paragraph 718-10-35-3). An entity’s estimate of the number of awards for which the requisite service is not expected to be rendered (or no estimate, if the entity has elected to account for forfeitures when they occur in accordance with paragraph 718-10-35-3) for the purpose of determining EPS under this Topic shall be consistent with the estimate used for the purposes of recognizing compensation cost under Topic 718. Paragraph 718-10-35-3 requires that an entity apply a change in the estimate of the number of awards for which the requisite service is not expected to be rendered in the period that the change in estimate occurs. This change in estimate will affect net income in the current period; however, a current-period change in an entity’s expected forfeiture rate would not affect prior-period EPS calculations. See Example 9 for an illustration of this guidance.
45-69 Paragraph not used.
45-70 See Example 9 (paragraph 260-10-55-71) for an illustration of this guidance.
The two-class method is an earnings allocation formula under which a
participating security is treated as having rights to earnings that
would have otherwise been available to common shareholders. Entities
are required to use the two-class method to calculate basic and
diluted EPS if their capital structure includes common stock and
either (1) participating securities or (2) multiple classes of common
stock.
12.4.3.1 Participating Securities
ASC Master Glossary
Participating Security
A security that may participate in
undistributed earnings with common stock, whether
that participation is conditioned upon the
occurrence of a specified event or not. The form
of such participation does not have to be a
dividend — that is, any form of participation in
undistributed earnings would constitute
participation by that security, regardless of
whether the payment to the security holder was
referred to as a dividend.
Provided that an instrument’s participation feature is nondiscretionary and
objectively determinable, the instrument’s classification as a
participating security depends on the participation mechanism
and the nature of the participating instrument. The table below
discusses whether instruments typically included in capital
structures are considered participating securities.
Instrument | Form of “Participation” | Is the Instrument a Participating Security? |
---|---|---|
Debt instruments | Potential participation is paid in cash or the contractual maturity amount is
increased according to a formula tied to dividends
on common stock. | Yes |
Preferred stock
|
Potential participation is paid in cash
according to a formula tied to dividends on common
stock.
|
Yes
|
Holders of preferred stock are
entitled to receive a current-period dividend
before holders of common stock can be paid
dividends.
|
No
| |
Convertible debt and preferred
stock
| For convertible debt, potential participation is paid in cash or the contractual
maturity amount is increased according to a
formula tied to dividends on common stock.
For convertible preferred stock, potential
participation is paid in cash according to a
formula tied to dividends on common stock.
Preferred stockholders may also be entitled to a
stated return in addition to the dividend
participation. | Yes |
For
convertible debt, potential participation is
achieved through a reduction of the conversion
price or an increase in the conversion ratio.
For convertible preferred stock, potential
conversion is achieved through a reduction of the
conversion price (i.e., an increase in the
conversion ratio). |
No
| |
Options or warrants to sell
common stock
| Potential participation is paid in cash according to a formula tied to dividends
on common stock. |
Yes
|
Potential participation is
achieved through a reduction of the exercise price
or an increase in the number of shares upon
exercise.
|
No
| |
Forward contract to sell
common stock
| Potential participation is achieved through a reduction of the forward price or
an increase in the number of shares under the
forward contract. | It depends. A facts-and-circumstances analysis must be performed |
A formula that adjusts the forward price and the number of shares under the
forward contract, depending on the market price of
the stock as of the date the forward contract is
settled. | It depends. A facts-and-circumstances analysis must be performed |
As noted in the ASC master glossary definition of a participating security, participation does not
need to be in the form of a dividend. Any participation by a
security in the distribution of a company’s earnings (under an
assumption that there is a full distribution of earnings) would
constitute participation, regardless of whether a cash payment
is, or would be accounted for as, a dividend.
Example 12-6
Warrants
on Common Stock With Yield Rights
Entity J issues warrants to
sell common stock that entitle the counterparty to
a yield right, payable in cash, equal to 25
percent of the dividends J pays on its common
stock for each common share into which the
warrants are exercisable. Although the yield right
is not labeled as a dividend, it is a
participation right because the holder of the
warrants is entitled to share in dividends
declared on J’s common stock without exercising
the warrants. Therefore, the two-class method of
calculating EPS must be applied to the warrants.
Regardless of whether J declared any dividends
during the period, it must allocate undistributed
earnings to the warrants.
Note that in this example, the warrants are
considered participating securities regardless of
the extent of participation. That is, because of
the holders’ entitlement to any participation in
dividends (i.e., between 1 and 100 percent), the
warrants meet the definition of a participating
security. However, if dividends paid by an entity
are held in abeyance and paid to a warrant holder
only upon exercise, such warrants would not be
considered participating securities.
12.4.3.1.1 Dividend-Paying Share-Based Payment Awards — Before Vesting
An award is a participating security if, during the vesting period, it contains
a nonforfeitable right to
dividends or dividend equivalents that participate in the
distribution of earnings with common stock. That is, an
award is considered a participating security if it accrues
cash dividends (whether paid or unpaid) any time the
common shareholders receive dividends — when those
dividends do not need to be returned to an entity if the
grantee forfeits the awards. The entity is required to
apply the two-class method when calculating basic and
diluted EPS. By contrast, if the right to dividends or
dividend equivalents is forfeitable with the underlying
award, the award is not considered a participating
security.
12.4.3.1.2 Dividend-Paying Share-Based Payment Awards — After Vesting
ASC 260-10-45-61 states:
Fully vested share-based compensation subject to the provisions of Topic 718,
including fully vested options and fully vested
stock, that contain a right to receive dividends
declared on the common stock of the issuer, are
subject to the guidance in paragraph
260-10-45-60A.
After an award has vested, it is a participating security if it contains a right
to receive dividends or dividend equivalents with common
shareholders, because the right is nonforfeitable when the
award vests. Therefore, an entity must apply the two-class
method when calculating basic and diluted EPS unless the
shares become outstanding common shares. For example, the
two-class method does not apply to a restricted stock
award after a grantee receives outstanding common shares
because the good has been delivered or the service has
been rendered. Once the award becomes outstanding common
shares, the entity includes those shares in the
weighted-average number of common shares outstanding
(i.e., the denominator in the calculation of basic
EPS).
12.4.3.2 Calculation Under the Two-Class Method
When an entity’s capital structure includes
participating securities but only a single class of common
stock, the entity uses the following three-step process to
calculate basic and diluted EPS:
Step 1 | Use the two-class method to calculate basic EPS.2 |
Step 2 | Use the total earnings allocated to the common stock in step 1 to determine
diluted EPS. If the participating security is also
a potential common share, separately perform steps
2a and 2b to determine the dilutive effect. |
Step 2a | Assume that the participating security has been exercised, converted, or issued;
that is, apply the treasury stock method, the
if-converted method, or the contingently issuable
share method. |
Step 2b | Add back the undistributed earnings allocated to the participating security (or
securities) in arriving at basic EPS, and assume
that all other dilutive potential common shares
have been exercised, converted, or issued in the
order in which they are antidilutive. Next,
reallocate the undistributed earnings, including
any additional income that would result from the
exercise, conversion, or issuance of potential
common shares, to the (1) common shares and
potential common shares and (2) participating
security (or securities). |
Step 3 | Determine which step — 2a or 2b — results in the more dilutive effect. |
While an entity is required to present on the face of the income statement basic and diluted EPS for its common stock, the entity is permitted, but not required, to present basic and diluted EPS for a participating security.
The examples below illustrate (1) the calculation of basic and diluted EPS under the two-class method and (2) the use of this three-step process to determine diluted EPS.
Example 12-7
Use of the Two-Class Method to Calculate Basic and Diluted
EPS — Participating Convertible Preferred
Stock
Assume that Entity A has 1 million weighted-average shares of common stock
outstanding for the fiscal year ended December 31,
20X1; a current-period net income of $5 million;
and an effective tax rate of 40 percent.
On January 1, 20X1, A issues 100,000 convertible preferred securities. Each
preferred share is convertible into two shares of
A’s common stock. The preferred shareholders are
entitled to a noncumulative annual dividend of $5
per share before any dividend is paid to the
common shareholders. After the common shareholders
are paid a dividend of $2 per share, the preferred
shareholders participate in any remaining
undistributed earnings on a 40:60 per-share basis
with the common shareholders. Accordingly, the
preferred securities are participating securities
for which A must use the two-class method to
calculate basic and diluted EPS. In fiscal year
20X1, A declares and pays $2.5 million in
dividends (or a $5 dividend for preferred
shareholders and a $2 dividend for common
shareholders).
The calculations under the two-class method are as follows:
Step 1 — Use the two-class method to
calculate basic EPS.
Allocation of undistributed earnings:
To participating convertible preferred
shares:
{(0.4 × 100,000 preferred
shares*) ÷ [(0.4 × 100,000 preferred shares*) +
(0.6 × 1,000,000 common shares**)]} × $2,500,000
undistributed earnings*** = $156,250
$156,250 ÷ 100,000
preferred shares* = $1.56 per share
To common shares:
{(0.6 × 1,000,000 common
shares**) ÷ [(0.4 × 100,000 preferred shares*) +
(0.6 × 1,000,000 common shares**)]} × $2,500,000
undistributed earnings*** = $2,343,750
$2,343,750 ÷ 1,000,000
common shares** = $2.34 per share
|
* Weighted-average number of participating
convertible preferred shares outstanding.
** Weighted-average number of common shares
outstanding.
*** Total undistributed earnings for the
period.
|
Basic EPS amounts:
Step 2 — Determine diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the
contingently issuable share method to determine
diluted EPS.
Determine the antidilution sequencing:
Since there are no potential common shares other than the participating
convertible preferred shares, A determines that
antidilution sequencing is not required.
Calculation of diluted EPS for the common shares in which the use of the
if-converted method for the participating
convertible preferred shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Because A’s capital structure only includes common shares and participating convertible preferred shares (i.e., there are no other potential common shares), basic and diluted EPS would be the same under the two-class method ($4.34).
Step 3 — Determine which step — 2a or 2b — results in the
more dilutive effect.
In this example, A would disclose an amount of diluted EPS per common share that
would result from applying the if-converted method
($4.17) because that amount is more dilutive than
the amount that would result from applying the
two-class method ($4.34). In accordance with ASC
260-10-45-60, A would be permitted, but not
required, to present basic and diluted EPS for the
participating convertible preferred shares on the
face of the income statement.
Example 12-8
Use of the
Two-Class Method to Calculate Basic and Diluted
EPS — Participating Convertible Preferred Stock
With Convertible Debt and Warrants
Assume that Entity B has 1
million weighted-average common shares stock
outstanding for the fiscal year ended December 31,
20X1; a current-period net income of $5 million;
and an effective tax rate of 40 percent.
On January 1, 20X1, B issues 100,000
convertible preferred securities. Each preferred
share is convertible into two shares of B’s common
stock. The preferred shareholders are entitled to
a noncumulative annual dividend of $5 per share
before any dividend is paid to the common
shareholders. After the common shareholders are
paid a dividend of $2 per share, the preferred
shareholders participate in any remaining
undistributed earnings on a 40:60 per-share basis
with the common shareholders. Accordingly, the
preferred securities are participating securities
for which B must use the two-class method to
calculate basic and diluted EPS. In fiscal year
20X1, B declares and pays $2.5 million in
dividends (or a $5 dividend for preferred
shareholders and a $2 dividend for common
shareholders).
In addition, assume the
following:
-
On January 1, 20X1, B issues warrants to purchase 100,000 shares of its common stock at $50 per share for a period of five years. The average market price of B’s stock price for 20X1 was $60 per share. The warrants do not meet the definition of a participating security.
-
On January 1, 20X1, B issues 10,000 units of convertible bonds with an aggregate par value of $1 million. Each bond is convertible into 10 shares of B’s common stock and bears an interest rate of 3 percent. The convertible bonds do not meet the definition of a participating security.
The calculations under the
two-class method are as follows:
Step 1
— Use the two-class method to calculate basic
EPS.
Allocation of undistributed earnings:
To participating convertible
preferred shares:
{(0.4 ×
100,000 preferred shares*) ÷ [(0.4 × 100,000
preferred shares*) + (0.6 × 1,000,000 common
shares**)]} × $2,500,000 undistributed earnings***
= $156,250
$156,250
÷ 100,000 preferred shares* = $1.56 per share
To common shares:
{(0.6 ×
1,000,000 common shares**) ÷ [(0.4 × 100,000
preferred shares*) + (0.6 × 1,000,000 common
shares**)]} × $2,500,000 undistributed earnings***
= $2,343,750
$2,343,750 ÷ 1,000,000 common shares** = $2.34
per share
|
* Weighted-average number of
participating convertible preferred shares
outstanding.
** Weighted-average number of
common shares outstanding.
*** Total undistributed
earnings for the period.
|
Basic EPS amounts:
This calculation is the same
as the calculation of basic EPS in Example
12-7, because basic EPS is not affected
by the warrants and convertible debt since neither
security is a participating security.
Step 2
— Determine diluted EPS.
Step 2a — Use the treasury
stock method, the if-converted method, or the
contingently issuable share method to determine
diluted EPS.
Determine the antidilution
sequencing:
Calculation of diluted EPS for
the common shares in which the use of the
if-converted method for the participating
convertible preferred shares is assumed:
Step 2b — Use the two-class
method to determine diluted EPS.
Step 3
— Determine which Step — 2a or 2b — results in the
more dilutive effect.
In this example, B would
disclose an amount of diluted EPS per common share
that would result from applying the if-converted
methods ($3.81) because that amount is more
dilutive than the amount that would result from
applying the two-class method ($3.92). In
accordance with ASC 260-10-45-60, B would be
permitted, but not required, to present basic and
diluted EPS for the participating convertible
preferred shares on the face of the income
statement.
Example 12-9
Use of the Two-Class Method to Calculate Basic and Diluted
EPS — Participating Nonvested Share-Based Payment
Awards
Assume that Entity C has 1 million weighted-average shares of common stock
outstanding for the fiscal year ended December 31,
20X1; a current-period net income of $5 million;
and an effective tax rate of 40 percent.
On January 1, 20X1, C issues 250,000 nonvested share-based payment awards to its
employees. The nonvested shares have a grant-date
fair-value-based measure of $50 per share and vest
at the end of the fourth year of service (i.e.,
cliff vesting). The average market price of A’s
stock price for 20X1 was $60 per share.
Holders of nonvested shares have a nonforfeitable right to receive cash
dividends on a 1:1 per-share basis with the common
shareholders. Accordingly, the nonvested shares
are participating securities for which C must use
the two-class method in calculating basic and
diluted EPS. In fiscal year 20X1, C declares and
pays $2.5 million in dividends for both the common
shares and the nonvested shares.
Step 1 — Use
the two-class method to calculate
basic EPS.
Allocation of undistributed earnings:
To shares of restricted stock:
[250,000 shares of
restricted stock* ÷ (250,000 shares of restricted
stock* + 1,000,000 common shares**)] × $2,500,000
undistributed earnings*** = $500,000
$500,000 ÷ 250,000 shares
of restricted stock* = $2.00 per share
To common shares:
[1,000,000 common shares**
÷ (250,000 shares of restricted stock* + 1,000,000
common shares**] × $2,500,000 undistributed
earnings*** = $2,000,000
$2,000,000 ÷ 1,000,000
common shares** = $2.00 per share
|
* Weighted-average number of participating
restricted shares outstanding.
** Weighted-average number of common shares
outstanding.
*** Total undistributed earnings for the
period.
|
Basic EPS amounts:
Step 2 — Determine diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the
contingently issuable share method to determine
diluted EPS.
Determine the antidilution sequencing:
Because there are no potential common shares other than the participating
nonvested shares, antidilution sequencing is not
required.
Calculation of diluted EPS for the common shares in which the use of the
treasury stock method for the participating
nonvested shares is assumed:
Step 2b — Use the Two-Class Method to Determine Diluted EPS.
Because A’s capital structure only includes common shares and the participating shares of restricted stock (i.e., there are no other potential common shares), basic and diluted EPS would be the same under the two-class method ($4.00).
Step 3 — Determine which step — 2a or 2b — results in the
more dilutive effect.
In this example, C would disclose an amount of diluted EPS per common share that
would result from applying the two-class method
($4.00) because that amount is more dilutive than
the amount that would result from applying the
treasury stock method ($4.68). In accordance with
ASC 260-10-45-60, C would be permitted, but not
required, to present basic and diluted EPS for the
participating shares of restricted stock on the
face of the income statement.
Example 12-10
Use of the
Two-Class Method to Calculate Basic and Diluted
EPS — Participating Nonvested Share-Based Payment
Awards With Convertible Debt and Warrants
Assume that Entity D has 1 million
weighted-average shares of common stock
outstanding for the fiscal year ended December 31,
20X1; a current-period net income of $5 million;
and an effective tax rate of 40 percent.
On January 1, 20X1, D issues 250,000 nonvested
share-based payment awards to its employees. The
nonvested shares have a grant-date
fair-value-based measure of $50 per share and vest
at the end of the fourth year of service (i.e.,
cliff vesting). The average market price of D’s
stock price for 20X1 is $60 per share. Holders of
nonvested shares have a nonforfeitable right to
receive cash dividends on a 1:1 per-share basis
with the common shareholders. Accordingly, the
nonvested shares are participating securities for
which D must use the two-class method in
calculating basic and diluted EPS. In fiscal year
20X1, D declares and pays $2.5 million in
dividends for both the common shares and the
nonvested shares.
In addition, assume the
following:
-
On January 1, 20X1, D issues warrants to purchase 100,000 shares of its common stock at $40 per share for a period of five years. The warrants do not meet the definition of a participating security.
-
On January 1, 20X1, D issues 10,000 units of convertible bonds with an aggregate par value of $1 million. Each bond is convertible into 10 shares of D’s common stock and bears an interest rate of 3 percent.
Step 1
— Use the two-class Method to compute basic
EPS.
Allocation of undistributed earnings:
To shares of restricted stock:
[250,000 shares of
restricted stock* ÷ (250,000 shares of restricted
stock* + 1,000,000 common shares**)] × $2,500,000
undistributed earnings*** = $500,000
$500,000 ÷ 250,000 shares
of restricted stock* = $2.00 per share
To common shares:
[1,000,000 common shares**
÷ (250,000 shares of restricted stock* + 1,000,000
common shares**)] × $2,500,000 undistributed
earnings*** = $2,000,000
$2,000,000 ÷ 1,000,000
common shares** = $2.00 per share
|
* Weighted-average number of participating
restricted shares outstanding.
** Weighted-average number of common shares
outstanding.
*** Total undistributed earnings for the
period.
|
Basic EPS amounts:
Note that this calculation is
the same as the calculation of basic EPS in
Example 12-9 because basic EPS is not
affected by the warrants and convertible debt
since neither security is a participating
security.
Step 2
— Determine diluted EPS.
Step 2a — Use the treasury
stock method, the if-converted method, or the
contingently issuable share method to determine
diluted EPS
Determine the antidilution
sequencing:
Calculation of diluted EPS for
the common shares in which the use of the treasury
stock method for the participating nonvested
shares is assumed:
Step 2b — Use the two-class
method to determine diluted EPS.
Step 3
— Determine which Step — 2a or 2b — results in the
more dilutive Effect
In this example, D would use
the two-class method to disclose diluted EPS per
common share ($3.58) because that amount is more
dilutive than the amount that would result from
applying the if-converted method ($4.18). In
accordance with ASC 260-10-45-60, D would be
permitted, but not required, to present basic and
diluted EPS for the participating shares of
restricted stock on the face of the income
statement.
12.4.4 Settlement in Shares or Cash
ASC 260-10
Share-Based Payment
Arrangements
45-30 If share-based payment
arrangements are payable in common stock or in
cash at the election of either the entity or the
grantee, the determination of whether such
share-based awards are potential common shares
shall be made based on the provisions in paragraph
260-10-45-45. If an entity has a tandem award (as
defined in Topic 718) that allows the entity or
the grantee to make an election involving two or
more types of equity instruments, diluted EPS for
the period shall be computed based on the terms
used in the computation of compensation cost for
that period.
Contracts That May Be Settled in Stock or Cash
45-45 The
effect of potential share settlement shall be
included in the diluted EPS calculation (if the
effect is more dilutive) for an otherwise
cash-settleable instrument that contains a
provision that requires or permits share
settlement (regardless of whether the election is
at the option of an entity or the holder, or the
entity has a history or policy of cash
settlement). An example of such a contract
accounted for in accordance with this paragraph
and paragraph 260-10-45-46 is a written call
option that gives the holder a choice of settling
in common stock or in cash. An election to share
settle an instrument, for purposes of applying the
guidance in this paragraph, does not include
circumstances in which share settlement is
contingent upon the occurrence of a specified
event or circumstance (such as contingently
issuable shares). In those circumstances (other
than if the contingency is an entity’s own share
price), the guidance on contingently issuable
shares should first be applied, and, if the
contingency would be considered met, then the
guidance in this paragraph should be applied.
Share-based payment arrangements that are payable
in common stock or in cash at the election of
either the entity or the grantee shall be
accounted for pursuant to this paragraph and
paragraph 260-10- 45-46, unless the share-based
payment arrangement is classified as a liability
because of the requirements in paragraph
718-10-25-15 (see paragraph 260-10-45-45A for
guidance for those instruments). If the payment of
cash is required only upon the final liquidation
of an entity, then the entity shall include the
effect of potential share settlement in the
diluted EPS calculation until the liquidation
occurs.
45-45A For a
share-based payment arrangement that is classified
as a liability because of the requirements in
paragraph 718-10-25-15 and may be settled in
common stock or in cash at the election of either
the entity or the holder, determining whether that
contract shall be reflected in the computation of
diluted EPS shall be prepared on the basis of the
facts available each period. It shall be presumed
that the contract will be settled in common stock
and the resulting potential common shares included
in diluted EPS (in accordance with the relevant
guidance of this Topic) if the effect is more
dilutive. The presumption that the contract will
be settled in common stock may be overcome if past
experience or a stated policy provides a
reasonable basis to conclude that the contract
will be paid partially or wholly in cash.
45-46 A contract that is
reported as an asset or liability for accounting
purposes may require an adjustment to the
numerator for any changes in income or loss that
would result if the contract had been reported as
an equity instrument for accounting purposes
during the period. That adjustment is similar to
the adjustments required for convertible debt in
paragraph 260-10-45-40(b).
45-47 Paragraphs 260-10-55-32 through 55-36A provide additional guidance on contracts that may be settled in stock or cash.
Contracts That May Be Settled in Stock or Cash
55-32
Adjustments shall be made to the numerator for
contracts that are asset or liability classified,
in accordance with Section 815-40-25, but for
which the potential common shares are included in
the denominator in accordance with the guidance in
paragraph 260-10-45-45. For purposes of computing
diluted EPS, the adjustments to the numerator are
only permitted for instruments for which the
effect on net income (the numerator) is different
depending on whether the instrument is accounted
for as an equity instrument or as an asset or
liability (for example, those that are within the
scope of Subtopics 480-10 and 815-40).
Share-based payment awards that cannot be settled in the entity’s shares (e.g.,
liability-classified, cash-settled SARs) are not included in the
denominator of basic or diluted EPS. That is, share-based payment
awards that always must be settled in cash are
not included in the denominator in the EPS calculation. However, the
compensation cost recorded in net income (and therefore income
available to common shareholders) will affect the numerator in the EPS
calculation.
Conversely, a share-based payment award that can be settled in cash or shares is
evaluated under ASC 260-10-45-45 through 45-47. Subject to one
exception, regardless of whether the election to settle in cash or
shares is at the option of the issuing entity or the holder, the
entity must include the incremental number of shares that results from
applying the treasury stock method in the denominator of the
calculation of diluted EPS if the effect is dilutive on the basis of
the antidilution sequencing requirements of ASC 260. If the award is
classified as a liability, an entity may be required to adjust the
numerator in accordance with ASC 260-10-45-46. This adjustment is made
to remove the incremental effect of accounting for the award as a
liability (i.e., so that the numerator reflects only the compensation
cost that would have been recognized if the award had been classified
as equity). In addition, in calculating the average unrecognized cost
of the arrangement under the treasury stock method, the entity should
use the amount of cost that would have been left unrecognized if the
award had been classified as equity.
The one exception to the requirement to assume share settlement is
related to a share-based payment award that is classified as a
liability because of the requirements in ASC 718-10-25-15. For these
awards, if past experience or a stated policy provides a reasonable
basis for an entity to conclude that the arrangement will be settled
in cash, no incremental shares need to be included in the denominator
of the calculation of diluted EPS.3 In addition, no adjustment to the numerator is needed since the
assumed settlement for diluted EPS is aligned with the accounting
classification. See ASC 260-10-45-45A for additional discussion.
Changing Lanes
ASU 2020-06 eliminated the ability to
overcome the presumption of share settlement for contracts
other than share-based payment arrangements. For
share-based payment arrangements, the FASB decided to
retain the existing guidance. Paragraph BC114 of ASU
2020-06 states:
The classification
guidance in Topic 718 is different from the
classification guidance in Subtopic 815-40.
Specifically, the guidance in paragraph 718-10-25-15
states that “. . . 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.” Under current GAAP, a
liability-classified stock-based compensation
arrangement may not be included in diluted EPS
because of the existing guidance on contracts that
may be settled in cash or shares. The Board decided
to retain the current guidance for calculating
diluted EPS for stock-based compensation because
those arrangements are not within the scope of this
project.
12.4.5 Early Exercise of Stock Options
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 good has been delivered or the service has been rendered (i.e., before the award vests). If the employee terminates employment before rendering the requisite service (or a nonemployee forfeits the award before completion of the vesting period), the entity 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 is effectively to require the grantee to satisfy the vesting conditions to receive any economic benefit from the award. Early exercise is therefore not considered to be a substantive exercise for accounting purposes. See Section 3.4.3 for additional information.
12.4.5.1 Basic EPS
The shares issued to a grantee upon an award’s early exercise would not be
considered outstanding for basic EPS purposes until the award’s
vesting conditions have been satisfied. This conclusion is
consistent with the intent of ASC 260-10- 45-13, which is that
shares that are subject to a contingent repurchase provision, as
described above, are excluded from the calculation of basic EPS
until the shares are no longer contingently returnable (i.e.,
the entity’s call option lapses).
However, if the shares subject to repurchase contain nonforfeitable rights to
dividends or dividend equivalents, the shares are participating
securities. That is, an award is considered a participating
security if it accrues cash dividends (whether paid or unpaid)
any time the common shareholders receive dividends that do not
need to be returned to the entity if the grantee forfeits the
award. If legally issued shares are considered participating
securities, the entity must use the two-class method to
calculate basic EPS. See Section 12.4.3 for a
discussion of the two-class method.
12.4.5.2 Diluted EPS
After a grantee early exercises an option, the entity continues to use the
treasury stock method to calculate diluted EPS. When using this
method to calculate the number of incremental shares to be
included in diluted EPS, the entity normally is required to
include the exercise price of the award in the calculation of
assumed proceeds in accordance with ASC 260-10-45-29. (See
Section
12.4.2.1 for a discussion of the application of
the treasury stock method to share-based payment awards.)
However, in this case, because the grantee has early exercised
the award and has therefore already paid cash, (1) there is no
cash that will be received from the grantee in the future and
(2) the cash received hypothetically could have already been
used to repurchase shares during the requisite service period
(or before the nonemployee award has vested). As a result, the
cash received is not included in the calculation of assumed
proceeds.
When calculating diluted EPS for an early exercised award that is considered a
participating security, an entity must determine whether the
treasury stock method or the two-class method is more
dilutive.
12.4.6 Employee Stock Purchase Plans
12.4.6.1 General
An ESPP is a share-based payment plan that is
usually offered to a broad base of employees so that they can
participate in ownership of the entity, generally at a
discounted price. Employees contribute to the plan through
payroll deductions during the purchase period (e.g., six
months). At the end of the purchase period, the employer’s stock
is purchased at the purchase price, which is generally a
discounted price. See Chapter 8 for a
discussion of ESPPs.
The effect that an ESPP has on an entity’s EPS
depends on the terms of the plan. Generally, the participating
employees can choose not to purchase the shares and can have
their withholdings during the purchase period refunded because
either (1) the employees can elect to have previous withholdings
refunded before the end of the purchase period or (2) the shares
will not be purchased if the employee fails to provide the
requisite service (i.e., if the employee terminates employment
before the end of the purchase period). In practice, it is
atypical for an employee’s withholdings during the purchase
period not to be refundable because participants are generally
not allowed to purchase shares at the end of the purchase period
if they are no longer employed by the entity. However, the
section below addresses the EPS accounting for ESPPs for which
the participating employees are unable to receive a refund of
withholdings made during the purchase period.
12.4.6.2 Withholdings Are Not Refundable
If the terms of the ESPP do not allow employees to
choose not to purchase the shares (i.e., an employee’s
participation is irrevocable because the employee is not
entitled to a refund of amounts previously withheld during the
purchase period, regardless of whether the employee is
terminated), the guidance on contingently issuable shares
applies to the calculation of basic and diluted EPS. According
to this guidance, the number of shares, if any, that would be
issuable at the end of the reporting period, under the
assumption that the end of the reporting period is the end of
the purchase period (this number is based on the amounts
withheld by the entity to date), is included in the
weighted-average number of common shares outstanding for basic
and diluted EPS.
12.4.6.3 Withholdings Are Refundable
12.4.6.3.1 Basic EPS
If the terms of the ESPP allow employees to
choose not to purchase the shares (i.e., employees are
entitled to a refund of amounts previously withheld during
the purchase period either at their election or upon
termination of employment), the shares issuable under the
ESPP are treated as employee stock options that are
granted as of the beginning of the purchase period.
Accordingly, the shares issuable under the ESPP are not
included in the denominator of the calculation of basic
EPS until they have been actually issued. The fact that
the shares issuable under the ESPP are not included in
basic EPS during the purchase period is based on the
guidance in ASC 260-10-45-12C on contingently issuable
shares.
12.4.6.3.2 Diluted EPS
As discussed in the previous section, when
the terms of the ESPP allow employees to choose not to
purchase the shares, the shares issuable under the ESPP
are treated as employee stock options that are granted as
of the beginning of the purchase period. Accordingly, the
shares issuable under the ESPP are included in the
denominator of diluted EPS under the treasury stock
method, as discussed in ASC 260-10-45-22 through 45-29A.
To apply the treasury stock method to an ESPP, an entity
must also apply the guidance on contingently issuable
shares, as discussed in ASC 260-10-45-48 and 45-49 and ASC
260-10-45-52.
Because the participants’ ability to purchase shares under an
ESPP is based on a service condition, the grant date and
service inception date are the start date of the purchase
period provided that all conditions for establishing a
grant date have been met. The withholding of amounts from
the employees’ pay during the purchase period merely
represents the funding mechanism for the eventual payment
of the exercise price. This withholding mechanism does not
affect the grant date or service inception date of the
ESPP.
The number of incremental common shares to be included in the
calculation of diluted EPS is based on the number of
shares that would be issuable if the reporting date were
the end of the contingency period (i.e., the purchase
period) in accordance with ASC 260-10-45-52, net of the
hypothetical shares that could be repurchased in
accordance with the treasury stock method. Therefore, the
sponsor of an ESPP must consider each of the following to
calculate the effect of the ESPP on diluted EPS:
- Employee withholdings —
The amount of employee withholdings represents the
exercise price for the shares to be purchased by
employees and is also used to calculate the number
of shares assumed to be issued during the purchase
period. For diluted EPS purposes, this amount
should represent the total amount of employee
withholdings expected to be made during the entire
purchase period.4 To estimate this amount, entities should
consider the elections made by participating
employees. Expected forfeitures may affect the amount of recognized compensation cost during the purchase period but should not be factored into the estimation of employee withholdings. As discussed in Section 12.4.2.1.4, regardless of an entity’s accounting policy election related to how it reflects forfeitures in the recognition of compensation cost, the denominator in the calculation of diluted EPS is based on the actual number of awards outstanding (i.e., the number of awards is reduced only for actual forfeitures) in a given reporting period provided that the effect is dilutive.Changes to employee withholding elections during the purchase period are treated as modifications and are only reflected in EPS prospectively.
- Purchase price formula — The purchase price of an ESPP is generally based on the lesser of the stock price at the beginning of the purchase period and that at the end of the purchase period; therefore, the sponsor will need to consider its stock price as of both the beginning of the purchase period and the end of the reporting period. The stock price as of the end of the reporting period is used as the proxy for the stock price as of the end of the purchase period in accordance with the guidance in ASC 260-10-45-52 on contingently issuable shares. The sponsor would use the lower of these two stock prices to calculate the purchase price when the ESPP allows employees to purchase shares on the basis of a formula that incorporates the lesser of the stock price at the beginning and that at the end of the purchase period.
- Average unrecognized compensation cost — The average amount of unrecognized compensation cost attributable to future service, if any, is a component of the assumed proceeds under the treasury stock method.
The incremental number of common shares
included in diluted EPS is calculated as follows (see also
Example 12-11):
Number of shares assumed issued under the ESPP:
Employee withholdings
(item 1 above) ÷ purchase price (item 2
above)
less
Number of shares assumed repurchased:
Assumed proceeds (i.e.,
employee withholdings [item 1 above] plus average
unrecognized compensation cost [item 3 above]) ÷
average market price of the issuer’s stock for the
reporting period
Connecting the Dots
Unlike an entity’s accounting for diluted EPS for
early exercised stock options, an entity may
include the money withheld (and expected to be
withheld during the remaining purchase period)
from employees’ pay as a component of the assumed
proceeds in calculating diluted EPS for ESPPs.
These withholdings are not considered a prepayment
of the exercise price for diluted EPS purposes
because the entity must refund such amounts to
employees that do not ultimately purchase shares
under the ESPP. (This requirement differs from the
terms of early exercised stock options.)
Example
12-11
Diluted EPS for
ESPP
On July 1, 20X1, Entity A establishes a
qualified ESPP that allows its employees to
purchase shares of its common stock during a
six-month purchase period that begins on July 1,
20X1, and ends on December 31, 20X1. The ESPP
permits A’s employees to elect to withhold up to
10 percent of their salary to purchase A’s common
stock at the end of the purchase period. Employees
may make their election at any time during the
purchase period, but once the election is made it
cannot be changed during the purchase period. The
shares will be purchased at a price per share that
is equal to the lesser of (1) 90 percent of A’s
stock price as of July 1, 20X1, or (2) 90 percent
of A’s stock price as of December 31, 20X1.
Participants are allowed to withdraw from the ESPP
at any time before the end of the purchase period
and are automatically withdrawn if they are
terminated before the end of the purchase period.
For any such withdrawals, A must refund the
amounts withheld from the participant’s pay.
Shares are issued under the ESPP on January 1,
20X2.
Assumptions related to A’s calculation of
diluted EPS for the quarterly period ended
September 30, 20X1, include the following:
- Common stock prices per share:
- July 1, 20X1 — $50.
- September 30, 20X1 — $40.
- Average market price during the period beginning on July 1, 20X1, and ending on September 30, 20X1 — $45.
- Employee payroll withholdings:
- Actual through September 30, 20X1 — $3.5 million.
- Expected from October 1, 20X1, through December 31, 20X1 — $3.7 million.
- Average unrecognized compensation cost for the period — $1.3 million.
The effect on diluted EPS of the ESPP for the
quarterly period ended September 30, 20X1, is
calculated as follows:
The shares issuable under the
ESPP would be included in basic EPS prospectively
once they are issued (i.e., on January 1, 20X2).
While not relevant to this example, if the
purchase period ended during a quarterly financial
reporting period, in addition to including the
shares as outstanding on a weighted-average basis
for the period, an entity would need to include
incremental shares in diluted EPS on a
weighted-average basis for the portion of the
quarterly period for which the shares had not yet
been issued. See Section
4.2.2.1.3.1 of Deloitte’s Roadmap
Earnings per
Share for further discussion.
Connecting the Dots
ASC 260-10-45-21A states:
Changes in an entity’s share
price may affect the exercise price of a financial
instrument or the number of shares that would be
used to settle the financial instrument. For
example, when the principal of a convertible debt
instrument is required to be settled in cash but
the conversion premium is required to (or may) be
settled in shares, the number of shares to be
included in the diluted EPS denominator is
affected by the entity’s share price. In applying
both the treasury stock method and the
if-converted method of calculating diluted EPS,
the average market price shall be used for
purposes of calculating the denominator for
diluted EPS when the number of shares that may be
issued is variable, except for contingently
issuable shares within the scope of the guidance
in paragraphs 260-10-45-48 through 45-57. See
paragraphs 260-10-55-4 through 55-5 for
implementation guidance on determining an average
market price.
In accordance with this guidance, the number of
shares assumed to be issued under an ESPP would be
calculated by using the average market price of
the entity’s stock. However, before ASC
260-10-45-21A was added by ASU 2020-06, entities
applied the guidance on contingently issuable
shares in ASC 260-10-45-52 to calculate the number
of shares assumed to be issued under an ESPP (as
noted in the guidance and example above). This
guidance is consistent with footnote 1 of FASB
Technical Bulletin 97-1 (superseded), which
indicated that an entity applies the guidance on
contingently issuable shares to determine the
accounting for diluted EPS.
On the basis of informal discussions with the
FASB staff, we understand that the amendments made
to ASC 260 by ASU 2020-06 (i.e., the addition of
ASC 260-10-45-21A) were not intended to address
when the guidance on contingently issuable shares
applies to the calculation of diluted EPS. Indeed,
ASC 260-10-45-21A specifically states that these
amendments do not apply to contingently issuable
shares. Therefore, we believe that the accounting
for diluted EPS that entities applied in practice
before adopting ASU 2020-06 is still acceptable.
However, because it is often difficult to
determine when to apply the guidance on
contingently issuable shares in ASC 260, it would
also be acceptable for an entity to apply the
guidance in ASC 260-10-45-21A on variable
denominators to calculate the number of shares
assumed to be issued under an ESPP. Such
accounting for diluted EPS would represent an
accounting policy election that must be applied
consistently.
If ASC 260-10-45-21A is applied
to calculate the number of shares assumed to be
issued in Example 12-11,
the number of shares would equal 177,778 (i.e.,
total expected withholdings of $7,200,000 divided
by $40.50 [$45 average market price for the period
multiplied by 90 percent]). As a result, the ESPP
would be antidilutive for the period since the
number of shares assumed to be repurchased would
be greater than the number of shares assumed to be
issued. This example illustrates that an entity’s
application of ASC 260-10-45-21A to calculate the
number of shares assumed to be issued in an ESPP
would result in less dilution (or no dilution)
compared with application of the contingently
issuable share method.
12.4.7 Redeemable Awards
ASC 260-10
Certain Redeemable Financial Instruments
45-70A Paragraph 480-10-45-4 provides guidance on calculating basic and diluted EPS if an entity has mandatorily redeemable shares of common stock or has entered into certain forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares of common stock.
ASC 480-10
EPS
45-4 Entities that have
issued mandatorily redeemable shares of common
stock or entered into forward contracts that
require physical settlement by repurchase of a
fixed number of the issuer’s equity shares of
common stock in exchange for cash shall exclude
the common shares that are to be redeemed or
repurchased in calculating basic and diluted
earnings per share (EPS). Any amounts, including
contractual (accumulated) dividends and
participation rights in undistributed earnings,
attributable to shares that are to be redeemed or
repurchased that have not been recognized as
interest costs in accordance with paragraph
480-10-35-3 shall be deducted in computing income
available to common shareholders (the numerator of
the EPS calculation), consistently with the
two-class method set forth in paragraphs
260-10-45-60 through 45-70.
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(21) Common stock instruments issued by a parent (or single reporting entity). Regardless of the accounting method selected in paragraph 15, the resulting increases or decreases in the carrying amount of redeemable common stock should be treated in the same manner as dividends on nonredeemable stock and should be effected by charges against retained earnings or, in the absence of retained earnings, by charges against paid-in capital. However, increases or decreases in the carrying amount of a redeemable common stock should not affect income available to common stockholders. Rather, the SEC staff believes that to the extent that a common shareholder has a contractual right to receive at share redemption (in other than a liquidation event that meets the exception in paragraph 3(f)) an amount that is other than the fair value of the issuer’s common shares, then that common shareholder has, in substance, received a distribution different from other common shareholders. Under Paragraph 260-10-45-59A, entities with capital structures that include a class of common stock with different dividend rates from those of another class of common stock but without prior or senior rights, should apply the two-class method of calculating earnings per share. Therefore, when a class of common stock is redeemable at other than fair value, increases or decreases in the carrying amount of the redeemable instrument should be reflected in earnings per share using the two-class method.FN17 For common stock redeemable at fair valueFN18, the SEC staff would not expect the use of the two-class method, as a redemption at fair value does not amount to a distribution different from other common shareholders.FN19
________________________________________
FN17 The two-class method of computing earnings per share is addressed in Section 260-10-45. The SEC staff believes that there are two acceptable approaches for allocating earnings under the two-class method when a common stock instrument is redeemable at other than fair value. The registrant may elect to: (a) treat the entire periodic adjustment to the instrument’s carrying amount (from the application of paragraphs 14–16) as being akin to a dividend or (b) treat only the portion of the periodic adjustment to the instrument’s carrying amount (from the application of paragraphs 14–16) that reflects a redemption in excess of fair value as being akin to a dividend. Under either approach, decreases in the instrument’s carrying amount should be reflected in the application of the two-class method only to the extent they represent recoveries of amounts previously reflected in the application of the two-class method.
FN18 Common stock that is redeemable based on a specified formula is considered to be redeemable at fair value if the formula is designed to equal or reasonably approximate fair value. The SEC staff believes that a formula based solely on a fixed multiple of earnings (or other similar measure) is not considered to be designed to equal or reasonably approximate fair value.
FN19 Similarly, the two-class method is not required when share-based payment awards granted to employees are redeemable at fair value (provided those awards are in the form of common shares or options on common shares). However, those share-based payment awards may still be subject to the two-class method pursuant to Section 260-10-45.
SAB Topic 14.E requires public entities to consider the requirements of ASR 268 (FRR Section 211) and ASC 480-10-S99-3A for redeemable share-based payment awards. See Section 5.10 for a discussion of the recognition and measurement requirements for redeemable share-based payment awards.
12.4.7.1 Share-Based Payment Awards Redeemable at Fair Value
Share-based payment awards on common shares that are redeemable at fair value
are accounted for in the same manner as common shares that are
redeemable at fair value. In ASC 480-10-S99-3A, the SEC staff
clarified that increases or decreases in the carrying amount of
common shares that are redeemable at fair value do not affect
income available to common shareholders. That is, changes in the
redemption amount do not affect income available to common
shareholders (the numerator in the calculation of basic EPS) if
the redemption value of redeemable shares is based on the fair
value of the shares. When calculating diluted EPS, an entity
must apply the treasury stock method to determine the number of
incremental shares to include in the calculation’s denominator.
See Section
12.4.2.1 for a discussion of the application of
the treasury stock method to share-based payment awards.
12.4.7.2 Share-Based Payment Awards Redeemable at an Amount Other Than Fair Value
Share-based payment awards on common shares that are redeemable at an amount
other than fair value are accounted for in the same manner as
common shares that are redeemable at an amount other than fair
value (e.g., formula price). That is, increases or decreases in
the carrying amount of redeemable share-based payment awards are
reflected in EPS under the two-class method, as discussed in ASC
260-10-45-59A through 45-70. The increase or decrease in the
carrying amount of redeemable share-based payment awards is
treated similarly to the reduction in income from continuing
operations (or net income) from current-period distributions.
See Section
12.4.3 for a discussion of the application of
the two-class method. In calculating diluted EPS, an entity must
determine whether the treasury stock method or the two-class
method is more dilutive. See Section 12.4.2.1 for a
discussion of the application of the treasury stock method to
share-based payment awards.
12.4.7.3 Share-Based Payment Awards Redeemable at Intrinsic Value
The SEC’s guidance in ASC 480-10-S99-3A does not address the EPS treatment of share-based payment awards with a redemption amount that is based on an award’s intrinsic value. Entities may therefore make a policy decision to (1) analogize to the guidance in ASC 480-10-S99-3A on common shares that are redeemable at fair value or (2) treat the increases or decreases in the carrying amount of these awards as an additive or subtractive amount in arriving at income available to common shareholders.
Under the first alternative, the increase or decrease in the carrying amount of
the redeemable share-based payment award (i.e., changes in the
redemption amount) does not affect income available to common
shareholders (the numerator in the calculation of basic EPS).
Under the second alternative, however, such increase or decrease
is treated like a preferential distribution. That is, the entity
accounts for the current-period change in the carrying amount of
the redeemable share-based payment award as an additive or
subtractive amount in arriving at income available to common
shareholders (the numerator in the calculation of basic EPS).
Regardless of the alternative selected, the entity must apply
the treasury stock method to determine the number of incremental
shares to include in the denominator of the calculation of
diluted EPS. See Section 12.4.2.1 for a
discussion of the application of the treasury stock method to
share-based payment awards.
12.4.7.4 Contingently Redeemable Share-Based Payment Awards
Share-based payment awards on common shares that are contingently redeemable at
fair value or at an amount other than the awards’ fair value
(e.g., redeemable upon a change in control) do not affect income
available to common shareholders (the numerator in the
calculation of basic EPS) until it is probable that the
contingency will occur. That is, awards that are contingently
redeemable are not remeasured to their redemption amount until
it is deemed probable that the contingency will occur. When
calculating diluted EPS, an entity must apply the treasury stock
method to determine the number of incremental shares to include
in the denominator of the calculation. See Section
12.4.2.1 for a discussion of the application of
the treasury stock method to share-based payment awards.
12.4.8 Awards of a Consolidated Subsidiary
12.4.8.1 Share-Based Payment Awards Issued by a Consolidated Subsidiary and Settled in the Subsidiary’s Common Shares
ASC 260-10
Securities of Subsidiaries
55-20 The effect on
consolidated EPS of options, warrants, and
convertible securities issued by a subsidiary
depends on whether the securities issued by the
subsidiary enable their holders to obtain common
stock of the subsidiary or common stock of the
parent entity. The following general guidelines
shall be used for computing consolidated diluted
EPS by entities with subsidiaries that have issued
common stock or potential common shares to parties
other than the parent entity
-
Securities issued by a subsidiary that enable their holders to obtain the subsidiary’s common stock shall be included in computing the subsidiary’s EPS data. Those per-share earnings of the subsidiary shall then be included in the consolidated EPS computations based on the consolidated group’s holding of the subsidiary’s securities. Example 7 (see paragraph 260-10-55-64) illustrates that provision.
-
Securities of a subsidiary that are convertible into its parent entity’s common stock shall be considered among the potential common shares of the parent entity for the purpose of computing consolidated diluted EPS. Likewise, a subsidiary’s options or warrants to purchase common stock of the parent entity shall be considered among the potential common shares of the parent entity in computing consolidated diluted EPS. Example 7 (see paragraph 260-10-55-64) illustrates that provision.
55-21 The preceding provisions also apply to investments in common stock of corporate joint ventures and investee companies accounted for under the equity method.
55-22 The if-converted method shall be used in determining the EPS impact of securities issued by a parent entity that are convertible into common stock of a subsidiary or an investee entity accounted for under the equity method. That is, the securities shall be assumed to be converted and the numerator (income available to common stockholders) adjusted as necessary in accordance with the provisions in paragraph 260-10-45-40(a) through (b). In addition to those adjustments, the numerator shall be adjusted appropriately for any change in the income recorded by the parent (such as dividend income or equity method income) due to the increase in the number of common shares of the subsidiary or equity method investee outstanding as a result of the assumed conversion. The denominator of the diluted EPS computation would not be affected because the number of shares of parent entity common stock outstanding would not change upon assumed conversion.
Example 7: Securities of a Subsidiary — Computation of Basic and Diluted EPS
55-64 This Example
illustrates the EPS computations for a
subsidiary’s securities that enable their holders
to obtain the subsidiary’s common stock based on
the provisions in paragraph 260-10-55-20. The
facts assumed are as follows:
55-65 Parent Entity:
- Net income was $10,000 (excluding any earnings of or dividends paid by the subsidiary).
- 10,000 shares of common stock were outstanding; the parent entity had not issued any other securities.
- The parent entity owned 900 common shares of a domestic subsidiary entity.
- The parent entity owned 40 warrants issued by the subsidiary.
- The parent entity owned 100 shares of convertible preferred stock issued by the subsidiary.
55-66 Subsidiary Entity:
- Net income was $3,600.
- 1,000 shares of common stock were outstanding.
- Warrants exercisable to purchase 200 shares of its common stock at $10 per share (assume $20 average market price for common stock) were outstanding.
- 200 shares of convertible preferred stock were outstanding. Each share is convertible into two shares of common stock.
- The convertible preferred stock paid a dividend of $1.50 per share.
- No interentity eliminations or adjustments were necessary except for dividends.
- Income taxes have been ignored for simplicity.
55-67 The following table illustrates subsidiary’s EPS.
Share-based payment awards issued by a consolidated subsidiary that are settled
by issuing the subsidiary’s common shares affect not only the
subsidiary’s calculation of diluted EPS but also the calculation
of the parent’s diluted EPS, as described in ASC 260-10-55-20
through 55-22 and illustrated in Example 7 in ASC 260-10-55-64
through 55-67.
While such awards do not affect the weighted-average number of common shares
outstanding (i.e., the denominator in the calculation of basic
EPS for either the subsidiary or the parent), the compensation
cost associated with these awards (during the requisite service
period or nonemployee’s vesting period) will generally affect
both the subsidiary’s and the parent’s net income or loss.
To calculate the parent’s diluted EPS, the subsidiary must first calculate its
own diluted EPS (regardless of whether the subsidiary reports
EPS). The amount of the subsidiary’s diluted EPS is then
multiplied by the number of the subsidiary’s shares that the
parent is assumed to own (after the hypothetical exercise of the
awards is taken into consideration). The product of those two
amounts is then included in the numerator (as a substitute for
the parent’s proportionate share of the subsidiary’s earnings)
of the calculation of the parent’s diluted EPS.
As noted in ASC 260-10-55-21, the guidance in ASC 260-10-55-20 also applies to investments in common stock of corporate joint ventures and investee companies that are accounted for under the equity method.
Example 12-12
Impact on EPS of Share-Based Payment Awards
Issued by a Subsidiary
Assume that the following apply to Parent P:
- Its net income is $100, excluding any net income or loss of Subsidiary A (i.e., as if A is unconsolidated).
- Throughout the period, 100 shares of its common stock were outstanding. No other securities have been issued.
- It owns 90 of A’s common shares (out of 100 outstanding).
Assume that the following apply to A:
- Its net income is $100 (after intercompany eliminations, etc.).
- Throughout the period, 100 shares of its common stock were outstanding.
- At the beginning of the period, it granted 10 fully vested stock options to its employees to purchase 10 shares of its common stock at $1 per share.
- The average market price of its common stock during the period is $2 per share.
The calculation of A’s diluted EPS is as follows:
The calculation of P’s consolidated diluted EPS is as follows:
12.4.8.2 Share-Based Payment Awards Issued by a Subsidiary but Settled in the Parent’s Common Shares
Share-based payment awards issued by a consolidated subsidiary that are settled
by issuing the parent’s common shares will not affect the
subsidiary’s denominator in the calculation of diluted EPS
because the awards do not represent potential common shares of
the subsidiary. However, during the employee’s requisite service
period or nonemployee’s vesting period, the compensation cost
associated with these awards will affect the subsidiary’s net
income or loss. (See Sections 2.8 and
2.9 for a discussion of the accounting for
share-based payment awards issued by a subsidiary but settled in
the parent’s common shares.)
By contrast, for the parent, the share-based payment awards do represent
potential common shares in the calculation of diluted EPS.
Therefore, the awards are included in the parent’s denominator
of the calculation of diluted EPS under the treasury stock
method. (See Section 12.4.2.1 for a discussion of the
application of the treasury stock method to share-based payment
awards.) Because the subsidiary is recording compensation cost
in its financial statements for these awards during the
requisite service period or nonemployee’s vesting period, the
parent’s proportionate share of the compensation cost will have
been included in the parent’s net income or loss.
Footnotes
1
The inclusion of the average
amount of unrecognized compensation cost
attributed to future goods or services not yet
recognized is unique to share-based payment
awards. That is, this component is only included
in the assumed proceeds for share-based payment
awards.
2
Undistributed losses would
generally not be allocated to share-based payment
awards in accordance with ASC 260-10-45-67 because
such awards typically would not have a
“contractual obligation to share in the losses of
the issuing entity on a basis that was objectively
determinable.” See Example 6 in ASC 260-10-55-62
and 55-63 for an illustration of the use of the
two-class method for calculating basic EPS.
3
An entity would need to have a sufficient
past practice of cash settlement as well as evidence of
its intent to cash-settle the arrangement.
4
The entire purchase period is
considered in the calculation of diluted EPS
because the shares to be purchased under the ESPP
are treated as employee stock options. Therefore,
all amounts to be withheld from employees’ pay to
purchase shares under the ESPP (i.e., withholdings
to date and expected future withholdings during
the remaining purchase period) must be considered
in the calculation of diluted EPS.
Chapter 13 — Disclosure
Chapter 13 — Disclosure
13.1 Disclosure Objective
ASC 718 specifies the information entities must disclose about their share-based payment arrangements in the notes to the financial statements. The disclosure objectives related to such arrangements are outlined in ASC 718-10-50-1.
ASC 718-10
50-1 An entity with one or more share-based payment arrangements shall disclose information that enables users of the financial statements to understand all of the following:
- The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders
- The effect of compensation cost arising from share-based payment arrangements on the income statement
- The method of estimating the fair value of the equity instruments granted (or offered to grant), during the period
- The cash flow effects resulting from share-based payment arrangements.
This disclosure is not required for interim reporting. For interim reporting see Topic 270. See Example 9 (paragraphs 718-10-55-134 through 55-137) for an illustration of this guidance.
See Section 13.3 for examples of the disclosures required under ASC 718.
13.2 Minimum Disclosures
ASC 718-10-50-2 and 50-2A outline the “minimum information” an entity must disclose in its annual financial statements to achieve the four objectives specified in ASC 718-10-50-1.
ASC 718-10
50-2 The following list indicates the minimum information needed to achieve the objectives in paragraph 718-10-50-1 and illustrates how the disclosure requirements might be satisfied. In some circumstances, an entity may need to disclose information beyond the following to achieve the disclosure objectives:
- A description of the share-based payment arrangement(s), including the general terms of awards under the arrangement(s), such as:
- The employee’s requisite service period(s) and, if applicable, the nonemployee’s vesting period and any other substantive conditions (including those related to vesting)
- The maximum contractual term of equity (or liability) share options or similar instruments
- The number of shares authorized for awards of equity share options or other equity instruments.
- The method it uses for measuring compensation cost from share-based payment arrangements.
- For the most recent year for which an income statement is provided, both of the following:
- The number and weighted-average exercise prices (or conversion ratios) for each of the following groups of share options (or share units):
- Those outstanding at the beginning of the year
- Those outstanding at the end of the year
- Those exercisable or convertible at the end of the year
- Those that during the year were:01. Granted02. Exercised or converted03. Forfeited04. Expired.
- The number and weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses that method or intrinsic value for awards measured pursuant to paragraph 718-10-30-21) of equity instruments not specified in (c)(1), for all of the following groups of equity instruments:
- Those nonvested at the beginning of the year
- Those nonvested at the end of the year
- Those that during the year were:01. Granted02. Vested03. Forfeited.
- For each year for which an income statement is provided, both of the following:
- The weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses that method or intrinsic value for awards measured at that value pursuant to paragraphs 718-10-30-21 through 30-22) of equity options or other equity instruments granted during the year
- The total intrinsic value of options exercised (or share units converted), share-based liabilities paid, and the total fair value of shares vested during the year.
- For fully vested share options (or share units) and share options expected to vest (or unvested share options for which the employee’s requisite service period or the nonemployee’s vesting period has not been rendered but that are expected to vest based on the achievement of a performance condition, if an entity accounts for forfeitures when they occur in accordance with paragraph 718-10-35-1D or 718-10-35-3) at the date of the latest statement of financial position, both of the following:
- The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value (except for nonpublic entities), and weighted-average remaining contractual term of options (or share units) outstanding
- The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value (except for nonpublic entities), and weighted-average remaining contractual term of options (or share units) currently exercisable (or convertible).
- For each year for which an income statement is presented, both of the following (An entity that uses the intrinsic value method pursuant to paragraphs 718-10-30-21 through 30-22 is not required to disclose the following information for awards accounted for under that method):
- A description of the method used during the year to estimate the fair value (or calculated value) of awards under share-based payment arrangements
- A description of the significant assumptions used during the year to estimate the fair value (or calculated value) of share-based compensation awards, including (if applicable):
- Expected term of share options and similar instruments, including a discussion of the method used to incorporate the contractual term of the instruments and grantees’ expected exercise and postvesting termination behavior into the fair value (or calculated value) of the instrument.
- Expected volatility of the entity’s shares and the method used to estimate it. An entity that uses a method that employs different volatilities during the contractual term shall disclose the range of expected volatilities used and the weighted-average expected volatility. A nonpublic entity that uses the calculated value method shall disclose the reasons why it is not practicable for it to estimate the expected volatility of its share price, the appropriate industry sector index that it has selected, the reasons for selecting that particular index, and how it has calculated historical volatility using that index.
- Expected dividends. An entity that uses a method that employs different dividend rates during the contractual term shall disclose the range of expected dividends used and the weighted-average expected dividends.
- Risk-free rate(s). An entity that uses a method that employs different risk-free rates shall disclose the range of risk-free rates used.
- Discount for postvesting restrictions and the method for estimating it.
-
Practical expedient for current price input. A nonpublic entity that elects to apply the practical expedient in paragraphs 718-10-30-20C through 30-20F shall disclose that election.
- An entity that grants equity or liability instruments under multiple share-based payment arrangements shall provide the information specified in paragraph (a) through (f) separately for different types of awards (including nonemployee versus employee) to the extent that the differences in the characteristics of the awards make separate disclosure important to an understanding of the entity’s use of share-based compensation. For example, separate disclosure of weighted-average exercise prices (or conversion ratios) at the end of the year for options (or share units) with a fixed exercise price (or conversion ratio) and those with an indexed exercise price (or conversion ratio) could be important. It also could be important to segregate the number of options (or share units) not yet exercisable into those that will become exercisable (or convertible) based solely on fulfilling a service condition and those for which a performance condition must be met for the options (share units) to become exercisable (convertible). It could be equally important to provide separate disclosures for awards that are classified as equity and those classified as liabilities. In addition, an entity that has multiple share-based payment arrangements shall disclose information separately for different types of awards under those arrangements to the extent that differences in the characteristics of the awards make separate disclosure important to an understanding of the entity’s use of share-based compensation.
- For each year for which an income statement is presented, both of the following:
- Total compensation cost for share-based payment arrangements
- Recognized in income as well as the total recognized tax benefit related thereto
- Capitalized as part of the cost of an asset.
- A description of significant modifications, including:
- The terms of the modifications
- The number of grantees affected
- The total (or lack of) incremental compensation cost resulting from the modifications.
- As of the latest balance sheet date presented, the total compensation cost related to nonvested awards not yet recognized and the weighted-average period over which it is expected to be recognized
- Subparagraph superseded by Accounting Standards Update No. 2016-09
- If not separately disclosed elsewhere, the amount of cash used to settle equity instruments granted under share-based payment arrangements
- A description of the entity’s policy, if any, for issuing shares upon share option exercise (or share unit conversion), including the source of those shares (that is, new shares or treasury shares). If as a result of its policy, an entity expects to repurchase shares in the following annual period, the entity shall disclose an estimate of the amount (or a range, if more appropriate) of shares to be repurchased during that period.
- If not separately disclosed elsewhere, the policy for estimating expected forfeitures or recognizing forfeitures as they occur.
50-2A Another item of minimum information needed to achieve the objectives in paragraph 718-10-50-1 is the
following:
- If not separately disclosed elsewhere, the amount of cash received from exercise of share options and similar instruments granted under share-based payment arrangements and the tax benefit from stock options exercised during the annual period
50-3 Paragraph not used.
50-4 In addition to the information required by this Topic, an entity may disclose supplemental information
that it believes would be useful to investors and creditors, such as a range of values calculated on the basis
of different assumptions, provided that the supplemental information is reasonable and does not lessen
the prominence and credibility of the information required by this Topic. The alternative assumptions shall
be described to enable users of the financial statements to understand the basis for the supplemental
information.
13.3 Examples of Required Disclosures
ASC 718-10-55-134 through 55-137 contain examples that illustrate the disclosure requirements
described in ASC 718-10-50-1 through 50-2A (see Sections 13.1 and 13.2).
ASC 718-10
Example 9: Disclosure
55-134 This Example illustrates
disclosures (see paragraphs 718-10-50-1 through 50-2) of a
public entity’s share-based compensation arrangements. The
illustration assumes that compensation cost has been
recognized in accordance with this Topic for several years.
The amount of compensation cost recognized each year
includes both costs from that year’s grants and costs from
prior years’ grants. The number of options outstanding,
exercised, forfeited, or expired each year includes options
granted in prior years. Although this Example focuses on
employee share-based payment plans, the disclosures are
equally applicable to share-based payment awards issued to
nonemployees. An entity should refer to the guidance in
paragraph 718-10-50-2(g) when evaluating whether separate
disclosure of nonemployee share-based payment awards is
warranted.
55-135 On December 31, 20Y1,
the Entity has two share-based compensation plans: The
compensation cost that has been charged against income for
those plans was $29.4 million, $28.7 million, and $23.3
million for 20Y1, 20Y0, and 20X9, respectively. The total
income tax benefit recognized in the income statement for
share-based compensation arrangements was $10.3 million,
$10.1 million, and $8.2 million for 20Y1, 20Y0, and 20X9,
respectively. Compensation cost capitalized as part of
inventory and fixed assets for 20Y1, 20Y0, and 20X9 was $0.5
million, $0.2 million, and $0.4 million, respectively.
Case A: Share Option Plan
55-136 The following
illustrates disclosure for a share option plan.
The Entity’s 20X4 employee share option plan, which is shareholder-approved, permits the grant of
share options and shares to its employees for up to 8 million shares of common stock. Entity A believes
that such awards better align the interests of its employees with those of its shareholders. Option
awards are generally granted with an exercise price equal to the market price of Entity A’s stock at the
date of grant; those option awards generally vest based on 5 years of continuous service and have 10-
year contractual terms. Share awards generally vest over five years. Certain option and share awards
provide for accelerated vesting if there is a change in control (as defined in the employee share option
plan).
The fair value of each option award is estimated on the date of grant using a lattice-based option
valuation model that uses the assumptions noted in the following table. Because lattice-based option
valuation models incorporate ranges of assumptions for inputs, those ranges are disclosed. Expected
volatilities are based on implied volatilities from traded options on Entity A’s stock, historical volatility of
Entity A’s stock, and other factors. Entity A uses historical data to estimate option exercise and employee
termination within the valuation model; separate groups of employees that have similar historical
exercise behavior are considered separately for valuation purposes. The expected term of options
granted is derived from the output of the option valuation model and represents the period of time that
options granted are expected to be outstanding; the range given below results from certain groups of
employees exhibiting different behavior. The risk-free rate for periods within the contractual life of the
option is based on the U.S. Treasury yield curve in effect at the time of grant.
A summary of option activity under the employee share option plan as of December 31, 20Y1, and
changes during the year then ended is presented below.
The weighted-average grant-date fair value of options granted during the years 20Y1, 20Y0, and 20X9
was $19.57, $17.46, and $15.90, respectively. The total intrinsic value of options exercised during the
years ended December 31, 20Y1, 20Y0, and 20X9, was $25.2 million, $20.9 million, and $18.1 million,
respectively.
A summary of the status of Entity A’s nonvested shares as of December 31, 20Y1, and changes during
the year ended December 31, 20Y1, is presented below.
As of December 31, 20Y1, there was $25.9 million of total unrecognized compensation cost related to
nonvested share-based compensation arrangements granted under the employee share option plan.
That cost is expected to be recognized over a weighted-average period of 4.9 years. The total fair value
of shares vested during the years ended December 31, 20Y1, 20Y0, and 20X9, was $22.8 million, $21
million, and $20.7 million, respectively.
During 20Y1, Entity A extended the contractual life of 200,000 fully vested share options held by 10
employees. As a result of that modification, the Entity recognized additional compensation expense of
$1.0 million for the year ended December 31, 20Y1.
Case B: Performance Share Option Plan
55-137 The following
illustrates disclosure for a performance share option
plan.
Under its 20X7 performance share option plan, which is
shareholder-approved, each January 1 Entity A grants
selected executives and other key employees share option
awards whose vesting is contingent upon meeting various
departmental and company-wide performance goals, including
decreasing time to market for new products, revenue growth
in excess of an index of competitors’ revenue growth, and
sales targets for Segment X. Share options under the
performance share option plan are generally granted
at-the-money, contingently vest over a period of 1 to 5
years, depending on the nature of the performance goal, and
have contractual lives of 7 to 10 years. The number of
shares subject to options available for issuance under this
plan cannot exceed 5 million.
The fair value of each option grant under the performance
share option plan was estimated on the date of grant using
the same option valuation model used for options granted
under the employee share option plan and assumes that
performance goals will be achieved. If such goals are not
met, no compensation cost is recognized and any recognized
compensation cost is reversed. The inputs for expected
volatility, expected dividends, and risk-free rate used in
estimating those options’ fair value are the same as those
noted in the table related to options issued under the
employee share option plan. The expected term for options
granted under the performance share option plan in 20Y1,
20Y0, and 20X9 is 3.3 to 5.4 years, 2.4 to 6.5 years, and
2.5 to 5.3 years, respectively.
A summary of the activity under the performance share
option plan as of December 31, 20Y1, and changes during the
year then ended is presented below.
The weighted-average grant-date fair value of options
granted during the years 20Y1, 20Y0, and 20X9 was $17.32,
$16.05, and $14.25, respectively. The total intrinsic value
of options exercised during the years ended December 31,
20Y1, 20Y0, and 20X9, was $5 million, $8 million, and $3
million, respectively. As of December 31, 20Y1, there was
$16.9 million of total unrecognized compensation cost
related to nonvested share-based compensation arrangements
granted under the performance share option plan; that cost
is expected to be recognized over a period of 4 years.
Cash received from option exercise under all share-based
payment arrangements for the years ended December 31, 20Y1,
20Y0, and 20X9, was $32.4 million, $28.9 million, and $18.9
million, respectively. The actual tax benefit for the tax
deductions from option exercise of the share-based payment
arrangements totaled $11.3 million, $10.1 million, and $6.6
million, respectively, for the years ended December 31,
20Y1, 20Y0, and 20X9.
Entity A has a policy of repurchasing shares on the open
market to satisfy share option exercises and expects to
repurchase approximately 1 million shares during 20Y2, based
on estimates of option exercises for that period.
13.4 Interim Reporting
ASC 270-10
Accounting Principles and Practices
45-1 Interim financial information is essential to provide investors and others with timely information as to the
progress of the entity. The usefulness of such information rests on the relationship that it has to the annual
results of operations. Accordingly, each interim period should be viewed primarily as an integral part of an
annual period.
Disclosure of Summarized Interim Financial Data by Publicly Traded Companies
50-1 Many publicly traded companies report summarized financial information at periodic interim dates in
considerably less detail than that provided in annual financial statements. While this information provides
more timely information than would result if complete financial statements were issued at the end of each
interim period, the timeliness of presentation may be partially offset by a reduction in detail in the information
provided. As a result, certain guides as to minimum disclosure are desirable. (It should be recognized that
the minimum disclosures of summarized interim financial data required of publicly traded companies do
not constitute a fair presentation of financial position and results of operations in conformity with generally
accepted accounting principles [GAAP].) If publicly traded companies report summarized financial information
at interim dates (including reports on fourth quarters), the following data should be reported, as a minimum: . . .
g. Changes in accounting principles or changes in accounting estimates (see paragraphs 270-10-45-12
through 45-16)
h. Significant changes in financial position (see paragraph 270-10-50-4) . . . .
50-2 If interim financial data and disclosures are not separately reported for the fourth quarter, users of the
interim financial information often make inferences about that quarter by subtracting data based on the third
quarter interim report from the annual results. In the absence of a separate fourth quarter report or disclosure
of the results (as outlined in the preceding paragraph) for that quarter in the annual report, disposals of
components of an entity and unusual or infrequently occurring items recognized in the fourth quarter, as well
as the aggregate effect of year-end adjustments that are material to the results of that quarter (see paragraphs
270-10-05-2 and 270-10-45-10) shall be disclosed in the annual report in a note to the annual financial
statements. If a publicly traded company that regularly reports interim information makes an accounting
change during the fourth quarter of its fiscal year and does not report the data specified by the preceding
paragraph in a separate fourth quarter report or in its annual report, the disclosures about the effect of the
accounting change on interim periods that are required by paragraphs 270-10-45-12 through 45-14 or by
paragraph 250-10-45-15, as appropriate, shall be made in a note to the annual financial statements for the
fiscal year in which the change is made.
50-3 Disclosure of the impact of the financial results for interim periods of the matters discussed in paragraphs
270-10-45-12 through 45-16 and 270-10-50-5 through 50-6 is desirable for as many subsequent periods as
necessary to keep the reader fully informed. There is a presumption that users of summarized interim financial
data will have read the latest published annual report, including the financial disclosures required by generally
accepted accounting principles (GAAP) and management’s commentary concerning the annual financial
results, and that the summarized interim data will be viewed in that context. In this connection, management
is encouraged to provide commentary relating to the effects of significant events upon the interim financial
results.
50-4 Publicly traded companies are encouraged to publish balance sheet and cash flow data at interim dates
since these data often assist users of the interim financial information in their understanding and interpretation
of the income data reported. If condensed interim balance sheet information or cash flow data are not
presented at interim reporting dates, significant changes since the last reporting period with respect to liquid
assets, net working capital, long-term liabilities, or stockholders’ equity shall be disclosed.
ASC 718-10-50-1 states that the disclosure requirements for annual periods (see Sections 13.1 and
13.2) are not required for interim periods. In addition, ASC 718 does not specify the requirements for share-based compensation disclosures in interim financial statements. However, paragraph B239 of the Basis for Conclusions of FASB Statement 123(R) refers to the requirements for disclosing “information about changes in accounting principles or estimates and significant changes in financial position,” which were codified in ASC 270-10-50-1.
Paragraph B239 of Statement 123(R) also notes that when “share-based
compensation cost is significant [registrants] may
wish to provide additional information, including
the total amount of that cost, on a quarterly
basis.” This may apply to registrants that grant a
substantial portion of their share-based payment
awards at a single time each year.
In addition, SEC Regulation S-X, Rule 10-01(a)(5), requires registrants to
disclose in their quarterly financial statements information that is “sufficient so
as to make the interim information presented not misleading.” When assessing the
volume and type of information to be disclosed in quarterly financial statements,
registrants should consider factors such as the amount and timing of grants of
share-based payment awards, material modifications to existing share-based payment
awards, material share repurchases, material changes in assumptions used in the
valuation of awards, and material changes to the type of awards issued.
13.5 Subsidiary Disclosures
SEC Staff Accounting Bulletins
SAB Topic 1.B.1, Allocation of Expenses and
Related Disclosure in Financial Statements of Subsidiaries,
Divisions or Lesser Business Components of Another Entity:
Costs Reflected in Historical Income Statements [Excerpt;
Reproduced in ASC 220-10-S99-3]
Facts: A company
(the registrant) operates as a subsidiary of another company
(parent). Certain expenses incurred by the parent on behalf
of the subsidiary have not been charged to the subsidiary in
the past. The subsidiary files a registration statement
under the Securities Act of 1933 in connection with an
initial public offering.
Question 1: Should
the subsidiary’s historical income statements reflect all of
the expenses that the parent incurred on its behalf?
Interpretive
Response: In general, the staff believes that the
historical income statements of a registrant should reflect
all of its costs of doing business. Therefore, in specific
situations, the staff has required the subsidiary to revise
its financial statements to include certain expenses
incurred by the parent on its behalf. Examples of such
expenses may include, but are not necessarily limited to,
the following (income taxes and interest are discussed
separately below):
-
Officer and employee salaries,
-
Rent or depreciation,
-
Advertising,
-
Accounting and legal services, and
-
Other selling, general and administrative expenses.
When the subsidiary’s financial statements
have been previously reported on by independent accountants
and have been used other than for internal purposes, the
staff has accepted a presentation that shows income before
tax as previously reported, followed by adjustments for
expenses not previously allocated, income taxes, and
adjusted net income.
A subsidiary must comply with the disclosure requirements of ASC 718-10-50 in
its stand-alone financial statements. SAB Topic 1.B.1 notes that a registrant
(subsidiary) should reflect all the costs of doing business in the subsidiary’s
financial statements (to help financial statement users understand such costs). SAB
Topic 1.B.1 also requires a registrant to reflect expenses incurred by a parent on
behalf of its subsidiary in the historical financial statements of the subsidiary
and provides examples of such expenses.
In determining what to disclose in their stand-alone financial statements, subsidiaries (regardless of
whether they are SEC registrants) should apply the same requirement as that in SAB Topic 1.B.1. In
addition, subsidiaries’ disclosures should be similar to those of their parent.
13.6 Nonemployee Awards
The disclosure requirements in ASC 718-10-50-1 and 50-2 apply to nonemployee
awards. As noted in ASC 718-10-50-2(g), an entity must consider whether it should
provide the disclosures required by ASC 718-10-50-2(a)–(f) separately for employee
and nonemployee awards if the differences between the awards’ characteristics are
important to an investor’s understanding of them.
13.7 Change in Valuation Techniques
ASC 718-10
Consistent Use of Valuation Techniques and Methods for Selecting Assumptions
55-27 Assumptions used to estimate the fair value of equity and liability instruments granted in share-based payment transactions shall be determined in a consistent manner from period to period. For example, an entity might use the closing share price or the share price at another specified time as the current share price on the grant date in estimating fair value, but whichever method is selected, it shall be used consistently. The valuation technique an entity selects to estimate fair value for a particular type of instrument also shall be used consistently and shall not be changed unless a different valuation technique is expected to produce a better estimate of fair value. A change in either the valuation technique or the method of determining appropriate assumptions used in a valuation technique is a change in accounting estimate for purposes of applying Topic 250, and shall be applied prospectively to new awards.
SEC Staff Accounting Bulletins
SAB Topic 14.C, Valuation Methods
[Excerpt]
Question 3: In
subsequent periods, may a company change the valuation
technique or model chosen to value instruments with similar
characteristics?21
Interpretive
Response: As long as the new technique or model
meets the fair value measurement objective as described in
Question 2 above, the staff would not object to a company
changing its valuation technique or model.22 A
change in the valuation technique or model used to meet the
fair value measurement objective would not be considered a
change in accounting principle.23 As such, a
company would not be required to file a preferability letter
from its independent accountants as described in Rule
10-01(b)(6) of Regulation S-X when it changes valuation
techniques or models. However, the staff would not expect
that a company would frequently switch between valuation
techniques or models, particularly in circumstances where
there was no significant variation in the form of
share-based payments being valued. Disclosure in the
footnotes of the basis for any change in technique or model
would be appropriate.24
______________________________
21 FASB ASC paragraph
718-10-55-17 indicates that an entity may use different
valuation techniques or models for instruments with
different characteristics.
22 The staff believes that a
company should take into account the reason for the change
in technique or model in determining whether the new
technique or model meets the fair value measurement
objective. For example, changing a technique or model from
period to period for the sole purpose of lowering the fair
value estimate of a share option would not meet the fair
value measurement objective of the Topic.
23 FASB ASC paragraph 718-10-55-27.
24
See generally FASB ASC paragraph 718-10-50-1.
ASC 718-10-55-27 states, in part, that the “valuation technique an entity
selects . . . shall be used consistently and shall not be changed unless a different
valuation technique is expected to produce a better estimate of fair value.” It also
states that a change in valuation technique should be accounted for as a change in
accounting estimate under ASC 250 and applied prospectively to new awards. In
addition, Question 3 of SAB Topic 14.C states that the SEC staff would not object to
a change in an entity’s valuation technique or model as long as the new technique or
model meets the fair value measurement objective of ASC 718.
ASC 250-10-50-5 indicates that entities do not need to disclose the information required by ASC 250-10-
50-4 for a change in estimate that results from a change in valuation technique. However, SAB Topic
14.C states that for a share-based payment award, “[d]isclosure in the footnotes of the basis for any
change in technique or model would be appropriate.” Accordingly, entities are encouraged to disclose
the basis for a change in their technique for valuing share-based payment awards. In addition, SEC
registrants may consider additional disclosures in MD&A if the change in estimate materially affected the
entity’s results of operations.
13.8 Transition From Nonpublic to Public Entity Status
Question 4 of SAB Topic 14.B discusses the SEC staff’s views on the disclosure
requirements for share-based payment awards during an entity’s transition from
nonpublic to public entity status (e.g., when filing its initial registration
statement with the SEC).
SEC Staff Accounting Bulletins
SAB Topic 14.B, Transition From Nonpublic to
Public Entity Status [Excerpt]
Facts: Company A is
a nonpublic entity4 that first files a
registration statement with the SEC to register its equity
securities for sale in a public market on January 2, 20X8.
As a nonpublic entity, Company A had been assigning value to
its share options5 under the calculated value
method prescribed by FASB ASC Topic 718, Compensation —
Stock Compensation,6 and had elected to measure
its liability awards based on intrinsic value. Company A is
considered a public entity on January 2, 20X8 when it makes
its initial filing with the SEC in preparation for the sale
of its shares in a public market. . . .
Question 4: Upon
becoming a public entity, what disclosures should Company A
consider in addition to those prescribed by FASB ASC Topic
718?13
Interpretive
Response: In the registration statement filed on
January 2, 20X8, Company A should clearly describe in
MD&A the change in accounting policy that will be
required by FASB ASC Topic 718 in subsequent periods and the
reasonably likely material future effects.14 In
subsequent filings, Company A should provide financial
statement disclosure of the effects of the changes in
accounting policy. In addition, Company A should consider
the requirements of Item 303(b)(3) of Regulation S-K
regarding critical accounting estimates in MD&A.
______________________________
4 Defined in the FASB ASC Master
Glossary.
5 For purposes of this staff
accounting bulletin, the phrase “share options” is used to
refer to “share options or similar instruments.”
6 FASB ASC paragraph 718-10-30-20
requires a nonpublic entity to use the calculated value
method when it is not able to reasonably estimate the fair
value of its equity share options and similar instruments
because it is not practicable for it to estimate the
expected volatility of its share price. FASB ASC paragraph
718-10-55-51 indicates that a nonpublic entity may be able
to identify similar public entities for which share or
option price information is available and may consider the
historical, expected, or implied volatility of those
entities’ share prices in estimating expected volatility.
The staff would expect an entity that becomes a public
entity and had previously measured its share options under
the calculated value method to be able to support its
previous decision to use calculated value and to provide the
disclosures required by FASB ASC subparagraph
718-10-50-2(f)(2)(ii).
13 FASB ASC Section
718-10-50.
14
See Item 303 of Regulation S-K.
SEC Financial Reporting Manual
9520 Share-Based
Compensation in IPOs
9520.1 Estimates
used to determine share-based compensation are often
considered critical by companies going public. In
particular, estimating the fair value of the underlying
shares can be highly complex and subjective because the
shares are not publicly traded. The staff will consider if a
company performing these estimates is providing the
following critical accounting estimate disclosures in its
IPO prospectus:
- The methods that management used to determine the fair value of the company’s shares and the nature of the material assumptions involved. For example, companies using the income approach should disclose that this method involves estimating future cash flows and discounting those cash flows at an appropriate rate.
- The extent to which the estimates are considered highly complex and subjective.
- The estimates will not be necessary to determine the fair value of new awards once the underlying shares begin trading.
Companies may cross-reference to the extent that this, or
other material information relevant to share-based
compensation, is provided elsewhere in the prospectus.
9520.2 The staff may issue comments
asking companies to explain the reasons for valuations that
appear unusual (e.g., unusually steep increases in the fair
value of the underlying shares leading up to the IPO). These
comments are intended to elicit analyses that the staff can
review to assist it in confirming the appropriate accounting
for the share-based compensation, not for the purpose of
requesting changes to disclosure in the MD&A or
elsewhere in the prospectus.
9520.3 The staff will also consider
other MD&A requirements related to share-based
compensation, including known trends or uncertainties
including, but not limited to, the expected impact on
operating results and taxes.
Typically, a registrant undergoing an IPO of its equity securities identifies share-based compensation
as a critical accounting estimate because the lack of a public market for the pre-IPO shares makes the
estimation process complex and subjective.
Further, paragraph
7520.1 of the FRM outlines considerations related to the
“estimated fair value of [stock that] is substantially below the IPO price” (often
referred to as “cheap stock”). Registrants should be able to reconcile the change in
the estimated fair value of the underlying equity between the award grant date and
the IPO by taking into account, among other things, intervening events and changes
in assumptions that support the change in fair value.
The SEC staff had historically asked registrants to expand the disclosures in their critical accounting
estimates to add information about the valuation methods and assumptions used for share-based
compensation in an IPO. In 2014, however, it updated Section 9520 of the FRM to indicate that
registrants should significantly reduce, in the critical accounting estimates section of MD&A, their
disclosures about share-based compensation and the valuation of pre-IPO common stock. Nevertheless,
paragraph 9520.2 of the FRM notes that the SEC staff may continue to request that companies “explain
the reasons for valuations that appear unusual (e.g., unusually steep increases in the fair value of the
underlying shares leading up to the IPO).” Such requests are meant to ensure that a registrant’s analysis
and assessment support its accounting for share-based compensation; they do not necessarily indicate
that the registrant’s disclosures need to be enhanced.
At the Practising Law Institute’s “SEC Speaks in 2014” Conference, the SEC staff discussed the types of
detailed disclosures it had observed in IPO registration statements that had prompted the updates to
Section 9520 of the FRM. The staff noted that registrants have historically included:
- A table of equity instruments issued during the past 12 months.
- A description of the methods used to value the registrant’s pre-IPO common stock (i.e., income approach or market approach).
- Detailed disclosures about certain select assumptions used in the valuation.
- Discussion of changes in the fair value of the company’s pre-IPO common stock, which included each grant leading up to the IPO and resulted in repetitive disclosures.
The staff indicated that despite the volume of share-based compensation information included in IPO
filings, disclosures of such information were typically incomplete because registrants did not discuss all
assumptions related to their common stock valuations. Further, disclosures about registrants’ pre-IPO
common stock valuations were not relevant after an IPO and were generally removed from their
periodic filings after the IPO. The SEC staff expressed the view that in addition to reducing the volume of
information, streamlined share-based compensation disclosures also make reporting more meaningful.
The staff also indicated that by eliminating unnecessary information, registrants could reduce “down to
one paragraph” many of their prior disclosures.
At the conference, the SEC staff also provided insights into how registrants would be expected to apply
the guidance in paragraph 9520.1 of the FRM (and thereby reduce the share-based compensation
disclosures in their IPO registration statements):
- The staff does not expect much detail about the valuation method registrants used to determine the fair value of their pre-IPO shares. A registrant need only state that it used the income approach, the market approach, or a combination of both.Further, while registrants are expected to discuss the nature of the material assumptions they used, they would not be required to quantify such assumptions. For example, if a registrant used an income approach involving a discounted cash flow method, it would only need to provide a statement that a discounted cash flow method was used and involved cash flow projections that were discounted at an appropriate rate. No additional details would be needed.
- Registrants would have to include a statement indicating that the estimates in their share-based compensation valuations are highly complex and subjective but would not need to provide additional details about the estimates. Registrants would also need to include a statement disclosing that such valuations and estimates will no longer be necessary once the entity goes public because it will then rely on the market price to determine the fair value of its common stock.
The staff emphasized that its ultimate concern is whether registrants correctly
accounted for pre-IPO share-based compensation. Accordingly, the staff will continue
to ask them for supplemental information to support their valuations and accounting
conclusions — especially when the fair value of a company’s pre-IPO common stock is
significantly less than the expected IPO price.1 See Section
4.12.1 for additional considerations related to cheap stock.
Footnotes
1
At the conference, the SEC staff noted that valuations that
appear to be unusual may be attributable to the peer companies selected when
a market approach is used. Specifically, the staff indicated that there are
often inconsistencies between the peer companies used by registrants and
those used by the underwriters, which result in differences in the
valuations. Accordingly, the staff encouraged registrants to talk to the
underwriters “early and often” to avoid such inconsistencies.
13.9 MD&A Disclosures — Expected Volatility
Question 5 of SAB Topic 14.D.1 presents the SEC staff’s views on the disclosures about expected
volatility related to share-based payment awards that registrants would be expected to provide in their
financial statements and MD&A.
SEC Staff Accounting Bulletins
SAB Topic 14.D.1, Certain Assumptions Used
in Valuation Methods: Expected Volatility [Excerpt]
Facts: Company B is a public entity whose common
shares have been publicly traded for over twenty years.
Company B also has multiple options on its shares
outstanding that are traded on an exchange (“traded
options”). Company B grants share options on January 2,
20X6. . . .
Question 5: What disclosures would the staff expect
Company B to include in its financial statements and
MD&A regarding its assumption of expected
volatility?
Interpretive
Response: FASB ASC paragraph 718-10-50-2 prescribes
the minimum information needed to achieve the Topic’s
disclosure objectives.52 Under that guidance,
Company B is required to disclose the expected volatility
and the method used to estimate it.53
Accordingly, the staff expects that, at a minimum, Company B
would disclose in a footnote to its financial statements how
it determined the expected volatility assumption for
purposes of determining the fair value of its share options
in accordance with FASB ASC Topic 718. For example, at a
minimum, the staff would expect Company B to disclose
whether it used only implied volatility, historical
volatility, or a combination of both, and how it determined
any significant adjustments to historical volatility.
In addition, Company B should consider the
requirements of Regulation S-K Item 303(b)(3) regarding
critical accounting estimates in MD&A. A company should
determine whether its evaluation of any of the factors
listed in Questions 2 and 3 of this section, such as
consideration of future events in estimating expected
volatility, resulted in an estimate that involves a
significant level of estimation uncertainty and has had or
is reasonably likely to have a material impact on the
financial condition or results of operations of the
company.
______________________________
52 FASB ASC paragraph
718-10-50-1.
53 FASB ASC subparagraph
718-10-50-2(f)(2)(ii).
13.10 Disclosures of Spring-Loaded Awards
In November 2021, the SEC staff issued SAB
120, which amends SAB Topic 14.D and provides the SEC staff’s
views on the measurement and disclosure of certain share-based payment awards
granted when entities possess material nonpublic information (i.e., “spring-loaded”
awards).
SAB 120 describes a spring-loaded award as follows:
A share-based payment award granted when a company is in possession of
material nonpublic information to which the market is likely to react
positively when the information is announced is sometimes referred to as
being “spring-loaded.”
As amended by SAB 120, Question 2 of SAB Topic 14.D.3 provides the SEC staff’s views
on the disclosure expectation regarding spring-loaded awards:
Facts: Company D is a public company that entered into a material
contract with a customer after market close. Subsequent to entering into the
contract but before the market opens the next trading day, Company D awards
share options to its executives. The share option award is non-routine, and
the award is approved by the Board of Directors in contemplation of the
material contract. Company D expects the share price to increase
significantly once the announcement of the contract is made the next day.
Company D’s accounting policy is to consistently use the closing share price
on the day of the grant as the current share price in estimating the
grant-date fair value of share options. . . .
Question 2: What disclosures would the staff expect Company D to
include in its financial statements regarding its determination of the
current price of shares underlying newly-granted share options?
Interpretive Response: FASB ASC paragraph 718-10-50-1 requires
disclosure of information that enables users of the financial statements to
understand, among other things, the nature and terms of share-based payment
arrangements that existed during the period and the potential effects of
those arrangements on shareholders. FASB ASC paragraph 718-10-50-2
prescribes the minimum information needed to achieve the Topic’s disclosure
objectives, including a description of the method used and significant
assumptions used to estimate the fair value of awards under share-based
payment arrangements.
Accordingly, the staff expects that, at a minimum, Company D would disclose
in a footnote to its financial statements how it determined the current
price of shares underlying share options for purposes of determining the
grant-date fair value of its share options in accordance with FASB ASC Topic
718. For example, the staff would expect Company D to disclose its
accounting policy related to how it identifies when an adjustment to the
closing price is required, how it determined the amount of the adjustment to
the closing share price, and any significant assumptions used to determine
such adjustment, if material. Further, the characteristics of the share
options, including their spring-loaded nature, may differ from Company D’s
other share-based payment arrangements to such an extent Company D should
disclose information regarding these share options separately from other
share-based payment arrangements to allow investors to understand Company
D’s use of share-based compensation.
Additionally, Company D should consider the applicability of
MD&A and other disclosure requirements, including those related to
liquidity and capital resources, results of operations, critical accounting
estimates, executive compensation, and transactions with related persons.
[Footnotes omitted]
See Section 4.9.2.6 for additional information
related to spring-loaded awards.
Chapter 14 — Accounting for Share-Based Payments Issued as Sales Incentives to Customers
Chapter 14 — Accounting for Share-Based Payments Issued as Sales Incentives to Customers
14.1 Background
Recognition of share-based payments issued to a customer that are not in
exchange for a distinct good or service (i.e., share-based sales incentives) is outside
the scope of ASC 718 and must be accounted for under ASC 606. While ASC 606 addresses
the recognition of share-based sales incentives (i.e., as a reduction of revenue), it
does not provide guidance on the measurement (or measurement date) of such incentives.
Measurement and classification of share-based sales incentives is subject to the
guidance in ASC 718.
14.2 Overview
The guidance in ASC 718 on measuring and classifying share-based sales
incentives requires entities to use a fair-value-based measure to calculate such
incentives on the grant date. The grant date is the date on which the grantor (the
entity) and the grantee (the customer) reach a mutual understanding of the key terms and
conditions of the share-based consideration. The result is reflected as a reduction of
revenue in accordance with the guidance in ASC 606 on consideration payable to a
customer. After initial recognition, the measurement and classification of the
share-based sales incentives continue to be subject to ASC 718 unless (1) the award is
subsequently modified when vested and (2) the grantee is no longer a customer.
14.3 Scope
ASC 718-10
Transactions
15-3 The guidance
in the Compensation — Stock Compensation Topic applies to all
share-based payment transactions in which a grantor acquires
goods or services to be used or consumed in the grantor’s own
operations or provides consideration payable to a customer by
issuing (or offering to issue) its shares, share options, or
other equity instruments or by incurring liabilities to an
employee or a nonemployee that meet either of the following
conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award of share-based compensation may be indexed to both the price of an entity’s shares and something else that is neither the price of the entity’s shares nor a market, performance, or service condition.)
- The awards require or may require settlement by issuing the entity’s equity shares or other equity instruments.
15-5A Share-based
payment awards granted to a customer shall be measured and
classified in accordance with the guidance in this Topic (see
paragraph 606-10-32-25A) and reflected as a reduction of the
transaction price and, therefore, of revenue in accordance with
paragraph 606-10-32-25 unless the consideration is in exchange
for a distinct good or service. If share-based payment awards
are granted to a customer as payment for a distinct good or
service from the customer, then an entity shall apply the
guidance in paragraph 606-10-32-26.
ASC 606-10
32-25 Consideration payable to a
customer includes:
- Cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer)
- Credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer)
- Equity instruments (liability or equity classified) granted in conjunction with selling goods or services (for example, shares, share options, or other equity instruments).
An entity shall account for consideration payable to a customer
as a reduction of the transaction price and, therefore, of
revenue unless the payment to the customer is in exchange for a
distinct good or service (as described in paragraphs
606-10-25-18 through 25-22) that the customer transfers to the
entity. If the consideration payable to a customer includes a
variable amount, an entity shall estimate the transaction price
(including assessing whether the estimate of variable
consideration is constrained) in accordance with paragraphs
606-10-32-5 through 32-13.
ASC 718 applies to share-based payments granted in conjunction with the
sale of goods and services to a customer that are not in exchange for a distinct good or
service. However, entities apply ASC 718 only to measure and classify share-based sales
incentives, and they reflect the measurement of such incentives as a reduction of the
transaction price and recognize it in accordance with the guidance in ASC 606 on
consideration payable to a customer. Entities that receive distinct goods or services
from a customer in exchange for share-based payments should account for such payments in
the same manner as they account for other purchases from suppliers (i.e., by applying
the guidance in ASC 718). Any excess of the fair-value-based measure of the share-based
payment award over the fair value of the distinct goods or services received should be
reflected as a reduction to the transaction price and recognized in accordance with the
guidance in ASC 606 on consideration payable to a customer.
See Chapter
6 of Deloitte’s Roadmap Revenue Recognition for additional guidance on consideration
payable to a customer.
Connecting the Dots
ASC 718 applies to share-based sales incentives issued to
customers under ASC 606 but does not directly address similar equity-based
incentives issued by a lessor to a lessee under ASC 840 or ASC 842.1
Footnotes
1
See paragraph BC17 of ASU 2019-08.
14.4 Initial Measurement
ASC 606-10
32-25A Equity
instruments granted by an entity in conjunction with selling
goods or services shall be measured and classified under Topic
718 on stock compensation. The equity instrument shall be
measured at the grant date in accordance with Topic 718 (for
both equity-classified and liability-classified share-based
payment awards). Changes in the measurement of the equity
instrument (through the application of Topic 718) after the
grant date that are due to the form of the consideration shall
not be included in the transaction price. Any changes due to the
form of the consideration shall be reflected elsewhere in the
grantor’s income statement. See paragraphs 606-10-55-88A through
55-88B for implementation guidance on equity instruments granted
as consideration payable to a customer.
Share-based sales incentives are reflected as a reduction in the
transaction price on the basis of the grant-date fair-value-based measure in accordance
with ASC 718 (for both equity- and liability-classified awards). In addition,
share-based sales incentives may contain vesting conditions (i.e., service or
performance conditions that must be satisfied for the customer to vest in an award) or
conditions that affect factors other than the vesting of an award (i.e., market
conditions, service or performance conditions that affect factors other than vesting or
exercisability, or “other” conditions that do not meet the definition of a service,
performance, or market condition). Both vesting and nonvesting conditions should be
evaluated in accordance with ASC 718, which specifies that vesting conditions, unlike
nonvesting conditions, are not directly factored into the fair-value-based measure of
the award. Therefore, the amount recognized as a share-based sales incentive would (1)
reflect the actual outcome of any vesting condition and (2) incorporate in its
measurement any nonvesting conditions.
Connecting the Dots
An entity is required to use judgment when determining whether a
vesting condition related to a share-based sales incentive is a service
condition or a performance condition.
The recognition of a share-based sales incentive with a service
condition that affects vesting will depend on the entity’s accounting policy for
forfeitures of nonemployee share-based payment awards. For example, if the
entity elects to estimate forfeitures, it bases its estimate of the share-based
sales incentive on the probable outcome for both service and performance
conditions. However, if the entity elects to recognize forfeitures when they
occur, it reflects the entire share-based sales incentive with a service
condition that affects vesting in the transaction price unless the award is
forfeited.
Many share-based sales incentives include conditions that are tied to customer
purchase levels (or to a customer’s remaining purchases for a specified period).
We believe that such conditions are akin to service conditions.
Example 14-1
Share-Based Sales Incentive Issued for Each Purchase
On January 1, 20X1, Entity A executes a one-year master supply
agreement (MSA) to sell and deliver widgets to Customer B. The
MSA includes general terms and conditions but does not contain
any minimum purchase requirements. Accordingly, legally
enforceable rights and obligations associated with a revenue
contract between A and B do not exist until B issues a purchase
order for a specific number of widgets. In other words, the
criteria in ASC 606-10-25-1 that must all be met for an entity
to conclude that a contract with a customer exists are only met
each time B issues a subsequent purchase order under the
MSA.
Customer B agrees to pay A $1,000 for each widget purchased under
the MSA. As a share-based sales incentive, A includes terms in
the MSA that grant B 500 fully vested shares of A’s common stock
for each widget that B purchases. The share-based sales
incentive is not in exchange for distinct goods or services.
Entity B issues three separate purchase orders, each for one
widget, on January 31, March 1, and December 31, 20X1. On the
same day on which A receives each purchase order, it transfers
control of each widget to B and also issues to B 500 shares of
A’s common stock in fulfillment of the terms of the MSA.
The fair value of A’s common stock is $1.00 per share on January
1, 20X1, and appreciates during 20X1 as follows:
Entity A concludes that the terms of the MSA are
sufficient to establish a grant date for the share-based sales
incentive in accordance with the guidance in ASC 718. Entity A
measures the share-based sales incentive issued to B on January
1, 20X1, because a grant date exists for the share-based sales
incentive in accordance with the criteria in ASC 718. For each
separately sold widget, A will thus recognize revenue reduced by
the grant-date fair-value-based measure of the share-based sales
incentive of $500 (500 shares × $1.00), measured as of January
1, 20X1. Accordingly, A will recognize the following revenue
during 20X1:
Entity A will classify the share-based sales incentive in
accordance with the guidance in ASC 718. Likewise, A will
continue to apply ASC 718 to classify and measure the
share-based sales incentive unless it is subsequently modified
when it vests and B is no longer a customer. Although there are
changes to the fair-value-based measure of the common stock
after the grant date, if the award remains within the scope of
ASC 718 and is not modified, there is no accounting effect for
those changes because the measurement date for an
equity-classified award is the grant date.
Example 14-2
Share-Based Sales Incentive Contingent on Cumulative
Purchases
Assume the same facts as in the example above,
except that Customer B will earn 1,000 shares of Entity A’s
common stock when it purchases five widgets within one year of
the MSA’s execution. Entity A concludes that the share-based
sales incentive includes a service condition and applies its
policy election under ASC 718-10-35-1D for nonemployee
share-based payment awards to recognize forfeitures as they
occur. Entity A calculates the reduction in transaction price as
$1,000 (1,000 shares × $1 grant-date fair-value-based measure),
which A will recognize with the related revenue. If at the end
of 20X1 B has purchased five or more widgets, there is no effect
on the total reduction in transaction price. By contrast, if at
the end of 20X1 B has purchased fewer than five widgets and
therefore forfeits the share-based sales incentive, A will
reverse the portion of the $1,000 that it previously recorded as
a reduction of revenue.
While vesting and nonvesting conditions are not subject to the variable
consideration guidance in ASC 606, such guidance could still be applicable in certain
circumstances. For example, an entity should apply ASC 606-10-32-7 and estimate the
fair-value-based measure of an equity instrument before the grant date when a grant date
has not been established but (1) the customer has a valid expectation that a share-based
sales incentive will be issued (e.g., because of an entity’s history of issuing
share-based sales incentives or its ongoing negotiations related to the issuance of a
share-based sales incentive for which the terms of the equity instruments have not yet
been finalized) or (2) other facts and circumstances indicate that the entity intends to
issue a share-based sales incentive. In the period in which a grant date is established,
the entity adjusts the transaction price for the cumulative effect of calculating the
fair-value-based measure on the grant date. This treatment is similar to the accounting
applied when the service inception date precedes the grant date for employee awards.2 For example, an entity could enter into a revenue contract with a customer for the
purchase of goods or services while negotiating a share-based sales incentive with that
customer. If a grant date has not been established for that award because the terms are
still being negotiated, the entity would be required to estimate the fair-value-based
measure of the award and reflect that estimate (or a portion of the estimate) as a
reduction of the transaction price. That estimate will be adjusted in each reporting
period until a grant date has been established.
Footnotes
2
See Section
3.6.4.
14.5 Classification
As discussed above, the classification of share-based sales incentives
is subject to the guidance in ASC 718. Therefore, an entity applies ASC 718-10-25-6
through 25-19A to determine whether an award is classified as equity or a liability. As
in the case of other nonemployee awards, if (1) the award is subsequently modified when
vested and (2) the grantee is no longer a customer, the award becomes subject to other
U.S. GAAP (e.g., ASC 480, ASC 815) unless the modification is made in conjunction with
an equity restructuring that meets certain conditions.3
See Chapter 5 for more information about
determining whether an award is classified as equity or a liability.
Footnotes
3
See Section
5.8.
14.6 Subsequent Measurement and Presentation
ASC 718-10
35-1D The total
amount of compensation cost recognized for share-based payment
awards to nonemployees shall be based on the number of
instruments for which a good has been delivered or a service has
been rendered. 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 nonemployee
share-based payment awards, including share-based payment awards
granted to customers, to do either of the following:
- Estimate the number of forfeitures expected to occur. The entity shall base initial accruals of compensation cost on the estimated number of nonemployee share-based payment awards for which a good is expected to be delivered or a 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 estimates shall be recognized in compensation cost in the period of the change.
- Recognize the effect of forfeitures in compensation cost when they occur. Previously recognized compensation cost for a nonemployee share-based payment award shall be reversed in the period that the award is forfeited.
ASC 606-10
32-25A Equity
instruments granted by an entity in conjunction with selling
goods or services shall be measured and classified under Topic
718 on stock compensation. The equity instrument shall be
measured at the grant date in accordance with Topic 718 (for
both equity-classified and liability-classified share-based
payment awards). Changes in the measurement of the equity
instrument (through the application of Topic 718) after the
grant date that are due to the form of the consideration shall
not be included in the transaction price. Any changes due to the
form of the consideration shall be reflected elsewhere in the
grantor’s income statement. See paragraphs 606-10-55-88A through
55-88B for implementation guidance on equity instruments granted
as consideration payable to a customer.
Share-based sales incentives are measured on the grant date (for both equity-classified
and liability-classified share-based payments) in accordance with the guidance in ASC
718. In addition, under ASC 718, equity-classified awards are not remeasured, whereas
liability-classified awards are remeasured until settlement.
Further, since both vesting and nonvesting conditions should be
evaluated under ASC 718, a change in the probable or actual outcome of a service or
performance condition that results in a change in the measurement of the award should be
reflected as a change in the transaction price.4 If an estimate is required, an entity should estimate the total fair-value-based
measure of the sales incentive (e.g., by determining the number of equity instruments
that it will be obligated to issue) and update that amount until the award ultimately
vests or is forfeited. See Sections
3.4.1 and 3.4.2 for further discussion of service conditions and performance
conditions, respectively.
By contrast, any changes in measurement that are due to the form of
consideration are not reflected as changes to the transaction price but instead are
presented elsewhere in the grantor’s income statement. This includes changes to the
fair-value-based measure of liability-classified awards that are not related to service
or performance conditions.
Connecting the Dots
While ASC 606-10-32-25A states that subsequent changes in
measurement due to the form of the consideration should not be included in the
transaction price (i.e., should not be presented as an adjustment to revenue),
it does not specify where such changes should be reflected in the income
statement. Therefore, an entity must use judgment to determine the appropriate
presentation in such circumstances.
ASC 718 does not explicitly provide guidance on the accounting for a modification of a
share-based payment issued as a sales incentive to a customer when the modification
occurs while the grantee remains a customer. We generally believe that in these
situations, it would be appropriate to apply the modification guidance in ASC 718 when
measuring the modification’s impact. (See Chapter
6 for a discussion of modification accounting under ASC 718.)
14.6.1 Equity-Classified Share-Based Payments
ASC 718 requires that entities measure equity-classified share-based
payment awards on the grant date and not remeasure them unless the awards are
modified. Entities should determine the grant-date fair-value-based measure of the
award on the basis of the probable or actual outcomes of any service or performance
conditions (whether vesting or nonvesting). The probable or actual outcomes are
reassessed in each reporting period, and the final measurement of the award
associated with the ultimate outcomes of those conditions will be reflected as a
reduction of the transaction price. Therefore, any change to the total measurement
of a share-based sales incentive that is not attributable to the form of
consideration should be recognized as a change to the transaction price.
Example 14-3
Share-Based Sales Incentives That Include Both Service and
Performance Conditions
On January 1, 20X1, Entity A sells 10,000
units of Product X to Customer B, a retailer, for $10 each
(resulting in a total sales value of $100,000). Assume that
Entity A has elected to estimate forfeitures of nonemployee
share-based payment awards. The arrangement is within the
scope of ASC 606.
As part of the arrangement, B promises to
display Product X in a favorable location within its store
to encourage sales of Product X to the end consumer. In
return for the favorable in-store placement of Product X, A
grants B 1,000 unvested equity-classified warrants on A’s
common stock. The warrants have a term of five years and a
grant-date fair-value-based measure (as calculated under ASC
718) of $7 (resulting in a total grant-date fair-value-based
measure of $7,000). The warrants vest if B displays Product
X in the favorable location for one year. In addition, to
protect A’s existing shareholders from dilution if A
experiences poor financial results, the warrants will vest
only if A achieves a specified EBITDA target during the
one-year vesting period.
Entity A determines the following:
- The grant date established for the warrants is January 1, 20X1.
- The requirement to provide favorable in-store placement of Product X for one year is a service condition, and the specified EBITDA target is a performance condition.
- As of the grant date of the warrants, A estimates that it is probable that the warrants will vest under the service and performance conditions.
- The benefit received from B (i.e., favorable in-store placement of Product X) in exchange for the warrants does not represent a distinct good or service.
On the basis of the above determinations, A concludes that
the warrants should be recognized as a reduction of the
transaction price for its sale of Product X to B (i.e., the
warrants represent a share-based sales incentive). To
calculate the amount of that reduction, A considers that it
is probable that the service and performance conditions will
be met. Therefore, on January 1, 20X1, A reduces the
transaction price for its sale of Product X to B by $7,000.
If A determines that the share-based sales incentive is
associated with the revenue from the sale of the 10,000
units of Product X, the net revenue for those units will be
$93,000 ($100,000 – $7,000). The reduction in the
transaction price would be reversed and reflected as an
increase in the transaction price in a subsequent reporting
period if the warrants do not vest or it becomes probable
that the warrants will not vest.
Example 14-4
Share-Based Sales Incentive That Includes a Performance
Condition That Affects the Quantity of Awards
(Nonvesting Condition)
Assume the same facts as in the example
above except that in this case, the performance condition
affects the quantity of the warrants earned instead of their
vesting, and minimum, target, and maximum awards can be
earned depending on the level of the EBITDA target achieved.
The table below shows the amount of warrants that can be
earned, as well as the resulting grant-date fair-value-based
measure of the warrants, depending on the relative
achievement of the performance.
Entity A determines the following:
- The grant date established for the warrants is January 1, 20X1.
- The requirement to provide favorable in-store placement of Product X for one year is a service condition, and the specified EBITDA target is a performance condition.
- As of the grant date of the warrants, A estimates that it is probable that the warrants will vest under the service condition and that 1,000 warrants will be issued (in accordance with the target level) on the basis of the probable outcome of the performance condition.
- The benefit received from Customer B (i.e., favorable in-store placement of Product X) in exchange for the warrants does not represent a distinct good or service.
On the basis of the above determinations, A concludes that
the warrants should be recognized as a reduction of the
transaction price for its sale of Product X to B (i.e., the
warrants represent a share-based sales incentive). To
calculate the amount of that reduction, A considers that it
is probable that the service condition will be met and that
the target performance condition resulting in the issuance
of 1,000 warrants will be met. Therefore, on January 1,
20X1, A reduces the transaction price for its sale of
Product X to B by $7,000. If A determines that the
share-based sales incentive is associated with the revenue
from the sale of the 10,000 units of Product X, the net
revenue for those units will be $93,000 ($100,000 – $7,000).
The reduction in the transaction price would be reversed and
reflected as an increase in the transaction price in a
subsequent reporting period if the warrants do not vest or
it becomes probable that the warrants will not vest under
the service condition.
In addition, A would reflect as an adjustment to the
transaction price a subsequent change in the measurement of
the warrants on the basis of the expected outcome or actual
outcome of the performance condition. For example, if A
determines in a subsequent reporting period that the
probable outcome is that 150 percent of the EBITDA target
will be achieved, which would result in a total grant-date
fair-value-based-measurement of $10,500, A would adjust the
transaction price to reflect the revised grant-date
fair-value-based measure of the warrants (i.e., from $7,000
to $10,500) and record net revenue of $89,500 for Product X.
The final reduction in the transaction price would be based
on the grant-date fair-value-based-measure of the ultimate
outcome achieved for both the service and performance
conditions.
14.6.2 Liability-Classified Share-Based Payments
Under ASC 718, liability-classified share-based payment awards must
be remeasured at the end of each reporting period until settlement. However, ASC
606-10-32-25A requires that entities reflect only the grant-date fair-value-based
measure of a liability-classified share-based sales incentive as a reduction of
revenue. Any changes to the measurement of the share-based sales incentive after the
grant date that are attributable to the form of the consideration (i.e., not due to
the probable or actual outcome of any service or performance conditions) would be
reflected elsewhere in the income statement. Therefore, although entities would be
required to remeasure liability-classified share-based sales incentives at the end
of each reporting period until settlement, they would not reflect as an adjustment
to revenue subsequent changes to the fair-value-based measure because such changes
are attributable to the form of the consideration.
Example 14-5
Liability-Classified
Share-Based Sales Incentive
Assume the same facts as in Example
14-3 except that instead of equity-classified
warrants, Entity A grants Customer B 1,000 cash-settled SARs
that are liability classified. The grant-date
fair-value-based measure is $7 (resulting in a total
grant-date fair-value-based measure of $7,000). On December
31, 20X1, the fair-value-based measure is $9 (resulting in a
total fair-value-based measure of $9,000). Entity A
concludes that it is probable that the SARs will vest, and
the SARs actually do vest, on December 31, 20X1.
On January 1, 20X1, A initially measures and
reduces its transaction price for its sale of Product X to B
by $7,000 (for net revenue of $93,000). On December 31,
20X1, the subsequent measurement of the award is $9,000.
This represents a change in the measurement of the award
after the grant date that is attributable to the form of
consideration (changes in the fair-value-based measure of a
liability-classified share-based payment award that are
unrelated to a change in service or performance conditions).
Therefore, A does not revise its estimate of the transaction
price; rather, A reflects the change of $2,000 elsewhere in
the income statement.
14.6.3 Practical Expedients for Nonpublic Entities
Except as noted below, under ASC 718 nonpublic entities may apply the same practical
expedients to share-based sales incentives as they apply to employee and nonemployee
awards.
A nonpublic entity is permitted to use a practical expedient to measure all
liability-classified share-based payment awards for goods and services at intrinsic
value instead of a fair-value-based measure. This practical expedient must be
applied consistently to both employee and nonemployee awards. However, in accordance
with ASC 718-30-30-2, a nonpublic entity’s initial and subsequent measurement of its
liability-classified share-based sales incentives should be calculated at the
fair-value-based measure even when the entity makes the intrinsic value measurement
election for other liability-classified awards within the scope of ASC 718.
For more information about measurement-related practical expedients available to
nonpublic entities, see Section 4.13.
Footnotes
4
If an entity has elected as an accounting policy to recognize
the effects of forfeitures for nonemployee share-based payment awards when they
occur, it would not assess the probable outcome of a service condition that
affects the awards’ vesting. It would instead include the entire share-based
sales incentive in the transaction price unless the incentive is forfeited.
14.7 Recognition
ASC 718-10
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.
An entity applies ASC 718 only to the measurement and classification of share-based sales
incentives. To recognize and present such incentives, the entity should apply the
guidance in ASC 606 on consideration payable to a customer.
For example, under ASC 606-10-32-27, an entity would recognize the grant-date
fair-value-based measure of share-based sales incentives as a reduction of revenue when
(or as) the later of either of the following events occurs:
- The entity recognizes revenue for the transfer of the related goods or services to the customer.
- The entity pays or promises to pay the consideration (even if the payment is conditional on a future event). That promise might be implied by the entity’s customary business practices.
In accordance with the above guidance, an entity will typically
recognize a share-based sales incentive as a reduction of revenue when, or as, the
entity recognizes revenue for the transfer of the related goods or services to the
customer.5 Because the vesting of share-based sales incentives may not align with the
recognition of revenue for the transfer of the related goods or services to the
customer, an entity will need to use judgment in those circumstances to determine what
the “related” goods and services are.
See Chapter
8 of Deloitte’s Roadmap Revenue Recognition for additional guidance on determining
when to recognize revenue.6
Example 14-6
Recognition of Fully Vested Share-Based Sales
Incentives
On January 1, 20X1, Entity A executes a one-year
MSA to sell Product X to Customer B, a retailer, for $10 per
unit. The MSA includes general terms and conditions and also
contains a minimum purchase requirement of 12,000 units (which
establishes legally enforceable rights and obligations
associated with the revenue contract), resulting in a total
minimum commitment of $120,000. The arrangement is within the
scope of ASC 606.
As incentive for B to agree to a minimum purchase commitment, A
grants B 1,000 fully vested equity-classified shares of A’s
common stock. The shares have a grant-date fair-value-based
measure of $10 (resulting in a total grant-date fair-value-based
measure of $10,000). The terms of the contract are sufficient to
establish a grant date of January 1, 20X1, for the shares.
Entity A concludes that it does not receive a
distinct good or service in exchange for the shares and
therefore determines that it should account for the shares as a
reduction of the transaction price for its sale of Product X
(i.e., the shares represent a share-based sales incentive). In
addition, A determines that the up-front grant of a fully vested
share-based sales incentive with a grant-date fair-value-based
measure of $10,000 meets the definition of an asset as defined
in Chapter 4 of FASB Concepts Statement 8.7 Entity A also determines that the share-based sales
incentive is solely related to the 12,000 units of Product X in
the initial contract on the basis of its best estimate of the
probable amount of units that B is expected to purchase.
Entity A measures and classifies the shares in
accordance with ASC 718 and recognizes revenue (and the
reduction of revenue) for the share-based sales incentive
payable in accordance with ASC 606. Because it determined that
the up-front fully vested share-based sales incentive meets the
definition of an asset, A recognizes an asset and corresponding
credit to equity on the basis of the grant-date fair-value-based
measure of $10,000. The net transaction price is $110,000
($120,000 – $10,000), and A subsequently derecognizes the asset
as a reduction of revenue as the related goods or services are
provided to the customer (i.e., as control of the 12,000 units
of Product X transfers to the customer, with net revenue of
approximately $9 per unit).
Footnotes
5
As discussed in Section 14.4, there may be circumstances
in which a grant date has not been established but the customer has a valid
expectation that share-based consideration will be issued. In such
circumstances, the entity should apply the variable consideration guidance in
ASC 606-10-32-7 and estimate the fair-value-based measure of the equity
instrument before the grant date.
6
See Chapter
6 of Deloitte’s Roadmap Revenue Recognition for additional
guidance on the measurement and recognition of consideration payable to a
customer.
7
See Chapter 6 of
Deloitte’s Roadmap Revenue
Recognition for guidance on the
recognition of up-front payments to customers.
14.8 Disclosure
The FASB decided not to establish specific disclosure requirements for
share-based sales incentives because ASC 606 and ASC 718 already provide guidance on
disclosures related to revenue transactions and share-based payment arrangements.
Accordingly, an entity should evaluate the disclosure requirements in both ASC 606 and
ASC 718 when it grants share-based sales incentives to customers.8
Footnotes
8
See paragraph BC18 of ASU 2019-08.
Appendix A — Comparison of U.S. GAAP and IFRS Accounting Standards
Appendix A — Comparison of U.S. GAAP and IFRS Accounting Standards
Under IFRS Accounting Standards, the primary source of guidance on
the accounting for share-based payment awards is IFRS 2. While ASC 718 and IFRS 2
share the same principles-based approach and are largely converged, there are some
differences in how entities apply those principles
The table below summarizes some of the significant differences
between U.S. GAAP and IFRS Accounting Standards in the accounting for share-based
payment awards.1 For detailed interpretive guidance on IFRS 2, see A16, “Share-Based Payment,”
of Deloitte’s iGAAP publication.
Accounting for Share-Based Payment
Transactions
Subject
|
U.S. GAAP
|
IFRS Accounting Standards
|
---|---|---|
Scope
|
Share-based payments issued to a customer
that are not in exchange for a distinct good or service
(i.e., share-based sales incentives) are measured and
classified in accordance with ASC 718.
Share-based consideration payable to a customer is calculated
by using a fair-value-based measure of the equity instrument
as of the grant date. (See Chapter 14.)
|
IFRS 15 does not specify whether equity
instruments granted by an entity to a customer are a type of
consideration paid or payable to a customer. Further, IFRS
15 does not address how equity instruments granted to a
customer in a revenue arrangement should be accounted for
with regard to initial and subsequent measurement.
Therefore, an entity should consider which standard (e.g.,
IFRS 2, IFRS 15, IAS 32), or combination of standards, could
be applicable.
|
Accounting for employee and nonemployee awards
|
ASC 718 generally applies to share-based payment awards
granted to employees and nonemployees in exchange for goods
or services. While the accounting for employee and
nonemployee awards is largely aligned, differences in the
guidance are discussed in Chapter
9.
|
IFRS 2 applies to share-based payment transactions with
employees and nonemployees in exchange for goods or
services. Under IFRS 2, the accounting treatment is
different for (1) share-based payment awards granted to
employees and nonemployees that provide services in a manner
similar to an employee and (2) share-based payment awards
exchanged for goods or services that are not similar to
employee services.
|
Measurement of awards
|
Share-based payment awards are generally
recognized at a fair-value-based measure (for both employee
and nonemployee awards).
For awards granted by a nonpublic entity,
the entity is required to use a fair-value-based measure or
calculated value if it is not practicable for it to estimate
the expected volatility of its share price (see Section
4.13.2). In addition, a nonpublic entity can
make an entity-wide accounting policy election to use either
a fair-value-based measure (or a calculated value as noted
above) or intrinsic value to measure its
liability-classified awards (see Section 4.13.3).
|
Share-based payment awards issued to
nonemployees in exchange for services that are similar to
employee services are measured on the same basis as employee
awards (i.e., a fair-value-based measure).
Share-based payment awards issued to
nonemployees in exchange for goods or for services that are
not similar to employee services are measured as of the date
the entity obtains the goods or the counterparty renders the
service. The awards should be measured on the basis of the
fair value of the goods or services received unless that
fair value cannot be estimated reliably. If the entity
cannot estimate reliably the fair value of the goods or
services received, the entity should measure their value by
reference to the fair value of the equity instruments
granted. However, there is a rebuttable presumption that the
fair value of the goods or services received can be
estimated reliably.
There are no practical expedients for
nonpublic entities. A fair-value-based measure must be used
for all share-based payment awards.
|
Estimating the expected term of stock
options and similar instruments
|
If certain conditions are met, public and
nonpublic entities can apply a practical expedient for
estimating the expected term (see Sections 4.9.2.2.2 and
4.9.2.2.3).
In addition, for nonemployee awards, an
entity can make an award-by-award election to use the
contractual term as the expected term.
|
There is no practical expedient for
estimating the expected term or, for nonemployee awards,
election to use the contractual term as the expected
term.
|
Classification — bearing the risks and
rewards of equity share ownership for a reasonable period of
time (put options)
|
A share-based payment award that can be
repurchased for cash at fair value is not classified as a
liability if the grantee bears the risks and rewards of
equity share ownership for a reasonable period of time (see
Section 5.3).
|
A share-based payment award is recognized as
a liability if there is a present obligation to settle it in
cash. There is no exception for a grantee that bears the
risks and rewards of share ownership for a reasonable period
of time.
|
Classification of awards with “other”
conditions
|
Awards with conditions or other features
that are indexed to something other than a market,
performance, or service condition must be classified as
liabilities, and the additional condition should be
reflected in the award’s fair value (see Section
5.5).
|
Awards with conditions or other features
that are indexed to something other than a market,
performance, or service condition may be classified as
equity if there is no obligation to settle the awards in
cash, and the additional condition should be reflected in
the award’s fair value as a non-vesting condition.
|
Classification of net-share-settled awards
with statutory tax withholding obligations
|
The net share settlement of an employee
award for statutory tax withholding purposes would not, by
itself, result in liability classification of the award
provided that the amount withheld does not exceed the
maximum statutory tax rates in the employees’ relevant tax
jurisdictions. If the amount withheld exceeds the maximum
statutory tax rate, the entire award is classified as a
liability (see Section 5.7.2).
|
A net share settlement feature that permits
or requires an entity to withhold the number of equity
instruments equal to the monetary value of the employee’s
tax obligation does not, by itself, result in liability
classification. When the number of equity shares withheld
exceeds the number needed to settle the employee’s tax
obligation, only the excess is accounted for as a
liability.
|
Classification of awards settled with a
variable number of shares
|
Certain awards that are settled with a
variable number of shares are classified as a liability if
the monetary value is solely or predominantly based on a
fixed monetary amount, variations in something other than
the fair value of the entity’s equity shares, or variations
inversely related to changes in the fair value of the
entity’s equity shares (see Section 5.2).
|
Awards that are settled with a variable
number of shares are classified as equity.
|
Attribution of employee awards with service
conditions and graded vesting
|
An entity makes an accounting policy
election to recognize compensation cost for an employee
award with only a service condition and a graded vesting
schedule on a straight-line basis over either (1) the
requisite service period for each separately vesting portion
of the award as if the award was, in substance, multiple
awards (i.e., on an accelerated basis) or (2) the total
requisite service period for the entire award (see Section
3.6.5).
|
Such awards must be recognized only as
in-substance multiple awards (i.e., on an accelerated
basis).
|
Performance targets satisfied after the
requisite service period
|
Performance conditions that can be met after
the requisite service period or nonemployee’s vesting period
are treated as vesting conditions. Therefore, the
performance conditions are not directly reflected in an
award’s fair-value-based measure (see Section
3.4.2.2).
|
Performance conditions that can be met after
the requisite service period are treated as nonvesting
conditions. Therefore, the performance condition is directly
reflected in the award’s fair-value-based measure.
|
Share-based payment awards with a
performance condition based on the occurrence of a liquidity
event (e.g., IPO or change in control)
|
A liquidity event such as a change in
control or an IPO is generally not considered probable
(i.e., future event is likely to occur) 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.
|
For awards in which a liquidity event is
assessed as a performance condition, compensation cost is
recognized if or when the liquidity event is expected to
occur.
Often, it will not be possible to conclude
that a liquidity event such as an IPO is expected to occur
until plans are well advanced.
|
Forfeitures of awards
|
For service conditions, an entity makes an
entity-wide accounting policy election (separately for
employee awards and nonemployee awards) to either (1)
estimate the total number of awards for which the requisite
service period or nonemployee’s vesting period will not be
rendered (i.e., estimate forfeitures expected to occur) or
(2) account for forfeitures when they occur (see Section
3.4.1).
|
An entity is required to estimate
forfeitures expected to occur.
|
Modification accounting for awards for which
vesting is improbable but becomes probable (i.e., improbable
to probable modifications)
|
Compensation cost is recognized on the basis
of the modified award’s fair-value-based measure as of the
modification date (see Section 6.3.3).
|
Compensation cost is recognized on the basis
of the grant-date fair-value-based measure of the original
award plus the incremental value of the modified award on
the modification date.
|
Modification accounting for awards that
change from liability-classified to equity-classified
|
Upon modification, the liability is
reclassified to equity. If the fair-value-based measure of
the modified award is less than the fair-value-based measure
of the liability at the time of the modification, the
difference is deemed to be a capital contribution and
recognized in equity. If the fair-value-based measure of the
modified award is greater than the fair-value-based measure
of the liability at the time of the modification, the excess
is generally recognized as compensation cost over the
remaining employee’s requisite service period or
nonemployee’s vesting period (see Section 6.8.2).
|
Upon modification, the existing liability is
derecognized. The fair-value-based measure of the equity
awards on the modification date is recognized in equity on
the basis of which goods or services have been received
(i.e., on the basis of the vesting period that has lapsed).
Any difference between the liability derecognized and the
amount recognized in equity is reflected immediately in the
income statement.
|
Accounting for income tax effects
|
For awards that ordinarily give rise to a
tax deduction under existing tax law, deferred taxes are
computed on the basis of compensation expense that is
recognized for financial reporting purposes. Tax benefits in
excess of or less than the related DTA are recognized in the
income statement in the period in which the amount of the
deduction is determined (typically when an award vests or,
in the case of options, is exercised or expires). (see
Chapter 11).
|
For awards that ordinarily give rise to a
tax deduction, deferred taxes are computed on the basis of
the hypothetical tax deduction for the share-based payment
corresponding to the percentage earned to date (i.e., the
intrinsic value of the award on the reporting date
multiplied by the percentage vested). Recognition of
deferred taxes could be recorded through either profit or
loss or equity.
|
Recognition of payroll taxes
|
Payroll tax liabilities related to
share-based payment awards should be recognized on the date
on which the measurement and payment of the tax are
triggered (e.g., upon exercise or vesting; see Section
3.12).
|
Payments of payroll taxes are outside the
scope of IFRS 2 because they are not payments to the
suppliers of goods or services. However, in a manner
consistent with the guidance in IAS 37, entities should
recognize a liability for them at the end of each reporting
period because they are similar to cash-settled share-based
payments under IFRS 2.
|
Group share-based payment awards
|
Share-based payment awards that are issued
by a subsidiary to employees or nonemployees of the
subsidiary and that are settled in the parent’s equity are
generally classified as equity awards in the stand-alone
financial statements of the subsidiary (see Section
2.9).
Liability-classified awards (e.g.,
cash-settled awards) that are issued by a parent to
employees or nonemployees of a subsidiary are generally
remeasured at the end of each period in the determination of
compensation cost in the stand-alone financial statements of
the subsidiary (i.e., the same amount of compensation cost
recognized by the parent on a consolidated basis). If the
subsidiary has no obligation associated with the awards, the
offset would be recognized as a capital contribution in
equity (see Section 2.9).
|
Share-based payment awards that are issued
by a subsidiary to employees of the subsidiary and that are
settled in the parent’s equity are generally classified as
liability awards under IFRS 2 in the stand-alone financial
statements of the subsidiary unless the subsidiary does not
have an obligation to settle the awards.
If a parent provides cash-settled awards to
employees of a subsidiary and the subsidiary has no
obligation to settle the awards, the awards are treated as
equity-settled awards in the stand-alone financial
statements of the subsidiary.
|
Employee stock purchase plan (ESPP)
|
The guidance in ASC 718-50 on ESPPs may be
different from that for other share-based payment awards
(e.g., the requisite service period for ESPPs is the
purchase period). In addition, an ESPP may be considered
compensatory or noncompensatory. To qualify as a
noncompensatory plan and, therefore, not give rise to the
recognition of compensation cost, an ESPP must meet certain
conditions (see Chapter 8).
|
The accounting requirements for ESPPs are
the same as those for all share-based payment awards.
Therefore, ESPPs are compensatory and treated in the same
manner as any other equity-settled share-based payment
arrangement.
|
Footnotes
1
Differences are based on a comparison of authoritative
literature under U.S. GAAP and IFRS Accounting Standards and do not
necessarily include interpretations of such literature.
Appendix B — Glossary of Selected Terms
Appendix B — Glossary of Selected Terms
Selected glossary terms in ASC 718-10-20 and the ASC master glossary are reproduced
below.
ASC 718-10 Glossary and ASC Master Glossary
Award
The collective noun for multiple instruments with the same terms
and conditions granted at the same time either to a single
grantee or to a group of grantees. An award may specify multiple
vesting dates, referred to as graded vesting, and different
parts of an award may have different expected terms. References
to an award also apply to a portion of an award.
Blackout Period
A period of time during which exercise of an equity share option
is contractually or legally prohibited.
Broker-Assisted Cashless Exercise
The simultaneous exercise by a grantee of a share option and sale
of the shares through a broker (commonly referred to as a
broker-assisted exercise).
Generally, under this method of exercise:
- The grantee authorizes the exercise of an option and the immediate sale of the option shares in the open market.
- On the same day, the entity notifies the broker of the sale order.
- The broker executes the sale and notifies the entity of the sales price.
- The entity determines the minimum statutory tax-withholding requirements.
- By the settlement day (generally three days later), the entity delivers the stock certificates to the broker.
- On the settlement day, the broker makes payment to the entity for the exercise price and the minimum statutory withholding taxes and remits the balance of the net sales proceeds to the grantee.
Call Option
A contract that allows the holder to buy a specified quantity of
stock from the writer of the contract at a fixed price for a
given period.
Combination Award
An award with two or more separate components, each of which can
be separately exercised. Each component of the award is actually
a separate award, and compensation cost is measured and
recognized for each component.
Customer
A party that has contracted with an entity to obtain goods or
services that are an output of the entity’s ordinary activities
in exchange for consideration.
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. See Explicit Service Period,
Implicit Service
Period, and Requisite
Service Period.
Economic Interest in an Entity
Any type or form of pecuniary interest or arrangement that an
entity could issue or be a party to, including equity
securities; financial instruments with characteristics of
equity, liabilities, or both; long-term debt and other
debt-financing arrangements; leases; and contractual
arrangements such as management contracts, service contracts, or
intellectual property licenses.
Employee
An individual over whom the grantor of a share-based compensation
award exercises or has the right to exercise sufficient control
to establish an employer-employee relationship based on common
law as illustrated in case law and currently under U.S. Internal
Revenue Service (IRS) Revenue Ruling 87-41. A reporting entity
based in a foreign jurisdiction would determine whether an
employee-employer relationship exists based on the pertinent
laws of that jurisdiction. Accordingly, a grantee meets the
definition of an employee if the grantor consistently represents
that individual to be an employee under common law. The
definition of an employee for payroll tax purposes under the
U.S. Internal Revenue Code includes common law employees.
Accordingly, a grantor that classifies a grantee potentially
subject to U.S. payroll taxes as an employee also must represent
that individual as an employee for payroll tax purposes (unless
the grantee is a leased employee as described below). A grantee
does not meet the definition of an employee solely because the
grantor represents that individual as an employee for some, but
not all, purposes. For example, a requirement or decision to
classify a grantee as an employee for U.S. payroll tax purposes
does not, by itself, indicate that the grantee is an employee
because the grantee also must be an employee of the grantor
under common law.
A leased individual is deemed to be an employee of the lessee if
all of the following requirements are met:
- The leased individual qualifies as a common law employee of the lessee, and the lessor is contractually required to remit payroll taxes on the compensation paid to the leased individual for the services provided to the lessee.
- The lessor and lessee agree in writing to all of the
following conditions related to the leased
individual:
- The lessee has the exclusive right to grant stock compensation to the individual for the employee service to the lessee.
- The lessee has a right to hire, fire, and control the activities of the individual. (The lessor also may have that right.)
- The lessee has the exclusive right to determine the economic value of the services performed by the individual (including wages and the number of units and value of stock compensation granted).
- The individual has the ability to participate in the lessee’s employee benefit plans, if any, on the same basis as other comparable employees of the lessee.
- The lessee agrees to and remits to the lessor funds sufficient to cover the complete compensation, including all payroll taxes, of the individual on or before a contractually agreed upon date or dates.
A nonemployee director does not satisfy this definition of
employee. Nevertheless, nonemployee directors acting in their
role as members of a board of directors are treated as employees
if those directors were elected by the employer’s shareholders
or appointed to a board position that will be filled by
shareholder election when the existing term expires. However,
that requirement applies only to awards granted to nonemployee
directors for their services as directors. Awards granted to
those individuals for other services shall be accounted for as
awards to nonemployees.
Employee Stock Ownership Plan
An employee stock ownership plan is an employee benefit plan that
is described by the Employee Retirement Income Security Act of
1974 and the Internal Revenue Code of 1986 as a stock bonus
plan, or combination stock bonus and money purchase pension
plan, designed to invest primarily in employer stock. Also
called an employee share ownership plan.
Equity Restructuring
A nonreciprocal transaction between an entity and its
shareholders that causes the per-share fair value of the shares
underlying an option or similar award to change, such as a stock
dividend, stock split, spinoff, rights offering, or
recapitalization through a large, nonrecurring cash
dividend.
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. See Derived
Service Period, Implicit Service Period, and Requisite Service Period.
Fair Value
The amount at which an asset (or liability) could be bought (or
incurred) or sold (or settled) in a current transaction between
willing parties, that is, other than in a forced or liquidation
sale.
Freestanding Financial Instrument
A financial instrument that meets either of the following
conditions:
- It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
- It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
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.
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. See Derived Service Period,
Explicit Service
Period, and Requisite
Service Period.
Intrinsic Value
The amount by which the fair value of the underlying stock
exceeds the exercise price of an option. For example, an option
with an exercise price of $20 on a stock whose current market
price is $25 has an intrinsic value of $5. (A nonvested share
may be described as an option on that share with an exercise
price of zero. Thus, the fair value of a share is the same as
the intrinsic value of such an option on that share.)
Issued, Issuance, or Issuing of an Equity Instrument
An equity instrument is issued when the issuing entity receives
the agreed-upon consideration, which may be cash, an enforceable
right to receive cash, or another financial instrument, goods,
or services. An entity may conditionally transfer an equity
instrument to another party under an arrangement that permits
that party to choose at a later date or for a specified time
whether to deliver the consideration or to forfeit the right to
the conditionally transferred instrument with no further
obligation. In that situation, the equity instrument is not
issued until the issuing entity has received the consideration.
The grant of stock options or other equity instruments subject
to vesting conditions is not considered to be issuance.
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.
Measurement Date
The date at which the equity share price and other pertinent
factors, such as expected volatility, that enter into
measurement of the total recognized amount of compensation cost
for an award of share-based payment are fixed.
Modification
A change in the terms or conditions of a share-based payment
award.
Nonpublic Entity
Any entity other than one that meets any of the following
criteria:
- Has equity securities that trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
- Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
- Is controlled by an entity covered by the preceding criteria.
An entity that has only debt securities trading in a public
market (or that has made a filing with a regulatory agency in
preparation to trade only debt securities) is a nonpublic
entity.
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).
Option
Unless otherwise stated, a call option that
gives the holder the right to purchase shares of common stock
from the reporting entity in accordance with an agreement upon
payment of a specified amount. Options include, but are not
limited to, options granted and stock purchase agreements
entered into with grantees. Options are considered securities.
See Call Option.
Participating Security
A security that may
participate in undistributed earnings with common stock, whether
that participation is conditioned upon the occurrence of a
specified event or not. The form of such participation does not
have to be a dividend — that is, any form of participation in
undistributed earnings would constitute participation by that
security, regardless of whether the payment to the security
holder was referred to as a dividend.
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.
Public Business Entity
A public business entity is a business entity meeting any one of
the criteria below. Neither a not-for-profit entity nor an
employee benefit plan is a business entity.
- It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
- It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
- It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
- It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
- It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
An entity may meet the definition of a public business entity
solely because its financial statements or financial information
is included in another entity’s filing with the SEC. In that
case, the entity is only a public business entity for purposes
of financial statements that are filed or furnished with the
SEC.
Public Entity
An entity that meets any of the following criteria:
- Has equity securities that trade in a public market, either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
- Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
- Is controlled by an entity covered by the preceding criteria. That is, a subsidiary of a public entity is itself a public entity.
An entity that has only debt securities trading in a public
market (or that has made a filing with a regulatory agency in
preparation to trade only debt securities) is not a public
entity.
Purchased Call Option
A contract that allows the reporting entity to buy a specified
quantity of its own stock from the writer of the contract at a
fixed price for a given period. See Call Option.
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.
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.
Restriction
A contractual or governmental provision that prohibits sale (or
substantive sale by using derivatives or other means to
effectively terminate the risk of future changes in the share
price) of an equity instrument for a specified period of
time.
Security
A share, participation, or other interest in property or in an
entity of the issuer or an obligation of the issuer that has all
of the following characteristics:
- It is either represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
- It is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment.
- It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.
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.
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).
Settlement of an Award
An action or event that irrevocably extinguishes the issuing
entity’s obligation under a share-based payment award.
Transactions and events that constitute settlements include the
following:
- Exercise of a share option or lapse of an option at the end of its contractual term
- Vesting of shares
- Forfeiture of shares or share options due to failure to satisfy a vesting condition
- An entity’s repurchase of instruments in exchange for assets or for fully vested and transferable equity instruments.
The vesting of a share option is not a settlement because the
entity remains obligated to issue shares upon exercise of the
option.
Share Option
A contract that gives the holder the right, but not the
obligation, either to purchase (to call) or to sell (to put) a
certain number of shares at a predetermined price for a
specified period of time.
Share Unit
A contract under which the holder has the right to convert each
unit into a specified number of shares of the issuing
entity.
Share-Based Payment Arrangements
An arrangement under which either of the following conditions is
met:
- One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments.
- The entity incurs liabilities to suppliers that meet
either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity’s shares and something other than either the price of the entity’s shares or a market, performance, or service condition.)
- The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest that
may not take the legal form of securities (for example,
partnership interests), as well as other interests, including
those that are liabilities in substance but not in form. Equity
shares refers only to shares that are accounted for as
equity.
Also called share-based compensation arrangements.
Share-Based Payment Transactions
A transaction under a share-based payment arrangement, including
a transaction in which an entity acquires goods or services
because related parties or other holders of economic interests
in that entity awards a share-based payment to an employee or
other supplier of goods or services for the entity’s benefit.
Also called share-based compensation transactions.
Tandem Award
An award with two or more components in which exercise of one
part cancels the other(s).
Terms of a Share-Based Payment Award
The contractual provisions that determine the nature and scope of
a share-based payment award. For example, the exercise price of
share options is one of the terms of an award of share options.
As indicated in paragraph 718-10-25-15, the written terms of a
share-based payment award and its related arrangement, if any,
usually provide the best evidence of its terms. However, an
entity’s past practice or other factors may indicate that some
aspects of the substantive terms differ from the written terms.
The substantive terms of a share-based payment award, as those
terms are mutually understood by the entity and a party (either
an employee or a nonemployee) who receives the 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. See paragraph
718-10-30-5.
Time Value
The portion of the fair value of an option that exceeds its
intrinsic value. For example, a call option with an exercise
price of $20 on a stock whose current market price is $25 has
intrinsic value of $5. If the fair value of that option is $7,
the time value of the option is $2 ($7 – $5).
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.
Volatility
A measure of the amount by which a financial variable such as a
share price has fluctuated (historical volatility) or is
expected to fluctuate (expected volatility) during a period.
Volatility also may be defined as a probability-weighted measure
of the dispersion of returns about the mean. The volatility of a
share price is the standard deviation of the continuously
compounded rates of return on the share over a specified period.
That is the same as the standard deviation of the differences in
the natural logarithms of the stock prices plus dividends, if
any, over the period. The higher the volatility, the more the
returns on the shares can be expected to vary — up or down.
Volatility is typically expressed in annualized terms.
Appendix C — Titles of Standards and Other Literature
Appendix C — Titles of Standards and Other Literature
AICPA Literature
Accounting and Valuation Guide
Valuation of
Privately-Held-Company Equity Securities Issued as Compensation
Technical Questions and Answers
Section 4110, “Issuance of
Capital Stock”
FASB Literature
ASC Topics
ASC 210, Balance
Sheet
ASC 235, Notes to
Financial Statements
ASC 250, Accounting
Changes and Error Corrections
ASC 260, Earnings per
Share
ASC 270, Interim
Reporting
ASC 310, Receivables
ASC 323, Investments —
Equity Method and Joint Ventures
ASC 360, Property, Plant,
and Equipment
ASC 450,
Contingencies
ASC 470, Debt
ASC 480, Distinguishing
Liabilities From Equity
ASC 505, Equity
ASC 606, Revenue From
Contracts With Customers
ASC 610, Other
Income
ASC 710, Compensation —
General
ASC 718, Compensation —
Stock Compensation
ASC 740, Income
Taxes
ASC 805, Business
Combinations
ASC 815, Derivatives and
Hedging
ASC 820, Fair Value
Measurement
ASC 835, Interest
ASC 840, Leases
ASC 842, Leases
ASC 855, Subsequent
Events
ASUs
ASU 2016-09, Compensation
— Stock Compensation (Topic 718): Improvements to Employee Share-Based
Payment Accounting
ASU 2017-09, Compensation
— Stock Compensation (Topic 718): Scope of Modification Accounting
ASU 2018-07, Improvements
to Nonemployee Share-Based Payment Accounting
ASU 2019-08, Compensation
— Stock Compensation (Topic 718) and Revenue From Contracts With
Customers (Topic 606): Codification Improvements — Share-Based
Consideration Payable to a Customer
ASU 2020-06, Debt — Debt
With Conversion and Other Options (Subtopic 470-20) and Derivatives and
Hedging — Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting
for Convertible Instruments and Contracts in an Entity’s Own
Equity
ASU 2021-04, Issuer’s
Accounting for Certain Modifications or Exchanges of Freestanding
Equity-Classified Written Call Options (a consensus of the FASB Emerging
Issues Task Force)
ASU 2021-07, Compensation — Stock
Compensation (Topic 718): Determining the Current Price of an Underlying
Share
Proposed ASU
No. 2023-ED300, Compensation — Stock
Compensation (Topic 718): Scope Application of Profits Interest
Awards
IFRS Literature
IAS 32, Financial
Instruments: Presentation
IAS 37, Provisions, Contingent Liabilities and
Contingent Assets
IFRS 2, Share-Based
Payment
IFRS 15, Revenue From Contracts With
Customers
IRC
Section 162(m), “Trade or
Business Expenses; Certain Excessive Employee Remuneration”
Section 409A, “Inclusion in
Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation
Plans”
Section 421, “General Rules”
Section 422, “Incentive Stock
Options”
Section 423, “Employee Stock
Purchase Plans”
Section 424, “Definitions and
Special Rules”
SEC Literature
Accounting Series Release (ASR)
No. 268 (FRR Section 211),
Presentation in Financial Statements of “Redeemable Preferred
Stocks”
Codified Financial Reporting Release
Section 211, “Redeemable
Preferred Stocks”
Final Rule Release
No. 33-11126, Listing
Standards for Recovery of Erroneously Awarded Compensation
FRM
Topic 7, “Related Party
Matter”
Topic 9, “Management’s
Discussion and Analysis of Financial Position and Results of Operations
(MD&A)”
Regulation S-K
Item 303, “Management's Discussion and
Analysis of Financial Condition and Results of Operations“
Item 402, “Executive
Compensation”
Item 404, “Transactions With
Related Persons, Promoters and Certain Control Persons”
Regulation S-X
Rule 5-02, “Commercial and
Industrial Companies; Balance Sheets”
Rule 7-03, “Insurance
Companies; Balance Sheets”
Rule 9-03, “Bank Holding
Companies; Balance Sheets”
Rule 10-01, “Interim
Financial Statements”
SAB Topics
No. 1.B, “Financial
Statements; Allocation of Expenses and Related Disclosure in Financial
Statements of Subsidiaries, Divisions or Lesser Business Components of
Another Entity”
No. 3.C, “Senior Securities;
Redeemable Preferred Stock”
No. 4.E, “Equity Accounts;
Receivables From Sale of Stock”
No. 5.T, “Miscellaneous
Accounting; Accounting for Expenses or Liabilities Paid by Principal
Stockholder(s)”
No. 14, “Share-Based
Payment”
-
No. 14.B, “Transition From Nonpublic to Public Entity Status”
-
No. 14.C, “Valuation Methods”
-
No. 14.D, “Certain Assumptions Used in Valuation Methods”
-
No. 14.D.1, “Expected Volatility”
-
No. 14.D.2, “Expected Term”
-
No. 14.D.3, “Current Price of the Underlying Share (Including Considerations for Spring-Loaded Grants)“
-
-
No. 14.E, “FASB ASC Topic 718, Compensation — Stock Compensation, and Certain Redeemable Financial Instruments”
-
No. 14.F, “Classification of Compensation Expense Associated With Share-Based Payment Arrangements”
-
No. 14.I, “Capitalization of Compensation Cost Related to Share-Based Payment Arrangements”
Superseded Literature
Accounting Principles Board (APB) Opinion
No. 25, Accounting for
Stock Issued to Employees
AICPA Accounting Interpretation
AIN-APB 25, Accounting
for Stock Issued to Employees: Accounting Interpretations of APB Opinion
No. 25
AICPA Accounting Statement of Position
SOP 76-3, Accounting
Practices for Certain Employee Stock Ownership Plans
EITF Abstracts
Issue No. 00-23, “Issues Related to the Accounting for Stock Compensation Under APB Opinion No. 25 and FASB Interpretation No. 44”
Issue No. 08-8, “Accounting
for an Instrument (or an Embedded Feature) With a Settlement Amount That Is
Based on the Stock of an Entity’s Consolidated Subsidiary”
Topic No. D-98, “Classification and
Measurement of Redeemable Securities”
FASB Interpretations
No. 28, Accounting for
Stock Appreciation Rights and Other Variable Stock Option or Award
Plans — an interpretation of APB Opinions No. 15 and 25
No. 44, Accounting for
Certain Transactions Involving Stock Compensation — an
interpretation of APB Opinion No. 25
FASB Staff Position (FSP)
FAS 123(R)-6, Technical
Corrections of FASB Statement No. 123(R)
FASB Statements
No. 123(R), Share-Based
Payment
No. 128, Earnings per Share
No. 141(R), Business Combinations
No. 150, Accounting for Certain Financial
Instruments With Characteristics of Both Liabilities and Equity
No. 157, Fair Value
Measurements
FASB Technical Bulletin
No. 97-1, Accounting
Under Statement 123 for Certain Employee Stock Purchase Plans With a
Look-Back Option
Appendix D — Abbreviations
Appendix D — Abbreviations
Abbreviation
|
Description
|
---|---|
AICPA
|
American Institute of Certified Public
Accountants
|
AIN-APB
|
Accounting Interpretations of an APB
Opinion
|
APB
|
Accounting Principles Board
|
APIC
|
additional paid-in capital
|
ASC
|
FASB Accounting Standards Codification
|
ASR
|
Accounting Series Release
|
ASU
|
FASB Accounting Standards Update
|
CEO
|
chief executive officer
|
CFO
|
chief financial officer
|
CPI
|
consumer price index
|
CTO
|
chief technology officer
|
DLOM
|
discount for lack of marketability
|
DRIP
|
dividend reinvestment program
|
DTA
|
deferred tax asset
|
EBITDA
|
earnings before interest, taxes,
depreciation, and amortization
|
EITF
|
Emerging Issues Task Force
|
EPS
|
earnings per share
|
ESOP
|
employee stock ownership plan
|
ESPP
|
employee stock purchase plan
|
FASB
|
Financial Accounting Standards Board
|
FIFO
|
first in, first out
|
FRM
|
SEC Division of Corporation Finance’s
Financial Reporting Manual
|
FRR
|
Financial Reporting Release
|
GAAP
|
generally accepted accounting principles
|
GARCH
|
Generalized Autoregressive Conditional
Heteroskedasticity
|
IAS
|
International Accounting Standard
|
IBC
|
incentive-based compensation
|
IFRS
|
International Financial Reporting
Standard
|
IPO
|
initial public offering
|
IRC
|
Internal Revenue Code
|
IRR
|
internal rate of return
|
IRS
|
Internal Revenue Service
|
ISO
|
incentive stock option
|
LTIP
|
long-term incentive plan
|
MD&A
|
Management’s Discussion and Analysis
|
MOIC
|
multiple of invested capital
|
MSA
|
master supply agreement
|
Nasdaq
|
National Association of Securities Dealers Automater
Quotations
|
NQSO or NSO
|
nonqualified stock option
|
NYSE
|
New York Stock Exchange
|
OEA
|
SEC’s Office of Economic Analysis
|
PCAOB
|
Public Company Accounting Oversight
Board
|
PHLX
|
Philadelphia Exchange
|
RSU
|
restricted stock unit
|
SAB
|
SEC Staff Accounting Bulletin
|
SAR
|
stock appreciation right
|
SEC
|
U.S. Securities and Exchange Commission
|
SOP
|
AICPA Statement of Position
|
S&P 500
|
Standard & Poor’s 500 stock market
index
|
TSR
|
total shareholder return
|
Appendix E — Roadmap Updates for 2023
Appendix E — Roadmap Updates for 2023
The tables below summarize the
substantive changes made in the 2023 edition of this Roadmap.
New Content
Section
|
Title
|
Description
|
---|---|---|
Employees of Pass-Through Entities
|
Added guidance on whether an individual
qualifies as an employee of a pass-through entity (e.g.,
partnership, limited liability corporation, limited
liability partnership) in the context of the ASC master
glossary definition of “share-based payment
arrangements.”
| |
SEC’s Final Rule on the Recovery of
Erroneously Awarded Compensation (“Clawback
Policies”)
|
Added guidance to reflect the SEC’s
final rule on the recovery of erroneously awarded
compensation, which 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.
| |
Grant Date
|
Added guidance on determining the grant
date for ESPPs.
| |
Classification
|
Added guidance on determining the
classification of ESPP awards.
|
Amended Content
Section
|
Title
|
Description
|
---|---|---|
Added discussions of the FASB’s proposed ASU on the scope
application of profits interest awardsand the SEC’s
final rule related to the recovery of erroneously
awarded compensation (“clawbacks”).
| ||
Profits Interests and Other Awards
Issued by Pass-Through Entities
|
Added Changing Lanes to acknowledge the FASB’s
proposed ASU on the scope application of profits
interest awards.
| |
Communication Date
|
Expanded discussion of considerations
related to determining whether a recipient has the
ability to negotiate the key terms and conditions of an
award. Clarified that the term “relatively short time
period” applies only to determining the communication
date of a share-based payment award and should not be
applied to other aspects of ASC 718.
| |
Service Condition
|
Clarified that an entity would make its
accounting policy election for forfeitures separately
for employee and nonemployee awards.
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Estimating Forfeitures
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Expanded discussion to include
considerations for entities that elect to estimate
forfeitures related to recognizing compensation that is
at least equal to the grant-date fair-value-based
measure of the vested portion of that award.
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Performance Condition
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Added ESG targets to the examples of
performance conditions.
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Graded Vesting for Employee Awards
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Clarified that an entity’s use of either
a straight-line or an accelerated attribution method
represents an accounting policy election that should be
applied consistently to all similar awards, including
awards that have been modified.
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Only One Condition Must Be Met —
Employee Awards
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Added Example 3-26
to illustrate an award that vests upon the satisfaction
of either a performance condition or a market
condition.
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Liquidity Event and Target IRR
|
Clarified the guidance for certain
awards that may vest only if (1) a target IRR to
shareholders is achieved while the grantee is employed
and (2) the IRR is based on the payment of sufficient
proceeds tendered as a result of either distributions to
shareholders or the sale of sufficient equity.
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Multiple Performance Conditions and
Multiple Service Periods
|
Expanded the discussion of Case A in ASC
718-10-55-94 (regarding an award with multiple annual
performance targets) to clarify that when a performance
condition in one particular year does not affect the
outcome of any preceding or subsequent period, each
tranche should be accounted for as a separate award with
its own service inception date.
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Cash Loans Through Nonrecourse Notes
|
Added Example 3-38
to illustrate the accounting for cash loaned to an
employee in exchange for a nonrecourse note secured by
shares.
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Capitalization of Compensation Cost
|
Updated to list examples of other
sections of U.S. GAAP under which the capitalization of
share-based compensation costs is required.
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Fair-Value-Based Measurement
|
Clarified that although the valuation of
share-based payments that are subject to ASC 718 is
excluded from the scope of ASC 820, entities should
apply the measurement guidance in ASC 820 unless it is
inconsistent with the guidance in ASC 718.
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Current Market Price of the Underlying Share
|
Expanded the discussion of the guidance in SAB 120 to
note that a material increase in the market price of an
entity’s shares upon the release of “material non-public
information within a short period of time after the
measurement date” indicates that “market participants
would have considered an adjustment to the observable
market price on the measurement date.”
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Repurchase Features — Noncontingent Puttable Stock
Awards
|
Added Example 5-9 to illustrate the
accounting for the repurchase of shares at fair value
more than six months from the date on which stock
options were exercised and the shares became
outstanding.
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Substantive Terms
|
Added Example 5-18 to illustrate the
impact of an entity’s ability to deliver shares on the
substantive terms and classification of the award.
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SEC Guidance on Temporary Equity
|
Updated to provide examples of situations in which awards
would be classified in temporary equity.
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Replacement of Acquiree Awards
|
Updated to discuss circumstances in which (1) the terms
of the acquiree’s award are silent or give the acquiree
discretion regarding the award’s treatment upon a
change-in-control event and (2) the acquiree’s award is
replaced. In such cases, the acquirer should account for
the replacement award as if the acquirer were obligated
to replace it.
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Changes in Forfeiture Estimates or Actual Forfeitures in
the Postcombination Period
|
Expanded the discussion of View B (reversal of
compensation cost for the acquisition-date
fair-value-based measure of the awards not expected to
vest or that do not actually vest, regardless of whether
that measure was attributed to precombination or
postcombination vesting) to analogize to ASC
805-30-55-13, which describes changes in the
fair-value-based measure of liability-classified awards
after the acquisition date.
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Changes in the Probability of Meeting a Performance
Condition in the Postcombination Period
|
Clarified that a change in the expected outcome of a
performance condition from improbable to probable should
result in the accrual of compensation cost on the basis
of the acquisition-date fair-value-based measure of all
awards expected to vest.
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Modification to the Original Terms of the Awards to Add a
Change-in-Control Provision in Contemplation of a
Business Combination
|
Expanded the discussion of “in contemplation of” to
indicate that (1) a modification during the negotiation
of a business combination is presumed to benefit the
acquirer and (2) a modification before negotiations have
been entered into is presumed to benefit the
acquiree.
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