In May 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2017-09, Stock Compensation, Topic 718, Scope of Modification Accounting (the ASU). The FASB issued the ASU to provide clarity and reduce the “diversity in practice” among companies and accountants in applying ASC 718 to changes to the terms or conditions of share-based payment awards. When a company makes a substantive change to a share-based payment award, it must apply modification accounting (which is usually undesirable). However, ASC 718 offered little guidance as to what changes are substantive, thereby leading to the diversity in practice among accounting firms.
The ASU should reduce the instances that an entity is required to apply modification accounting to a share-based payment award. While we are not accountants (and don’t pretend to be), we do try to understand the rules. For accounting purposes, a modification is viewed as the exchange of the original award for a new award. If a company modified an award, ASC 718 generally would require it to (i) calculate the incremental fair value of the new award, (ii) assess the effect of the modification on the number of award shares expected to vest, including a reassessment of the probability of vesting, and (iii) immediately recognize the incremental difference between the fair value of the modified award and the fair value of the original award as a compensation cost.
Some of the impetus for the ASU was the question of whether a change to the maximum withholding rate permitted under ASU 2016-09 would be considered a “modification” under ASC 718 (see, FASB Changes the Rules for Accounting for Equity Compensation). However, companies change the terms of outstanding award agreements for a variety of reasons, including to provide for continued vesting following an employee’s change in status to an independent contractor/consultant or to extend the expiration date of options held by a terminated employee (e.g., to one year from 90 days).
The ASU streamlines the application of modification accounting by stating that when making a change to the terms or conditions of a share-based payment award, a company should apply modification accounting to the award, unless each of the following conditions is met:
- The fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the modified award is the same as the fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the original award immediately before the original award is modified. If the modification does not affect any of the inputs to the valuation technique that the entity uses to value the award, the entity is not required to estimate the value immediately before and after the modification.
- The vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified.
- The classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified.
Helpfully, ASC 718, as amended by the ASU, provides some examples of changes to an award that generally require modification accounting, and changes that do not require modification accounting. The former category includes:
- repricing of share options that results in a change in value of the options (as most would);
- changes in a service condition;
- changes in a performance condition or a market condition (e.g., to increase the likelihood of vesting or payout);
- changes in an award that result in a reclassification of the award (equity to liability or vice versa); or
- adding a provision for accelerated vesting of the award in the event of employment termination, in anticipation of a sale of a business unit.
Examples of changes to an award that generally do not require modification accounting include the following:
- changes that are administrative in nature, such as a change to the company name, company address, or plan name; or
- changes in an award’s net settlement provisions related to tax withholdings that do not affect the classification of the award.
FASB cautions that the examples in paragraphs “are educational in nature, are not all-inclusive, and should not be used to override the guidance in paragraph 718-20-35-2A.”
The ASU is effective for all companies for fiscal years beginning after December 15, 2017. Public companies may elect early adoption of the ASU, including adoption in any interim period, for reporting periods for which financial statements have not yet been issued. The ASU should be applied prospectively to an award modified on or after the effective date.