Why Discretion in Equity Plan Awards Matters to Boards and the C-Suite

Corporate boards are taking steps to codify the ability to adjust the final payout of an equity award in executive and employee compensation award agreements in response to recent stock market volatility, supply chain challenges, inflation and interest rate increases. Creating this level of flexibility is referred to as discretion, and boards typically embrace this tactic during prolonged periods of uncertainty.

When including discretionary provisions in any compensation plan, the ramifications should be considered from a governance perspective — balancing the fairness between executives and shareholders relative to unplanned events.

However, unlike cash performance plans, there could be additional accounting considerations under United States General Accepted Accounting Principles (U.S. GAAP) when discretion is used in equity awards that might lead to volatile or negative expense from these plans. This is true regardless of the order of magnitude or the direction (positive or negative) of the discretion. The accounting that could be triggered is referred to as mark-to-market, which we describe below.

Firms typically work to avoid mark-to-market accounting for equity awards because when equity awards are subject to this account practice, expense can fluctuate dramatically from financial reporting period to financial reporting period, and if the stock price has increased over the life of the award, then the aggregate expense associated with the grant will increase as well. Said differently, one of the key benefits of equity classification is that the fair value is fixed at grant.

For example, if a firm grants 100,000 RSUs, participants receive dividend equivalents over the vesting period, the stock price on the date of grant is $50, and the awards are paid in stock, then the firm will have $5,000,000 of expense to spread over the life of the award.

Since the fair value is fixed at grant, this is largely a fixed expense at the time of grant, though will need to be adjusted for any forfeitures that occur.

On the other hand, under mark-to-market accounting, if a firm grants 100,000 RSUs, the original stock price on the date of grant is $50, but the stock price ultimately ends at $75, then the firm will have $7,500,000 of expense (adjusted for any forfeitures that may occur) to be recognized by the settlement date.

In this article, we describe the possible accounting impact when discretion is applied during or at the end of the performance period, and we share how and why corporate boards might draft provisions in a way that codifies the reasons for discretion into the upfront definition, thereby, avoiding the potential for mark-to-market accounting. The discussion that follows is independent of any individual executive or corporate tax implications.

Discretion Provisions Might Help Boards Foresee Unexpected Circumstances, But They Threaten Poor Financial Accounting Outcomes

Corporate boards can choose to deliver compensation to executives or employees, which is different than would otherwise be given based on their performance by including terms in award agreements that we refer to as positive discretion.

The wording in agreements with these provisions usually specifies that the board “may” increase or decrease the payout of the award at their discretion, but they are not required to under any circumstances.

The wording in these provisions will usually specify that the board “may” increase or decrease the payout of the award at their discretion, but they are not required to under any circumstances.

When the discretion provisions in the award agreement are negative, this results in a lack of an accounting grant date under Topic 718 because a mutual understanding of key terms and provisions does not exist between the employee and employer.

Therefore, mark-to-market accounting will be required throughout the life of the award resulting in greater compensation costs if the company’s stock price increases over the life of the award.

When positive discretion is involved, there might be no immediate financial statement impact, but an exercise of such discretion might lead to further expense recognition as a result of a modification.

In our experience, most companies will not want to add this additional volatility to their corporate reporting expense numbers for stock-based compensation and therefore discretion provisions should be generally avoided.

There is confusion on this point generally as some boards and executives still believe, for example, that negative discretion provisions are generally okay because many negative discretion provisions were included in award agreements as a result of pre-Tax Cuts and Jobs Act of 2017 (TCJA) 162(m) regulations. Post-TCJA, it was later clarified that such provisions would not allow compensation to be grandfathered under those rules.

If a CEO, CFO or any of the named executive officers of the firm is benefiting from positive discretion, then incremental compensation would be included in the summary compensation table for that individual.

Non-Discretionary Provisions Guarantee Adjusted Payout in Certain Situations

Non-discretionary adjustment provisions are equity compensation award agreement terms that specify a unique set of circumstances where the board is required to make certain adjustments to the final payout of an executive or employee in response to a series of events.

For instance, some award agreements contain a provision that requires the board to adjust the payout measurement if the payout changes as a result of a legislative action or a change to the accounting standards.

The wording in these provisions will usually specify that the board “shall” or “will” adjust the award payout in response to a unique set of circumstances. This language is in contrast to other discretionary provisions where the language in the agreement usually specifies that the board “may” make an adjustment.

The existence of a non-discretionary agreement provision does not trigger any grant date accounting consequences because the provision is understood to merely state how the plan will operate. However, care must be taken by boards to ensure that the provisions are not too open ended to be considered fully discretionary.

The inclusion of a more narrowly defined set of non-discretionary adjustment provisions could provide companies with the ability to adjust the payout of the awards without any additional accounting ramifications.

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The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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