Eight Equity Plan Conditions That Create Tricky Financial Reporting

Compensation committees and HR executives are becoming increasingly creative in the awards they design, which translates into a variety of reporting challenges. Here are some of the most common ones we’ve seen.

1. Performance Conditions

Awards with performance conditions come with a host of accounting nuances. One is determining contingently issuable shares for purposes of computing diluted EPS.

Others have to do with issues around grant date. Examples include performance provisions not being stipulated at grant (resulting in delayed grant dates), a service inception date preceding the grant date, or performance period starting and ending dates not being aligned with requisite service period starting and ending dates.

And then there are multi-tranche awards containing multiple grant dates. Not only do these types of awards introduce a tiered (decelerated) amortization schedule, they also require multiple valuations at different points in time.

Finally, there are complexities around the interaction between retirement eligibility conditions and qualifying termination provisions in relation to performance provisions.

2. Market Conditions

Market awards have the same reporting challenges as performance awards, plus this one: computing unrecognized compensation cost and the excess tax benefit in the diluted EPS calculation. There’s considerable controversy among auditors as to whether these calculations should use the grant-date fair value (effected by the market condition) or EPS-specific multiplier (adjusted each period based on progress toward the market condition).

3. Performance and Market Conditions

With hybrid awards, you get all the complexities of stand-alone performance and market awards. You also get a couple of others. One is independent conditions, where the market condition and performance condition do not affect each other. This requires bifurcating the award so as to account for each condition separately and using the correct accounting model for that condition.

The other tricky nuance is interdependent conditions, where the outcome on one condition modifies that on the other condition. This requires estimation of a unit fair value that is affected by the market condition and then adjusted each period based on the expected performance condition outcome.

4. Liability Awards

The measurement date on a liability award is the settlement date, which means the fair value is re-measured each period until settlement. This gives rise to a variable accounting model in which expense (and the corresponding deferred tax asset) is continuously updated on a cumulative effect basis each period.

The result can be significant P&L volatility, as well as volatility in the deferred tax asset (although there will never be an excess benefit or deficiency at settlement).

5. Non-Employee Awards

Unlike liability awards, the measurement date for non-employee awards is the vesting date, which is typically prior to the settlement date. As a result, these awards face the same valuation issues as liability awards, as well as an additional complication in the deferred tax accounting since the cumulative DTA will likely not equal the actual tax deduction (giving rise to an excess benefit or deficiency).

6. Retirement Eligibility Conditions

Plain vanilla retirement eligibility provisions serve to truncate the stated service period, thus accelerating the period over which expense is recognized. But many firms have different retirement eligibility rules for different plans. This creates challenges in mapping the correct provisions to individual grants.

Some firms also have partial retirement eligibility provisions that accelerate only a pro rata portion of the award. These can be very mathematically complex to correctly factor into the amortization model.

7. Clawback Provisions

Clawback provisions are extremely new to equity compensation, and at this stage no two look the same. The onset of Dodd-Frank is bound to substantially change the structure of clawback provisions, both increasing their prevalence and their teeth. Clawback provisions can affect the requisite service period and even push out the grant date on an award.

8. Non-Forfeitable Dividends Classified as Participating Securities

Non-forfeitable dividends must be accounted for using the two-class method and not within the standard diluted EPS framework.

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