Accounting for Acceleration of Vesting Upon Termination

For this week’s blog entry, I continue my series on how to account for modifications to equity awards—explained in 75 words or less. Today’s topic is acceleration of vesting upon termination of employment (or service).

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

Sure can. Acceleration of vesting upon termination is another improbable-to-probable (Type III) modification:

1. The expense originally computed for the accelerated portion of the award will no longer be recognized. Any expense that has already been recognized for this portion of the award is reversed.
2. The new fair value of the modified portion of the award is recognized as expense in the period the acceleration occurs.

How about an example?

Say that an employee terminates while holding an award to purchase 10,000 shares that is 75% vested, and the company modifies the terms of the award to accelerate vesting on the remaining 2,500 unvested shares. Further assume that the fair value of the award at grant was $10 per share, and the fair value at the time the modification occurs is $16 per share.

The fair value of the vested portion of the option is $75,000 ($10 per share multiplied by 7,500 shares); this expense has already been recorded and is not reversed. 

The original fair value of the unvested/accelerated portion of the option was $25,000 ($10 per share multiplied by 2,500 shares).  Let’s say that the termination occurs after one-fifth of the last vesting period has elapsed, so that the company has already recognized $5,000 of expense for this tranche (assuming straight-line accrual and that the company accounts for forfeitures as they occur). The $5,000 of expense that has already been recognized is reversed and the remaining $20,000 of expense is never recognized.

The fair value of the unvested/accelerated portion of the option after the acceleration is $40,000 ($16 per share multiplied by 2,500 shares); this amount is recorded as expense in the period in which the acceleration occurs.

What about acceleration of vesting that isn’t in connection with a termination of employment?

This will be a facts and circumstances determination. In many cases, acceleration of time-based vesting outside of the context of termination of employment is a probable-to-probable (Type I) modification and will not result in any additional expense to the company (because the before and after fair values will be the same). Acceleration of vesting of underwater stock options can be an exception. This topic is beyond the scope of this blog entry but you can read all about it in my book “Accounting for Equity Compensation in the United States” (see section 8.2.1.1).

What about amendments to an award’s termination provisions in advance of an employee’s termination?

Here again, this will be a facts and circumstances determination—the operable fact being whether the modification is made in contemplation of the employee’s termination. For example, if a company expects its CEO to retire next year and, in light of this expectation, modifies the CEO’s awards to accelerate vesting upon her eventual retirement, that will be accounted for as an improbable-to-probable (Type III) modification. But if an award is modified to provide for accelerated vesting upon termination at a time when there is no expectation that the employee will terminate prior to vesting, the amendment is treated as a probable-to-probable (Type I) modification and will not result in any additional expense to the company (because the before and after fair values will be the same).

Are there any other considerations to worry about?

You bet! 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.