Accounting for Modifications to Performance Awards

Here’s the situation: you’ve got an equity award in which vesting is conditioned on non-market targets (i.e., targets other than stock price, market cap, or TSR) and the targets are not achievable. The company takes one of two actions: modifies the targets to make them achievable or pays out the award even though the targets aren’t achieved. What is the P&L cost of the company’s action?

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

Sure can. Either action is considered an improbable-to-probable modification (that’s a Type III modification, for those of you who like ASC 718 geek speak) and is accounted for in the following manner:

1. The expense originally computed for the modified portion of the award will no longer be recognized.
2. The fair value of the modified portion of the award is recognized as expense over the remaining service period of the award.

What about comparing the before and after fair values?

Ah, you’ve been studying up on equity award modifications. It is true that in some modifications, e.g., probable-to-probable, you value the award immediately before and immediately after the modification and recognize incremental expense equal to the increase in fair value. With an improbable-to-probable modification, however, the aggregate fair value of the award just prior to a modification is $0. This is because, without the modification, the award will be forfeited. Thus, there’s no need to compare the pre- and post-modification fair values.

How about an example?

Let’s say a company grants a performance award for 10,000 shares when its FMV is $30 per share, resulting in an initial grant date fair value of $300,000. Vesting in the award is contingent on an earnings per share target that must be achieved over the next three years. The company initially estimates that the target will be met, so for the first year, the company records expense of $100,000 for the award.

Towards the end of the second year of the performance period, the company comes to the conclusion that no portion of the target will be met; EPS will not be high enough to secure even the threshold payout under the award. At this point, the company reverses the $100,000 of expense recorded in year 1, as well as any expense already recorded in the second year of the performance period. Thus, heading into year three, the aggregate expense recorded for the award is $0.

At the start of year three, the company decides to modify the EPS target to make it achievable. At the time of the modification, the company’s FMV is $12 per share, resulting in a new aggregate fair value for the modified award of $120,000. The company expects that the new target will be achieved, so this fair value is recorded as an expense over the remaining service period. If the company’s expectations or actual outcome vary, the expense is adjusted accordingly.

What about modifications of market conditions?

Market conditions are different than performance conditions in two ways: 1) the market condition is incorporated into the grant date fair value of the award, and 2) the expense recorded for the award is not adjusted to reflect expected or actual outcome of the market condition. As a result, the accounting treatment of modifications of market conditions will differ from what I’ve described above.

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.