Companies have long used share-based payments to reward, incentivize and retain employees. These awards allow the company to conserve cash and incentivizes the employee to continue providing service in order to earn the award. Share-based payments have the potential to have significant upside and can be a very important part of an employee’s compensation package. Examples of share-based payments include stock options, RSUs and restricted stock awards. The accounting for the award is dependent on its terms and conditions and can vary greatly.

Scope

The accounting for share-based payments falls under ASC 718, Compensation- Stock Compensation (“ASC 718”). ASC 718 applies to share-based payments granted to employees and nonemployees in return for goods or services to be used in the company’s operations. The basic premise of ASC 718 is to estimate the fair value of the award on the grant date and then to recognize the fair value as compensation cost over the service period for awards that vest.

Classification

The first step in accounting for the award is to determine whether it should be liability-classified or equity-classified. The accounting for the award differs depending on its classification. Any terms or conditions that could result in cash settlement or settlement in a variable number of shares should be analyzed to see if it should be classified as a liability. ASC 718 states that share-based payments that would be classified as liabilities under ASC 480, Distinguishing Liabilities from Equity (“ASC 480”) must also be classified as liabilities under ASC 718.

The following are examples that would be classified as a liability under ASC 718:

• Options or similar instruments that are required to be settled in cash
• Instruments that include share repurchase features
• Awards with conditions that are indexed to something other a market, performance or service condition
• Awards classified as liabilities under ASC 480

Unlike equity-classified awards, liability-classified awards must be remeasured to fair value at each reporting date until settlement. Ultimately, the compensation cost recognized for a liability-classified award will equal the amount for which the award is settled (i.e., in cash or shares transferred). This article focuses on the accounting for equity-classified awards.

Measurement

Equity-classified share-based payments are measured at fair value on the grant date. The grant date is when an employer and an employee have a mutual understanding of the key terms and conditions of the share-based payment. This includes an understanding of the nature of the relationship established by the award, the compensatory relationship and the equity relationship subsequent to the date of the grant. Typically, this is reflected in the individual stock agreement that the employee signs. However, ASC 718 provides an exception to the application of “mutual understanding” in determining whether a grant has occurred. This exception allows companies to presume that a mutual understanding exists and measure compensation cost for equity awards on the board (or committee of the board) approval date, provided that certain criteria are met.

ASC 718 provides guidance on fair value as it pertains to share-based payments. The fair value for RSUs and restricted stock is equal to the fair value of the underlying instruments to be issued upon vesting (i.e., the common shares of the company). If the company is publicly-traded, the fair value for these restricted stock awards would equal the stock price on the grant date.

For stock options, fair value is not as straight-forward. ASC 718 requires that companies use an option-pricing model that takes into account the following inputs:

• Exercise price of option
• Expected term of the option
• Current price of the underlying share
• Expected volatility of the price of the underlying share
• Expected dividends
• Risk-free rate for the expected term

Most companies use the Black-Scholes Merton model to fair value their stock options. However, certain terms or conditions may require a more complex model (e.g., binomial or lattice model) which allows for more flexibility to take into account expected exercise behavior and other variables.  

Certain exercise conditions can also affect the measurement of the award. For example, the effect of a market condition should be reflected in the grant-date fair value of the award.

Recognition

Once the fair value is determined, the fair value is recognized as compensation cost over the employee’s requisite service period or the nonemployee’s vesting period.

The terms and conditions included in a share-based payment award affect the recognition of compensation cost. These conditions include the following:

Service Conditions

A service condition is a condition that requires an employee to remain employed for a stated period of time or a nonemployee to deliver goods or render service to the company to earn the right to the share-based payment. Service conditions affect whether an award vests and the determination of the employee’s requisite service period or nonemployee’s vesting period. The employee’s requisite service period is the period that an employee must provide service in exchange for the award and can be either explicit, implicit or derived based on the terms of the award.

Under ASC 718, compensation cost is based on the number of awards that ultimately vest, which depends on satisfaction of the service and performance conditions. If an employee leaves the company during the vesting period, their unvested awards are forfeited, and any compensation cost associated with the unvested options will be reversed. To take this into account, the guidance allows companies to make an entity-wide accounting policy to either 1) include an estimate of forfeitures in the compensation cost calculation each period or 2) account for forfeitures when they actually occur.

The nonemployee’s vesting period is the period that compensation is recognized for nonemployees. Generally, compensation cost for nonemployees is recognized in the same manner as if the company was paying cash for the goods or services.

Share-based payment awards may have either cliff or graded vesting. A cliff-vesting award vests in full at one point in time. Compensation cost for cliff-vesting awards is recognized ratably over the requisite service period. A graded vesting award vests gradually over time and has separate awards corresponding with each vesting tranche, each with a different expected term (e.g., an award that vests 25% each year for 4 years). For entities that grant employee awards with graded vesting based only on a service condition, ASC 718 allows an entity to choose to recognize compensation cost using one of the two following approaches: 1) straight-line, or 2) graded vesting. Graded vesting results in accelerated expense recognition. This policy election does not extend to awards that are subject to vesting or exercisability based on achieving performance or market conditions.

Performance Conditions

A performance condition is a condition that is based on the operations or activities of the company or the grantee. An employee share-based payment award with a performance condition may have an explicit or implicit service period. Compensation cost must be recognized over the employee’s requisite service period or the nonemployee’s vesting period if it is probable (70% likelihood of occurrence) that the performance condition will be satisfied. For performance conditions that only vest based on the consummation of a business combination or IPO, recognition of compensation cost is deferred until the consummation of the transaction, even when it became likely that the business combination would be consummated. If an entity determines the probability of the performance condition has changed during the period, it should account for the change by recording a cumulative catch-up adjustment to retroactively apply the new estimate in the period of the change. For awards with graded vesting, the compensation cost for each vesting tranche in an employee and nonemployee award subject to performance vesting must be recognized ratably over the requisite service period for each tranche.

Market Conditions

A market condition is a condition where the exercisability or other terms of a share-based payment may change based on the achievement of a market condition (e.g., a specified share price or a return on the share price). The compensation cost for awards with a market condition should be recognized over the requisite service period regardless if the market condition is met since the likelihood of achieving the market condition is already incorporated into the fair value of the award. An employee award with a market condition generally has a derived service period because it typically requires the employee to be employed when the market condition is achieved to vest in or exercise the award. If the employee terminates before the market condition is achieved, the award is forfeited. However, if the employee is not required to be employed at the time the market condition is achieved to vest in or exercise the award, the market condition does not affect the requisite service period of the award. The employee’s derived service period is the estimated period of time that would be required to satisfy the market condition, assuming the market condition will be satisfied. If an employee share-based payment award has a derived service period and does not have any explicit or implicit service periods, the derived service period is the employee’s requisite service period over which the compensation cost will be recognized. Compensation cost for an employee award with a market condition will be recognized ratably for each vesting tranche over the requisite service period in a similar manner as an award with a performance condition.

Multiple conditions

If an award contains multiple service, performance and market conditions, and all conditions must be satisfied in order for the award to vest, the employee’s requisite service period will be the longest explicit, implicit or derived service period. In this case, the employee must continue to provide service until the last condition is achieved. If an award contains multiple conditions and the award vests if any one of the conditions is satisfied, the employee’s requisite service period will be the shortest explicit or implicit service period. In this case, the employee must only work long enough to satisfy a single condition.

Modifications

Entities may modify existing share-based payment awards for a variety of reasons. Examples of modifications include extending the contractual term, accelerating vesting for nonvested stock awards, or repricing options if the stock price has dropped, etc. Modification accounting does not apply if the following are the same immediately before and after the modification:

• Award’s fair value
• Award’s vesting conditions
• Award’s classification

Therefore, if the change is administrative in nature, you will not need to perform modification accounting. Otherwise, you will need to apply modification accounting where the modification is treated as an exchange of the original award for a new award.

When a share-based payment is modified, an entity first must determine on the modification date whether the awards would vest under both the original vesting conditions and the new vesting conditions. There are 4 different types of modifications based on whether the vesting conditions are expected to be met immediately before and after the modification. Each type of modification has a different impact to compensation cost. The following table summarizes the accounting for each type:

Modification Type	Vesting immediately before	Vesting immediately after	Accounting
Type 1	Probable	Probable	Record compensation cost if the award ultimately vests under the modified terms or would have vested under the original terms. Measurement of the compensation cost would be the grant date fair value plus the incremental fair value on the modification date.
Type 2	Probable	Improbable	Record compensation cost if the award ultimately vests under the modified terms or would have vested under the original terms. Measurement of the compensation cost would be the grant date fair value plus the incremental fair value on the modification date.
Type 3	Improbable	Probable	Record compensation cost if the award vests under the modified terms. Use the fair value as of the modification date.
Type 4	Improbable	Improbable	Record compensation cost if the award vests under the modified terms. Use the fair value as of the modification date.