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Changes that awards undergo as a result of an equity restructuring (e.g., large non-recurring cash dividend, stock split, spin-off, etc.) are modifications under ASC 718.
Often, companies will adjust an award's terms to preserve its value after such an equity restructuring. Some awards may contain terms that require or allow for the adjustment of an award to protect the holder from changes in the award's value following an equity restructuring, commonly referred to as "antidilution provisions." For example, to offset the decrease in the per-share price of the stock underlying an option after a stock split or spin-off, a company may adjust the exercise price, the number of shares, or both. To determine whether these changes result in incremental compensation cost under ASC 718, companies will first need to assess whether the adjustments were required by the award's existing terms.
An adjustment to the terms of a stock-based compensation award to preserve its value after an equity restructuring may result in significant incremental compensation cost if there was no requirement to make such an adjustment based on the award's existing terms. Plan terms that merely permit adjustment of an award at the discretion of management or the compensation committee will not prevent a company from incurring additional compensation cost because such a provision does not require an adjustment if an equity restructuring event occurs.

4.5.1 Modifications of awards without an antidilution provision

If the adjustment of an award’s terms in an equity restructuring was not required by its existing terms, the modification will likely result in incremental fair value because the award’s fair value immediately before the modification contemplates the equity restructuring occurring but does not contemplate antidilution protection (i.e., protection against a decline in the value of an award upon restructuring). The fair value immediately after modification reflects the “equitable” (antidilution) adjustments to the award’s terms, which will increase its value relative to the award that is not adjusted.
Equity restructurings in which award holders receive a cash payment in lieu of modifying the award are also treated as a modification. Similar to the illustration in Example SC 4-7, the value of the award without the cash payment (i.e., the immediately before value) is compared to the value of the unmodified option together with the cash payment (i.e., the immediately after value of the entire award provided the holder). Any incremental fair value transferred to holders of vested awards would be recorded as compensation cost. For those awards that have not vested upon modification, the recognition of compensation cost for the portion of the arrangement that was settled in cash is accelerated (assuming the cash received by the employee is fully vested and does not need to be returned if the underlying award never vests). In equity restructurings, any change in the exercise price or other terms of the option, as well as the cash payment, should be included in the assessment of whether incremental fair value has been provided to the award holders.
Example SC 4-7 illustrates the accounting for the modification of stock options to preserve their value after a 2-for-1 stock split, assuming that the options do not contain an antidilution provision.
EXAMPLE SC 4-7
Modification of stock options without an antidilution provision for a stock split
On June 1, 20X1, SC Corporation grants 10,000 "at-the-money" equity-classified stock options with an exercise price of $20 and a grant-date fair value of $9.03. The options cliff-vest in four years based on a service condition. The options' original terms do not include antidilution protection (i.e., the plan is silent on the subject of preserving the options' value upon a future equity restructuring event).
One year after the grant date, SC Corporation completes a 2-for-1 stock split of its common stock when the market price of its stock is $50. Concurrent with the stock split, SC Corporation modifies the options so that the exercise price is adjusted to $10 and the number of options outstanding is increased to 20,000. The modification is intended to preserve the value of the options after the stock split.
All valuation assumptions remain constant before and after the modification: expected volatility of 40%, expected term of 6 years, dividend yield of 0%, and risk-free interest rate of 4%.
How should SC Corporation account for the stock split?
Analysis
Because the options' terms do not contain an antidilution provision, the estimated fair value of the options immediately before the modification should be based on the assumption that the market price of SC Corporation's stock will be reduced to $25 as a result of the stock split and the exercise price of the options will remain at $20. Using a Black-Scholes model and a stock price of $25, an exercise price of $20, and the other assumptions noted above, the fair value per option immediately before the modification is $13.05. The total compensation cost for the options outstanding immediately before the modification is $130,500 ($13.05 × 10,000 options).
Immediately after the modification, the value of the options is based on the new exercise price of $10 and the number of options increases to 20,000. Using a Black-Scholes model, the stock price of $25 and an exercise price of $10, the fair value per option is $17.88. The total fair value of the award immediately after the modification is $357,600 ($17.88 × 20,000 options).
Thus, this modification, which was intended only to make the option holders "whole," results in incremental fair value, and, in turn, compensation cost of $227,100 ($357,600 – $130,500). The following table summarizes the effect of the modification:
Immediately before the modification
Immediately after the modification
Market price of SC Corporation's stock
$25
$25
Exercise price
$20
$10
Fair value per option
$13.05
$17.88
Number of options
10,000
20,000
Total award fair value
$130,500
$357,600
View table
SC Corporation would recognize the remaining original grant-date fair value plus the incremental fair value at the date of the stock split as compensation cost over the remaining requisite service period.

4.5.2 Modifications of awards with an antidilution provision

If awards are adjusted based on an existing antidilution provision that requires the adjustment in the event of an equity restructuring, and is properly structured to preserve the value of the awards upon completion of the equity restructuring, incremental fair value generally should not result from the modification. In this situation, the fair value of the award immediately before the modification will reflect the required adjustment to the award’s terms in accordance with the antidilution provision. Thus, the fair value of the award immediately before the contractually-required modification should be equal to its fair value immediately after the contractually-required modification. However, this calculation should be performed to confirm that no incremental fair value is generated by the modification. As described in SC 4.5.4.3, the value used in keeping an award holder “whole” may not be the fair value of the award for accounting purposes and, as a result, modifications may inadvertently result in incremental fair value that would need to be recognized.
In order for a company to conclude that a modification is required, we believe the terms of the award need to, at a minimum, specify that an “equitable” or “proportionate” adjustment is required (not just that the company “may” make such an adjustment). In our view, it is not necessary for an antidilution provision to specify exactly how the awards will be adjusted. When assessing whether an antidilution provision is discretionary, consideration should be given to whether the employees could require the company to make “equitable” adjustments to an award’s terms if an equity restructuring event occurs. In some cases, input from legal counsel may be necessary.

4.5.3 Awards modified to add an antidilution provision

A modification also occurs when an antidilution provision is added to an award's terms. However, ASC 718 provides that if an award is modified to add an antidilution provision and the provision is not added in contemplation of an equity restructuring event, then the company is not required to calculate the incremental fair value of the modified award.
If an antidilution provision is added in contemplation of an equity restructuring event, modification accounting is required and would likely result in incremental fair value and, in turn, additional compensation cost. Similar to Example SC 4-7, the fair value immediately before the modification to add the antidilution provision would reflect the anticipated effect of the equity restructuring and assume no antidilution protection. ASC 718 does not define “in contemplation,” but Case B of Example 13 of ASC 718-20-55-105 indicates that once an equity restructuring event has been publicly announced, a modification would be considered “in contemplation.” Prior to the announcement of an equity restructuring event, judgment will be required to determine whether the antidilution provision was added in contemplation of that event.

4.5.4 Modifications of awards in a spin-off transaction

In a spin-off, a company distributes shares of a subsidiary to its shareholders, thereby reducing the parent company's share value. Consider a situation in which the parent company's market value was $30 per share immediately before the spin-off. The parent company distributes one share of the subsidiary's stock for each parent company share outstanding. Immediately after the spin-off, the parent company's shares trade at $25 per share, and the subsidiary's shares trade at $5 per share.
Companies will generally modify outstanding awards to keep employees in an equitable position after the spin-off. For example, employees holding options to purchase shares of the parent may receive options to purchase shares of the entity that has been spun off, or the exercise price and number of options on the parent company shares may be adjusted to reflect the decline in value of the parent company stock. Companies can use a variety of methods to keep employees “whole” upon the spin-off. Regardless of the method used, any exchange of awards or adjustment in connection with a spin-off transaction is accounted for as a modification in accordance with ASC 718. A spin-off generally creates a number of complex stock-based compensation issues. In this section, the following aspects of a stock-based compensation modification involving a spin-off are addressed:
  • Nature of the modification
  • Impact of a mandatory antidilution provision
  • Stock prices used in the incremental fair value calculation
  • Attribution of stock-based compensation cost

4.5.4.1 Nature of award modifications in a spin-off transaction

Understanding the form of the transaction and how share-based awards will be modified in connection with a spin-off is important to appropriately account for the modification. The fair value of the award immediately prior to the modification will be compared to the fair value of the award(s) immediately after the modification. Common examples of how companies modify awards to preserve the pre-spin value include providing employees with incremental awards in the parent company stock, providing awards in the former subsidiary's stock, or adjusting the exercise price of the existing awards. Different information is required to account for the modification depending on its nature. For example, if the company provides existing option holders with options of the former subsidiary, it will be necessary to estimate the fair value of the subsidiary in order to measure the fair value of those options.
Options granted on the equity of another entity are derivatives under ASC 815. However, a company that grants an option on its subsidiary as an equitable adjustment pursuant to an antidilution provision would still be subject to ASC 718 at the time of grant. If the parent company grants awards in the former subsidiary after the spin-off, those awards would be derivatives subject to ASC 815-10-55-46 through ASC 815-10-55-48.

4.5.4.2 Impact of a mandatory antidilution provision

Antidilution provisions are designed to equalize the value of awards before and after the spin-off. Whether awards contain an antidilution provision will impact the assumptions used to measure the fair value of the awards upon modification. The fair value immediately before the spin-off for awards that include an antidilution provision will reflect the required adjustment in accordance with the antidilution provision (e.g., an increase in the number of awards). The absence of an antidilution provision will usually result in significant incremental fair value. See SC 4.5.1 through SC 4.5.3 for further guidance.

4.5.4.3 Stock prices used in calculating incremental fair value

If the equitable adjustment for the spin-off will result in the parent company distributing stock options  in the former subsidiary to the parent's employees based on the spin-off ratio received by all shareholders, then the measurement of incremental compensation cost to be recorded by the parent company is based upon the fair value of the parent company stock options immediately prior to the spin-off as compared to the fair value of the parent company stock options plus the former subsidiary stock options to be distributed upon the spin-off.
The fair value of the parent company awards immediately prior to the spin-off should generally be based on the parent company's closing stock price on the day of the spin-off transaction, also known as the "record date." In many spin-offs, the parent company's shares will begin trading on an "ex-dividend" basis three business days before the record date, (i.e., the parent company's shares will trade excluding the fair value of the subsidiary's shares). After the subsidiary's registration statement is declared effective, the subsidiary's shares will generally begin trading on a "when issued" basis. In this situation, in order to determine the fair value of the parent company's shares immediately prior to spin-off, the fair value of the parent company's shares traded on an "ex-dividend" basis should be added to the fair value of the dividend of the subsidiary's shares traded on a "when issued" basis immediately prior to the spin-off.
The fair value of the parent company awards immediately after the modification should generally be based on one of the following:
  • The parent company's opening stock price on the day after the spin-off (assuming the parent company shares were not traded on an "ex-dividend" basis);
  • The difference between the closing price of the parent company's stock on the day of the spin-off ("before" the spin-off) and the closing price of the subsidiary's stock (either actual or "when issued") on the day of the spin-off; or
  • The parent company's shares if traded on an "ex-dividend" basis (it would not be necessary to deduct the closing price of the subsidiary's stock on the day of the spin-off, because it will already be reflected in the fair value of the parent company's shares).
The fair value of the subsidiary's options immediately after the modification should generally be based on either:
  • The subsidiary's opening stock price on the day after the spin-off (assuming the subsidiary's shares were not traded on a "when issued" basis), or
  • The closing price of the subsidiary's stock on the day of the spin-off (assuming the subsidiary's shares were traded on a "when issued" basis).
The use of an average price over a period of time, while perhaps deemed “equitable” for purposes of determining the terms of the modified awards, is not appropriate for purposes of determining fair value as of the modification date because the use of such averages introduces effects from market conditions or events other than the equity restructuring itself. The other assumptions used to estimate fair value (e.g., volatility, expected term, etc.) would also be determined based on the facts and circumstances immediately before and immediately after the spin-off transaction; however, the fair value of the awards immediately before the modification should generally include the effects of the contemplated transaction. Furthermore, volatility and dividend yield assumptions should be determined separately for the options to purchase parent and subsidiary shares. These assumptions may differ for the parent and subsidiary depending on the facts and circumstances.

4.5.4.4 Attribution of stock-based compensation cost

In connection with a spin-off and as a result of the related modification, employees of the parent company may receive stock-based compensation awards of the former subsidiary, or employees of the former subsidiary may retain stock-based compensation awards of the former parent company. The parent company and the former subsidiary would recognize compensation cost related to the modified awards that had been granted to employees who provide service to each respective entity. In other words, after the spin-off, each employer would recognize expense only for the stock-based compensation awards that are held by its employees, regardless of which company originally issued the awards.
Awards held by parent company employees would continue to be recognized in the financial statements of the parent company, including any incremental fair value created as a result of the modification.
If the employees of the former subsidiary were to retain their unvested awards of the parent company, the former subsidiary would recognize in its financial statements the remaining unrecognized compensation cost (with an offsetting credit to equity) pertaining to those awards over the remaining requisite service period. If the former subsidiary issued new awards in connection with the spin-off (for example, to keep the holder “whole” as a result of the decline in value of the former parent company awards upon the spin-off), the aggregate fair value of the awards immediately before and after the spin-off would be calculated, as described in SC 4.5.4.1. Any incremental fair value would be recognized prospectively in the financial statements of the former subsidiary for unvested awards. Incremental fair value for vested awards would be recognized immediately in the financial statements of the former subsidiary.
After the spin-off, the parent company would not recognize any compensation cost related to its unvested awards that are held by former employees who now work at the former subsidiary, because those employees will provide services solely to the former subsidiary post-spin. However, in this scenario, any incremental fair value arising from the spin modification for vested awards would also be recognized immediately in the parent company’s consolidated financial statements.
A parent company, in contemplation of a spin-off, may also arrange with its current employees, who are going to work exclusively for the former subsidiary (upon completion of the spin-off), to exchange unvested parent company options for unvested options to purchase the new shares of the former subsidiary pursuant to antidilution provisions. The employees will be terminated from the parent company following the spin-off, but the service they are providing to the former subsidiary will not be interrupted. In this situation, the parent company would not reverse the compensation cost recorded for the options prior to the date of the spin-off (that is, there will not be forfeiture of awards). Rather the parent company is effecting an exchange of awards pursuant to antidilution provisions in connection with the transaction. Following the spin-off, the parent company would no longer record compensation cost related to the unvested awards of the former employees. The remaining fair value of the unvested awards would be recognized by the former subsidiary.

*Although the market price of SC Corporation's stock is $50 prior to the 2-for-1 stock split, the market price is assumed to be $25 immediately before the options' modification as it is assumed that market participants would anticipate the stock split when determining the options' fair value.

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