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Accounting and Financial Reporting in Executive Compensation


The compensation committee’s decisions have ripple effects far beyond the C-suite— from shareholder relations, to public filing requirements, to tax effects. They also have accounting implications.


February 18, 2020 


Thanks to PwC, and Cleary Gottlieb Steen & Hamilton LLP 


Types of pay that seem economically similar may be recorded in the financial statements in different ways. Those accounting differences can impact the company’s earnings per share or industry ratios—attracting or driving away investors. Understanding them is important to the committee’s ability to effectively oversee compensation plans.
This module highlights the key accounting and financial reporting considerations that can help a savvy compensation committee member make the right decisions for the company.
Cash compensation
The form of payment—cash or equity—generally determines which accounting rules apply.
Cash, whether paid as base salary, an annual bonus, or a longer-term award, is typically recorded as an expense over the periods in which the services are provided. So annual cash bonuses, which are usually paid out in the first quarter of the following year, are often recorded during the year of the performance, not the year of payment. For a longer-term award, such as a bonus with a three- year performance period, the company typically recognizes the expense pro rata over the length of the performance period.
Deferred cash compensation
Executives are often keen to defer a portion of their cash compensation. By deferring payment, they also defer taxes. However, the accounting and tax rules don’t line up, and companies must recognize the cost of the deferred compensation during the period when it is earned.
Deferred compensation plans are often “unfunded”—meaning that unlike a 401(k) plan, there are no dedicated assets that belong to the executives. Instead, the company is bound by contract to pay the deferred compensation. The executives take the risk that the company will be able to honor its promise when the time comes.
In some cases, the company may set aside assets in a vehicle like a rabbi trust. In a rabbi trust, the assets are segregated, but remain subject to the claims of the company’s general creditors. The assets are accounted for as assets of the company, separate from the liability associated with the deferred compensation.
Frank Glassner weekly newsletter Compensation in Context on CEO Pay
Equity compensation
Equity compensation—which may include stock options, restricted stock, restricted stock units (RSUs) or other share-based payments—provides crucial “skin in the game” for executives. But unlike a typical cash bonus, equity compensation is subject to stricter accounting rules.
Equity compensation brings more complicated and time-consuming accounting and audit work, including lengthy disclosure about equity awards in a company’s financial statements.
Deeper insights
Not all awards that are paid in cash are accounted for as cash awards. If the value of the award is based on share price, such as a cash-settled RSU, or a cash bonus that depends on total shareholder return (TSR), it is reflected as an equity award in the company’s financial statements.
Determining the grant date of an equity award
The grant date of an equity award determines how much compensation is recognized and when.
Without an established grant date, there is generally no grant under the accounting rules. The compensation committee may have signed off on an award, but if they fail to follow proper procedures, the award may not exist in the accounting books and records. Attempting to fix the issue later could result in an immediate—and perhaps higher— charge to the company.
In some cases, a company may actually begin recognizing an equity award prior to the grant date. But this would also require variable accounting—remeasuring the fair value of the award on each reporting date. This adds volatility to the expense being recognized, and makes the accounting more complex.
Deeper insights
All of the key terms of an award must be confirmed to establish the grant date— including the relevant performance targets. This can create an issue for awards with multi-year performance periods. Compensation committees may want to wait to set the targets for the later years. But without setting the performance targets up front, they risk not having a properly- established grant date at the outset.
Retaining discretion in determining whether performance targets have been met can also affect whether the grant date has been established. If the compensation committee has too much discretion, it can also mean that there is no established grant date when the award is handed out.
Measuring and recognizing the expense— the “fair-value” based method
The value of equity compensation, unlike cash compensation, can be volatile as the company’s stock price rises and falls. On a good day, an executive’s unvested options could be worth millions, and on a bad day, they could be worth nothing. The executive shares in some of the risks and rewards of these fluctuations in the same way that a shareholder does.
Under the fair-value based method, the company calculates the fair value of the award on the grant date, using the stock price on that date. In most cases, this amount is fixed and is not adjusted for subsequent changes in the stock price. For options, the value is determined based on the term of the option and the historic volatility of the stock.
The type of vesting condition applicable to an award will impact when the expense gets recognized.
Deeper insights
Post-vest holding restrictions—which require that an executive hold a vested equity unit for a period of time before selling—are becoming more common. These restrictions can also have accounting effects. Depending on the type and length of the restriction, they can result in a discounted grant date fair value, meaning a smaller amount of expense to be recognized for the company.
Frank Glassner weekly newsletter Compensation in Context on CEO Pay
Determining whether a condition is classified as a performance or market condition for accounting purposes is not a straightforward task. Some awards may be subject to multiple conditions, which can further complicate the determination.
Equity versus liability accounting
Under the principles of equity accounting, an award is measured as of the grant date and is fixed at that amount. But not all stock- based awards are accounted for as an equity award. Some equity awards are instead classified as liabilities. Unlike an equity- classified award, liabilities are remeasured each reporting period until the award is settled (or forfeited). Remeasuring the awards could lead to a higher compensation charge for the company if the share price is increasing. Whether the stock price is increasing or decreasing, remeasurement affects the company’s key financial ratios and debt covenants.
Deeper insights
Many companies include “non-GAAP” measures in their public filings. They may be measures that the company thinks better reflect the operations or financial position, or ones that are commonly used to evaluate performance in the industry.
For years, some companies excluded equity compensation, on the basis that it represents non-cash payments. But the tides may be turning. In 2018, a group of top executives from major corporations and investment management firms released the “Commonsense Principles of Corporate Governance 2.0,” which urged companies to include equity compensation in any non-GAAP measures.
Frank Glassner weekly newsletter Compensation in Context on CEO Pay
Modifying equity awards
Adjustments to certain terms of equity awards may be viewed as modifications for accounting purposes, which triggers modification accounting. Modification accounting asks whether any additional value is given to the employee as a part of the modification. Modifications may result in additional charges going forward.
Common modifications include:
  • Accelerating vesting

  • Extending vesting

  • Extending an option exercise period

  • Repricing an option

  • Repricing an award for a stock split

  • Substituting or replacing an award in connection with a merger

  • Changing the performance targets

  • Extending the term of an award in connection with a termination of employment

Clawback provisions
Most companies have clawback policies (or provisions in award agreements) which allow them to recoup compensation payments in certain circumstances. These clawback rights can trigger accounting issues. For example, many clawback provisions give the compensation committee some discretion in determining whether a clawback is required. If the policy allows for too much discretion, it may raise questions as to whether a grant date has been established.
Under the accounting rules, a traditional clawback feature does not  impact  the equity award’s value and expense pattern. If the clawback is ever invoked, accounting recognition would be needed at that time to reflect the recoupment of the cash or shares.
Corporate transactions
Transactions such as mergers, spin-offs or asset sales have a major effect on executive compensation plans and programs. Plans may call for awards to be cashed out, accelerated, or rolled over into another type of award. The new company may put new plans into place, or amend and modify existing plans. All of these changes affect not only the company’s compensation arrangements, but also the financial statements. As companies begin to think about executing major transactions, it is key to understand the accounting effects of compensation arrangements.
Compensation committee members should understand the key concepts in the accounting for compensation so they can remain on the lookout for potential negative impacts of their programs in the company’s financial statements.
Veritas Executive Compensation Consultants, ("Veritas") is a truly independent executive compensation consulting firm.

We are independently owned, and have no entangling relationships that may create potential conflict of interest scenarios, or may attract the unwanted scrutiny of regulators, shareholders, the media, or create public outcry. Veritas goes above and beyond to provide unbiased executive compensation counsel. Since we are independently owned, we do our job with utmost objectivity - without any entangling business relationships.

Following stringent best practice guidelines, Veritas works directly with boards and compensation committees, while maintaining outstanding levels of appropriate communication with senior management. Veritas promises no compromises in presenting the innovative solutions at your command in the complicated arena of executive compensation.

We deliver the advice that you need to hear, with unprecedented levels of responsive client service and attention.

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