Too much discretion or exercise of upward discretion can lead to liability treatment for equity plans. This article discusses potential ramifications and ways to avoid them.
Many companies have discretion in equity award agreements as a common way to maintain flexibility during times of uncertainty. However, too much discretion allowed within the plan or exercising upward discretion can potentially trigger unanticipated and punitive accounting ramifications that could otherwise be avoided.
The Accounting Standard Codification Topic 718: Compensation – Stock Compensation (Topic 718) guidance has clearly defined terms for the classifications of equity versus liability accounting for stock-based compensation. Under Topic 718, there are four requirements for a grant date to be established for accounting purposes (ASC 718-10-25-5 EY 184.108.40.206 – 220.127.116.11) for an equity-classified award. They are as follows:
- The grantee and grantor have a mutual understanding of the key terms and conditions of the share-based payment.
- All necessary approvals have been obtained (i.e., board of directors, management, etc.).
- Grantee begins to benefit from, or be adversely impacted by, price changes.
- Grantor is obligated to issue equity instruments to an employee who renders the requisite service and satisfies any other conditions.
In this article, we outline some of the pitfalls and issues to be aware of when using discretion in your equity plans.
Discretionary Language Is Too Subjective
In most instances, there are no issues in meeting each of the four criteria to establish an accounting grant date. However, if there is a considerable amount of discretionary language that can be reasonably determined as “too subjective,” issues can arise. A company’s auditors could potentially argue that an accounting grant date cannot be established because a mutual understanding of the key terms and conditions is not possible if the employee has no clear understanding of how performance will ultimately be determined due to a discretionary component that is too subjective. When this occurs, the accounting grant date is assumed to occur on the day when performance is determined, which is often the vesting date.
Metrics Are Not Clearly Defined
Environmental, social and governance (ESG) metrics, which are increasingly being included in executive compensation plans, can also encounter a lack of an accounting grant date when the metric(s) cannot be defined nor measured. This could have consequences that are both measurable on the income statement and immeasurable in the sense of public and/or investor concern. While there is currently no best practice when a company defines its ESG metrics, as the use of such metrics is just emerging, the road best traveled is to have clearly defined metrics that are measurable to mitigate the possibility for punitive ramifications, such as the assumed performance date determined as the vesting date.
Service Inception Date Precedes the Grant Date
When the accounting grant date is set to the vesting date, another problem can arise whereby the service inception date precedes the grant date. The service inception date is often the beginning of the requisite service period. Under Topic 718, the requisite service period is defined as “the period during which an employee is required to provide service in exchange for an award, which often is the vesting period” (ASC 718-10-35-2). Topic 718 goes on to mention the following:
If the service inception date precedes the grant date, accrual of compensation cost for periods before the grant date shall be based on the fair value of the award at the reporting date. In the period in which the grant occurs, cumulative compensation cost shall be adjusted to reflect the cumulative effect of measuring compensation cost based on fair value at the grant date rather than the fair value previously used at the service inception date.
This passage means that the award is subject to liability accounting, requiring remeasurement of fair value and expense every reporting period until the accounting grant date occurs.
The Overuse of Upward Discretion
Additionally, while many companies maintain discretionary language within their plans already without issue, the exercise of such discretion can cause problems. Typically, a downward adjustment to a payout using discretion will not be the trigger. However, an upward adjustment, particularly a material one, can cause significant complications. Once material upward discretion is exercised, auditors can take the stance that the award adjusted using discretion is now a liability since the terms were never truly defined. In an even more punitive stance, if your auditors believe that the use of material upward discretion was particularly abusive, they may claim that not only is the award adjusted using discretion now a liability, but every currently outstanding award and every award going forward will be subject to liability accounting. This is due to the inability for auditors to now trust that the terms of these awards are truly pre-defined, given that the company has the ability to exercise upward discretion on the award.
This reality can be largely detrimental. Equity-classified accounting comes with a fixed fair value, helping to deliver high realized values to employees without increasing the compensation expense recognized by the company. The use of liability accounting matches the compensation expense to the value delivered to the employee, which can significantly increase cost and income statement volatility.
Adding discretion may seem like a positive decision to make in order to maximize flexibility; however, there are negative ramifications that can be easily avoided by making clear and measurable goals and not adding too much discretionary language in the award agreement or plan document. Additionally, the exercise of such discretion can lead to negative implications that last for several years. To combat such negativity on your equity plans, it’s important to engage with your auditors early to understand their interpretation of the discretion and determine the best path forward.
To learn more and seek additional guidance, please contact one of the authors or write to firstname.lastname@example.org.