Eleanor Finch
Modifications to equity awards are a natural part of life for companies that issue equity awards. They can take many forms, such as a change in vesting conditions or a repricing of options. When modifying equity awards, companies must consider the accounting treatment of modifications, which hinges on whether the awards were probable of vesting before the modification and are probable of vesting after. There are four types of modifications under ASC 718, with most falling under Type I (probable to probable) or Type III (improbable to probable). The financial impact of modifications can be complex, and companies must carefully review their equity award modification strategies to ensure the benefits outweigh the costs.
| Characteristics | Values |
|---|---|
| Type of modification | Type I (probable to probable), Type III (improbable to probable) |
| Examples of Type I modification | Repricing, option exchanges |
| Examples of Type III modification | Accelerating vesting upon termination, making performance targets easier to achieve |
| Accounting treatment | Depends on whether the awards were probable of vesting before and after the modification |
| Expense for Type I modification | Incremental cost on top of the original expense |
| Expense for Type III modification | Aggregate fair value of the modified award at the time of the modification |
| Consent | Required for modifications that require award holders to give up existing rights |
| Disclosure | Required for modifications made to grants held by named executive officers |
| Vesting | Modification date assessment of probability of satisfying original or modified vesting conditions |
| Fair value | Recognition of compensation cost at least equal to the award's grant-date fair value |
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What You'll Learn
Modification date assessment
Modifications of equity-classified awards may take many forms, such as a change in vesting conditions or a repricing of options. A modification date assessment is crucial for evaluating the probability of vesting conditions being met and determining the appropriate compensation cost. Here are some key considerations for a comprehensive modification date assessment:
Vesting Conditions and Probability Assessment
On the modification date of an equity-classified award, management should assess the likelihood of meeting either the original or modified vesting conditions. This assessment involves evaluating the probability of achieving the specified milestones. For awards with performance conditions, a periodic probability assessment is already mandated. Management should develop a consistent methodology for assessing vesting probabilities, incorporating reasonable assumptions and available objective evidence.
Types of Modifications and Cost Implications
Modifications can be categorised into different types, primarily Type I (probable to probable) and Type III (improbable to probable). Type I modifications, such as repricing or extending the expected term, may result in incremental fair value if terms affecting the estimate of fair value are altered. The original grant-date fair value sets the minimum compensation to be recognised. On the other hand, Type III modifications, such as accelerating vesting upon termination, make vesting more likely. The expense for Type III modifications is equal to the aggregate fair value of the modified award at the time of modification.
Equity Restructuring Considerations
In the context of equity restructuring, modifications may occur to protect award holders from dilution. If the modification is not mandated by the existing terms, it can lead to incremental fair value and increased compensation cost. Any change in the exercise price, option terms, or cash payments should be considered when assessing incremental fair value. Equity restructurings that provide cash payments in lieu of modifying the award are also treated as modifications.
Disclosure Requirements
Certain modifications, especially those involving named executive officers or Section 16 insiders, are subject to disclosure requirements. Repricings, extensions of the contractual term of stock options, and modifications to grants held by executives may need to be disclosed in financial statements, proxy statements, or other relevant documents.
Impact on Performance Metrics
Modifying performance targets or payout percentages requires careful consideration. While modifications can help restore performance metrics during challenging economic times, tracking original performance targets can become challenging after significant corporate transactions. It is important to review and assess the potential impact on performance-based compensation and related financial reporting.
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Repricing and option exchanges
Under ASC 718, a repricing is defined as the amendment of outstanding options or SARs to reduce the exercise price of such outstanding options or SARs. It can also refer to the cancellation of outstanding options or SARs in exchange for options or SARs with a lower exercise price than the original. Repricing can also refer to the cancellation of underwater options in exchange for stock awards, or cash buyouts of underwater options.
A repricing, however, would not impact the probability of vesting. Assuming the award is otherwise probable of vesting, a company that makes such a modification should measure compensation cost for the difference between the fair value of the modified award and the fair value of the original award on the modification date. This is the "incremental" cost that must be recognized on top of the expense that was determined for the options when they were originally granted.
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Vesting conditions
There are four types of modifications outlined in ASC 718, with most falling into Type I (probable to probable) or Type III (improbable to probable). Type I modifications, such as repricing and option exchanges, typically do not impact the likelihood of vesting. On the other hand, Type III modifications, like accelerating vesting upon termination or easing performance targets, increase the probability of vesting.
The accounting treatment of modifications depends on the vesting status before and after the change. Companies should recognise compensation costs based on the award's grant-date fair value, unless they anticipate that the employee will not meet the original conditions. This cost calculation considers the cumulative amount, including any incremental fair value resulting from the modification.
It's important to note that modifications that require award holders to accept extended vesting or reduced shares for repricing need their consent. Additionally, modifications that accelerate vesting may impact preferential tax treatment, and certain disclosures are required for modifications involving executive officers or Section 16 insiders.
In equity restructurings, adjustments to award terms that provide "equitable" or "proportionate" changes are considered modifications. These adjustments aim to protect against dilution and maintain the relative value of the awards. Any incremental fair value transferred to holders of vested awards is recorded as compensation cost, impacting the financial statements.
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Performance targets
Under ASC 718, modifications that make performance targets easier to achieve are generally classified as Type III modifications. This classification indicates that the vesting of the award has become more probable due to the modified performance targets. The expense associated with Type III modifications is equal to the aggregate fair value of the modified award at the time of modification. This expense recognition ensures that the company bears the cost of making the achievement of performance targets more attainable for the award recipient.
It is important to note that modifications to performance targets do not always require shareholder approval. However, modifications that require award holders to give up existing rights or result in a loss of preferential tax treatment may necessitate consent from the holders. Additionally, accelerating vesting upon termination or making significant changes to performance targets may require disclosure and be classified as material modifications in the company's financial statements.
When modifying performance targets, companies should carefully assess the potential impact on the compensation cost. The cumulative compensation cost includes the original grant-date fair value of the award, as well as any incremental fair value resulting from the modification. This incremental fair value arises when terms affecting the estimate of fair value are adjusted, such as repricing or extending the expected term of the award.
To summarise, modifications to performance targets can have significant implications for equity awards. Companies should carefully evaluate the likelihood of achieving modified performance targets, classify the type of modification, consider shareholder approval and disclosure requirements, and accurately calculate the compensation cost to ensure compliance and avoid potential mishaps in financial reporting.
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Equity restructuring
When modifying equity awards, it is important to consider the likelihood of the award vesting before and after the modification. This is classified as either Type I (probable to probable) or Type III (improbable to probable). Type I modifications, such as repricing and option exchanges, generally do not affect the likelihood of vesting and require shareholder approval. On the other hand, Type III modifications, such as accelerating vesting upon termination or making performance targets easier to achieve, increase the likelihood of vesting and are accounted for differently.
In the case of equity restructuring, companies must assess whether the modification will result in incremental fair value. This occurs when the award's value increases relative to its value before the modification due to "equitable" adjustments, such as antidilution protection. Any incremental fair value transferred to holders of vested awards is recorded as compensation cost. For awards that have not vested upon modification, the recognition of compensation cost for the portion settled in cash is accelerated.
To determine if a modification is required during equity restructuring, the award's terms should specify that an "equitable" or "proportionate" adjustment is necessary. Input from legal counsel may be required to assess whether an antidilution provision is mandatory or discretionary. Additionally, modifications that require award holders to give up existing rights or result in the loss of preferential tax treatment typically need the consent of the holders.
It is important to note that modifications to equity awards can have significant financial implications, and proper disclosure is crucial. Under ASC 718, all material modifications must be discussed in the notes to the company's financial statements, and certain modifications, such as repricings and extensions of the contractual term, are specifically reportable.
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Frequently asked questions
Under ASC 718, there are four types of modifications, though most are classified as either Type I (probable to probable) or Type III (improbable to probable). Type I modifications include repricing and option exchanges, while Type III modifications include accelerating vesting upon termination or making performance targets easier to achieve.
A company should recognize compensation cost in an amount at least equal to the award's grant-date fair value. The cumulative amount of compensation cost recognized includes the original grant-date fair value of the award plus any incremental fair value resulting from the modification.
No, most modifications such as acceleration of vesting or modifying performance targets generally do not require shareholder approval. However, repricing and option exchanges typically require shareholder approval, and modifications that require award holders to give up existing rights may require their consent.
One potential mishap is the unintended increase in expenses, especially with Type III modifications. Another pitfall is the challenge of tracking original performance targets after a corporate transaction, which can impact accounting and result in double-counting of shares in the financial statements.
