FASB Passes on Providing Easier Accounting for Clawbacks

A growing number of companies are attaching clawback policies and other discretionary features to their stock compensation arrangements, which can introduce complex and murky accounting. But don't expect any help from the Financial Accounting Standards Board.

FASB was asked anonymously to consider giving companies new guidance on how to set a grant date for stock compensation awards when they contain discretionary features that give the company the ability, when certain circumstances arise, to take back an award. FASB's seven-member board unanimously declined to take up the issue.

The tension is rising because accounting rules for share-based payment awards require companies to establish a clear grant date for an award based on terms and conditions that are mutually understood by both the company and the employee. With terms clearly defined, companies can treat such awards as equity and expense them evenly over the life of the award.

When discretionary terms are introduced, however, it muddles the picture considerably. In the absence of additional guidance, awards tied to discretionary terms must be treated as liabilities rather than equity, says Doug Reynolds, a partner with Grant Thornton. That means marking the liability to market value each period and expensing changes through earnings. “Nobody likes to have a plan where you have to adjust it based on value and expense it to earnings each period,” he says. “That means volatility.”

A variety of trends are driving interest in putting discretionary features and clawbacks into stock-based compensation awards, says Reynolds. With improvements in the economy and capital more available, companies are more interested in giving executives performance incentives. “People are more optimistic, and that usually happens on the upside of the economy,” he says.

With the financial crisis still a fresh memory, however, companies want strings attached to such plans so they can pull them back if they cause executives to game the system. Ken Stoler, a partner with PwC, says the banking sector has been most active at the front end of implementing clawbacks and other discretionary provisions.

The Securities and Exchange Commission has not yet finalized rules under the Dodd-Frank Act for how companies are required to claw back compensation when they end up restating results, but at least one banking regulator, the Federal Deposit Insurance Corp., has finalized rules of its own.

“Banks are interested in having a good amount of discretion in determining when they would be able to claw something back from an employee,” says Stoler. “But from an accounting perspective, the rules for stock compensation are pretty specific. To get equity treatment, you have to have a mutual understanding of all the key terms and conditions of an arrangement upfront. If you can't tell an employee everything they need to do to earn it up front, the key terms are not known. Some amount of discretion in a clawback may be OK, but there is a lot of judgment involved.”

Companies have become heavily entrenched in using the Black-Scholes model to measure the value of share-based payments for purposes of establishing the expense to be recognized in financial statements. That model doesn't work, though, when discretionary terms are introduced, says James Comito, a shareholder at audit firm Mayer Hoffman McCann. “The model is not built to deal with things that are contingent in nature,” he says. Adding contingencies or variabilities means switching from the Black-Scholes model to a binomial model, which produces ranges of possible outcomes based on varying factors. “That is almost always going to necessitate getting a specialist involved,” to figure out the accounting, he says.

“If we don't get guidance from accountants at the front end, there's a danger that companies could adopt clawbacks with all sorts of provisions that could create unsettled accounting consequences.”

—Jim Barrall,

Partner,

Latham & Watkins

Taking a Pass on Guidance

FASB staff recommended FASB members not re-open the accounting rules because they believed current accounting rules are adequate. FASB staff said its analysis suggests some companies are implementing clawbacks in anticipation of meeting the Dodd-Frank requirement and because shareholder advocacy groups are calling for them. Others, however, are writing clawback provisions that are more discretionary, and it is those provisions that are driving the demand for guidance, the staff said.

FASB's newest member, Jim Kroeker, former chief accountant of the Securities and Exchange Commission, quizzed the staff as it recommended denying the request. “Do we have evidence that people aren't able to reach consistent judgments when they have consistent fact patterns?”

None, the staff indicated. Staff members say the current rules provide adequate guidance on determining the grant date. “This issue does not arise from different interpretations of current U.S. GAAP but rather from the application of current U.S. GAAP to specific arrangements,” the staff wrote in its recommendation. In other words, companies know how to do the accounting, but they don't like the result when they apply it to their circumstances.

Jim Barrall, a partner with law firm Latham & Watkins, says FASB's refusal to produce new rules means accountants need to sort out the answers on their own. He worries companies could find themselves with problems like those encountered a few years ago when the backdated stock options scandal led to further discovery of all sorts of grant date mistakes with stock option awards. “This is a brand new issue,” he says. “If we don't get guidance from accountants at the front end, there's a danger that companies could adopt clawbacks with all sorts of provisions that could create unsettled accounting consequences.”

CLAWBACK POLICIES

The following chart from Equilar shows the prevalence of clawback policies from 2006-2012.

Source: Equilar.

Companies like Bank of America are already out there with discretionary provisions that take them down the path of liability treatment, according to its recent 10-K. A Bank of America footnote says certain clawback provisions allow the company to cancel all or part of an award under specified circumstances. The compensation cost for such awards—“substantially all of the awards in 2012,” the report says—are adjusted to fair value.

Companies are expected to only increase their use of discretionary provisions, according to a recent report from research firm Equilar. Clawback policies are getting increasingly complex, broader in scope, and more likely to affect all compensation vehicles, the firm says. “This is just starting to trickle out of the financial sector,” says Stoler. Companies are starting to see what banks are doing. “They're thinking if it's good for them, maybe it's good for us too.”

PwC's Stoler says companies would be wise to take great care in structuring compensation policies to incorporate not just the view of the human resources staff but of the finance and accounting staff as well. He agrees accountants can deal with the accounting based on current guidance, but they need to be involved early on so the consequences are understood. It's also a good idea to get the external auditor involved. “Have the auditor at the table at the same time to assure that they're comfortable with it,” he says.