The IASB recently finalized amendments to IFRS 2 relating to the accounting treatment of share withholding and cash-settled awards.
FASB in the Lead
The IASB issued the exposure draft of the amendments in November 2014—so long ago that I was beginning to think that maybe they had forgotten about the project and would never get around to it. By way of reference, the FASB issued the exposure draft of their amendments to ASC 718 seven months later and still managed to issue their final amendments three months ahead of the IASB.
Share Withholding
The most exciting amendment permits shares to be used to cover tax withholding without triggering liability treatment. Under the original IFRS 2, share withholding triggered liability treatment for the shares that were applied to the tax payment—no exceptions. This resulted in a bifurcated accounting treatment for the award: the portion that would be settled in cash to cover the tax payment was subject to liability treatment while the rest of the award was subject to equity treatment. It was also an area where IFRS 2 diverged from ASC 718, which has always included an exception to liability treatment for share withholding.
Unfortunately, the two standards still don’t converge. The IASB’s amendment only permits share withholding up to the statutorily required payment, and, as my readers know, the FASB recently expanded the exception in ASC 718 to apply to share withholding up to the maximum individual tax rate in the applicable jurisdiction. It’s ironic: the primary reason the FASB expanded the exception in ASC 718 was to facilitate share withholding for non-US employees but, unfortunately, for companies that have to report under IFRS, the international standard will still pose an obstacle to doing this.
Cash-Settled Awards
The IASB also amended IFRS 2 to clarify the vesting conditions that apply to cash-settled awards should be accounted for in the same manner as for stock-settled awards. The upshot is that for non-market conditions, the company records expense based on an estimated forfeiture rate and trues up to outcome. Market conditions (and non-vesting conditions) are incorporated into the fair value of the award. I’m surprised that anyone thought anything different. I guess that’s the problem with a “principles-based standard.” If you don’t spell everything out with a nice clear set of rules, someone is bound to interpret the principle in a way you don’t want them to.
The amendments also clarify how to account for modifications that change the classification of awards from cash-settled to stock-settled. I’m not going to bother to explain this because 1) it’s a total snore (as compared to the rest of the action-packed amendments) and 2) it happens so rarely that hardly anyone cares about it. And, as with any modification of stock awards, it’s crazy complicated—if this is something your company is doing, you should really be talking to your accounting advisors and not relying on an English major to tell you how to account for the modification.
Thanks to Ken Stoler of PwC for bringing the amendments to my attention and for providing a handy summary of them.
This week I write about how stock compensation can introduce volatility into the P&L and why this is a problem.
The Problem with Liability Treatment
The recent article “Higher Stock Price Triggers First-Quarter Loss for Barnwell” (Honolulu Star Advertiser, May 12, 2011, Andrew Gomes) highlighted for me the exact problem with stock compensation that is subject to liability treatment. The article explains that Honolulu-based Barnwell Industries experienced a $1.5 million loss this quarter–a reversal of a $1.5 million profit for the same quarter last year. The reason for the loss is that their stock price doubled during the quarter.
How can a stock price increase cause the company to recognize a loss? The answer is that Barnwell has granted options that can be paid out in cash (the options include a cash SAR component) and are therefore subject to liability treatment. Thus, the increase in their stock price had a very significant impact on their stock compensation expense. Although they haven’t granted options since 2009, Barnwell’s stock option expense went from $46,000 for the comparable quarter last year to $1,677,000 for the current quarter. That’s an increase of 3,546%–kind of hard to explain to shareholders, who, for the most part, probably don’t have the foggiest understanding of liability vs. equity treatment.
Performance Awards Too
While performance awards receive equity treatment under ASC 718, they can also introduce the potential for similar volatility to the P&L. When performance awards are contingent on non-market based goals (e.g., revenue, earnings, and other internal metrics), the likelihood of forfeiture is estimated and expense is recorded based on this estimate. If the company does well, the likelihood of forfeiture will be lower and the expense for the awards will increase.
It’s important to keep this in mind when designing performance award programs and to set appropriate caps on payouts as a means of controlling stock plan expense (not to mention, how do you handle a situation where awards vest based on earnings, the earnings target is hit, and this decreases the forfeiture estimate to the point where the additional expense for the awards reduces earnings below the target). This is also a reason to consider market-based awards–i.e., awards that vest based on stock price targets or total shareholder return. For these awards, the likelihood of meeting the targets is baked into the initial fair value estimate and there are no further adjustments if the likelihood that the targets will be achieved changes.
Need to know more about the accounting treatment and design considerations for performance awards? Don’t miss the NASPP’s pre-conference program, “Practical Guide to Performance-Based Awards” at this year’s NASPP Conference.
IFRS 2
If ever required for US companies (see last week’s blog entry, “IFRS 2: The Saga Drags On“), there are three requirements under IFRS 2 that could introduce significant volatility to the P&L:
Tax Accounting: IFRS 2 requires all tax shortfalls to run through the P&L and, moreover, requires companies to estimate their tax benefit/shortfall each accounting period and adjust tax expense accordingly. This is the opposite of Barnwell’s problem. Here, an increase in stock price wouldn’t be a problem, but a decrease that causes options and awards to be underwater (i.e., the current intrinsic value of the award is less than the expense) could result in significant increases in tax expense, which would reduce earnings for the period. Sort of rubbing salt into the wound–reduced earnings is not going to help get the stock price back up.
Share Withholding: Share withholding on either options or awards triggers liability treatment (for the portion of the award that will be withheld to cover taxes) under IFRS 2. As the company’s stock price increases, this liablity–and associated P&L expense–will increase.
Payroll Taxes: The company’s matching tax liability for payroll taxes (Social Security and Medicare in the US) is also treated as a liability that must be estimated and expensed each accounting period. Again, as the company’s stock price increases, this liability and expense will also increase.
See the NASPP’s IFRS 2 Portal for articles on these IFRS 2 requirements.
Last Chance to Qualify for Survey Results This is the last week to participate in the NASPP’s 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte). Issuers must complete the survey by this Friday, May 20, to qualify to receive the full survey results. Register to complete the survey today.
New “Early-Bird” Rate for the NASPP Conference If you missed last Friday’s early-bird deadline for the 19th Annual NASPP Conference, you can still save $200 on the Conference if you register by June 24.This deadline will not be extended–register for the Conference today, so you don’t miss out.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Register for 19th Annual NASPP Conference (November 1-4 in San Francisco). Don’t wait; the new early-bird rate is only available until June 24.
Participate in the NASPP’s 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte, with survey systems support provided by the CEP Institute). Don’t wait–this week is your last chance to participate.
The New Long-Term Incentive Paradigm–Conserving Share Usage Through Innovative Incentive Design by Myrna Hellerman, Sibson Consulting
The Dodd-Frank Act “Say-on-Pay” provision…something totally new? Not really. For years shareholders have had a voice in compensation decision making, especially through the power to approve incentive and equity compensation plans. They just haven’t used their power to its full potential. Dodd-Frank provides a clearer platform and framework to exercise this power.
Next year we will celebrate the “coming of age,” 18th anniversary of Section 162(m), the infamous “Million Dollar Cap” for non-performance-based compensation. Like Dodd-Frank, there was an expectation that Section 162(m) would “reel in” executive pay, create a greater alignment between pay and performance, and give the shareholder a “say on pay.” The logic was simple: “You lose deductibility of top executive pay if it exceeds $1 million unless the pay is earned under a shareholder approved performance-based incentive compensation plan.” In 2003 the SEC further strengthened shareholder’s “say on pay” by affirming the new NYSE and Nasdaq rules that expanded the shareholder approval requirement to equity compensation plans and amendments thereto.
So, does the existence of the formal Dodd-Frank Say-on-Pay Vote imply that earlier attempts to give shareholders a say on pay have been complete failures. Headline news over the years would suggest this to be so. However, we think not. Successful outcomes just don’t make the headlines. One of these formerly untold success stories will be presented at the 18th Annual NASPP Conference in September. The presentation, “The New Long-Term Incentive Paradigm–Conserving Share Usage Through Innovative Incentive Design,” provides an exemplar outcome in response to a pre-Dodd-Frank “say-on-pay” vote. The takeaways from this presentation will be valuable as organizations prepare for the more formal Say-on-Pay vote required under Dodd-Frank.
In 2005 stockholders rejected an additional share authorization at the 9,000+ employee Arthur J. Gallagher & Co due to burn-rate and dilution concerns. This “No” vote was unexpected at a company with generally shareholder-friendly, conservative pay practices. In response, the organization began a lengthy transformational journey that resulted in a new long-term incentive paradigm. The paradigm recognizes several key realities:
The voice of the shareholder is very powerful. Shareholders need to be continually educated about the company’s pay practices and deserve a reasoned response to their objections.
A purge of poor pay practices and a “diet” to get value transfer and burn-rates into line are not just part of a short-term solution. They are a way of life.
A culture of “ownership” in the long-term success of the organization can be preserved even when there is a paucity of equity. At Gallagher this was accomplished through the use of a uniquely designed, 162(m) compliant long-term cash incentive approach, which mirrors the risks and rewards of equity (this design will be detailed in the presentation).
Management must get comfortable with the difficult, prioritized decisions that are required to effectively manage long-term incentives.
The board, and especially the compensation committee, need to embrace a more intimate role in executive compensation decision making, especially with respect to long-term incentives. Management and the outside independent advisor must provide the education, transparency of information, and the analytics that allow the directors to be successful in this role.
The NASPP Conference presentation and the accompanying discussion will be lead by Myrna Hellerman (SVP, Sibson Consulting), Jon Minor (Sr. Consultant, Sibson Consulting) and Tom Paleka (VP Global Rewards, Arthur J. Gallagher)., three catalysts to Arthur J. Gallagher’s transformational journey that began because of a “say on pay” vote.