If the plan is compensatory, over what period is compensation recorded?

Requisite Service Period

Consistent with past requirements, compensation generally is accrued ratably over the period that the employee renders service in exchange for the award. In addition, for liability awards, compensation would continue to be adjusted for changes in value after vesting through settlement.

The period over which an employee renders service in exchange for the award is referred to in Statement 123(R) as the requisite service period. A requisite service period may be explicit, implicit or make-believe (derived), and requires careful analysis of the award's terms to determine what that period is. A stated employee service period is an explicit service period (e.g., an award that vests after two years of continuous service has an explicit two-year requisite service period). An award that provides for vesting of shares on successful completion of a project with an estimated completion date is an example of an implicit service period (e.g., an award that vests upon completion of a Stage II clinical trial that is expected to be completed in 24 months has an implicit two-year requisite service period). For awards that contain market conditions, Statement 123(R) requires an employer to estimate a make-believe service period representing an expected time interval until the market condition is satisfied (e.g., an award that is exercisable if the price of the stock doubles from its level at the grant date would require the use of a lattice model to estimate the average expected period of time for the stock price to double, and that period would be the make-believe [derived] service period for that award). For awards with market conditions, compensation is accrued over the make-believe service period rather than over any explicit service period in the award. For example, if options that are exercisable if the stock price doubles are fully vested at grant date, the explicit service period (zero) is ignored and compensation is accrued over the make-believe service period instead. The FASB's rationale is that some period of time is necessary for a market condition to be satisfied, and that an employee is effectively required to work for that period to earn the right to the award, regardless of any shorter explicit service period. The FASB's position has theoretical merit, but we question whether accruing the compensation over a different period was a sufficient reason to introduce the complications of the make-believe service period.

Estimation of the requisite service period and any subsequent adjustments to that estimate should be based on an analysis of each of the following:

• All vesting and exercisability conditions;
• All explicit, implicit and make-believe (derived) service periods; and
• Whether it is probable⁶ that performance or service conditions will be satisfied.

For awards with service or performance conditions, a company estimates how many awards will vest and accrues compensation only for those awards. The probability of vesting is updated at each reporting period, and compensation is adjusted via a cumulative catch-up adjustment to reflect the latest estimate. Ultimately, compensation is trued up to reflect actual forfeitures, so that compensation is recorded for awards that vest and not recorded for awards that are forfeited.

If an employee forfeits an award because he fails to fulfill a service requirement or fails to achieve a performance condition, no compensation cost is recorded for the forfeited award. If compensation was accrued in earlier periods, it is reversed in the period of forfeiture. If an employee fulfills all of the conditions and vests in an award but does not exercise it, because the stock price falls making exercise uneconomic, compensation cost is not reversed. Also, if an employee forfeits an award because a market condition is not satisfied, compensation is not reversed. We discuss the impact and accounting for performance, service and market conditions more fully in the next section.

For awards with explicit service conditions and graded vesting, a company may treat each vesting date as a separate award and accrue compensation separately, or it may treat all of the vesting dates as a unit and accrue compensation over the period to the last vesting date. For example, if an employer grants 100 shares of restricted stock with a fair value of $10 per share at grant date, with 25% vesting on each of the first four anniversary dates, and chooses to account for each tranche separately, compensation for each tranche of 25 shares would be accrued as follows (assuming zero expected forfeitures):

Note: More than 50% of the aggregate $1,000 of compensation expense is accrued over the first 12 months.

Alternatively, the employer could treat the entire award as a unit and accrue the total compensation of $1,000 ratably over the four-year service period at $250 per year. Under this approach, compensation should accrue at least as fast as the award vests.

Retirement-eligible employees

Another practice issue that companies will need to consider involves the treatment of option or restricted stock grants to retirement-eligible employees that continue to "vest" after retirement. Statement 123(R) requires companies to accrue compensation expense over the period from grant date to the earliest retirement date. This represents a change from prior practice under which many companies accrued compensation over an expected service period. Companies that permit periods after retirement to count toward vesting will need to develop procedures to identify grants to retirement-eligible employees and accrue compensation over the period to the earliest retirement date rather than the expected service period.

To help simplify the transition, the SEC staff indicated that companies that previously accrued compensation for awards to retirement-eligible employees over an expected service period should continue to apply their historical accounting policy for previous awards, with appropriate disclosure. They would apply the requirement of Statement 123(R) prospectively to new grants awarded after adoption.

As a simple example, assume that a company awards options that vest (become exercisable) at the end of two years of service to an employee who is already eligible to retire at the date of grant. If the employee retires, the options still vest (become exercisable) two years after grant. There are no other performance, service or market conditions associated with the award. Statement 123(R) would consider the award's explicit service period (the stated two-year vesting period) to be nonsubstantive, because the employee can retire at any time and receive the benefit of the options. That is, the employee is not required to render any service to enjoy the benefits of the options. In this scenario, the company should recognize as compensation the entire fair value of the award at the date of grant. Similar guidance was originally set forth in Issue 19 of EITF Issue No. 00-23, Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44, and is carried forward by Statement 123(R).⁷

Going a step further, the FASB Resource Group has been asked to consider how a company should account for awards issued to retirement-eligible employees (either currently eligible or that will become eligible during the explicit service period) that also contain performance conditions that may be substantive (e.g., cumulative net income targets over five years) with regard to estimating the requisite service period. To date, no consensus has been reached, but the Resource Group may discuss this topic at a future meeting.

How Statement 123(R) differs from Opinion 25

Opinion 25 has similar concepts in that compensation is accrued over the service period and zero compensation is recorded for forfeited awards. However, Opinion 25 has no specific requirement to estimate vesting or for how or when to reflect forfeitures. For awards with graded vesting, Opinion 25 requires separate accounting by tranche only for variable awards (those for which either the price the employee must pay or the number of shares is not known at date of grant). For fixed awards (those for which both the price the employee must pay and the number of shares are known at date of grant), practice predominantly treats the entire award as a unit and amortizes compensation expense over the period to the last vesting date.

How Statement 123(R) differs from Statement 123

Statement 123 has similar concepts in that compensation is accrued over the service period and zero compensation is recorded for forfeited awards. However, Statement 123 permits employers to accrue compensation for 100% of awards and record reversals of compensation as employees forfeit or to estimate the number of awards that will vest. Statement 123(R) eliminates that choice. For awards with graded vesting, Statement 123 permits employers a choice between accounting for the entire award as a unit or accounting for the individual tranches. Statement 123(R) retains that choice. Statement 123(R) introduces the term requisite service period and the requirement to derive a make-believe service period for awards with market conditions.

⁷Refer to Statement 123(R), paragraphs A57-A58.

Continue Reading - What is the impact of service, performance and market conditions?

MENU TOP