Topic 718 indicates that a modification to the terms of an award should be treated as an exchange of the original award for a new award. The accounting charge represents the incremental increase of the fair value of the new award compared against the remeasured fair value of the original award. Further, the incremental charge should consider the number of awards involved. For example, many companies desire to have a cost-neutral (or value for value) exchange such that an employee agrees to cancel certain underwater awards for a lesser number of at-the-money awards (or other equity vehicle).
The FASB did not describe the assumptions used to value the post-modification options, but it should be noted that the assumptions used to value the pre-modification and post-modification options likely will differ. For example, the pre-modification award is generally out-of-the-money (sometimes significantly), and would be expected to be held longer than an award that is not out-of-the-money. In fact, the examples provided in 718-20-55-93 to 718-20-55-102 apply a binomial model to value the awards, since a binomial model can consider exercise behavior as a function of the moneyness level. The use of a binomial model will result in a longer expected term for the out-of-the-money option than for the new at-the-money option. This is because on average it will take longer for the option with the higher exercise price to achieve the suboptimal exercise factors. As a result of the different expected terms, the other assumptions may vary as well.
Since the exchange will ultimately occur at the end of the Tender Offer period, the final valuation under Topic 718 and determination of incremental cost (if any), will need to occur on the exchange date. Final Topic 718 assumptions for the exchange (expected volatility, dividend yield, exercise behavior, and Risk-Free Rate) should occur on that exchange date. Sometimes those assumptions can differ than the assumptions used to develop conversion ratios prior to the commencement of the Tender Offer. Companies should discuss the underlying assumptions for the valuation prior to the development of the conversion ratios, in order to minimize risk of having an incremental charge due to the exchange. Test your assumptions at our Option Exchange Calculator.
718-20-55-93 to 718-20-55-102 provide examples of option-for-option exchanges and cash settlements for both vested and non-vested awards.