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Stock Awards and P&L Volatility

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May 17, 2011 | Barbara Baksa

Stock Awards and P&L Volatility

This week I write about how stock compensation can introduce volatility into the P&L and why this is a problem.

The Problem with Liability Treatment

The recent article "Higher Stock Price Triggers First-Quarter Loss for Barnwell" (Honolulu Star Advertiser, May 12, 2011, Andrew Gomes) highlighted for me the exact problem with stock compensation that is subject to liability treatment. The article explains that Honolulu-based Barnwell Industries experienced a $1.5 million loss this quarter--a reversal of a $1.5 million profit for the same quarter last year. The reason for the loss is that their stock price doubled during the quarter.

How can a stock price increase cause the company to recognize a loss? The answer is that Barnwell has granted options that can be paid out in cash (the options include a cash SAR component) and are therefore subject to liability treatment. Thus, the increase in their stock price had a very significant impact on their stock compensation expense. Although they haven't granted options since 2009, Barnwell's stock option expense went from $46,000 for the comparable quarter last year to $1,677,000 for the current quarter. That's an increase of 3,546%--kind of hard to explain to shareholders, who, for the most part, probably don't have the foggiest understanding of liability vs. equity treatment.

Performance Awards Too

While performance awards receive equity treatment under ASC 718, they can also introduce the potential for similar volatility to the P&L. When performance awards are contingent on non-market based goals (e.g., revenue, earnings, and other internal metrics), the likelihood of forfeiture is estimated and expense is recorded based on this estimate. If the company does well, the likelihood of forfeiture will be lower and the expense for the awards will increase.

It's important to keep this in mind when designing performance award programs and to set appropriate caps on payouts as a means of controlling stock plan expense (not to mention, how do you handle a situation where awards vest based on earnings, the earnings target is hit, and this decreases the forfeiture estimate to the point where the additional expense for the awards reduces earnings below the target). This is also a reason to consider market-based awards--i.e., awards that vest based on stock price targets or total shareholder return. For these awards, the likelihood of meeting the targets is baked into the initial fair value estimate and there are no further adjustments if the likelihood that the targets will be achieved changes.

Need to know more about the accounting treatment and design considerations for performance awards? Don't miss the NASPP's pre-conference program, "Practical Guide to Performance-Based Awards" at this year's NASPP Conference.

IFRS 2

If ever required for US companies (see last week's blog entry, "IFRS 2: The Saga Drags On"), there are three requirements under IFRS 2 that could introduce significant volatility to the P&L:

  • Tax Accounting: IFRS 2 requires all tax shortfalls to run through the P&L and, moreover, requires companies to estimate their tax benefit/shortfall each accounting period and adjust tax expense accordingly. This is the opposite of Barnwell's problem. Here, an increase in stock price wouldn't be a problem, but a decrease that causes options and awards to be underwater (i.e., the current intrinsic value of the award is less than the expense) could result in significant increases in tax expense, which would reduce earnings for the period. Sort of rubbing salt into the wound--reduced earnings is not going to help get the stock price back up.
  • Share Withholding: Share withholding on either options or awards triggers liability treatment (for the portion of the award that will be withheld to cover taxes) under IFRS 2. As the company's stock price increases, this liablity--and associated P&L expense--will increase.
  • Payroll Taxes: The company's matching tax liability for payroll taxes (Social Security and Medicare in the US) is also treated as a liability that must be estimated and expensed each accounting period. Again, as the company's stock price increases, this liability and expense will also increase.

See the NASPP's IFRS 2 Portal for articles on these IFRS 2 requirements.

Last Chance to Qualify for Survey Results
This is the last week to participate in the NASPP's 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte).  Issuers must complete the survey by this Friday, May 20, to qualify to receive the full survey results. Register to complete the survey today.

New "Early-Bird" Rate for the NASPP Conference
If you missed last Friday's early-bird deadline for the 19th Annual NASPP Conference, you can still save $200 on the Conference if you register by June 24.This deadline will not be extended--register for the Conference today, so you don't miss out.

NASPP "To Do" List
We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing "to do" list for you here in my blog. 

- Barbara 

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