Modifications
Whereas the FASB distilled modifications into four “types,” we continue to observe tricky variations that stress the simple lines of scope drawn in ASC 718. When you encounter modifications, don’t settle for check-the-box approaches because no two modifications are ever identical – small differentiating details can result in considerably different accounting treatment. Our solutions are custom developed to ensure the specific modification terms are appropriately handled.
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At the core, we separate between modifications as a result of a business combination (subject to ASC 718, but more closely by ASC 805) and all other modifications enacted outside of a business combination.
Modifications are among the most challenging areas of ASC 718. Not only is the accounting theory particularly complicated, but modifications also pose considerable data management difficulty. This challenge stems from the inevitable mismatch between award administration and financial reporting objectives. Administratively, it is optimal to display only the post-modification award terms, since this is what participants are expected to see. In contrast, financial reporting requires consideration, and often combination, of both the pre-modification and post-modification terms.
Business Combinations
Do you have a technique for bifurcating expense between pre-combination services and post-combination services?
- Fair value allocable to pre-combination services is recorded in goodwill (consideration transferred) and the fair value allocable to post-combination services is recognized as compensation cost during the vesting period.
- Bifurcation should be performed on a grant-by-grant basis.
Are forfeiture adjustments based on shares allocated to both the pre-combination services and post-combination services expense components?
- Entire adjustment is recognized in post-combination financial statements, but it references the entire award and not just the component allocated to the post-combination financial statements.
Are the fair values measured at acquisition based on a lattice model or some other technique for modeling exercise behavior in the context of the award’s then-current moneyness?
- Exercise behavior is a function of moneyness and remaining contractual term – unless the award is deeply in the money, then a lattice model or similar approach is needed to capture the impact of both variables.
Was a deferred tax asset recorded on both the pre-combination services fair value allocated to goodwill and the post-combination services fair value recognized in the post-combination financial statements?
- In contrast to prior practice, ASC 805 requires that a DTA be recorded on the entire award value assumed. This will tend to increase the frequency and magnitude of shortfalls.
Does your deferred tax reporting process correctly reconcile the entire DTA recorded on the grant, in particular, the portion attributable to pre-combination services expense?
- If the DTA attributable to pre-combination services expense was recorded outside your system, and the only DTA being tracked is that related to post-combination services expense, there will be an unintended overstatement of the excess benefit at settlement.
Modifications
We see the following typical modification cases:
Option exchange
- Option exchanges became popular in 2009 as a new and more shareholder-friendly way of repricing
- They create a number of valuation and reporting problems.
- Valuation it is necessary to use a lattice model to appropriately model exercise behavior in the context of each option’s moneyness and remaining contractual term.
- Reporting a few important questions:
- Is vesting extended? If so, expect to encounter cases in which the award will not vest under the modified terms but would have vested under the original terms. An accounting policy decision is required as to whether a Pooled or Bifurcated approach is taken, but under any case, the full expense must be recorded so long as the original vesting is satisfied.
- Does the modification create incremental cost? If so, this complicates the reporting process, especially in the context of a vesting schedule extension.
- Are many underwater options exchanged for a single new award (many-to-one exchange)? If so, this will complicate the reporting since the pre-modification data must still be referenced for forfeiture true-up, diluted EPS tracking, and deferred tax purposes – but there is not a clean match between the post-modification award and pre-modification awards.
- Are options exchanged for RSUs? If so, the reporting process will need to retain “memory” that any pre-adoption option grants would not have given rise to book expense and a corresponding balance sheet DTA. The risk is that the process will identify the post-modification award as an RSU and assume it had always been an RSU.
- Design should not be taken lightly. Average tender offer subscription rates are less than 50%, suggesting a mismatch between the program design and employee. goals/expectations. Equity Methods possesses end-to-end expertise in not only the valuation and reporting but also plan design.
Performance target resetting
- This is most prevalent on sliding scale payout awards in which a particular payout is set to be earned and the board modifies the award so that a higher payout is earned.
- General controversy exists as to whether this is a partial Type III (improbable to probable) and Type I (probable to probable) modification OR exclusively a Type I modification.
- Our position is that it is exclusively a Type I modification – not because this is simpler to account for (though it is), but because the underlying units granted are not being touched, only the payout criteria. We believe this is no different than repricing a SAR, which has the same effect of resulting in more shares being issued.
- Depending on the position taken as to the type of modification, various reporting implications arise, including but not limited to the quantification of incremental cost and treatment of the underlying data within the reporting process.
Acceleration of vesting when forfeiture (termination) is probable
- Companies often elect to accelerate the vesting for employees in a cost center or business unit that is about to be disposed or subjected to a reduction in force (RIF). Often the post-termination exercise window is extended in conjunction.
- This is a classic Type III modification and generally the simplest type to account for.
- The reporting of this transaction is straightforward, since the entire expense amount is recorded immediately or over any remaining vesting period.
- The valuation (quantification of incremental cost) is less straight forward. Here, it is necessary to measure the fair value of the awards at modification reflecting the impact of termination. An assumption concerning exercise behavior must be made, which can be accomplished using lattice modeling or even a simple assumption that exercise will occur at expiration.
- An interesting phenomenon most companies are not aware of is how this type of modification may be the only instance in ASC 718 that the grant-date fair value can be reversed in place of a lower amount.
Extension of post-termination exercise window when termination is probable
- Typically only performed for executives or board members. Describes a situation in which the employee has stated an intention to resign, and then the company responds by extending the post-termination exercise window on some/all of their vested, outstanding equity.
- Still a Type I modification since this scenario generally pertains to vested equity awards.
- Because the termination is expected, the pre-modification value is quite low, thus giving rise to much higher incremental cost.
Extension of post-termination exercise window when termination is not probable
- In this scenario, the incremental cost is usually much lower since the pre-modification fair value is higher because it does not reflect an expected termination event.
Equity Methods adopts an integrated approach in helping companies through modifications. Equity Methods’ experience in plan design enables upfront strategic support that takes into consideration downstream reporting issues, ultimately resulting in a smoother process with more well thought out decisions. Equity Methods has assisted hundreds of companies through different types of modifications – leverage our experience and processes to drive a superior outcome to your intended modification.
Relevant Case Studies
An Integrated Approach to ASC 718 Compliance
Equity Methods Solves Accounting and Financial Reporting Conundrum for Fortune 50 Technology Leader
Relevant Whitepapers
Introduction to IFRS 2 | 2010
Underwater Option Exchanges: Baseline Theory and Implementation Approaches | 2010
Exchanging Underwater Stock Options | 2009
Underwater Option Exchanges: Financial Reporting Challenges | 2009
Underwater Option Exchanges: Tender Offer Data Results | 2009
Relevant Issue Alerts
Equity Methods Underwater Exchanges Survey Results | 2008
ECIA: Identifying and Optimizing a Fragmented ASC 718 Process | 2010
