ASU 2017-09 Brings Partial Clarity to Modification Accounting
On May 10, Bloomberg BNA asked me about some new guidance that the Financial Accounting Standards Board (FASB) had just issued. The guidance, Accounting Standards Update No. 2017-09 (ASU 2017-09), is intended to clarify when changes to share-based payment awards must be accounted for as modifications.
Does ASU 2017-09 succeed? Bloomberg wanted to know. Yes and no, I replied. “The toughest facets of modification accounting are still there. In practice, the difficulty has been parsing through the dozens of different modification flavors.” I was talking about things like changes to performance targets, extensions to option exercise windows, and award conversions in acquisitions and spinouts. These and other tricky types of modifications aren’t even touched by the new GAAP.
To understand why, we’ll need to look at the details of running award modifications through ASC 718. But before we do that, let’s review a little history.
What was modification accounting like before ASU 2017-09?
The original ASC 718 framework that governs share-based payment accounting includes extensive commentary on how to handle award modifications. Broadly defined, a modification is any change to the terms and conditions of an award. The objective in ASC 718 is to ensure that value-enhancing modifications result in a congruent uptick in the expense a company recognizes in its financial statements. For example, if an option is about to expire underwater and the term is extended, this clearly creates economic value that should be measured and recorded as incremental expense.
But as I told Bloomberg, the types of modifications are legion. Companies face incentive and retention challenges, surprises in the capital markets, and unexpected corporate transactions—all of which can prompt them to initiate a modification. (We discuss the basic modification accounting framework and common types of modifications in our comprehensive modifications white paper.)
All this variety in how companies go about modifying awards has created ambiguity with regard to some modifications taking on a de minimus feel. In these cases, some say, the ASC 718 modification framework is unclear or costly to apply.
Does ASU 2017-09 deliver clearer guidance?
Yes, in that it sheds light on which award changes should run through ASC 718’s modification accounting framework (and which should not). In short, you can disregard modification accounting if all the following are present:
(1) The fair value of the post-modified award is the same as the pre-modified version. In other words, none of the inputs to an accepted valuation model change as a result of the change.
(2) The vesting conditions are unchanged.
(3) The award’s balance sheet classification is unchanged.
This seems like a complicated filter, but there’s a logic to it. The FASB is trying to delineate the modifications that create incremental costs to shareholders from those that are essentially administrative. Here’s an analogy. Suppose you correct the grammar in an employee’s award agreement. That’s a modification, sure, but it hardly changes the underlying economics.
A more practical example is when companies modify the tax withholding procedures for an award. Some award agreements state that taxes must be withheld at the minimum statutory rate. Because ASU 2016-09 (not to be confused with ASU 2017-09) paves the way for companies to withhold at higher rates, many companies want to update their award agreements to permit higher withholding. A fear of modification accounting can keep them from doing this.
Administrative modifications don’t impact the financials. So why go through the calculation effort?
Before ASU 2017-09, applying modification accounting to administrative modifications (as in the example above) would result in a determination that there is no extra charge to take. After ASU 2017-09, a company can conclude that modification accounting need not be applied in the first place.
From an accounting policy perspective, you look at the substance of the modification in the context of the three factors above (fair value, vesting, and balance sheet classification) to determine whether to proceed in performing modification accounting. If those factors are unchanged, document that, and you can stop there.
Is there a benefit?
While we don’t look at ASU 2017-09 unfavorably, it probably won’t change how things are done. Administrative modifications weren’t hard to begin with. It’s always been quick and easy to go through the modification framework of ASC 718 to verify that this type of modification has no financial statement impact.
ASU 2017-09 simply eliminates that extra step. From a FASB simplification initiative perspective, it checks the box. However, the very tricky modifications that most of us spend 99% of our time dealing with are not affected by the new ASU.
How many modifications will ASU 2017-09 affect?
Not so many. We continue to see companies implementing numerous types of modifications, and most don’t fall under the purview of ASU 2017-09. These are the more complex variety that somehow alter the vesting pattern, value of the compensation package, or balance sheet classification. They’re also the type that frequently get caught in an external audit because a non-compliant technique is used to account for them.
Since we’re on the topic of modifications, here are a few you should pay extra attention to:
1. Option modifications. Whereas it’s generally appropriate to use the (simple) Black-Scholes model to value new at-the-money grants, this doesn’t work well when valuing outstanding options that are part of a modification. These cases may require a more complex binomial lattice model. In the audit process, many companies run into difficulty from trying to shoehorn the modification accounting into a model that’s not really designed for that purpose.
2. M&A and spin-out transactions affecting equity awards.
3. Employee stock purchase plans (ESPPs). These are on the rise, and we’re seeing more designs with reset, rollover, or contribution increase provisions—all of which involve a form of modification accounting.
4. Performance assessment adjustments. Most performance metrics instruct the compensation committee to make certain adjustments when certifying performance and determining the correct payout amounts (e.g., stripping out the effect of accounting standard changes). Depending on how vague the grant agreement language is, these adjustments could be construed as modifying the award.
Will modifications continue to be a source of complexity?
Yes. ASU 2017-09 will help some, but more often than not, you’ll need all the normal tools of the trade.
As such, when granting your awards, take care to write the terms and conditions in a way that mitigates the likelihood of a subsequent action triggering modification accounting. Then, if you do need to modify your awards, use ASU 2017-09 to determine whether the modification has financial implications. If it does, always pro forma model the implications in advance to avoid surprises, and then follow the ASC 718 modification accounting framework.
We welcome questions about ASU 2017-09 and tricky modification cases. As I mentioned earlier, our white paper is a great resource for a deep discussion of modification theory and an analysis of the top 20-plus modification cases. Please get in touch if you’d like to discuss.
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