3.9 Clawback Features

ASC 718-10

30-24 A contingent feature of an award that might cause a grantee to return to the entity either equity instruments earned or realized gains from the sale of equity instruments earned for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature (see paragraph 718-10-55-8), shall not be reflected in estimating the grant-date fair value of an equity instrument.

55-8 Reload features and contingent features that require a grantee to transfer equity shares earned, or realized gains from the sale of equity instruments earned, to the issuing entity for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature, shall not be reflected in the grant-date fair value of an equity award. Those features are accounted for if and when a reload grant or contingent event occurs. A clawback feature can take various forms but often functions as a noncompete mechanism. For example, an employee that terminates the employment relationship and begins to work for a competitor is required to transfer to the issuing entity (former employer) equity shares granted and earned in a share-based payment transaction.

Contingency Features That Affect the Option Pricing Model

55-47 Contingent features that might cause a grantee to return to the entity either equity shares earned or realized gains from the sale of equity instruments earned as a result of share-based payment arrangements, such as a clawback feature (see paragraph 718-10-55-8), shall not be reflected in estimating the grant-date fair value of an equity instrument. Instead, the effect of such a contingent feature shall be accounted for if and when the contingent event occurs. For instance, a share-based payment arrangement may stipulate the return of vested equity shares to the issuing entity for no consideration if the grantee terminates the employment or vendor relationship to work for a competitor. The effect of that provision on the grant-date fair value of the equity shares shall not be considered. If the issuing entity subsequently receives those shares (or their equivalent value in cash or other assets) as a result of that provision, a credit shall be recognized in the income statement upon the receipt of the shares. That credit is limited to the lesser of the recognized compensation cost associated with the share-based payment arrangement that contains the contingent feature and the fair value of the consideration received. The event is recognized in the income statement because the resulting transaction takes place with a grantee as a result of the current (or prior) employment or vendor relationship rather than as a result of the grantee’s role as an equity owner. Example 10 (see paragraph 718-20-55-84) provides an illustration of the accounting for an employee award that contains a clawback feature, which also applies to nonemployee awards.

ASC 718-20

35-2 A contingent feature of an award that might cause a grantee to return to the entity either equity instruments earned or realized gains from the sale of equity instruments earned for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature (see paragraph 718-10-55-8), shall be accounted for if and when the contingent event occurs. Example 10 (see paragraph 718-20-55-84) provides an illustration of an employee award with a clawback feature.

Example 10: Share Award With a Clawback Feature

55-84 This Example illustrates the guidance in paragraph 718-20-35-2.

55-84A This Example (see paragraphs 718-20-55-85 through 55-86) describes employee awards. However, the principles on how to account for the various aspects of employee awards, except for the compensation cost attribution and certain inputs to valuation, are the same for nonemployee awards. Consequently, the accounting for a contingent feature (such as a clawback) of an award that might cause a grantee to return to the entity either equity instruments earned or realized gains from the sale of the equity instruments earned is equally applicable to nonemployee awards with the same feature as the awards in this Example (that is, the clawback feature). Therefore, the guidance in this Example also serves as implementation guidance for similar nonemployee awards.

55-84B Compensation cost attribution for awards to nonemployees may be the same or different for employee awards. That is because an entity is required to recognize compensation cost for nonemployee awards in the same manner as if the entity had paid cash in accordance with paragraph 718-10-25-2C. Additionally, valuation amounts used in this Example could be different because an entity may elect to use the contractual term as the expected term of share options and similar instruments when valuing nonemployee share-based payment transactions.

55-85 On January 1, 20X5, Entity T grants its chief executive officer an award of 100,000 shares of stock that vest upon the completion of 5 years of service. The market price of Entity T’s stock is $30 per share on that date. The grant-date fair value of the award is $3,000,000 (100,000 × $30). The shares become freely transferable upon vesting; however, the award provisions specify that, in the event of the employee’s termination and subsequent employment by a direct competitor (as defined by the award) within three years after vesting, the shares or their cash equivalent on the date of employment by the direct competitor must be returned to Entity T for no consideration (a clawback feature). The chief executive officer completes five years of service and vests in the award. Approximately two years after vesting in the share award, the chief executive officer terminates employment and is hired as an employee of a direct competitor. Paragraph 718-10-55-8 states that contingent features requiring an employee to transfer equity shares earned or realized gains from the sale of equity instruments earned as a result of share-based payment arrangements to the issuing entity for consideration that is less than fair value on the date of transfer (including no consideration) are not considered in estimating the fair value of an equity instrument on the date it is granted. Those features are accounted for if and when the contingent event occurs by recognizing the consideration received in the corresponding balance sheet account and a credit in the income statement equal to the lesser of the recognized compensation cost of the share-based payment arrangement that contains the contingent feature ($3,000,000) and the fair value of the consideration received. This guidance does not apply to cancellations of awards of equity instruments as discussed in paragraphs 718-20-35-7 through 35-9. The former chief executive officer returns 100,000 shares of Entity T’s common stock with a total market value of $4,500,000 as a result of the award’s provisions. The following journal entry accounts for that event.

55-86 If instead of delivering shares to Entity T, the former chief executive officer had paid cash equal to the total market value of 100,000 shares of Entity T’s common stock, the following journal entry would have been recorded.

Clawback features, as contemplated in ASC 718, are protective provisions that require or permit the recovery of value transferred to award holders who violate certain conditions. Examples include the violation of a noncompete or nonsolicitation agreement, termination of employment for cause (e.g., because of fraud or noncompliance with company policies), and material restatements of financial statements. ASC 718-20-35-2 requires that the effect of certain contingent features “such as a clawback feature . . . be accounted for if and when the contingent event occurs.” ASC 718-20-55-85 states that contingent features, such as clawback features, “are accounted for . . . by recognizing the consideration received in the corresponding balance sheet account and a credit in the income statement equal to the lesser of [1] the recognized compensation cost of the share-based payment [award] that contains the contingent feature . . . and [2] the fair value of the consideration received.” By contrast, in the absence of a clawback feature, a credit to the income statement is not recorded for vested awards (i.e., those for which the grantee has provided the required goods or services for earning the award) even if the awards are canceled or expire unexercised. Many share-based payment awards contain provisions requiring grantees to exercise vested stock option awards within a specified period after termination (i.e., the contractual term of the awards is truncated). Awards not exercised within the specified period expire.

The requirement to forfeit vested awards after a specified period because the vested awards are not exercised before their expiration is not considered a clawback feature. In accordance with ASC 718-10-35-3, entities are prohibited from accounting for these types of provisions as clawback features and from reversing the compensation cost for vested awards that are returned because they expire unexercised.

Example 3-34

On January 1, 20X1, Entity A grants to its CEO 1 million equity-classified at-the-money employee stock options, each with a grant-date fair-value-based measure of $6. The options vest at the end of the fourth year of service (cliff vesting). However, the options contain a provision that requires the CEO to return vested options, including any gain realized by the CEO related to vested and previously exercised options, to the entity for no consideration if the CEO terminates employment to work for a competitor any time within six years of the grant date. The CEO completes four years of service and exercises the vested options. Entity A has recognized total compensation cost of $6 million (1 million options × $6 grant-date fair-value-based measure) over the four-year service period. Approximately one year after the options vest, the CEO terminates employment and is hired as an employee of a direct competitor. Because of the options’ provisions, the former CEO returns 1 million shares of A’s common stock with a total fair value of $3 million. Entity A records the amounts below on the date the clawback feature is enforced.

Alternatively, assume that in accordance with the options’ provisions, the former CEO returns 1 million shares of A’s common stock with a total fair value of $7.5 million. Since the fair value of the shares returned ($7.5 million) is greater than the compensation cost previously recorded ($6 million), an amount equal to the compensation cost previously recorded would be recorded as other income. The difference ($1.5 million) would be recorded as an increase to APIC. See the journal entry below.

Section 3.4.3 discusses share-based payment awards that have repurchase features that function, in substance, as vesting conditions (i.e., forfeiture provisions). Similarly, some awards have repurchase features that function, in substance, as clawback features. For example, a feature is substantively a clawback feature if it gives an entity the option to repurchase a grantee’s share-based payment award for (1) cost (which often is zero or, for options, the exercise price) or (2) the lesser of the fair value of the shares on the repurchase date or the cost of the award if, for example, an employee is terminated for cause. Such a repurchase feature is a protective clause, not a forfeiture provision, because it does not create an in-substance service condition in the event, for example, the employee is terminated for cause. A repurchase feature that functions as a clawback feature does not affect the balance sheet classification for awards (i.e., liability versus equity). It is instead recognized if and when the contingent event occurs (e.g., an employee is terminated for cause).

Example 3-35

Entity A grants 1,000 stock awards to an employee that vest at the end of the second year of service (cliff vesting). However, if the employee is terminated at any time by A for cause, A has the right to call the shares at cost.

The repurchase feature (i.e., the call option) functions as an in-substance clawback feature. This type of repurchase feature is not a forfeiture provision because it does not create an in-substance service condition; rather, it is a protective clause that applies if the employee is terminated for cause. Accordingly, the requisite service period is the explicitly stated vesting period of two years.

3.9.1 SEC’s Final Rule on the Recovery of Erroneously Awarded Compensation (“Clawback Policies”)

In October 2022, the SEC issued a final rule aimed at ensuring that executive officers do not receive “excess compensation” if the financial results on which previous awards of compensation were based are subsequently restated because of material noncompliance with financial reporting requirements. Such restatements would include those correcting an error that either (1) “is material to the previously issued financial statements” (a “Big R” restatement) or (2) “would result in a material misstatement if the error were corrected in or left uncorrected in the current period” (a “little r” restatement). The final rule implements the mandate in Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) under which the SEC is required “to adopt rules directing the national securities exchanges . . . and the national securities associations . . . to prohibit the listing of any security of an issuer” that has not adopted and implemented a written policy providing for the recovery of incentive-based compensation (IBC) under certain circumstances.

The final rule requires issuers to “claw back” excess compensation for the three fiscal years before the determination of a restatement regardless of whether an executive officer had any involvement in the restatement. The final rule also requires an issuer to disclose its recovery policy in an exhibit to its annual report and to include new checkboxes on the cover page of its annual report to indicate whether the financial statements “reflect correction of an error to previously issued financial statements and whether [such] corrections are restatements that required a recovery analysis.” Additional disclosures are required in the proxy statement or annual report when a clawback occurs. Such disclosures include the date of the restatement, the amount of excess compensation to be clawed back, and any amounts outstanding that have not yet been clawed back.

The concept of clawbacks is not new. Section 304 of the Sarbanes-Oxley Act of 2002 contains a recovery provision that is triggered when an accounting restatement results from an issuer’s misconduct. The provision applies only to CEOs and CFOs, and the amount of required recovery is limited to compensation received in the 12-month period after the first public issuance or filing of the improper financial statements with the SEC. In addition, in the interim period before the issuance of the final rule, many companies already had voluntarily adopted compensation recovery policies based on investor sentiment and good governance practices. However, it is likely that even those companies will be required to make substantial changes to their policies in light of the following aspects of the final rule:

The inclusion of a broader list of executive officers, including former executive officers, within the rule’s scope.
The broader events that would trigger recovery analysis (“Big R” and “little r” restatements).
The “no-fault” nature of the final rule.
The longer look-back period of three completed fiscal years.

Changing Lanes

On June 9, 2023, the SEC approved amendments filed by the NYSE and Nasdaq that revise the date by which listed companies must comply with the requirements of the final rule. Under the approved amendments, the effective date of the new clawback requirements is October 2, 2023, and the official compliance date for public companies is December 1, 2023, which is the date by which public companies must have a clawback policy that complies with the requirements of the respective exchange.

3.9.1.1 Accounting Considerations Related to Adopting the Final Rule on Clawback Policies

Companies should consider the potential accounting consequences of adopting the final rule.

Depending on its category, the IBC subject to recovery may have been accounted for under ASC 718 (e.g., RSUs or stock options), ASC 710 and ASC 450 (e.g., profit-sharing arrangements), or other applicable accounting guidance.

The final rule’s accounting implications will be based on a company’s specific facts and circumstances. In particular, companies should consider possible effects on the accounting for share-based payment arrangements. Under ASC 718, an equity-classified award issued to an employee is generally (1) measured on the basis of the fair value of the award on the grant date and (2) recognized over the requisite service period.

The discussion below outlines various accounting considerations related to share-based payment awards that companies may need to take into account when applying the final rule.3

3.9.1.1.1 Establishing a Grant Date

One of the conditions for establishing a grant date is that the employer and its employees must “reach a mutual understanding of the key terms and conditions of a share-based payment award” (see Section 3.2 for guidance on determining the grant date). If the key terms of an award are overly broad, subjective, or discretionary, there may be a delay in establishing a grant date for accounting purposes, which would, in turn, delay the establishment of a measurement date for determining the fair-value-based measure of the award. In addition, if certain conditions are met and the service inception date precedes the grant date as a result (see Section 3.6.4 for discussion of the service inception date), compensation cost may need to be recognized on the basis of the fair value of the award as of each reporting date until a grant date is established, even if the award is classified as equity (i.e., “mark-to-market” or “variable” accounting before the grant date).

Connecting the Dots

We generally expect that recovery policies adopted to comply with the provisions of the final rule will not preclude a company from establishing a grant date because the rule would require such policies to be well-defined and sufficiently objective. Conversely, clawback policies that are subjective or that allow companies to exercise discretion in determining when an IBC clawback is triggered could preclude an issuer from establishing a grant date because the clawback-triggering event would generally be a “key” term or condition for which a mutual understanding must exist. Therefore, in a company’s policies, it is especially important for the contingent event that triggers the clawback to be well-defined and sufficiently objective.

3.9.1.1.2 Modification Considerations

ASC 718-10-20 defines a modification as a “change in the terms or conditions of a share-based payment award.” However, an entity is not required to apply modification accounting if the fair-value-based measure, vesting conditions, or classification is the same immediately before and after the modification. Companies will need to consider whether modification accounting is required for changes made to existing awards as a result of the final rule.

Under ASC 718-10-30-24, clawback provisions4 in share-based payment plans generally are not reflected in estimates of the fair-value-based measure of awards. Accordingly, the addition of a clawback provision to an award would typically not result in the application of modification accounting because such clawbacks generally do not change the award’s fair-value-based measure, vesting conditions, or classification.

Further, a company that is preparing to adopt the final rule may decide to make other changes to an award, such as changing its performance or market conditions. Companies should evaluate such changes under the modification framework in ASC 718. See Chapter 6 for more information about modifications.

3.9.1.1.3 Accounting for a Recovery

If a company concludes that an accounting restatement is required and that excess IBC has been received by an executive officer, there are additional considerations associated with accounting for the recovery. The final rule requires companies to apply their recovery policy to awards that are “received,” which may precede the date the awards may be earned (i.e., vested) under ASC 718.

A company should assess its specific facts and circumstances to determine the appropriate accounting for a recovery. Although the discussion below focuses on two possible approaches that depend on whether the awards have been earned, there may also be other acceptable approaches.

3.9.1.1.3.1 Recovery of Earned Awards (“Clawback”)

A company may conclude that clawback accounting, as described in ASC 718, is appropriate for the recovery related to awards that have been earned as of the trigger date. Contingent features, such as clawback provisions, are not reflected in the fair-value-based measure of an equity instrument on the grant date and do not affect the recognition of compensation cost if they are triggered after the equity instrument is earned. Therefore, a clawback provision has no day 1 impact on the accounting for an award, and the clawback would be accounted for only if and when it is triggered by a contingent event (i.e., an accounting restatement).

The guidance in ASC 718 addresses how to account for clawbacks of awards that have been earned (i.e., vested).5 Under that guidance, a clawback of IBC would be recognized when (1) the material restatement triggering the clawback occurs after an award has been earned and (2) the consideration is received or receivable. At that time, the company would recognize (1) the consideration returned by the individual; (2) a receivable for such consideration; or, if the individual returns shares, (3) treasury stock at the fair value of those shares. The company also would recognize as other income the fair value of the consideration received to the extent that it previously recognized compensation cost for awards that were subject to the clawback; any excess of the fair value of the consideration received over the previously recognized compensation cost would be recognized as an increase to APIC.

3.9.1.1.3.2 Recovery of Unearned Awards

For an award within the scope of ASC 718, as of the trigger date, if excess IBC is deemed received on the basis of the final rule but the requisite service period has not been satisfied and the award has not yet been vested under ASC 718, the company would still be required to apply the recovery policy. Effectively, the company’s recovery policy would reduce the number of units that could be earned.

Under ASC 718, if an award has a performance condition, accruals of compensation cost should be based on the probable outcome of that performance condition. That is, compensation cost is accrued only if it is probable that the performance condition will be achieved; otherwise, no compensation cost is accrued. Compensation cost is not recognized if awards are forfeited because a performance condition is not satisfied. However, if the award has a market condition, compensation cost is recognized even if the market condition is not satisfied, as long as the requisite service is rendered. This is because a market condition is not a vesting condition; rather, it is reflected in the fair-value-based measure of the award on the grant date.

ASC 718 addresses how to account for changes in estimates if an award has not vested. For example, assume that an award is based on a performance condition with a three-year performance period ending in the issuer’s 20X1 fiscal year but is subject to service-based vesting for two additional years beyond the performance period. If the issuer concludes in late 20X2 that its 20X1 fiscal year is subject to a material restatement that triggers recovery for awards received in 20X1, that award would be deemed “received” under the final rule in 20X1 because the performance condition is “attained” (i.e., the performance condition is achieved), even if the award is subject to additional vesting (i.e., has not been earned). In this situation, the company may conclude that when considering the effect of the restated financial statements, it is not probable that the award will vest (i.e., on the basis of the restated financial statements, the performance condition will not be achieved) and any compensation cost previously recognized would be reversed.

If, on the other hand, there is a material restatement and it is determined that the market condition was not achieved, compensation cost is still recognized even if the market condition is not satisfied, as long as the requisite service is rendered.

Footnotes

While this discussion focuses on share-based payment awards that are classified as equity, some of the same considerations could apply to awards classified as liabilities.

ASC 718 states that a clawback feature is an example of a “contingent feature of an award that might cause a grantee to return to the entity either equity instruments earned or realized gains from the sale of equity instruments earned.” The final rule requires companies to have a recovery policy that could extend beyond equity instruments earned under ASC 718. Thus, a company may adopt a recovery policy under the final rule that could extend beyond what is described as a clawback under ASC 718.

If the award is not vested, see Section 3.9.1.1.3.2.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.