Companies often decide to modify awards concurrent with an employee's termination of employment. For example, this might occur because the employee is a senior executive and a modification is agreed to in connection with a resignation or involuntary termination in order to avoid an acrimonious separation. Two common modifications made in connection with termination of employment are: (1) acceleration of the vesting of unvested awards and (2) extension of the award's post-termination exercise period for vested options.
For unvested awards, the company needs to assess whether it expects the original vesting conditions to be satisfied as of the modification date. If the employee would have forfeited the awards upon termination according to the awards' original terms, the awards would not be expected to vest under the original vesting conditions (i.e., vesting was improbable).
If the employee would have forfeited the awards upon termination under the original terms, and the company chooses to accelerate vesting or allow continued vesting, the modification is a Type III modification (improbable to probable). Therefore, incremental fair value is equal to the fair value of the modified awards on the modification date. This incremental compensation cost is recognized over the requisite service period, which may result in immediate recognition if the awards do not require further service, or over the period through a defined date if the employer requires the individual to work through a specified separation date in order to earn the award. This accounting treatment applies regardless of the company’s accounting policy for forfeitures (as described in SC 2.7
In some instances, the original terms of an award provide for automatic acceleration of vesting upon involuntary termination of employment. When involuntary termination becomes probable, the accelerated vesting is not treated as a modification (assuming it is consistent with the award's original terms) since it is not a discretionary action; however, the requisite service period may have changed. The change in requisite service period should be recognized on a prospective basis (see SC 2.6.10
for additional information).
A modification to extend the exercise period of a vested option is treated as a Type I modification because it does not change the expectation that the award will vest (i.e., it is already vested). Incremental fair value is equal to the difference between the fair value of the modified award and the fair value of the original award (immediately before it was modified). The expected term of the option prior to the modification should take into account any truncation of term that would occur pursuant to the option's original terms upon termination of employment. For example, option plans typically provide for a 30- to 90-day exercise period after termination of employment. The expected term of the modified option should consider the new exercise period. An extension of the exercise period generally results in some amount of incremental compensation cost, assuming no other terms were modified. Incremental compensation cost is recognized immediately because the options are vested.
Example SC 4-1, Example SC 4-2, Example SC 4-3, and Example SC 4-4 illustrate the accounting for modifications in connection with termination of employment.
EXAMPLE SC 4-1
Modification to awards in connection with termination of employment – no ongoing service
SC Corporation enters into an agreement with its CFO in connection with the termination of the CFO's employment. Under the original terms of the CFO's stock option award, the CFO would forfeit all unvested options upon termination of employment and would be permitted a period of 90 days from the termination date to exercise their vested options. Pursuant to the termination agreement, the CFO's outstanding stock options are modified as follows:
- The exercise period of vested options is extended to one year
- All unvested options are immediately vested, with an exercise period of one year
The CFO will immediately cease providing services to SC Corporation upon signing of the termination agreement.
How should SC Corporation account for the modification of the options?
The modification of the vested options is a Type I (probable to probable) modification and the modification of the unvested options is a Type III (improbable to probable) modification.
The modification of the vested options is a Type I modification because the options are already vested (i.e., the modification does not change the expectation that the awards will vest; the awards are probable of vesting both before and after the modification). The incremental fair value is calculated as of the modification date. The fair value of the options before the modification is based on the current stock price and an exercise period of 90 days, since the original terms of the award permitted only 90 days to exercise upon termination of employment. The fair value after the modification is also based on the current stock price, but the exercise period should be determined considering the revised one-year exercise period. This will result in some incremental compensation cost due to the longer expected term, which should be recognized immediately because the options are vested.
The modification of the unvested options is a Type III modification because prior to the modification, the unvested options are not probable of vesting as the CFO would have otherwise forfeited the award upon termination of employment. Accordingly, any compensation cost previously recognized for the unvested options should be reversed. The incremental fair value is equal to the fair value of the modified award, which is measured based on the current assumptions determined as of the modification date (e.g., the current stock price and an expected term based on a one-year exercise period). The resulting compensation cost is recognized immediately because the CFO is no longer providing any service to SC Corporation to earn the options.
EXAMPLE SC 4-2
Modification to awards in connection with termination of employment – continuing service period
SC Corporation granted stock options to its CFO that vest in five equal tranches; one tranche fully vests at the end of each of the five years. Upon termination of employment, any unvested options are forfeited, and the CFO would be permitted a period of 90 days from the termination date to exercise their vested options.
Halfway through year three, SC Corporation and the CFO agree to a separation agreement. Pursuant to the termination agreement, SC Corporation and the CFO agree to the following modifications to the CFO’s outstanding stock options:
- The exercise period of vested options is extended from the original 90-day period to one year from the date of termination
- All unvested options are immediately vested, with the same one-year exercise period
The CFO will continue to provide service during a transition period of three months from the date the separation agreement was reached. The original awards that were not yet vested would not vest during the three-month transition period based on their original terms. The CFO must complete the transition period in order to be eligible for the accelerated vesting of unvested options (i.e., outstanding unvested options will be forfeited unless the CFO provides service for three additional months). Assume the compensation cost recognized to date is $700,000 and the fair value of the modified award is $1,000,000.
How should SC Corporation account for the modification of the options?
The calculation of incremental fair value resulting from the modification is the same as described in Example SC 4-1. The incremental compensation cost calculated for the vested options would be recognized immediately, consistent with Example SC 4-1.
For the unvested options, the recognition of compensation cost will depend on whether SC Corporation elects to estimate forfeitures or to account for forfeitures when they occur. If SC Corporation's policy is to estimate forfeitures, it would reverse the compensation cost previously recognized and recognize the entire fair value of the modified award over the remaining three-month service period. If SC Corporation's policy is to account for forfeitures when they occur, we believe there are two acceptable views:
- View A: Assume a substantive forfeiture of the original award occurs on the modification date as it was exchanged for the modified award at a time when it was not probable of vesting. Therefore, the guidance for a Type III (improbable-to-probable) modification should be followed. The cumulative compensation cost recognized for the original award should be reversed ($700,000) and the fair value of the modified award ($1,000,000) should be recognized over the remaining service period. This is the same as the accounting outcome for a company that elects to estimate forfeitures.
- View B: Assume forfeiture of the original award does not occur until the CFO terminates employment. Under this view, the original award is not yet forfeited; therefore, expense should not be reversed at the time of the modification. Over the remaining three-month service period, SC Corporation would recognize compensation cost equal to the difference between the modified award's fair value (on the modification date) and the previously recognized amount of the grant-date fair value of the original award ($1,000,000 fair value of the modified award less $700,000 previously recognized compensation cost or $300,000 "incremental compensation cost"). If the modified award's fair value is less than the previously recognized compensation cost, SC Corporation would not recognize any further compensation cost and the difference between the previously recognized amount and the modified award's fair value would be reversed upon the CFO's termination of service. For example, if the modified award's fair value was $500,000, no cost would be recognized over the remaining service period and $200,000 ($700,000 previously recognized compensation cost less $500,000 fair value of modified award) would be reversed at termination.
Under either View A or View B, the cumulative amount of recognized compensation cost for the award will be the same, which is equal to the fair value of the modified award on the modification date.
EXAMPLE SC 4-3
Modification of awards to extend the post-termination exercise period
SC Corporation's option plan includes terms that allow employees a 30-day period to exercise vested options upon termination of employment. On January 1, 20X1, SC Corporation modifies the terms of the plan to extend the post-termination exercise period to 90 days. Assume that all of the options are probable of vesting and none of the employees are currently expected to terminate employment.
How should SC Corporation account for the modification?
The modification is a Type I (probable to probable) modification because the options are probable of vesting both before and after the modification. SC Corporation should calculate any incremental fair value resulting from the extension of the post-termination exercise period and the resulting impact, if any, to the expected term assumption. Because the modification is not being done in connection with an employee's termination, the expected term would not necessarily increase by 60 days as a result of the 60-day increase in the post-termination exercise period. The fair value before the modification would be based on an expected term for an option with a 30-day post-termination exercise period, while the fair value after the modification would be based on an expected term for an option with a 90-day post-termination exercise period.
The determination of the extent to which this modification impacts the expected term assumption will depend on the relevant facts and circumstances. Any incremental compensation cost would be recognized immediately for vested options and over the remaining requisite service period for unvested options.
EXAMPLE SC 4-4
Modification of awards in connection with termination of employment – WARN Act
SC Corporation announces on September 15 that it will be restructuring its business operations, resulting in the shutdown of one of its facilities and the termination of 300 employees. The restructuring, shutdown, and terminations were not probable prior to September 15. SC Corporation's restructuring plan falls under the WARN Act, which requires employers with 100 or more employees to notify affected employees 60 days in advance of a plant closing or mass layoff. Also, under the Act, all employees are legally employed and paid by SC Corporation until the end of the 60-day notification period (in this case, November 14). The terminated employees will cease providing services immediately on September 15.
Employees affected by this layoff have unvested options that will legally continue to vest through November 14 based upon the above provisions, even though no further service is required. Awards that do not vest by November 14 will be forfeited according to their original terms.
Has SC Corporation modified the terms of the options that will vest between September 15 and November 14?
No. A modification to the terms of the award has not occurred because the continued vesting of the awards through November 14 pursuant to the WARN Act is deemed to be an original term of the award. That is, SC Corporation was required to allow vesting of these options under the original terms of the award, which implicitly included the requirements of the WARN Act. However, SC Corporation should adjust the requisite service period for these options since further service will not be required beyond September 15 in order to retain the awards. Accordingly, any unrecognized compensation cost for options that will vest between September 15 and November 14 should be recognized on September 15.