Article by Mark Bradford, Dan Meehan, Buff Miller,Tom Reicher, David Walsh and Thomas Welk
Recently, many accounting firms have alerted their clients to the application of FAS 123(R) in the context of equity restructurings (e.g., stock splits and stock dividends). These firms have noted that the discretionary adjustment of equity compensation under plans and arrangements that do not provide for automatic adjustments upon an equity restructuring may result in an additional compensation expense.
Under FAS 123(R), companies that modify stock awards are required to recognize as an additional compensation cost the excess, if any, of the fair value of a modified award over the fair value of the original award immediately prior to the modification (the "Incremental Cost").1 In an equity restructuring, outstanding stock awards typically are adjusted to reflect the event. For example, a company will adjust its outstanding stock awards to reflect a stock dividend by increasing the numbers of shares subject to the stock awards and reducing their exercise prices.
If the stock award contains an automatic antidilution provision,2 there is typically no Incremental Cost associated with the adjustment to the stock award. However, if the stock award does not contain an antidilution provision, then the adjustment of the stock award to reflect the equity restructuring may result in a significant Incremental Cost.3 FAS 123(R) also provides, however, that if a stock award is modified to add an antidilution provision and that modification is not made in contemplation of an equity restructuring, then a measurement of the Incremental Cost is not required.4
In interpreting FAS 123(R), the accounting firms have recognized that some equity compensation plans contain discretionary antidilution provisions—i.e., provisions that permit (but do not require) the company to adjust stock awards. Often a plan’s antidilution provision will require that stock awards be adjusted in the event of an equity restructuring, but leave the company or its board to determine whether a particular event is an equity restructuring and, if so, what adjustment is appropriate. Such a provision should be treated as automatic and non-discretionary.
The accounting firms have concluded that a equity compensation plans containing discretionary antidilution provisions should be treated, in effect, as not having an antidilution provision at all. As such, the adjustment of stock awards to reflect an equity restructuring could result in a significant Incremental Cost.
Companies are encouraged to review the antidilution provisions of their equity compensation plans to determine whether they are automatic.5 If the plan does not contain an antidilution provision and no equity restructuring is currently contemplated, the accounting firms are encouraging companies to amend their equity compensation plans to add an automatic, nondiscretionary antidilution provision.
Before amending their equity compensation plans, however, companies should first consider the tax impact, if any, of any such modifications. In addition, if such an amendment could impair the rights of the holder of a stock award, the underlying plan may prohibit such an amendment without the holder’s consent.
Notes
1 For more information on the application of FAS 123(R) to stock-based compensation, please see our prior Alerts.
2 An antidilution provision is "a provision designed to equalize an award’s value before and after an equity restructuring." See FAS 123(R), paragraph A156.
3 See FAS 123(R), paragraph A158.
4 See FAS 123(R), paragraph A156. Note, however, that if a company adds an antidilution provision "in contemplation" of an equity restructuring, then the company will be required to measure the Incremental Cost associated with that modification.
5 In reviewing a plan’s antidilution provision, it is important to determine whether the provision was "designed to equalize an award’s value before and after an equity restructuring" and whether the plan mandates an adjustment. No specific plan language is necessary for a company to conclude that the purpose of the provision was to "equalize the award’s value before and after an equity restructuring."
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