How do you account for a stock option repricing under ASC 718?

Why a repricing is a modification

ASC 718 treats a change in the terms or conditions of an equity-classified award as an exchange of the original award for a new one. In substance, the company is deemed to repurchase the original option by issuing a new option of equal or greater value, and it recognizes compensation cost for any incremental value (ASC 718-20-35-3).

Modification accounting applies only when something that matters changes. Under ASC 718-20-35-2A, a company does not apply modification accounting if all three of the following are the same immediately before and after the change:

1. the award's fair value (or calculated value or intrinsic value, for entities that use those methods);
2. its vesting conditions; and
3. its classification as equity or liability.

Lowering the exercise price of an underwater option almost always increases its fair value, so a repricing almost always triggers modification accounting. Administrative changes — a plan renamed, a tax withholding change that does not affect classification — generally do not. Where no valuation input changes, the company does not need to run a before-and-after valuation to reach that conclusion.

Grantees rarely accept a change that makes an award less valuable. If a modification appears to reduce value or make vesting less likely, look for other consideration — cash, new awards, or other compensation — that was given to persuade the holder to accept it.

Measuring the incremental cost

Incremental compensation cost is:

Fair value of the modified option at the modification date − Fair value of the original option immediately before the modification, both measured on that date

Mechanically, the company runs its option-pricing model twice on the modification date with the same current inputs — share price, volatility, risk-free rate, expected dividends — changing only what the modification changes (here, the exercise price, and any knock-on effect on expected term). The pre-modification value of a deep underwater option is small but not zero; using zero overstates the incremental cost.

The modification date is set the same way as a grant date: when there is a mutual understanding of the key terms of the modified award and all necessary approvals are obtained. If the repricing requires shareholder approval, the modification generally does not occur before that approval, and if it is offered to holders who may accept or decline, only the awards of holders who accept are modified.

How the cost is recognized

What happens to the incremental cost depends on whether the option is vested:

Two points carry most of the weight in review:

• The original grant-date cost does not go away. For an award that was expected to vest under its original terms, cumulative compensation cost is the original grant-date fair value plus the incremental value. A repricing can add cost; it cannot remove cost already measured.
• The "expected to vest" assessment is required even under a forfeitures-as-they-occur policy. At the modification date the company assesses whether the original award would have vested under its original terms, because that assessment determines which modification type applies (below). The company's forfeiture policy then governs how it accounts for the modified award going forward.

Worked example 1: repricing vested options

A company granted 50,000 options at an exercise price of $25. They are fully vested and all grant-date cost has been recognized. The share price has fallen to $8, and the board reprices the options to $8 with no other changes.

On the modification date, using the same valuation inputs:

Fair value of repriced option (strike $8)        $3.10
Fair value of original option (strike $25)       (0.90)
Incremental fair value per option                $2.20
x 50,000 options                                  $110,000

Because the options are vested, the full amount is recognized at the modification date:

Modification date
Dr. Share-based compensation expense    110,000
Cr. Additional paid-in capital                  110,000

Worked example 2: repricing unvested options

On January 1, Year 1, a company grants 120,000 options with a $20 exercise price and a grant-date fair value of $7.50, cliff vesting after four years. Total grant-date cost is $900,000, recognized at $225,000 a year. The company accounts for forfeitures as they occur, and none have occurred.

On January 1, Year 3 — halfway through vesting — the share price is $9 and the board reprices the options to $9. Vesting terms are unchanged, and the options were and remain expected to vest (a probable-to-probable modification).

Fair value of repriced option (strike $9)        $3.60
Fair value of original option (strike $20)       (1.40)
Incremental fair value per option                $2.20
x 120,000 options = incremental cost              $264,000

Unrecognized original cost (120,000 x $7.50 x 2/4)  $450,000
Total cost remaining to recognize                  $714,000
Recognized over Years 3 and 4                      $357,000 per year

Each of Years 3 and 4
Dr. Share-based compensation expense    357,000
Cr. Additional paid-in capital                  357,000

Cumulative cost over the four years is $1,164,000: the original $900,000 plus the $264,000 incremental value. If an employee later forfeits by leaving before vesting, cost for that employee's options — original and incremental — is reversed under the forfeiture policy.

If the vesting schedule were graded (one quarter vesting each year) and the company used straight-line attribution, the incremental cost relating to the two vested tranches would be recognized immediately and the rest over the remaining service period.

Worked example 3: a value-for-value exchange

Many companies avoid a large charge by exchanging underwater options for a smaller number of new at-the-money options. ASC 718-20-35-8 accounts for a cancellation accompanied by the concurrent grant of a replacement award as a modification of the cancelled award, so the same incremental-value test applies.

Facts: 100,000 underwater options with a grant-date fair value of $4.00, four-year cliff vesting, two years remaining ($200,000 unrecognized). The company offers to exchange them for 40,000 new at-the-money options that vest over the same remaining two years.

Fair value of original options immediately before
  100,000 x $0.95                                 $95,000
Fair value of replacement options
  40,000 x $2.30                                  $92,000
Incremental fair value                            none

The replacement awards are worth less than the awards surrendered, so there is no incremental cost — and no reduction either. The company continues to recognize the $200,000 of unrecognized original cost over the remaining two years. Had the replacement options been worth $2.60 each ($104,000), the incremental cost would be $9,000, recognized over the same period.

When the replacement award vests over a different period from the original, the attribution of the remaining original cost follows the replacement's service period where it is shorter. Where it is longer, the treatment is a judgment area that companies document as a policy.

The four modification types

Repricings that also change vesting — or that happen while some awards are not expected to vest — need the type analysis illustrated in ASC 718-20-55-107 through 55-119:

A common Type III case: an employee who would forfeit unvested options on termination is allowed to keep them as part of a separation. The original award was not expected to vest, so the cost is the full modification-date fair value of the vested award — not just the incremental value.

Cancellations without replacement

Cancelling underwater options with nothing given in return is accounted for as a repurchase for no consideration. For an award that was expected to vest under its original terms, any previously unrecognized compensation cost is recognized at the cancellation date (ASC 718-20-35-9). If the award was not expected to vest under its original service or performance condition, no cost is recognized on cancellation, and awards that combine a market condition with a service or performance condition need a closer look at why they were cancelled. Cancelling to "clear the overhang" therefore accelerates expense rather than avoiding it. If a replacement grant is promised or understood at the time of the cancellation, evaluate the two together as a cancellation and replacement.

Liability-classified awards and private companies

Liability-classified awards are remeasured each reporting period through settlement, so the effect of a repricing appears in the next remeasurement rather than through the incremental-value calculation. A repricing that changes classification (for example, adding a cash settlement feature) is analyzed under the classification-change guidance instead.

A nonpublic company that measures options at calculated value because it cannot estimate its own volatility measures the before-and-after values on that same basis — ASC 718-20-35-2A refers to fair value, calculated value, or intrinsic value as applicable. Private companies also need a supportable share value at the modification date, which is often the hardest input to evidence.

Tax and disclosure

A repricing can have tax consequences even when the accounting is simple. For tax purposes a repriced option may be treated as a newly granted award, which can affect incentive stock option status, deferred compensation rules, and the deductibility of executive compensation. Companies usually involve tax advisers before approving a repricing.

ASC 718-10-50-2(h) requires a description of significant modifications, including the terms, the number of grantees affected, and the total incremental compensation cost (or the lack of it). That disclosure applies even when the modification produces no incremental cost.