Revisiting the Reporting Treatment of Retirement-Eligible Employees
Retirement eligibility has been a central challenge in stock-based compensation (SBC) accounting since the inception of ASC 718. The basic ASC 718 model says that if the legal vesting date is non-substantive, then the requisite service period should end whenever the employee can terminate and still vest in their award.
An emerging issue is how retirement eligibility can affect the service inception date (i.e., when to begin recognizing expense). If an employee is retirement-eligible at grant, should expense be recognized on their award during the year prior to grant instead of at grant? According to some, the answer is prior to grant if the award takes into consideration performance during the year leading up to grant (e.g., a 2018 grant reflects an individual’s effectiveness in 2017).
While this topic is hardly resolved, it is getting more attention. To understand why, let’s walk through some of the nuances.
Retirement Eligibility On or After Grant Date
Suppose an employee becomes eligible to retire, and retain all unvested shares, at some point on or after the grant date but before the legal vest date. On that retirement eligibility date, there is no further risk of forfeiture and therefore all expense must be recognized. The guidance introduces the retirement eligibility framework in ASC 718-10-55-88:
Because the employee is eligible to retire at the grant date, the award’s explicit service condition is nonsubstantive. Consequently, Entity A has granted an award that does not contain a performance or service condition for vesting, that is, the award is effectively vested, and thus, the award’s entire fair value should be recognized as compensation cost on the grant date. All of the terms of a share-based payment award and other relevant facts and circumstances must be analyzed when determining the requisite service period.
While the guidance focuses on retirement eligibility on the grant date, standard industry practice is to view future retirement eligibility dates as the end of the requisite service period. This shortening of the requisite service period leads to expense being compressed over the shorter period.
Consider a single-tranche award with a total value of $300 vesting over 3 years. Setting aside forfeiture rates, for an employee with no retirement eligibility, we would amortize $100 each year. Now let’s assume the employee is retirement eligible after 2 years. This compression of the service period would lead to amortization of $150 in each of the first 2 years, with no further amortization in the third year. It’s important to note that this future retirement eligibility should be reflected when an award is first granted (i.e. compression of the service period as noted above), not at the time when the retirement eligibility date is reached (i.e. amortizing the example above over 3 years and accelerating the remaining $100 of expense at the end of 2 years).
Retirement Eligibility Before Grant Date
Historically, employees meeting the retirement eligibility requirements as of the grant date will have the full value of their awards recognized on the date of grant (provided there isn’t a minimum service requirement, as is becoming increasingly common due to revisions in ISS policy). This follows a literal reading of ASC 718-10-55-88.
The alternative reading—that a grant is, in effect, a reward based on the employee’s performance in the year before the grant—would require making an accrual in the year before grant, akin to cash bonus accruals. This approach appeals to the matching principle by aiming to link the period in which expense is recorded to the period in which service was provided.
We’re not sold on this position, but the argument isn’t half bad. There’s no way that a grant to a retirement-eligible employee could be construed as a gift. It’s clearly compensation for some type of service. If no future service is required, then it must be logically construed as a compensatory reward for the prior year’s service.
ASC 718 provides a reasonably robust framework for assessing pre-grant amortization in special cases, specifically in ASC 718-10-55-108:
This Topic distinguishes between service inception date and grant date. The service inception date is the date at which the requisite service period begins. The service inception date usually is the grant date, but the service inception date precedes the grant date if all the following criteria are met:
a. An award is authorized. (Compensation cost would not be recognized before receiving all necessary approvals unless approval is essentially a formality [or perfunctory].)
b. Service begins before a mutual understanding of the key terms and conditions of a share-based payment award is reached.
c. Either of the following conditions applies:
- The award’s terms do not include a substantive future requisite service condition that exists at the grant date (see paragraph 718-10-55-113 for an example illustrating that condition).
- The award contains a market or performance condition that if not satisfied during the service period preceding the grant date and following the inception of the arrangement results in forfeiture of the award (see paragraph 718-10-55-114 for an example illustrating that condition).
The most common hurdle is (c)(1). An award may have been authorized and service may have begun, but there is typically substantive service required after the grant date. Retirement eligibility by its nature neutralizes any substantive future service.
The more likely problem is (a). A grant made in February 2018 may receive airtime from the compensation committee a couple of months before then, but certainly not 12 months earlier. The bright line, if there is one, is this idea that an award can be considered authorized if its approval is a foregone conclusion.
Supposing a grant is made in February 2018, when might its implementation be considered “authorized?” In the cases we’ve seen, board of director review and approval of total dollars is sufficient to satisfy this first clause. But the board might not closely scrutinize individual grant levels, in which case the question shifts to determining when any given award recipient’s grant amount is substantially locked down.
For an annual grant scheduled to occur in February 2018, it’s plausible that a listing of proposed recipients circulates in October 2017. Facts and circumstances would require us to examine whether that list is likely to be condensed or grant quantities reallocated. Suppose, however, that by mid-November the 2018 grant recipients are substantially determined, including their amounts. In that event, one can argue that the analysis process leading up to locking down grant values—both at a corporate and individual level—results in authorization.
At that stage—if the award is authorized, service is being rendered, and we conclude that retirement eligibility negates the requirement for substantive future service—then the service inception date would indeed precede the grant date. And, the service inception date would fall in the fiscal year before the grant date. The exact service inception date would be the point when the award has been authorized and service is being rendered. Since there is no substantial service required after the grant date, the grant date would represent the end of the requisite service period.
Even when these facts and circumstances line up nicely—and often they won’t—we remain skeptical. But if it’s something a firm wants to do, these are the considerations to work through.
The EPS Impact
For stock-based compensation without retirement eligibility (and without nonforfeitable dividends), there’s a clear impact on EPS. Before awards are settled, they’re included in diluted EPS using the treasury stock method set forth in ASC 260. Once lapsed (for restricted shares) or exercised (for options), the shares are included in basic EPS.
Now let’s layer in retirement eligibility. The common practice is to directly include in basic EPS the shares that have met all retirement eligibility requirements (and lack any contingencies such as a yet-to-be-measured performance condition). This is based on the logic that there is no substantial risk of forfeiture.
But what if the company has decided to amortize pre-grant retirement eligibility before the grant date? Is there any impact to EPS in the pre-grant period?
It’s likely that the accrual is based on a pool of dollars and is recorded as a liability before the number of shares is finalized. Put simply, the debit for pre-grant amortization is to stock-compensation expense, and ASC 480-10-25-14 directs us that the offsetting credit is a liability:
A financial instrument that embodies an unconditional obligation, or a financial instrument other an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following:
a. A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)…
This subsection of ASC 480 continues, but clause (a) is enough to confirm that we have a liability. Arguments can be made to exclude liability-classified instruments from diluted EPS. Usually this is because liability classification results from cash settlement, but a broader concept applies here.
It seems conceptually flawed to simply omit these awards from a diluted EPS calculation simply because the number of shares to be issued is variable. Most likely, the framework of ASC 260 would require modeling how many shares would be issued if the compensation committee locked down the number of shares based on the reporting period’s stock price. Again, for any of this to even be possible, a total value amount must have already been approved, such that some simple arithmetic can supply a quantity of dilutive shares.
Again, take caution because this is a novel topic without much guidance. It’s not entirely clear that retirement-eligible employees should have expense recorded on non-granted awards in the year before grant. But if a company were to take this position, it would be wise to consider any dilutive impact of these awards.
Each passing year brings additional interpretation and refinement to ASC 718 and related stock-based compensation reporting.
Our goal in this post was to introduce a topic that’s gaining attention among some of our clients with hefty populations of retirement-eligible employees.
It’s far too early for us to take a position on this issue of amortizing expense before the grant date for any expected awards to individuals who are already retirement-eligible. We can appreciate the argument that these cases involve a service inception date preceding the grant date (following ASC 718-10-55-108). However, we can also appreciate why this might be reading too much into guidance that was written with other situations in mind.
We welcome questions in this area. We also encourage consulting with auditors and accounting policy groups before revising financial reporting methodologies.