United States

Audit and Enterprise Risk Services

Accounting Considerations Related to the New Policies Proposed by the Special Master for TARP Executive Compensation

Financial Reporting Alert 10-9

August 4, 2010

On July 23, 2010, the Special Master for TARP¹ Executive Compensation, Kenneth R. Feinberg, announced the completion of his review of compensation payments made by TARP recipients to top executives (for periods before February 17, 2009). As part of the announcement, the Special Master proposed that TARP recipients prospectively adopt policies that would give compensation committees special restructuring rights related to executive pay plans. Under the proposal, an entity could voluntarily include in its executive pay plans a provision that allows the entity to restructure or retract some or all of an executive’s pay in times of crisis. The proposal states that compensation committees would have “the authority to restructure, reduce, or cancel pending payments to executives — and this authority would supersede any rights and entitlements executives have in normal circumstances.” While the Special Master directed the proposed new policies toward entities that received money from TARP, other entities are not precluded from adopting the same or similar policies.

This Financial Reporting Alert addresses (1) how the proposed new policies may call into question whether an entity has established a grant date in accordance with ASC 718² if the entity’s executive share-based payment plans allow the compensation committee, at its discretion, to restructure or retract a share-based payment award and (2) the potential accounting implications if a grant date has not been established. Note that while the Special Master’s proposal suggests adopting these policies prospectively (i.e., for new plans or awards), if an entity changes any of the terms or conditions of its existing executive share-based payment plans (or awards) as a result of the proposal, the entity also should consider the guidance on modification accounting in ASC 718. (This alert does not discuss the accounting for a modification of the terms or conditions of an existing plan (or award).) Before amending existing executive compensation plans (or awards) or adopting the proposal for new plans (or awards), entities should consider consulting with their advisers (e.g., legal, tax, compensation, and accounting) regarding their specific facts and circumstances.

New Policies

If implemented, the Special Master’s proposal would allow compensation committees to restructure awards or retract them from executives if the entity’s board of directors has determined that the entity is in a crisis situation. One common feature that compensation committees may use to retract an award is a “clawback” provision (i.e., a provision that gives the entity the ability to claw back some or all of an executive’s share-based compensation).

Historically, some entities may have used clawback provisions that function as a noncompete mechanism.³  Generally, such provisions would require an employee to return any previously earned awards if the employee terminated employment and began to work for a competitor. Such provisions typically possess the characteristics of a contingent feature, as described in ASC 718-20-35-2, and therefore are not reflected in the grant-date fair-value-based measure of the award; rather, they are accounted for when and if they occur. In contrast, a clawback provision added to the terms of a plan (or award) under the Special Master’s proposal would allow an entity to retract an award to align its executive compensation packages with the interests of shareholders and would offer the entity greater flexibility to adjust executive compensation when it is in economic turmoil.

Note that a clawback provision is only one provision that an entity may consider adding to the terms of its plans (or awards) in response to the Special Master’s proposal. To the extent that an entity considers other provisions to restructure or retract awards, the entity should evaluate the related accounting considerations.

The Special Master’s proposal does not specifically prescribe the terms an entity would add to its share-based payment awards; rather, the compensation committee would have discretion to determine the appropriate policy. Accordingly, any provisions to retract or restructure awards may vary from plan to plan. Some provisions may be very broad, allowing the entity significant discretion to decide when and how to exercise its right, while others may stipulate when the entity would be able to exercise its right and outline specific terms and conditions related to the retraction or restructuring of the plans (or awards).

Establishing a Grant Date

The accounting for these expanded provisions in share-based payment awards is highly dependent on the facts and circumstances. If the terms of the provision are broad, subjective, and discretionary, an entity may be precluded from establishing a grant date⁴ for the award in accordance with ASC 718, since the nature of the provision may prevent the employee from reaching a mutual understanding about the key terms and conditions of the share-based payment award.

If the terms of the provision are clear and measurable, do not allow for the entity’s exercise of discretion, and are communicated to the employees, an entity may be able to establish a grant date. If the criteria for a grant date are met and the provisions are only applicable after the award has been earned, the provisions may be accounted for as contingent features in accordance with ASC 718-20-35-2. Alternatively, if the criteria for a grant date are met and the provisions affect whether and when an award is earned (e.g., the award is conditioned on attainment of performance targets), the award may contain a performance condition⁵ and should be accounted for in accordance with ASC 718-10-25-20. 

Implications of Not Establishing a Grant Date

If an entity determines that the terms of an award do not establish a grant date, the entity must consider whether a service-inception date exists. The service-inception date is the beginning of the requisite service period, which is normally the same as the grant date but may precede the grant date if certain criteria are met. The service-inception date is important because it is used to determine when the recognition of compensation cost begins. ASC 718-10-55-108 states that the following criteria must be met for a service-inception date to precede the grant date:

a.   An award is authorized. . . .

b.   Service begins before a mutual understanding of the key terms and conditions of a share-based payment award is reached.

c.    Either of the following conditions applies:

1.   The award’s terms do not include a substantive future requisite service condition that exists at the grant date . . . .

2.   The award contains a market or performance condition that if not satisfied during the service period preceding the grant date and following the inception of the arrangement results in forfeiture of the award.

If the service-inception-date criteria are met, compensation cost is recognized on the basis of the award's estimated fair-value-based measure at the end of each reporting period in proportion to the amount of services that have been rendered until a grant date is established. Said differently, the measure of the award is variable until a grant date has been established. In the period in which the grant date occurs (if the award’s classification as equity is assumed), the entity would make one final determination of the fair-value-based measure (i.e., the grant-date fair-value-based measure) and would record any unrecognized compensation cost over the remaining requisite service period of the award. The award would not be subsequently remeasured after the grant date. Conversely, if the service-inception-date criteria are not met, an entity would not begin recognizing compensation cost until a grant date has been established.

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1   Troubled Asset Relief Program.

2   For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”

3   This discussion of clawback provisions that function as a noncompete mechanism is not meant to address situations in which the clawback provision creates an in-substance service period.

4   ASC 718-10-20 defines a grant date as follows:

     The date at which an employer and an employee reach a mutual understanding of the key terms and conditions of a share-based payment award. The employer becomes contingently obligated on the grant date to issue equity instruments or transfer assets to an employee who renders the requisite service. Awards made under an arrangement that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality (or perfunctory), for example, if management and the members of the board of directors control enough votes to approve the arrangement. Similarly, individual awards that are subject to approval by the board of directors, management, or both are not deemed to be granted until all such approvals are obtained. The grant date for an award of equity instruments is the date that an employee begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer's equity shares. Paragraph 718-10-25-5 provides guidance on determining the grant date. See Service Inception Date.

5   ASC 718-10-20 defines a performance condition, in part, as a “condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that relates to both of the following:

a.  An employee’s rendering service for a specified (either explicitly or implicitly) period of time.

b.  Achieving a specified performance target that is defined solely by reference to the employer’s own operations (or activities).”