Accounting for Accelerating Service Conditions of Performance 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 covers modification to the service conditions of performance and market-conditioned awards.

Performance and market-conditioned awards are often subject to service conditions as well. When award holders terminate, a company could modify such an award to waive or remove the service conditions (essentially accelerating vesting for the service conditions) but not the performance or market conditions. As a result, payout of the award would not occur until the end of the originally stipulated performance period.

Because acceleration of the service conditions makes it more probable that the award will be earned (indeed, without the acceleration, the award would have been forfeited upon termination), this is accounted for as an improbable to probable (Type III) modification.

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

Sure can!

1. Any expense previously recognized for the portion of the award to which the acceleration of the service-vesting conditions applies is reversed.
2. The new fair value of the modified award is recognized over the remaining service period.
3. If the award is subject to nonmarket performance conditions, the expense recorded for the award is adjusted for the expected payout and for actual outcome.

How about an example?

You got it! Let’s start with an award that has a target grant date fair value of $10,000 and that vests based on continued service and earnings per share targets. Now assume that the employee terminates after 75% of the performance/service period has elapsed and the award is modified at that time to waive the service-based vesting conditions (but the earnings per share targets still have to be met for the award to be paid out). The fair value on the modification date is $15,000, and the company expects the award to pay out at 80% of target.

As of the modification date, the company has already recorded aggregate expense of $6,000 (the $10,000 target grant date fair value multiplied by 75% of the service period multiplied by the 80% expected payout). Since no portion of the award has vested as of the employee’s termination date, this $6,000 is fully reversed.

The company will record a new expense of $12,000 in the period of the modification (the $15,000 modification date fair value multiplied by the 80% expected payout). This $12,000 expense is not adjusted based on the portion of the service period that is complete because the service-based vesting requirements have been waived (thus there is no possibility that the now former employee will fail to meet these conditions).

The company will continue to adjust the expense recognized for the award until the end of the performance period. If the expected payout increases to 90%, the company will record an additional $1,500 of expense in that period ($15,000 modification date fair value multiplied by the 90% expected payout less the $12,000 of expense already recognized). Likewise, if the expected payout decreases, the company would reverse some of the previously recognized expense. At the end of the performance period, the expense recognized must be trued up to the actual vesting outcome for the award.

What about market-conditioned awards?

If the award in this example were subject to market conditions instead of nonmarket conditions, the accounting treatment would be the same, except that the expense for the modified award would not be adjusted for the expected payout. The full expense for the modified award would be recorded in the period that the modification occurs and would not be adjusted further. Also, the fair value would be determined using a Monte Carlo simulation to incorporate the market condition. As a result, the fair value would differ from the FMV of the stock on the modification date.

Can the company get a break on the modification date fair value?

Because the now former employee can’t sell the stock underlying the award until the performance conditions are met, theoretically, the new fair value of the modified award can be discounted for the period until the performance/market conditions are achieved. In practice, however, this discount is often immaterial and may be more trouble than it’s worth.

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 Terry Adamson of BDO for helping me out with this one.