Financial Reporting Alert 09-2: Acceleration of the Vesting of Deep Out-of-the-Money Share Option Awards
February 19, 2009
Entities that may be considering accelerating the vesting of their "deep out-of-the-money" share option awards should be mindful of footnote 69 of FASB Statement No. 123(R), Share-Based Payment. This footnote indicates that the acceleration of the vesting of a deep out-of-the-money award is not a substantive modification "because the explicit service condition is replaced by a derived service condition." Accordingly, any unrecognized compensation cost associated with the award should not be recognized immediately. Rather, the unrecognized compensation cost should generally continue to be recognized over the remaining original requisite service period.
In the current economic environment, prices of a number of equity securities traded in public markets have significantly deteriorated. Many share option awards previously granted "at-the-money" are currently "out-of-the-money" because of declines in the value of the underlying securities. Certain securities may be so severely depressed that the share option awards are considered "deep out-of-the-money."
Entities may be questioning whether deep out-of-the-money share option awards continue to provide the appropriate retention motivation to employees. Accordingly, some entities may contemplate whether to accelerate the vesting of these awards. This Financial Reporting Alert addresses the accounting for a share option award with an explicit service condition that is subsequently modified to accelerate the vesting at a time when the award is deep out-of-the-money.
In informal discussions, the SEC staff has indicated that the guidance in footnote 69 of Statement 123(R) applies to modifications of share option awards that are deep out-of-the-money. That is, as indicated in the footnote, the acceleration of the vesting of a deep out-of-the-money award is not substantive because the explicit service period is replaced with a derived service period. The notion that the explicit service period is replaced by a derived service period is based on the premise that because most employee share option awards contain a term truncation feature that becomes operative upon separation (e.g., the term of the award is truncated to 90 days after the date of separation), the employee must continue to work for the entity and the share price must increase during this period for the employee to receive any value from the award. Accordingly, any remaining unrecognized compensation cost should not be recognized immediately. In addition, the staff indicated that because the acceleration of the vesting of the award is not substantive, an entity should generally continue to recognize the compensation cost over the remaining original service period.
On January 1, 20X1, Entity A granted 100 at-the-money employee share options, each with a grant-date fair value of $10. The awards vest at the end of the fourth year of service (cliff vesting) and have an exercise price of $20. Accordingly, the compensation cost is being recognized ratably over the four-year service period. On January 1, 20X4, when the share options are deemed to be deep out-of-the-money, A modifies the award to accelerate the remaining service period of the award. Because the award is deemed to be deep out-of-the-money, the acceleration of the remaining service period of the award is nonsubstantive. Accordingly, the remaining unrecognized compensation cost should not be recognized immediately on January 1, 20X4. Rather, A should recognize the remaining $250 ($10 grant-date fair value × 100 awards × ¼ remaining service period) in compensation cost in 20X4 (i.e., over the remaining original service period).
Upon a modification to accelerate the vesting of a share option award, an entity will need to determine whether the accelerated share option award is considered deep out-of-the-money. Because Statement 123(R) does not provide guidance on determining when an award is deep out-of-the-money, an entity must use professional judgment in making this determination. Among other factors, an entity may consider the period it would take for the award to return to being at-the-money. An entity is recommended to consult with its professional advisers on this matter.