Accounting for Cash Settlement of Equity Awards

This week, I return to my series on how to account for modifications to equity awards—explained in 75 words or less. Today’s topic is settling equity awards in cash.
 

When equity awards are settled in cash, the accounting treatment will vary depending on whether it is the vested or unvested portion of the award that is being paid out. If both portions are settled in cash, the expense for each portion will have to be calculated separately. 
 

Can you explain the accounting treatment in 75 words or less?

1. The expense for the vested portion of the award is the greater of (i) the settlement fair value or (ii) the original grant date fair value.
2. All remaining unamortized expense for the unvested portion of the award is recognized immediately. If the cash payout exceeds the current fair value of the award, the excess is recorded as additional compensation cost.
3. The above expense is recorded in the period of settlement.

How about an example?

Let’s say that an executive is granted an option with a grant date fair value of $400,000. When the option is one-quarter vested, the company pays the option holder $500,000 in cash (the option’s then-current fair value) to settle the option.
 

• The company will recognize expense of $125,000 for the vested portion of the option (25% of the $500,000 payout).  If this portion of the option had already been exercised and paid out in stock, there would be no further expense for it.
• In addition, the remaining $300,000 of expense for the unvested portion of the option is recognized in full in the period in which the cancellation occurs (to the extent that it hasn’t already been recognized).

The total expense for the option can’t be less than the original grant date fair value of $400,000. Thus, if the cash payout had been only $200,000, the company would recognize $100,000 of expense for the vested portion and the remaining $300,000 of expense for the unvested portion.

What if the award in the example is an RSU award?

The accounting treatment would be the same, except that if the vested portion of the RSU had already been paid out in stock, there would be no further expense for that portion of the award.

What other financial risks does the company need to think about?

Two come to mind. First, any time awards are being paid out in cash it is important for the company to ensure that it has enough cash to cover the payouts.
 

Second, if the cash payouts are part of a pattern or create the expectation that the company will pay out awards in cash in the future, they could trigger liability treatment for the entire plan, in addition to the expense for the awards currently being settled in cash. It’s best to document any rationale for why the cash payouts should be treated as a one-time occurrence.  

Are there any other considerations to worry about?

So many! To learn about the securities law, tax, and other considerations that apply to award modifications, check out my blog entry “5 Things to Know About Award Modifications” and this handy table summarizing the considerations for various types of modifications.
 

Thanks to Dan Kapinos of Aon Rewards Solutions for confirming my understanding of the accounting treatment for cash settlements.
 

- Barbara