The Importance of Equity Compensation Accounting During Uncertain Times
By: Pam Chernoff, Curriculum Coordinator, Certified Equity Professionals Institute; Nathan O’Connor, Managing Director, Equity Methods
When equity markets become as volatile as they’ve been in recent months, the equity awards that companies provide to their employees are directly impacted.
These are equity awards, after all, and as underlying stock prices fluctuate, their value to the company and to employees changes. Incentives stand to be broken. Performance goals that everyone agreed made sense before the pandemic hit no longer seem relevant. As new grants are made at lower share prices, share pools are depleted more rapidly than expected. The retentive and motivational value of awards is called in to question. And, as companies shift into damage control mode, even the solutions have financial statement costs.
When issuing companies change previously issued awards, modification accounting takes center stage. Equity compensation accountants might warn the good-willed CEO who is asking to have her January 2020 stock options cancelled that shareholders may be unhappy that the company will still be stuck with compensation expense even after the cancellation occurs. “This is a Type II modification,” the accountant would say. “It’s a rare type of modification. However, I suppose these are rare times.”
For many companies, modification accounting isn’t even the most complex area of equity compensation that requires attention right now. Forecasting has received new attention in recent months as companies try to divine the EPS and tax effects of the current downturn.
Companies’ diluted EPS, a metric of key interest to investors, will be impacted by equity compensation forces. Some, like decreased payouts on performance awards and decreased average stock prices, will tend to lower diluted EPS, but others, such as new grants that otherwise wouldn’t have been made and the likelihood of fewer option exercises, can actually increase it. EPS forecasting attempts to model how a company’s diluted EPS will change under various future stock price and award settlement scenarios, while factoring in new awards, the possibility of forfeitures, and provisions such as acceleration of vesting upon retirement.
Tax settlement forecasting aims to provide senior leaders with insight into how tax windfalls and shortfalls associated with equity compensation may directly impact the company’s earnings as stock prices move over time. Under current accounting guidelines, for example, when awards settle at intrinsic values that are below their grant date fair values, the company must record a tax shortfall, which increases tax expense, creating a drag on earnings.
All of this underscores the importance of equity compensation accounting to the ongoing operation of any company that issues equity to its employees, especially during volatile periods. A well-trained equity compensation accountant can be a company’s first line of defense for assessing the costs and benefits of equity compensation practices. Only the equity compensation accountant can assimilate information from HR, legal, tax, and other departments and fully analyze the spectrum of potential future financial risks and rewards reflected by various approaches to stock compensation. How and to what extent can the company adjust previous awards and issue new awards to employees in a way that is responsible to the company’s bottom line? Only the equity compensation accountant can say reliably.
How can any company that takes equity compensation seriously manage all of these moving pieces? Having an accounting team that is trained in equity compensation can be especially valuable—especially if those people have a credential that’s recognized by senior leaders and that reflects an understanding of these topics.
Many finance, accounting, and equity compensation professionals are not up to speed on equity compensation accounting. In fact, this area is a substantial knowledge gap in the equity compensation industry. This is where the Advanced Equity Compensation Accounting Certificate (AECA) program comes into play. The AECA is the newest offering from the Certified Equity Professional Institute at Santa Clara University. Over 30 years, the Certified Equity Professional (CEP) program has been the equity compensation industry’s educational standard, certifying those who have demonstrated proficiency in accounting, tax, law, and administration. The new AECA program culminates in a 77-question, open-book exam that is strictly focused on accounting for equity compensation, including:
- The implications of policy-level decisions, including those around amortization, valuation models, and forfeiture application methodologies
- The practical application of expense measurement and recognition, including the effect of different variables on valuation of grants
- Accounting for the tax effects of equity compensation
- Calculation of earnings per share
- Reporting and disclosures required under ASC 718
- Journal entries
The exam will be administered across the country November 9-21 and registration is open now. For more information, visit https://www.scu.edu/business/cepi/aeca-certificate/.