Financial reporting considerations during plan design

A company needs to decide whether to grant restricted stock, stock options, or both at the initial plan design stage. In addition to understanding the expense impact of the awards granted, a company should also consider the complexities associated with Fair Value Measurements for share-based compensation. 

While RSUs valuation is generally simpler using the closing stock price as the Fair Value, stock options can be more complicated requiring option pricing models such as Black Scholes, Binomial method and Monte Carlo simulations. 

Varying accounting methods are required between equity-settled and cash-settled awards. Equity-settled awards are measured at their fair value on their grant date, with no subsequent changes to the value. 

Cash-settled awards require mark-to-market (MTM) at each reporting date until their settlement, typically resulting in additional workload on administration and reporting. Equity-settled awards have a relatively stable month-to-month expense, while cash-settled awards have a more fluctuating expense and impose financial burden on company's cash flow.

Share-based payments are typically subject to a vesting schedule. When designing a plan, it’s important to understand the three main types of vesting schedules:

➤ Cliff vesting. Cliff vesting requires employees to complete a specific period before becoming fully vested or fully entitled to their benefits. Share-based compensation expense is amortized evenly over this period.

➤ Graded vesting. Graded vesting is a method in which vesting takes place in a gradual manner and employees are entitled to a bigger percentage over time. The straight-line attribution method and the accelerated attribution method can lead to different expensing processes throughout the vesting period. 

➤ Immediate vesting. While not common, immediate vesting does not require a grantee to provide any service to receive and be fully vested in RSUs or stock options. In this case, they are immediately expensed without any amortization to follow. 

To motivate and retain employees, companies typically require employees to fulfil certain conditions to earn and retain stock-based compensation awards. An award is considered vested when an employee's right to receive or retain the award is no longer contingent on satisfying the vesting condition. In general, there are three types of vesting conditions:

➤ Service condition. Requiring an employee to remain employed at the company for a predetermined period of time (i.e. time-based vesting).

➤ Market performance conditions. As these are tied to company financial performance metrics such as Earnings Per Share (EPS), Total Shareholder Return (TSR), Relative TSR (a comparison against industry peers) and profitability metrics, they are generally favored by shareholders.    

➤ Non-market performance conditions. Are metrics used to assess performance that are not directly tied to market value or share prices. Instead, these focus on operational, strategic, or qualitative measures. Examples include performance against ESG targets, Customer Satisfaction, Brand Reputation, Risk Targets etc.  

If the awards are subject to performance conditions, different accounting treatments and valuation models, e.g., amortization method, expense recognition period, fair value measurement, are required compared to those that are subject only to time-based vesting conditions. Depending on whether the performance vesting conditions are based on non-market or market performance conditions. 

The key accounting difference is that market performance conditions are included in the grant-date fair value and not reassessed,  while non-market performance conditions are excluded from initial valuation and require ongoing reassessment on their achievement results. This affects how expense is recognized and reported over time.

As part of plan design, a company can determine whether the employee will receive the dividends paid on the underlying shares for the unvested RSUs. If the grantees of the RSUs are entitled to dividends, the expected dividends should be incorporated in the measurement of the grant date fair value of RSUs. 

Generally, common law employees and directors that are elected by shareholders, and who receive awards for services as directors, are considered employees. A non-employee is considered an independent contractor, consultant, temporary worker, or vendor. As the grantee’s status determines the accounting for the award, determining whether the grantee is an employee or non-employee is an important part of the plan design. Some additional factors to consider when determining employee vs non-employee include:

➤ The cost of share-based payments can be recognized over the employee’s requisite service period or the non-employee’s vesting period.

➤ Companies should elect to estimate forfeitures of employee awards based upon providing the requisite service. Consequently, an estimated forfeiture rate is adopted in share-based compensation for employees, while it’s not required for non-employees. 

➤ Fair value measurements procedures on employee awards and non-employee awards may vary depending on the accounting standards that companies follow.