Five Internal Controls for Best-in-Class Equity Reporting

Daniel Hunninghake Yang Zhao

Clean, honest financial statements are an essential link between companies and investors. Misstatements, even innocent ones, can carry a high price—not just financially but also reputationally as investors wonder what other issues could exist.

A misstatement is more likely to happen in a relatively new and dynamic area like stock-based compensation than it is in more established areas of accounting. The risk is amplified as companies make greater use of equity compensation (in lieu of cash) to engage executives and rank-and-file employees alike. With large corporations expensing billions of dollars for stock-based compensation each year, the simplest error could prove material to financial statements.

But large companies aren’t the only ones facing the risk of reporting errors. In fact, the risk can be greater for small companies with lean reporting teams. The best way to reduce it is the same as many other areas of reporting: a robust system of controls. Here are five key internal controls that will help any company improve its stock compensation reporting processes.

1. Maintaining Expertise

In financial reporting, the human element is often the most important input.  A process or control is only as good as the person designing or using it. Put another way, the more expertise that person has, the better the process is likely to be.

But the typical organization has only a few people with any level of familiarity with stock compensation reporting. And despite the extensive guidance in ASC 718, the sheer variety of awards and multi-faceted impact on financial statements make share-based payments a complex topic.

In some cases, there might be more than one accepted approach, such as electing to estimate forfeitures over the life of an award or to record forfeitures only as they occur. In other instances, there may be no clear approach at all—such as when the company undergoes a change in control, and the award terms turn out to be vague or altogether silent. Either way, it takes informed judgement to move forward to a resolution.

Another challenge? Staying up to date, particularly in an environment where accounting professionals must oversee many disparate areas. Between standards updates (e.g., ASU 2016-09, ASU 2017-09, and ASU 2018-07), tax reform (the Tax Cuts and Jobs Act of 2017), and ever-evolving industry trends and best practices, stock compensation is in a state of monumental flux. On top of that, every year we see auditors asking more questions about equity compensation as their teams become better informed. One example is the dilution considerations for market and performance awards. By prioritizing expertise, there is an opportunity for cost savings in terms of lower audit and advisory fees.

The question is how to create internal expertise. Understanding the accounting codification is the natural first step. For robust interpretation and application of the guidance, consider the resources from your auditors and advisors. The Big Four each publish guides to share-based compensation accounting, while industry-specific groups such as the National Association of Stock Plan Professionals (NASPP) regularly weigh in on accounting and administration. Of course, the Equity Methods knowledge center provides white papers on technical topics as well as perspectives on the practical considerations of designing, valuing, and reporting for stock compensation, ESPPs, and complex securities.

A professional’s toolbelt should also include experienced advisors. As award designs evolve and compensation receives more scrutiny from external auditors, a thoughtful sounding board becomes essential to responsible decision-making. We at Equity Methods have hundreds of conversations each year about the new developments cropping up in stock compensation, and are happy to lend an ear.

2. Mastering Inputs

With knowledgeable professionals at the helm, the next step is to ensure quality data for financial reporting. This highlights the need to test data upfront, before the formal reporting process begins. Time spent on the front end can expedite reviews on the back end and prevent rework, mitigating the risk of restatement.

The most effective way to test equity compensation data, especially when it’s stored in a stock administration system, is to compare the whole set of data inputs as of the current month to that of the prior month. The goal is to identify two key dimensions: new (incremental) activity and changes in historical data. The former is generally more straightforward and may be as easy as filtering the data by effective date (we’ll get into exceptions to that later). The latter can be far more complex as data can change in many different, hard-to-detect ways.

Before starting your review, there should be a preliminary expectation of new activity. For example, if two million shares of restricted stock were scheduled to vest at the beginning of the month, you would expect to see release records for those two million shares. Similarly, if a population of new grants was issued in the middle of the month, then we would expect to see these when compared to prior month’s data. New grants in particular are important because they require a review of other accounting inputs such as fair values, forfeiture rates, performances factors, and applicable tax rates.

If these records are missing, perhaps there’s a reasonable explanation. If the reporting process starts before the end of the period, records from the last few days may not have been loaded. Similarly, the stock administration system may have a one- or two-day lag between when data is loaded and when it becomes viewable. If the activity is material to the current period, consider whether to incorporate it (e.g., it may require an on-top adjustment). If it isn’t material, make sure the reporting process is robust enough to capture the activity in the following period, and document it for review then (this is the exception we mentioned earlier).

Seeing new activity dated in the past is fairly common in our experience. Large organizations often formally accept new awards a month or two after the grant date, or learn of terminations (particularly in remote locations) well after the fact. These post-dated events must be recognized in the current period with a retrospective adjustment. Very rarely would a restatement be required, assuming the information was the best available in the prior period.

New grants and settlements occur almost every period. Shifts in historical data are less common, yet more likely to confound the financial reporting process and preparers. Imagine a historical grant showing an increase in the number of instruments granted. It could be a legitimate change—or a potential error. For example, the HR department may have determined that an employees’ pay grade failed to reflect a recent promotion. If the change is appropriate, ensure that any necessary adjustments flow through. (In the case of the historical grant, expense may need to be caught up to reflect the higher number of instruments granted.) If the change was a mistake, then we should make no adjustments and instead correct the data source.

After validating all new and changing data, you can have an idea of what financial reports will look like. For example, you might know that an issuance of new grants will lead to an increase in expense, and lapses/exercises will require unwinding the deferred tax asset (among other impacts).

3. Performing Variance Analysis

Our surveys on best practices in stock compensation confirm one thing that many accounting and finance groups already know. A great way to validate the current period’s financial reporting figures is to compare them with forecasts and prior periods via flux analyses.

In quiet times, we wouldn’t expect to see significant variances from one period to the next. If there are variances, keep in mind that they may not necessarily indicate an error. When there are period-over-period fluctuations, start by asking why. Are there a lot of new grants? Or did something happen last period that caused a one-time spike in that period? If the data has been adequately tested (see tip #2 above), answering these questions is much easier.

In any given month, data could be moving in all directions. Old awards are fully vested, forfeitures are deleted, awards are revoked, employees become retirement eligible, etc. This is where a detailed flux analysis could be helpful. Just as its name implies, a flux analysis flexes one number in relation to another, revealing insights on compensation expense movements. Flux analyses can be a powerful tool for senior management who look beyond grant-level details to focus more on the overall trend.

Another key predictor for the current period is any forecasting we’ve performed. Many companies have both a recent forecast using up-to-date assumptions and a forecast that was set before the current year, both of which need to be reconciled. Not only is forecasting a great budgeting tool, it’s also a great control for financial reporting. It can help to set expectations about what the numbers are likely to be using our best assumptions about the future. Comparing forecast numbers to actual numbers—and analyzing the variances with granular data—provides one extra layer of assurance over the report. It can also allow for refinement of forecasting procedures if there are significant forecast-to-actual variances.

With all the factors that go into stock compensation reporting, it’s difficult to predict every potential cause of the variances. That’s why the best practice is to have multiple forecast scenarios which flex the material factors on stock compensation. Forecasts of EPS dilution should consider different price scenarios, for example, in order to better understand how fluctuations in average market price affect dilution.

That said, remember that little to no variance from a forecast or the prior period is no guarantee of accuracy. Multiple factors can be netting together to cloud underlying discrepancies. For example, a forecast may have underestimated new awards and overestimated termination activity, which netted together to limit the overall variance. This is where a detailed review can help review forecasting procedures. Trust your understanding of recent events as well as your intuition.

For more in-depth discussion on forecasting and flux analysis, please see our issue brief.

4. Separation of Duties

Separation of duties is a best practice found in every corner of the organization, not just equity compensation. And for good reason. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) listed segregation of duties as a key control activity in their internal control framework. Requiring multiple people to oversee a task brings inherent checks and balances to the process, making it easier to identify misstatements and harder for individuals to engage in fraudulent activity.

One way that a segregation of duties prevents misstatements is by avoiding confirmation bias. This is the natural tendency for people to seek information that confirms a preexisting conclusion. Going back to the use of forecasts, this means being careful not to over-rely on expectations that were set in a forecast, given the potential to support erroneous results.

Within stock-based compensation, it’s common to separate the administration of the stock plan from accounting for it. But this isn’t always possible in lean organizations. If a single person oversees the data entry as well as the compilation of financial reporting information, blind spots are possible, making an independent review of data changes and financial reporting results critical. In this situation, it’s possible for outside advisors to play a role in performing the initial compilation and analysis, thereby allowing the internal team to focus on review and final entries. Engaging an outside partner can also bring specialized expertise and alleviate key person dependency.

If a full segregation of duties isn’t possible in your organization, consider what other compensating controls you can put in place, including the other tips in this article.

5. Creating an Atmosphere of Openness and Integrity

The standard controls we’ve reviewed so far can protect your company only so much. All are predicated on the environment in which people are working. That’s why the best control is to develop a culture of openness and integrity.

The control environment is one of the five main components of the COSO framework. It’s management’s duty to maintain an atmosphere of openness, as well as promote and uphold strong ethics. The tone at the top absolutely permeates the organization. Honest companies attract honest people, honest people build a company through honest work, and the virtuous cycle repeats. As Jim Collins asserts in Good to Great, greatness starts with having the right people on the bus.

To build a healthy control environment, the first step is to establish open lines of communication. Open-door policies cost nothing to implement and lead to enhanced engagement within teams.

Although management is responsible for establishing and maintaining strong ethics, it takes effort from everyone to make it all work. Detective controls—like whistleblower systems and anonymous hotlines—also help to maintain a clean control environment. With proper motivation, everyone in the organization can become auditors of the company’s integrity. For example, the SEC currently awards whistleblowers 10% of recuperated amounts. A control environment is harder to corrupt when people are free to protect their own integrity and bring concerns over unethical behaviors without fear of retribution.

The importance of having an ethical control environment and people with integrity can’t be overstated. But creating a strong culture of integrity isn’t always easy. It takes time and commitment. It also requires an organization to recognize that people are imperfect. Rewards like those for whistleblowers are one way to influence behavior. Another tool is clawback provisions. If an employee commits fraud or violates a non-compete clause (since enforcing a non-compete agreement is often difficult in practice), firms can claw back previously-paid compensation as restitution. If your company ever faces a fraud situation, backtesting is an important tool to assess what the impact was to the financial statements.

Conclusion

It’s tempting to view internal control as a linear checklist. But a better way to view it is as a network made up with control activities connected by an honest control environment. A weakness in one link can affect the entire process.

Another important point: Internal controls can’t be static. They must quickly adapt to change and remain a work in progress.

We hope this introduction is helpful. We would love to hear about your best practices and are happy to review a company’s control framework.