Equity-Based Compensation Update – New Accounting Rules & Trends
Author: Gary Schafer
With shifting workforce demographics and an increasingly competitive talent market, designing an effective compensation package to attract and retain key employees is more important than ever. Employers often turn to equity-based or equity-like compensation plans to enhance engagement, promote alignment and encourage retention. Recent changes intended to simplify certain accounting rules for stock option awards also will affect other types of share-based payment awards.
Stock-Based Compensation Accounting Update
In March 2016, some complex accounting rules for stock-based employee compensation awards within U.S. generally accepted accounting principles (GAAP) were simplified. While the remaining guidance often is far from simple, the changes were welcomed by many companies that use employee stock options in their compensation packages. Some of the more significant changes were:
- Simplified alternative for accounting for forfeitures – Employers may make an entitywide election to recognize forfeitures as a reduction to compensation expense as they occur, rather than estimating them at the time awards are granted.
- Simplified accounting for tax effects of stock options – Several simplifications were made to how income tax effects of employee stock option awards are presented in the financial statements. Companies will recognize income tax effects of awards in the income statement when the awards vest or are settled and the record keeping of additional paid-in capital pools will no longer be necessary. In certain cases, stock options accounted for as liabilities due to tax withholding requirements may now qualify for treatment as equity instruments.
Some of the most significant changes were made available to nonpublic companies. Accounting Standards Codification Topic 718, Compensation—Stock Compensation, specifically defines a nonpublic company. For those who qualify, the update provides additional options:
- One-time election to adopt simplified intrinsic value accounting for liability-classified awards rather than the more complex fair value accounting
- Intrinsic value is the difference between the option’s exercise price and current redemption value. This is typically easier for nonpublic entities to estimate than fair value.
- This election wouldn’t only apply to employee stock options, but also to other stock-based compensation—such as stock appreciation rights, restricted stock, stock warrants, profits interests or phantom stock—that the entity may have previously calculated using a fair value model.
- Nonpublic entities will still use fair value for equity-classified awards.
- Simplified method of estimating the expected term of awards that meet certain criteria
- Within current GAAP, this must be estimated based on assumptions regarding the behavior of employees based on historical experience.
- The new alternative allows employers to use a practical expedient for estimating this period, which typically will be the midpoint between the date the award vests and when it expires.
For full-change details implemented by Financial Accounting Standards Board Accounting Standards Update Topic 718 read the article, “Share-Based Payment Accounting Simplifications.”
Trend in Equity-Based Compensation: Profits Interests
Through recent years, profits interest-style plans have seen a significant popularity increase. This type of plan is especially common in nonpublic entities with a limited liability company structure. With a profits interest plan, participants are granted an equity interest in a company’s future profits. A significant amount of flexibility is available on how compensation is calculated and vesting is determined within such plans. Determining the fair value of profits interest awards at issuance can be challenging. While many of these plans are structured to pay out only when the interests are redeemed upon liquidation and accounted for as equity, some plans provide for redemption features that can result in the employer recording a liability on the balance sheet. In those cases, the option to elect intrinsic value accounting for such awards may be popular.
For a refresher on accounting for stock and other options for equity-based variable compensation plans, including restricted stock grants, phantom stock plans, stock appreciation rights and similar plans, read the article “Refresher – Stock & Other Options.”
Contact your BKD advisor for more information.