The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Here’s this interview with Paula Todd & Don Delves of Towers Watson:

Late last month, as part of the 23d annual conference of the National Association of Stock Plan Professionals (NASPP), we participated in a panel discussion reflecting on the tenth anniversary of FAS 123(R) (now ASC 718), the accounting rule change that requires companies to expense stock options. The following article was originally published as a “Meet the Speaker” interview in NASPP Advisor and is republished here with NASPP’s permission.

In the period leading up to the adoption of FAS 123(R), there were a lot of predictions of dire consequences. Do you think any of those predictions were accurate?

Don Delves: One of the predictions was that companies would stop granting options to all or substantially all employees in the organization. This has largely taken place and it happened very quickly at the vast majority of companies. While some smaller firms and technology firms still grant options to all or most employees, most others grant equity only down to the director or manager level. Prior to the adoption of FAS 123(R), a substantial number of both technology and other companies granted options to a significant slice of the employee population.

Other predictions about FAS 123(R)’s impact for the most part did not come to pass, including:

– Executive pay did not decrease, although it did level off and slow its ascent.
– Company stock values did not drop dramatically because of the added (noncash) expense.
– The United States did not lose its edge in technology, nor did U.S. companies lose their ability to attract talent.
– Start-ups did not evaporate, nor lose their ability to attract investors.
– California neither slid off into the Pacific, nor seceded from the union. (Yes, this one is a canard. The others were actual predictions brandished by FAS 123(R)’s opponents.)

Has there been a silver lining to FAS 123(R)?

Don Delves: Yes, absolutely. There are three significant positive results of FAS123(R):

– First, boards now carefully weigh the cost versus benefits of various long term-incentive (LTI) vehicles and designs and choose the mix, vehicles, performance measures and goals that are right for their company. Prior to FAS 123(R), well over 90% of all LTI grants by all companies were in the form of stock options. Hard to believe, but very true. Given the choice of plan types and vehicles, the vast majority of boards chose to grant “free” stock options. LTI programs are now highly tailored to each company’s situation, and LTI alternatives are carefully weighed against each other, using a reasonably consistent estimate of their potential costs and benefits to shareholders.

– Second, executive pay now tracks much better with both absolute financial performance and relative stock performance. Long-term performance plans tie pay to long-term financial results. Relative total shareholder return (TSR) plans reward stock performance relative to the market or peers. Options, while still part of the LTI package, reward increases in the stock price, but are now part of a much more balanced package that rewards both financial performance and relative stock performance. The inclusion of either time-based or performance-based restricted stock in most LTI programs also rewards and encourages the payment of dividends, which options do not. These are all significant improvements in overall incentive design.

– Third and perhaps most important, FAS 123(R) helped slow the dramatic increase in CEO and executive pay that had been fueled by “free” stock options. It was true that CEO pay was “spiraling out of control,” with no real governor on the system, in the late 1990s and early years of the new millennium. That is no longer the case and has not been the case for over 10 years. The accounting expense did what it was supposed to do. It added accountability and rationality to a system that needed it. While it certainly hurt rank-and-file employees, it also improved corporate governance and pay-for-performance alignment for executives.

What are some of the areas of compliance with the standard that are still a challenge for companies today?

Paula Todd: During the past 10 years, most companies have adapted pretty well to the compliance aspect of the standard. Further, the Financial Accounting Standards Board’s proposed amendments contained in its June 2015 Exposure Draft, if adopted, would address many of the most bothersome aspects of the requirements, such as allowing a broader range of tax-withholding rates (beyond just the minimum withholding rate) as well as providing relief for certain private (nonpublic) companies.

Interestingly, the biggest push-back in comment letters on the proposed amendments relates to the accounting treatment for the income tax effects from equity plans. Even though the proposal would do away with an administratively complicated requirement (related to the APIC pool), most of the companies submitting comments said they’d prefer the current administrative complexity to the potential earnings volatility that could result from the proposed change. It will be interesting to see how this issue gets resolved in final rules.

To my mind, the bigger ongoing challenge with ASC 718 comes from the disconnect in accounting treatment between plans with market and performance conditions. In order to achieve more predictable earnings, many companies won’t consider using equity plans that have nonmarket performance conditions even where such plans could make good sense from an incentive design perspective. As valuation techniques improve, it would seem the bright line between market and performance conditions might be softened so that more plans could receive grant-date valuation.

What do you think the next 10 years will bring in terms of stock plan accounting? Are we going to be talking about IFRS 2 at the 2025 NASPP Conference?

Paula Todd: I certainly wouldn’t expect to see the same degree of change related to stock plan accounting in the next 10 years as we’ve seen in the past 10 to 20 years. To the extent there are any changes, they likely would come from program changes that are the direct outgrowth of congressional action (along the lines of Dodd-Frank or major tax reform) or investor mandates. For example, if Institutional Shareholder Services or some other shareholder group would push companies to adopt a particular plan feature that didn’t exist or wasn’t common when the current accounting guidance was adopted, then fine-tuning in the current accounting guidance might be needed to accommodate the new design element or practice. But, I certainly wouldn’t expect the need for significant further changes to the accounting treatment of equity plans.

Of course, the issues raised by the international convergence of accounting standards are part of a broader discussion about U.S. versus international GAAP. With regard to this aspect of corporate accounting, however, any issues with convergence would tend to be fairly minimal considering that the two standards were debated and adopted in concert.