What is the impact of service, performance and market conditions?
Impact of service, performance and market conditions--Key Points:
- Under Opinion 25, grants with performance or market conditions triggered variable accounting.
- Under Statement 123(R), measurement of equity awards is generally fixed at fair value at inception, yielding more favorable treatment.
- A company will need to separately assess at each reporting date the probability of achieving each service or performance condition.
- Recognize compensation cost only if requisite service is rendered.
Employee awards may require satisfaction of one or more service, performance or market conditions or a combination thereof. The FASB makes a distinction in Statement 123(R) between performance and service conditions that affect vesting and exercisability and those that affect factors other than vesting or exercisability (e.g., factors affecting exercise price, contractual term, quantity, conversion ratio, etc.).
Market, performance and service conditions that affect vesting or exercisability8
In general, compensation cost is recognized if the requisite service is rendered. Performance or service conditions that affect vesting are not reflected in estimating the fair value of an award at the grant date as they represent restrictions that stem from the forfeitability of awards to which the employees have not yet earned the right. However, a market condition affecting vesting would be reflected in the grant-date fair value. Stated differently, service or performance conditions do not affect the per share or per option fair value of an award. Instead, service or performance conditions affect compensation expense to the extent that they cause employees to forfeit awards, because no compensation is recorded for forfeited awards, but they do not reduce the value of the individual shares or options. By contrast, market conditions do reduce the per share or per option fair value of an award, but if the employee renders the requisite service (works for the entire make-believe service period), compensation expense is recorded for the entire award even if the market condition is not satisfied. Statement 123(R) provides several illustrations of awards that contain market, performance and service conditions or a combination thereof that affect vesting or exercisability in Appendix A.
Practically speaking, Statement 123(R) requires a company to typically perform the following steps in determining the appropriate amount of compensation expense to recognize and over what period to recognize it for equity awards that contain market, performance and service conditions affecting vesting or exercisability (This process has been greatly simplified for our discussion purposes):
- Estimate the number of shares that will vest and how and over what time period they will vest (This requires an estimate of forfeiture rates that may vary over time)
- Estimate the grant date fair value of the options.
- Determine how to allocate expense recognition based upon probability of targets being achieved and how to track each respective tranche.
- Assess Step 3. at each reporting date and adjust accordingly.
An award containing both a performance and a service condition that affect vesting:
By way of example, let's assume Company A grants options to purchase one million shares to 100 employees on January 1, 2006 with an exercise price of $8 per share (based on the market price on that date). The estimated fair value of the options is $4 million. Half of the options are linked to performance targets for Year 1, and half are linked to performance targets in Year 2. The options become exercisable if the performance targets are met and the employee remains employed for 4 years from date of grant. Company A needs to determine the amount of compensation expense to recognize for each reporting period given the following additional information:
- At March 31, 2006, Company A believes it is probable that the performance targets will be met in both years and estimates a 5% forfeiture rate for this group of employees.
- At September 30, 2006 due to poor quarterly results, Company A concludes it is no longer probable that the Year 1 performance targets will be met.
- At December 31, 2007, Year 2 performance targets are met.
Market, performance and service conditions that affect factors other than vesting or exercisability9
For either performance and service conditions or for market conditions that affect factors other than vesting or exercisability, the grant-date fair value should be estimated for each possible outcome of such conditions and the final measure of compensation cost should be based on the amount estimated at grant date for the condition or outcome that is actually satisfied. Statement 123(R) provides several in-depth illustrations in Appendix A.
How Statement 123(R) differs from Opinion 25
Opinion 25 treated grants of awards with performance or market conditions as variable awards requiring variable accounting. Statement 123(R) generally allows for fixed accounting for equity awards and thus, we would expect to see more performance or market conditions being incorporated in future award grants.
How Statement 123(R) differs from Statement 123
Statement 123(R) retains the modified grant-date approach of Statement 123 and accounting for service, performance, and market conditions is similar under both standards. Also like Statement 123, the effect of a market condition on vesting (for example, an option that becomes exercisable only if the stock price exceeds a certain amount) is factored into the fair value estimate, and compensation is not reversed if the award never vests because the target condition is not reached. Statement 123(R) introduces the concept of a make-believe (derived) service period for awards with market conditions.
9 See Footnote 8.
Continue Reading - What about nonvested and restricted shares?