ASC 718, Stock Compensation has been around a while now, so most of us are familiar with estimating the fair value of share-based payment awards at the grant date (for equity classified awards) or each reporting period (for liability classified awards) and recognizing that value over the vesting period. But what happens when awards don’t perform as expected? If a stock option is out-of-the-money, or “underwater,” should you continue to recognize expense? What happens if a restricted stock award is unlikely to vest because a required goal is not reached? Read on to find out.

Share-based awards can be a great way to compensate and motivate groups of executives, managers, and other employees. When everything goes as planned, the recipients get a nice bump in their overall compensation while the company holds on to cash. It’s a win-win situation because these awards tie recipients and the company to the same goal: increasing company performance to ensure a payout. Sometimes, these awards don’t have the intended results, whether as a result of poor company performance or unforeseen events, such as the havoc caused by the worldwide COVID-19 pandemic.

The accounting established at the grant date may need to change when awards are underperforming.

Simple Underwater Options

Let’s start with an easy scenario. When a stock option is “underwater,” the exercise price is higher than the current market value. No one would want to exercise an option under those circumstances, but can the company consider them worthless and stop recording expense?

Not if the award is accounted for as an equity award! When accounting for equity awards, remember to “just keep swimming, just keep swimming”…er, keep recognizing that same expense.

When SFAS 123R was issued (later codified as ASC 718), the goal was to recognize the cost to the employer of share-based payment arrangements. Even if the award is underwater and has no value to the company or recipient, the initial calculated value is still recognized over the vesting period, because the grant date fair value already took into account expectations about the future.

Now, if the award is classified as a liability (which usually happens when the payout will be, or could be, in cash rather than shares), the effects of an underwater option are taken into account when the award is adjusted to its new fair value each reporting period.

Other “Underwater” Situations

Many share-based payment awards aren’t as simple as the stock option example above. Awards can contain all types of features that affect vesting or fair value. Here’s a little refresher before we dive into the implications of these features.

There are three categories of “conditions” that can affect the vesting, payout, or fair value of an award: service, performance, and market conditions. Let’s use an open water swim race to illustrate these conditions.

1. A service condition is simply a requirement to complete a period of service (work) in exchange for the vesting of the award. Using the race analogy, a service period would be equivalent to simply finishing the designated swim length.
2. A performance condition includes a specific target goal tied to either the entity’s own performance or the recipient’s performance in relation to the entity. Examples of performance conditions include sales goals or individual performance goals. In the swimming illustration, it could be a time goal that must be beat in order to get credit for finishing.
3. A market condition is not a vesting condition. These types of conditions affect the fair value of an award. The Glossary of ASC 718 states that a market condition relates to a specified price of the issuer’s shares or intrinsic value related to those shares, or to a specified price of the shares in comparison to similar shares or an index. In the swim race example, market conditions could be similar to the weather, wave conditions, or the finishing place of a particular swimmer.

Now that we’ve established the basics, let’s consider the accounting implications for underwater awards classified as equity.

Expense must be recognized over the vesting period for equity-classified awards with service or performance conditions, or a combination of these two, as long as the condition(s) are probable of being met. The achievement of performance conditions that affect vesting should be reassessed each reporting period, and the expense recognized should reflect the new assessment.

Of course, normal forfeiture accounting also applies, and the company should follow its established policy of either reducing the expense to account for estimated forfeitures all along, or reversing expense when awards are actually forfeited.

Here comes the crazy part though: If an award has a market condition that is not likely to be met, nothing changes in the expense recognition! This is because the probability of achievement of the market condition was already considered in the fair value estimation at the grant date, so there is no need to adjust the expense over the vesting period. Even crazier still, the expense is not reversed at the vesting date if the award does not pay out! The only reason to reverse expense recorded for awards with market conditions is if the award is forfeited.

This simplified chart summarizes the proper basis for expense recognition over the vesting period for equity and liability awards with each type of condition:

Earnings Per Share Implications for Underwater Awards

Share-based awards only impact the calculation of basic EPS when the shares are actually issued, or if they are considered participating securities. However, these awards affect diluted EPS under the treasury method from the date of grant. Remember that awards should not be included in the diluted EPS calculation if the effect is anti-dilutive, meaning it would increase EPS.

So, are underwater awards anti-dilutive? Typically, yes, but not always. The exercise price must be less than the average market price of the stock during the period to cause dilution. Whether the award is dilutive or anti-dilutive will depend on the share price throughout the period, not just the end of the reporting period.

Modifications of Underwater Awards

Sometimes, companies will restructure awards, offer a cash payout in place of the original award, or take other measures to ensure award recipients still get a benefit when awards have gone underwater. ASC 718 provides specific guidance on accounting for modifications, therefore these changes need to be analyzed thoroughly to determine the appropriate accounting.

This post only touches on a few aspects of the accounting for share-based payment arrangements, and not all situations are covered. If you’d like more in-depth examples and analysis, ASC 718 is your best source, but Deloitte’s Roadmap for ASC 718 and PwC’s Stock-Based Compensation Guide are also helpful resources. Feel free to reach out to us for more information and additional training as well!

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