The Year in Equity Compensation—and a Look Ahead to 2017

Perspectives on Executive Compensation and Accounting

In the world of equity compensation, this has been a landmark year. A slew of ASU 2016-09 (the revision to ASC 718) early adopters, ongoing innovation in long-term incentive design, preparation for the CEO pay ratio, and more have defined the past 11 months. Throw in a presidential election, and 2016 won’t be forgotten anytime soon.

At Equity Methods, this is an important time as we set research and development priorities for the following year. Now is when we try to get ahead of evolving client needs and top-of-mind issues. Since what we do touches on design, valuation, and accounting for equity compensation—as well as the valuation of other complex securities—we strive to take a cross-functional view of the landscape.

With that aim, we asked a group of prominent industry leaders for their outlook. We split the focus between executive compensation and the accounting for equity awards. Here’s what they told us, followed by my own take.

Changes in Executive Compensation

How do you see the presidential election influencing incentive compensation and corporate governance in 2017?

BROC ROMANEK, editor, Although it’s difficult to know in practice, on paper, there’s a wide gulf between a Trump administration and a Clinton one in how the markets would be regulated. Whereas a Clinton administration might have been widely influenced by Senator Elizabeth Warren and resulted in restraints on how Wall Street operated, a Trump presidency might result in unprecedented deregulation at the behest of a GOP Congress. A Clinton administration was rumored to pick an investor as the next SEC chair, which would have been a first. It appears that Trump will tap someone who believes that minimal regulation is good regulation.

So I think it’s clear that restraints on how companies can govern themselves will become looser. However, executive compensation specifically could be another matter. Trump ran a populist campaign, often railing about excessive executive compensation. It’s unknown whether that was empty campaign fodder to generate votes—or whether he’ll follow through and do something concrete in this area.

DAVID CHUN, CEO, Equilar: Given the robust equity markets in Q4 (as of November 28), I don’t expect the outcome of the election to have a material impact on incentive compensation. The economy remains robust with further stimulus expected on the horizon after the inauguration. Barring a major geopolitical event, I’m expecting a pro-growth agenda to continue with Republicans in full control of Washington.

BRUCE BRUMBERG, editor in chief and cofounder, and Actually, we just published an article on this subject. In summary, tax changes are expected. Trump’s tax plan does not propose to change the capital gains rates. But the House GOP Tax Reform Blueprint calls for the simplification of individual income tax rates to 12%, 25%, and 33%. How these would tie into the flat supplemental rate of withholding on stock compensation is unclear, as the structure of the rate is based on the current seven tax brackets.

Changes may also include the elimination of the alternative minimum tax (AMT). That would be welcome news for anyone receiving grants of incentive stock options, as currently the income spread at ISO exercise can trigger the alternative minimum tax and complicate tax planning.

In addition, Trump vehemently asserted throughout his campaign that he wants to “repeal and replace” Obamacare. Presumably, that would eliminate the additional Medicare taxes used to fund Obamacare under the Affordable Care Act.

There are no guarantees that these proposals will become law. One possible way to balance these tax cuts in a way that might not worsen the national debt would be to eliminate provisions that are favorable to stock compensation, such as the performance-based exception for limiting the corporate tax deduction under IRC Section 162(m).

DAN LADDIN, partner, Compensation Advisory Partners: The place they may start is loosening regulations and reporting requirements on smaller companies, public and private, where in some cases the costs could be fairly onerous. I believe there may be less sympathy in Congress for larger companies, depending on the populist mentality.

BARBARA BAKSA, executive director, National Association of Stock Plan Professionals (NASPP): That’s the million-dollar question. And now that I’m on the spot, my best answer is, “Can I phone a friend?” It’s clear that there will be a push to repeal part or all of the Dodd-Frank Act. It’s already happening. The benignly-named “Financial Choice Act” currently pending in the House would repeal or severely weaken many of the corporate governance provisions of Dodd-Frank, including the CEO pay ratio disclosure, Say-on-Pay, and the clawback provisions.

But it remains to be seen how much of this will be enacted. Senate minority leader Chuck Schumer recently announced that he has the votes to block a repeal of Dodd-Frank. The GOP holds the Senate by only a few seats. Assuming all the Democrats toe the line, Schumer needs only a few Republicans to join him to make good on his threat. And there’s always the filibuster… If nothing else, the political arena promises to be exciting next year.

Even if the GOP were to accomplish a full repeal of Dodd-Frank, I don’t think that would lead to a corporate governance free-for-all. Much of the pressure for corporate governance reform originates with institutional investors and proxy advisors. Weakening or repealing Say-on-Pay diminishes their influence but doesn’t eliminate it altogether. In particular, stock plans would still be subject to shareholder approval.

Lastly, I think we might see legislation enacted that will encourage the use of equity compensation. Currently, there’s a bill pending in Congress that would make it easier for private companies to use equity awards and another bill that would create a new type of tax-qualified award. Both bills have bipartisan sponsorship, and the private company bill has already passed in the House. If we don’t see further activity this year, I think it’s likely that one or both bills will be reintroduced next year.

TAKIS’ TAKE: Much has been written about the president-elect being unconfined to a particular ideology, so we might not see the “consistency” of, say, an Obama or Bush administration. I expect we’ll see a patchwork of policy-making, some of which deregulates and some of which makes business harder. Deregulation and infrastructure spending would, at least in the short run, stimulate growth. Protectionist activity may make equity recharging harder, among other things. And if the populist campaigning we saw continues, this could show up in unexpected ways.

My advice? Stick to the basics instead of trying to predict every political eventuality over the next four years. In executive compensation, focus on linking incentive design to business strategy. If the current bull market continues, the war for talent will only intensify. Selecting the right incentives and making sure executives understand them will be more important than ever.

Do you see the executive compensation components of Dodd-Frank being repealed or revised under the new administration? If so, what effects might that have?

BRUCE: Some aspects of it are vulnerable to repeal. However, even with GOP control of Congress, the Senate filibuster rules (which require 60 votes to stop a filibuster) can make it harder than realized to repeal Dodd-Frank. Supposedly Senate Minority Leader Chuck Schumer (D-NY) says he has enough votes to block a vote on repeal. In addition, it seems that some Dodd-Frank provisions are consistent with the new president’s anti-elite, rigged system message. Thus, it’s not clear what will happen in the end. A new SEC chairperson could revise some of the rules, too.

ERIC HOSKEN, partner, Compensation Advisory Partners: The Financial Choice act that was passed in the House of Representatives could serve as a template for the modification or elimination of executive compensation regulations under Dodd-Frank. If it became law, it would scrap the pay ratio requirement, eliminate the regulation of financial institution’s incentive compensation under Dodd-Frank 956, and limit the scope of the Say on Pay vote to only apply to CEO’s compensation in years when there are material changes. That said, many of the changes in executive pay may be here to stay as shareholders have become more active and engaged on the topic following the introduction of the Say on Pay vote. We suspect that even if Say on Pay were no longer mandatory, many companies would still choose to do it.

BROC: Although signs definitely point toward part of Dodd-Frank being repealed—with the House’s recent passage of the “Financial Choice Act” serving as the model—it’s unclear if that repeal would touch all of the executive pay provisions in Dodd-Frank. When the House passed the Financial Choice Act, it did so as a “wish list,” never expecting that the GOP would actually control the government entirely. And it obviously did so without the imprimatur of Trump and his people. So things like pay ratio might survive a partial repeal if Trump decides to uphold some of his campaign promises. But probably some of the pay provision in Dodd-Frank will die.

And here’s something noteworthy that I recently blogged about: The “Financial Choice Act” is much more than merely repealing big chunks of Dodd-Frank. There are a handful of provisions that would render the SEC’s ability to conduct rulemaking much more difficult. But this provision in particular—infamous “Section 631”—just blows me away:

SEC. 631. CONGRESSIONAL REVIEW. If the agency classified a rule as “major,” according to specified criteria, the rule would require a joint resolution of Congress to go into effect, unless the President finds that an emergency requires that it be effective (for 90 days). Congress would also have the right to disapprove certain non-major rules.

Read that provision again. A joint Congressional resolution to adopt a “major” rule—and even some non-major ones! Its goal appears to be neutering the so-called “independent” federal agencies that govern our financial institutions and markets. Talk about putting partisan politics into independent agencies. And here I was worried that having Congress involved in the SEC’s budget process was too much meddling with a federal agency!

Remember that federal agencies are part of the executive branch of government. Not to mention that members of Congress don’t have the expertise, resources, or time to understand what the various rules of an agency are. This would be a major windfall for lobbyists who would be able to effectively pay Congress to stop an agency from doing anything. Either the Senate or the House could stop a rulemaking—by simply sitting on their hands. The polar opposite of needing an “Act of Congress” to change something. It’s brazen and breathtaking—and a whole lot of other things that I can’t mention in this family-oriented blog.

AMY HILLMAN, Board Member and Dean of WP Carey Business School: Yes, I anticipate they’ll be repealed but doubt companies will stop providing a “say on pay” as one example. I think investors appreciate this transparency and inclusion. So whether required or not, companies will continue this practice.

TAKIS’ TAKE: I don’t have a crystal ball. We ordered one on Amazon, but I now understand why it has such terrible reviews. Seriously, I can see it going both ways. But I’d be surprised if the new administration took a hatchet to the entirety of Dodd-Frank given all their competing priorities. If they do go after Dodd-Frank, I would expect to see a more surgical focus on the banking regulation sections or conflict minerals, and not the more populist issues surrounding executive compensation.

My advice is to move forward assuming no changes, because even if Dodd-Frank does enter the crosshair, policy-making is never quick. What I’d hate to see is companies fall behind in their compliance efforts because they bet on a rollback, the rollback didn’t happen, and suddenly they’re in a pickle.

If there were one change you’d like to see in executive compensation, what would it be?

ERIC: The obvious answer on this is the elimination of the CEO pay ratio; however, that’s more of an inconvenience. The best improvement would be to have a consistent form of relative pay and performance assessment that applied to companies within an industry. Examining the alignment of pay and performance over a three- to five-year period using three or four key measures of financial and stock price performance and a consistent realizable pay definition would help to provide clarity to shareholders about the effectiveness of pay programs.

ROB MAIN, head of corporate governance, Vanguard: I wouldn’t say we have a specific change per se, but rather we would like to see companies continue to adopt sensible compensation programs that emphasize long-term performance.

BROC: Less reliance on external benchmarking by compensation committees to arrive at the size of pay packages. Rather, committees should balance out that reliance by also looking at a historical perspective of how the CEO gets paid as a ratio to the company’s workforce. In other words, committees should be looking at pay ratios over time as another surveying mechanism.

So while I believe that public disclosure of pay ratios is not a good thing, I think committees should be demanding that information over a 20-year span—so that they have more reliable (and less manipulate-able) survey data to base their decisions.

TAKIS’ TAKE: Since we work with management in modeling new incentive designs, I’ve seen the consequences of not measuring twice before you cut. When we’re brought in to help enhance or restore an LTIP design, we find that there was usually a disconnect between how the company thought its award would work and how it actually did. So if I were to change anything, it would be to more consistently conduct upfront modeling to uncover potential surprises.

Changes in Accounting

What’s the word on the street been so far with regard to ASU 2016-09? How are companies thinking about the revisions as the formal go-live date approaches?

BARBARA: Share withholding was the “talk of the town” at this year’s NASPP conference. Now that the ASU expands the exception to liability treatment for shares that are withheld to cover taxes, companies are wrestling with whether they want to allow employees to request additional withholding on RSUs. And, if yes, whether they want to follow the prescribed W-4 process or risk circumventing it. It will be interesting to see how practices evolve over the next year.

I also think more companies are going to choose to account for forfeitures as they occur than a lot of us expected. When the FASB announced this proposal, my immediate thought was “too little, too late.” I had assumed that the majority of public companies had worked through the challenges here and were happy with their process. But according to Equity Method’s study, just over one-third of early adopters have decided to stop estimating forfeitures. Color me surprised!

TAKIS’ TAKE: It’s all over the map. Each company looks at the revisions and forms a point of view on which are helpful, which are counterproductive, and which are essentially irrelevant. Those views vary tremendously. For example, some companies are thrilled with running positive excess benefits through the P&L, whereas others rely so heavily on a non-GAAP framework that they view the revision as not moving the needle.

The same is true with the tax withholding revision. Some companies are rushing to change their withholding policies, others are cautiously optimistic but adopting a wait-and-see approach, and yet others say their executives are fine with the current setup and not even asking to withhold more.

We capture these sentiments in a survey we released in June. What does it all boil down to? If you haven’t already, pull together a cross-functional team to examine what risks and opportunities ASU 2016-09 will create for your organization. Pay attention to how peers are thinking through the revisions, but know that your situation may be different.

Do you see ASU 2016-09 being net positive or negative? What are the primary advantages or challenges you see resulting?

BARBARA: Ultimately, I think it will be net positive. There will be some surprises as the market adjusts to the fluctuations in earnings and effective tax rates resulting from the new tax accounting, but I think eventually companies will develop better forecasting processes and the market will adapt. And I think the tradeoff in terms of simplification will be worth it, especially when you consider the ASU as a whole and the further simplifications that the FASB is working on now with respect to nonemployees and modifications.

CAROLINA KOCH, senior accountant, Procter & Gamble: We see ASU 2016-09 being a net negative for our company, mainly due to the fact that the addition of the excess tax benefit introduces more volatility to our bottom line. Additionally, the impact is highly dependent on people’s exercise behavior and stock price for which we have little to no control. The key challenge we have is to accurately forecast the impact on our quarterly and annual results.

MIKE ROSWOG, director of tax reporting, Dr Pepper Snapple Group: I believe that no longer requiring excess tax benefits to be reported in the statement of cash flow as a financing activity is a positive change, as this benefit will be classified consistent with other income tax cash flows as an operating activity. Mandating the cash flow presentation for employee taxes paid by withholding shares as a financing activity is a positive change, as there was inconsistent classification by companies. Relaxing the tax withholding requirements to avoid triggering liability accounting is a significant positive change.

I’m not in favor of allowing companies to elect to estimate forfeitures over the service period or recognize forfeitures when they occur. I would have liked a consistent approach rather than an election. The requirement to record excess tax benefits as discrete items in the quarter that they occur is a negative, in my opinion. Often companies will have a significant tax benefit or detriment in one quarter of the year, and this may cause a major variance in the effective tax rate when compared to other quarters during the same year. Furthermore, there will be variability in tax rates from this quarter to last quarter, this quarter compared to same quarter in prior year, and year to date this year versus year to date last year.

Overall, I think a big driver of this assessment is whether your stock has appreciated or depreciated. Companies with appreciating stock prices will likely see an additional boost when exercises or vestings occur. They’ll generate a significant tax benefit, which in turn will lead to higher net income and ultimately help increase their share price even further. Conversely, companies that are experiencing share depreciation will look even worse as detriments occur when stock awards are exercised or vest. Their tax rate will increase, resulting in lower net income which will lead to even more pressure on their stock price.

BROOKE RICHARDS, director of global accounting practice, Connor Group: The APIC pool elimination is not a simplification, at least for large companies with positive APIC. It actually causes more complexity since those companies will now have to track APIC on a timely basis, add systems for reporting, produce reports and forecasts for corporate planning, and in general explain the share price-based volatility to investors not intimately familiar with share-based payment accounting rules. Eliminating the APIC pool will also result in less comparability between companies. It will likely end up as another non-GAAP adjustment, even if it isn’t reported that way.

Other parts of the new guidance aren’t really simplifications either, but at least they don’t complicate things. For instance, I’m not sure how much accounting for expected forfeitures is going to change, since most companies using the established method will likely continue doing so. Likewise, the midpoint method for expected term isn’t any simpler than using the contractual term. But it does make more sense, as expense would be higher than what’s expected.

And then there are some definite improvements. One is the use of maximum statutory tax rates. Another is the practical expedient for intrinsic value. This helps private companies, because for them fair value is hard to determine and probably not useful anyway.

TAKIS’ TAKE: ASU 2016-09 is what we get in a world without “big GAAP” and “little GAAP”—that is, without an entirely different set of accounting procedures for smaller reporting companies to follow. As a result, ASU 2016-09 contains revisions that are primarily intended to benefit private companies (e.g., the forfeiture rate optionality was the hot-button item being pushed by the private company council) alongside revisions that will help multinationals (e.g., relaxing the minimum statutory rate liability trigger). This peanut buttering effect is odd.

At a more conceptual level, I’m concerned about the earnings volatility that will stem from eliminating the APIC pool. I appreciate that it’s normal to flow temporary difference resolutions through earnings. But the book-tax temporary difference for stock compensation is unique, because book rules are based on fair value and tax rules are based on settlement-date stock prices. So my bar is very high for letting stock prices influence earnings.

From a purely pragmatic perspective, we’re already seeing companies invest more energy in forecasting tax provision effects than they ever did in managing their APIC pool. The primary difficulty in APIC pool tracking was linking settlements back to grants, especially in the context of stock options that required a LIFO or FIFO convention for partial exercises. None of that will change under the revision. If anything, tax accounting will become tougher since auditors will scrutinize the process more given the income statement tie-in.

One thing everyone welcomes is changing the liability trigger for tax withholding from the minimum statutory rate to the maximum statutory rate. For US participants, the debate continues as to whether IRS rules allow choice in withholding levels. But all in all, the flexibility is clearly a positive.

As companies prepare to adopt ASU 2016-09, are there any surprises or areas they should pay special attention to?

BARBARA: I think the earnings-per-share implications are a real sleeper issue. In general, I feel like companies haven’t focused enough on the impact the new tax accounting will have on their P&L. But diluted EPS will be impacted in both the numerator (because of the change in earnings) and the denominator (because the tax effects will no longer play into the calculation of transactions proceeds available to buy back stock). Because of this double effect, it’s tricky to project the impact of the ASU on diluted EPS.

CAROLINA: When adopting, companies should pay special attention to the implications of the change and all the organizations that may be affected or are stakeholders (e.g., accounting, tax, forecast group, and even investor relations). Specifically, moving the excess tax benefit from the APIC bank to tax expense will require changing the existing process. This may affect people in different countries, and it will likely require changes to the accounting flow and system configuration that supports the process.

MIKE: I think companies should be prepared for more scrutiny from their audit firms in terms of proving the deferred tax asset as well as the permanent benefit. I believe that the audit firms will be more concerned since the permanent benefit will be recorded in tax expense (P&L) as opposed to additional paid-in capital (balance sheet). Companies that use a roll-forward approach, whereby they take the prior year-end balance and just add current year activity to determine their deferred tax asset as opposed to a true-life to-date analysis, may find more requests for proof of their deferred tax asset. Additionally, companies calculating the tax impacts of stock compensation in massive Excel workbooks should be prepared for more challenges to prove that their spreadsheet is reliable and free of calculation errors.

I have not seen much discussion around Section 162(m), but this is an area that needs to be considered. Companies need to review the IRS regulations related to permissible and impermissible discretion, and also need to review their stock plan documents to see if they specifically address changes in accounting principles. Some plans may indicate that the impact of changes in accounting principles should be excluded when calculating any financial metrics upon which payouts are based.

Additionally, should performance targets consider the impact in future years or not? Should you consider the change in accounting when setting your 2017 performance goals? Consider also that there are accounting changes coming in the near future that will be significant to some companies—revenue recognition and lease accounting—so it’s imperative to gain an understanding of the tax rules as well as your plan documents.

On the other hand, a much-discussed area is the relaxation of the rules around tax withholding to avoid liability accounting for equity awards. There are many items to consider. Although helpful from an accounting standpoint, companies need to consider the administrative cost and time if they were to provide flexibility to their entire employee population. Can payroll handle withholding changes that almost all employees will want to only be effective for the income related to the stock award? Do the company systems speak well with their stock compensation administrator, or will it be a painful manual process? Will companies continue to use the supplemental withholding rate for all wages less than $1 million? Will they only allow flexibility to the C-suite?

A sometimes overlooked payroll tax withholding provision relates to the specific supplemental wage payment which causes an individual to exceed $1 million in supplemental wages. This can be withheld at 39% for the entire amount, as opposed to the standard provision whereby only the supplemental wage in excess of $1 million is withheld at 39%.

TAKIS’ TAKE: I agree with all the other comments. I can’t stress enough the earnings volatility issue. Today, our clients invest at least as much energy in management accounting (budgeting and forecasting) as they do external reporting. The bar is higher than ever to explain and justify variances.

Right now, we’re in a bull market, so the effect of running excess benefits and deficiencies through the P&L is net positive. That won’t be the case when the markets turn and we enter a bear market, and that’s when I think the surprise will be felt most acutely.