PricewaterhouseCoopers has published a summary of SEC comments on stock compensation (“2013 SEC Comment Letter Trends: Employee Stock Compensation,” available in the NASPP’s Surveys & Studies Portal). The comments were made in the course of the SEC’s review of various types of public filings (mostly Forms S-1, but also some Forms 10-K and other filings). I thought it would be interesting to take a look at what PwC found for today’s blog.
Companies Targeted
The majority (79%) of the companies to receive comments were technology, pharmaceutical, and life science companies. But don’t read anything into this–as noted above, the majority of the SEC’s comments were on S-1 filings, and these industries represented the majority of IPOs last year (particularly IPOs where employees held substantial amounts of stock compensation).
Areas Commented On
81% of the SEC’s comments related to information on stock compensation included in the MD&A. Of the comments related to the MD&A, 90% related to the discussion of critical accounting policies, et. al., for stock compensation. Based on the sample comments excerpted by PwC, it seems that many of these comments requested more information on the valuation of the company’s stock on grant dates.
Types of Comments
PwC found that, overall, 50% of the comments related to disclosure, 41% related to valuation, and 9% related to other accounting issues. Of the 41% of comments related to valuation, many of these seem to relate to the valuation of the company’s underlying stock on grant dates, rather than the valuation of stock options. Also, a little over one-third of the comments that PwC classified as disclosure-related were on the disclosures related specifically to valuation. Another 29% were on disclosures related to IPOs; many of these comments focused on valuation of the company’s stock (specifically on the differences between the most recent valuation and the IPO price).
Accounting Recognition Comments
Not much here. PwC notes that:
“Interestingly, we did not come across many comments related to some of the more complex areas of stock compensation accounting. For example, we saw only one comment on classification of awards as equity verses liability, no comments on expense attribution methodology, one comment on award modifications, and no comments on determination of the grant date.”
Key Takeaways
Overall, it seems that the SEC either (1) focused primarily on stock valuation-related issues in their review of stock compensation info in public filings, or (2) focused on everything but simply didn’t find much to comment on beyond the stock valuation issues.
If you are a public company, this is probably good news. Because your stock is publicly traded, so long as your grant dates are accurate, there’s not a lot for the SEC to question with regards to your stock value. But if you are a private company, you’ll want to make sure your house is in order when it comes to grant date stock valuations.
Here are a few items that recently showed up in my Google Alert/email that I found interesting.
Return on Executives Exequity is promoting a new way to measure alignment of pay with performance: return on executives (ROX). This measure compares the change in compensation paid to executives with the aggregate change in shareholder wealth. According to Exequity’s alert, ROX results in greater correlation between pay and performance and fewer disconnects in pay for performance alignment than other models (e.g., relative degree of alignment) typically used by ISS, Glass Lewis, and institutional investors.
The alert doesn’t go into a lot of detail on the calculation, but if you are having trouble with your Say-on-Pay story, maybe you should give Exequity a call.
Canada’s Loophole Activists in Canada are jumping on the stock options loophole bandwagon. Their objection isn’t related to corporate tax deductions, however (companies already don’t typically get a deduction for stock compensation in Canada). Stock options that meet certain requirements are taxed as capital gains in Canada, which generally results in a 50% income deduction. The requirements seem to be somewhat straightforward (you can read about them on pg 28 the NASPP’s Canada Guide) and there isn’t a limit on the number of shares that can qualify for this benefit, like there is with ISOs in the US. Canadian tax activists think option gains should be taxed as compensation. But I wonder, if the options are taxed as compensation, shouldn’t companies then be entitled to a corporate tax deduction for them?
Less Disclosure It’s not often that you hear about the SEC reducing the disclosures companies are required to make. Recently, however, the Corporation Finance staff updated the SEC’s Financial Reporting Manual to reduce the amount of disclosure companies have to make about their pre-IPO stock price valuations. The SEC doesn’t note what is new in the Manual, but a blog by Polk Davis describes what has changed with respect to the disclosures. This seems to be an outcome of the SEC’s Reg S-K study that I blogged about last week.
Volatility is one of the inputs used to calculate a Black-Scholes model valuation of stock options. As volatility increases, so does the maximum gain that an employee could realize through a future exercise of their option. This, in turn, increases the value of that option, which may be a difficult concept to reconcile when the volatility is increased because of a down market!
With the recent turmoil in the stock markets, companies may find that the volatility they are using to value their stock options is jumping up as their stock price drops. Whether companies are using implied volatility or their own historical volatility, the recent changes in stock price could have impacted those numbers dramatically. There was a thread on this in our NASPP Discussion Forum recently on how to handle these changes, and I’m sure the question on many peoples’ minds right now is “should my company be doing something to deal with this increase in volatility?”
Companies may have created their method of calculating the volatility assumption without anticipating such a sharp downturn in the market. Now, they are looking at their method to see if it is still the best approach. The real intent of calculating volatility is to provide the best estimation of what future volatility will be. Ideally, the period of time the company is using to analyze historical or implied volatility will be long enough to provide an appropriate amount of stability which will accommodate short-term fluctuations. The shorter the period of time being analyzed, the more impact short-term fluctuations have, which may not be a reasonable reflection of what the company’s stock price volatility will look like over the life of the option. On the other hand, won’t options granted during this economic downturn have a higher chance of realizing gain through a dramatic increase in stock price over the life of the grant?
If this is the beginning of the fiscal year for your company, then it is a good time to take a look at how you are coming up with your valuation assumption. This is your opportunity to review your process for estimating volatility to see if it really is the most appropriate. Keep in mind, however, that FAS 123(R) clearly states that the method for determining the estimates should not only be “reasonable and supportable” (Paragraph 16), but also be “determined in a consistent manner from period to period” (Paragraph 23). So, if you are considering a change, such as an increase in length of time included in the calculation or a change to the way you weigh different periods, you will need to make sure that it is a change your company can not only justify to your auditors now, but also sustain as a valid method going forward.