Best Practices in 10K Disclosures for Complex Equity Awards
Despite recent forays into refining ASC 718, the standard still has a number of gaps in its equity compensation-related disclosure guidance. Here are the ones that affected issuers this 10-K season.
ASC 718-10-50-2(g) states that issuers with multiple share-based payment arrangements should provide carve-out disclosures in the annual report according to award type, “to the extent that the differences in the characteristics of the awards make separate disclosure important to an understanding of the entity’s use of share-based compensation.” It also says that liability awards and performance awards have characteristics that “could be important” enough to merit separate disclosure.
Many companies issue performance-based awards to top executives but service-based awards to other recipients. For some of them, the materiality of the performance-based awards may be too low to worry about for 10-K purposes. (The proxy, of course, is a different story.) But if the quantities of cash awards, non-employee awards, or performance-based awards are more substantial, companies should consider carve-out disclosures for each category.
Performance Award Roll-Forwards
If performance award carve-outs turn out to be necessary for materiality reasons, then you have another decision to make: how to present the roll-forward. Should you use base shares (the original number of share units used as a reference point in the award agreement)? Or should you go with target shares (the number of shares expected to be earned as of the disclosure date)?
To illustrate, suppose an award agreement states that 1,000 share units are being granted. Recipients can receive anywhere from 0% to 150% of the 1,000 share units in actual units of stock at the time of payout, depending on performance. Suppose also that, one year into a three-year performance period, the issuer anticipates payout at 125%. In this case, the number of base shares equals 1,000, and the number of target shares equals 1,250.
On the one hand, the target share approach requires additional adjustments to the number of awards in subsequent disclosures. That’s in line with expense reporting requirements. On the other hand, basic share disclosures require no adjustments until the actual payout level is known and additional grants or cancellations are made. That yields a constant share count for a given award until final payout.
Consistency versus simplicity. How to choose? From our perspective, the target share approach does a better job of helping users interpret financial statements and construct forward-looking estimates. The base share approach can force financial statement users into making “apples-to-oranges” comparisons between reported expense amounts and share disclosures during the performance period. Moreover, it reveals any big changes in share counts only after the performance period has ended. The target share option shows them sooner, helping to set expectations—particularly when performance gains and losses are incremental and produce a smoothing effect on share count fluctuation.
Process and Technology Changes
Companies are upgrading their processes and technology to accommodate more complex awards and reporting structures. As they do so, they need to reconcile the new output with the old. How should differences be handled?
Because they represent refinements to an older process that was based on the best available information at the time, such amounts are usually treated as a change in estimate. They can be recorded in the current period and, like forfeiture rate changes, don’t need to be disclosed under ASC 250-10-50-4.
The quality of the reconciliation matters. In working with our clients, we’ve found that the reconciliation needs to be done at the individual grant level and should tease out the drivers of variance. In fact, actively managing and shepherding the reconciliation has proven invaluable to ensuring the right dashboards get produced so that the client can explain the adjustment.
Some are still using the traditional Black-Scholes option pricing formula to value cash options and non-employee awards. This places issuers at risk of reporting skewed results when the awards are revalued over time. The reason? Black-Scholes is ill-suited for valuing awards that are not at-the-money.
While cash-based options and non-employee awards may be granted at-the-money, they’re likely to be in-the-money or out-of-the-money as they are revalued each period. Either way, the Black-Scholes model may yield poor outcomes. The best way to value these awards each period is with a lattice-based model designed to handle fluctuations in moneyness.
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