In Accounting Standards Update (ASU) No. 2014-12, the Financial Accounting Standards Board (FASB) answered an important question regarding the treatment of share-based awards: What happens if an award contains a performance target that affects vesting and may be achieved after an employee retires or otherwise completes the requisite service period?
The new rules require companies to treat this type of performance target as a performance condition. That means the business shouldn’t reflect the target in the award’s estimated grant-date fair value. Rather, it should recognize compensation cost when it becomes probable that the target will be achieved (if ever). If that occurs during the requisite service period, the business should recognize the remaining unrecognized compensation cost over the remainder of the service period.
Why it Matters
It’s common for businesses to grant stock options or other share-based compensation awards that are tied to a specific performance target, such as achieving a certain level of earnings or completing an IPO. Typically, for an award to vest, the employee must continue working for a specified period of time and the performance target must be achieved during that time. But some companies grant awards that are permitted to vest even if the target is achieved after the requisite service period and even if an employee has retired or otherwise left the company.
Prior to ASU 2014-12, FASB’s standards didn’t address this situation. As a result, businesses currently treat these awards inconsistently. Some account for performance targets as performance conditions that affect vesting. But others account for them as nonvesting conditions, which are reflected in an award’s grant-date fair value and expensed during the requisite service period (or, if there’s no requisite service period, on the grant date).
The choice of accounting treatment has a significant impact on the amount and timing of compensation expense. If a performance target is treated as a nonvesting condition, the estimated grant-date fair value should incorporate a discount based on the likelihood the target will be met and its expected timing.
The resulting compensation expense isn’t reversed if the target ultimately isn’t met. If the target is treated as a performance condition, as required by the ASU, a company should recognize compensation expense during and after the requisite service period to reflect the number of awards expected to vest and then adjust that expense based on the number of awards that actually vest.
Putting it Into Practice
The following example illustrates the application of ASU 2014-12.
A privately held business grants unvested shares of stock to its employees, subject to a two-year service requirement. The awards provide that the shares will vest only if the company completes an IPO within five years after the grant date. If the company fails to complete an IPO within that period, the awards expire. The awards also provide that, once an employee meets the two-year service requirement, he or she may leave the company and still receive the shares if the company completes an IPO during the five-year period.
Assume that an IPO takes place in year three and didn’t become probable until that year. Also assume that the grant-date fair value of the awards is $50 million. If the IPO requirement were treated as a nonvesting condition, the fair value would be discounted to reflect uncertainty regarding whether and when the IPO will occur and compensation expense would be recognized over the two-year service period.
Under the ASU, however, the IPO requirement is treated as a performance condition that affects vesting. The company recognizes no compensation expense in years one and two, because it doesn’t deem an IPO probable. In year three, when an IPO becomes probable (and actually occurs), the business recognizes $50 million in compensation expense.
Assess the Impact
For all entities, ASU 2014-12 applies to fiscal years (and interim periods within) beginning after Dec. 15, 2015, but early adoption is permitted. If your company uses share-based compensation, be sure to review your accounting policies and assess the impact of the new rules. If you need to change your accounting treatment, the ASU provides special rules for making the transition.