The Insanity Workout and Accounting for Stock Option Modifications

I feel like every Saturday morning when I wake up and turn on the TV, I see infomercials for the Insanity workout.  Developed by fitness guru Shaun T., the commercial boasts that the workout’s “max interval training” can completely makeover your body in 60 days. 

Having a toddler at home, the only free time I have for an “insanity” workout involves chasing my son around the house to prevent him from running into everything headfirst;  with that said, I cannot testify to the merits of Shaun T.’s DVD workouts.  What I do know, however, is that no fitness infomercial would be complete without the obligatory before and after photos.  What’s ironic is that before and after concept also plays a role in accounting for stock option modifications – just what pops to mind when you think of a killer workout, right?  So while Shaun T. is helping people achieve their weight loss goals and documenting the results in before and after pictures, Sean S. is helping companies through the before and after process of accounting for stock option modifications.

When stock options are issued, their grant date fair value must be determined. This is commonly done through the application of a Black-Scholes option pricing model.  The fair value of the option is then recorded as an expense over its vesting period.  Sometimes, before an option is exercised, the issuing company will change the terms of certain options, or “modify” them.  When this occurs, although the option-holders haven’t actually been issued new options, GAAP essentially treats the modification as such, which adds a few additional valuation-related steps to the accounting process.

• First, the fair value of the originally-issued options (based on the original terms) must be determined as of the modification date.
• Next, the fair value of the modified options must be determined as of the modification date.  Typically, modifications result in an extension of the option term or a lowering of the strike price, so they normally make the modified options more valuable than the existing options.
• Finally, the difference in the fair value of the originally-issued and modified options is determined and any excess value stemming from the modification will be recognized as an expense in addition to any compensation cost yet to be recorded in connection with the original options.

For example, let’s assume that a set of options with 25% annual vesting was issued on January 1, 2013 with a grant date fair value of $100.  By January 1, 2016, 75% of the option expense would have been recorded ($75), with the remaining 25% to be recognized in 2016 ($25).  Next, let’s assume that the options were modified on January 1, 2016 by lowering the strike price to allow the holder to have a greater likelihood of the options being “in the money.”  If the fair value of the originally issued options on the modification date is determined to be $90 and the modified options have a fair value of $110, an additional $20 of compensation cost would need to be recorded.  Since ¾ of the options had already vested, ¾ of the additional compensation cost ($15) would be recognized immediately upon the modification and the remaining $5 would be recognized over the remaining vesting term of the option (in addition to the $25 expense from the vesting of the original option).  If the option had been fully-vested on the date of modification, the total amount of additional compensation expense ($20) would be fully-recognized on the date of modification with no future compensation expense to be recorded.

Stock option modifications can be complicated (actual modifications may be much more complex than the simple example above), so make sure to work closely with your accountants and valuation experts when addressing these issues.  While not quite as exciting as turning yourself into a before and after advertisement for the Insanity workout, the same before and after concept plays a central role in accounting for stock option modifications, so make sure that you’re following the program correctly to achieve the best results.

To learn more about stock option modifications, understand how your business is valued or gain insight on the financial and economic issues that affect today’s business world, call the experts in the Valuation and Litigation Support group at (855) MARCUM1.