“When a company gives something of value to its employees in return for their services, it is clearly a compensation expense. And if expenses don’t belong in the earnings statement, where in the world do they belong?”
Warren Buffett, investor extraordinaire and outspoken advocate of reporting stock option compensation expenses on the income statement.
Equity-based compensation (stocks, options, or something more exotic) is a useful tool for firms to hire and retain employees. Through shared ownership, such remuneration is commonly thought to align the incentives of employees, firms and other shareholders. In the case of startups, equity-based compensation can be particularly effective as it allows younger firms to conserve cash and obtain a greater degree of employee buy-in while competing effectively with much larger, established entities to acquire talent. Equity based compensation is attractive also because of the flexibility in structuring pay – human resources personnel and compensation experts are able to continually tinker terms and conditions to tailor awards to promote short, medium or long term goals of firms.
FASB Statement 123(R), Share Based Payment (now codified as ASC 718, Compensation–Stock Compensation) was issued in December 2004, in part as a response to financial reporting shenanigans that came to light in the early 2000s. Antecedent accounting guidance had progressively acknowledged the cost of equity based compensation, and introduced the option to use fair value as the basis for reporting. Prior to the promulgation of Statement 123(R), however, reporting entities had not been required to use fair value in recording equity compensation costs in their financial statements.
A post-implementation review (PIR) conducted by the Financial Accounting Foundation released a report on its review of Statement 123(R) in August 2014. The PIR team received input from users of financial statements (buy side analysts, sell side analysts, credit analyst, and a data gatherer), accounting practitioners, preparers of financial statements, as well as staff members of regulatory bodies. The PIR concluded that Statement 123(R):
- Addressed the need to reflect the cost of equity based compensation in earnings presented on the income statement.
- Resolved differences in practice and improved comparability of reported financial information among reporting entities.
- Attained substantial convergence with IFRS 2, Share Based Payment.
- Provided useful information with regards to equity based compensation to the users of financial statements.
- Was generally understandable to, and could be applied as intended by, the public preparers and practitioners.
- Did not result in any unexpected significant changes to financial reporting or operating practices at the reporting entities.
- Engendered implementation costs that were generally anticipated, and ongoing costs for public reporting entities were not significant.
- Achieved expected benefits.
- Was developed by the FASB through a process that was thorough and open.
While the conclusions were mostly positive, especially with regards to public reporting entities, the PIR report does indicate that nonpublic entities reported some difficulties in implementing Statement 123(R), and felt compliance costs were high.
In our experience, nonpublic clients perceive a measure of difficulty in complying with Statement 123(R) because unlike public entities, equity instruments used as compensation generally do not reference liquid securities with readily available prices. Further, many nonpublic reporting entities lack the internal resources necessary to analyze equity compensation structures and comply with related financial reporting requirements. In these situations, we help our clients work through the structural nuances of equity-based compensation by providing valuation analyses that meet the expectations of their external auditors. We are able to provide our services in a cost effective manner, with minimal strain on the part of our client firms’ internal resources.
For both start-up and mature companies, Mercer Capital’s valuation experts assist in the measurement of grant-date fair value of equity-based compensation across a variety of industries. Call us – we would like to work with you to find the best equity compensation structure and provide a reliable opinion regarding grant date fair value.
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