Weird and Challenging Accounting Issues in Plain-English Weird and Challenging Accounting Issues in

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Transcript of Weird and Challenging Accounting Issues in Plain-English Weird and Challenging Accounting Issues in

  • Weird and Challenging Accounting

    Issues in Plain-English

    Nathan O’Connor

    Rado Kanev

    Steve Tamsula, CEP

    Thanks to Winny VanVeeren for the clip art, funny baby pictures, and parts of the content.

  • -2-

    WEIRD AND CHALLENGING ISSUES

     Odd, Obscure and Volatile Service Periods

     Psychotic and Schizophrenic Fair Values

     Weird Expensing

     Bizarre and Unexpected Modifications

     Peculiar EPS Issues

     Additional Oddities – Problematic Post-Vest Holdings

    – Whacky Windfalls and Shortfalls

  • Odd, Obscure and Volatile Service Periods

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     Service Period = “The period during which an employee is required to provide service in exchange for an award”

    – Service Inception Date = “The service period start date”

     Could Service Period for TIME BASED Awards start before the Grant Date?

    – Very unusual, but ASC 718 allows for it

    – If the award’s terms do not include a substantive future requisite service

     Could Service Period for TIME BASED Awards start after the Grant Date?

    – Not per ASC 718

    – If board grants with Vest Start Date after Grant Date, then

     Grant Date = Vest Start Date for ASC 718 expense amortization purposes

    ODD SERVICE PERIODS Time-Based Awards

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     Performance targets can result in different service periods

     Performance target is $100 million, $150 million and $200 million of revenues in year 1, 2 and 3, respectively.

    – Single goal for each year is known at grant

    – Service period = 3 years

    – Measurement date = Grant date

    – Graded vesting over three years

    OBSCURE SERVICE PERIODS Performance Awards

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     Performance target is a 10%, 11% and 12% ROE in each of years 1, 2 and 3, respectively.

    – Dependent targets, thus three consecutive service periods of one year each.

    – Three measurement dates: on grant date and at beginning of years 2 & 3

    – Expense amortization separate for each year

    – Fair value is locked at grant date for all three tranches

    OBSCURE SERVICE PERIODS Grant Date before Service Inception Date Performance Awards

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    – Service period = 3 years

    – Measurement date = Grant date

    – Market or performance condition that is resolved during the period leading up to the grant date

    – Upon issuance of the award, there isn’t a mutual understanding as

    to what must be done in order to vest in the awards

    – Variable accounting is required before the grant date and therefore this award must be marked to market until the grant date fair value is determined

    OBSCURE SERVICE PERIODS Service Inception Date before Grant Date Performance Awards

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     The service period can change during the life of the award

     Example:

    – 100 shares; fair value $10; vest when achieve $200 million in revenues.

    – At grant: Total expense: (100 * $10) = $1,000

    – CASE A: probable that takes 24 months to reach target

     Expense taken after 12 months: (100 * $10) * (12/24) = $500

    – CASE B: In month 12 probable it will only take 18 months to reach target

     Adjust expensing in month 12

     YTD expense under CASE A: $500

     YTD expense under CASE B: (100 * $10) * (12/18) = $666

     Catchup expense: $666-$500 = $116 recorded in month 12

     Remaining expense of next 6 months: (100 * $10) / 18 * 6 = $334

    VOLATILE SERVICE PERIODS Performance & Market Condition Awards

  • Psychotic and Schizophrenic Fair Values

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     A single grant with performance targets could require different ASC 718 fair value approaches depending on the fact pattern

     Examples:

    – CASE A - One Grant with concurrent dependent targets

     Target 1: sell $50 million in year 1

     Target 2: sell an additional $100 million in year 2

    – CASE B - One Grant with concurrent independent targets

     Target 1: sell $50 million of product A in year 1

     Target 2: sell $50 million of product B by end of year 2

    – CASE C - One Grant with both market and performance conditions

     50% vests based on TSR target, 50% vests based on revenue targets

    – CASE D - One Grant w/ dependent targets (like Case A), but Target 2 set in year 2

     Award has 2 grant dates, so two fair values will be used

    SCHIZOPHRENIC FAIR VALUES Performance Awards

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    PROBLEMATIC POST-VEST HOLDINGS

    Pros

    Simplifies monitoring and enforcement of ownership

    guidelines

    Simplifies enforcement of clawback provisions

    Positive signal to proxy advisory firms (e.g., ISS, Glass

    Lewis)

    Valuation discount allows reduction to total expense or

    increase in # awards granted

    Absent an aggressive valuation approach, available

    techniques are relatively straightforward

    Improved proxy story

    Cons

    Limited market adoption to date = potential for

    competitive disconnects between companies

    May worsen an executive’s already poorly diversified

    wealth concentration

    Not-so-hot comments given by SEC in response to

    valuation discount available

    Ambiguous shareholder story if valuation discount is

    plowed back into more shares (which is dilutive)

    Administration and tracking of share lockup and

    different withholding timings

    Our views:

     Tough to un-ring the bell – once you do it, difficult to eliminate the provision

     Concerns regarding eventual audit and SEC view toward valuation discount

     Reasonable for some companies, but benefits also achievable in other ways

  • Weird Expensing

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     Vest period is not always same as expense period.

     Example: Grant Date 1/1/17; valuation $3,000; 3-year cliff vest.

    – Grant #1: VSD is before GD  Expense period < 3 years (i.e. vest period)

    – Grant #2: VSD is same as GD  Expense period = 3 years (i.e. vest period)

    – Grant #3: VSD is after GD  Expense period > 3 years (i.e. vest period)

    WEIRD EXPENSING Time-Based Awards – SL Expense

    SL Expense

    Year

    GRANT # 1

    VSD: 1/1/16

    Grant Date: 1/1/17

    VED: 1/1/2019

    GRANT # 2

    VSD: 1/1/17

    Grant Date: 1/1/17

    VED: 1/1/2020

    GRANT # 3

    VSD: 1/1/18

    Grant Date: 1/1/17

    VED: 1/1/2021

    1/1/2017 $ 0 $ 0 $ 0

    1/1/2018 $ 1,500 $1,000 $ 750

    1/1/2019 $ 1,500 $1,000 $ 750

    1/1/2020 $ 0 $1,000 $ 750

    1/1/2021 $ 0 $ 0 $ 750

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    WEIRD EXPENSING Performance Awards

    Performance Target Market Condition

    Expense Attribution Graded Graded

    Multiplier/Probability Determine expense based on

    probable multiplier

    Ignore – expense at target

    shares

    Expense Acceleration Accelerate expensing if target

    achieved earlier

    Accelerate expensing if target

    achieved earlier

    Forfeiture Rate Application Apply forfeiture rate (unless

    no forfeiture rate policy)

    Apply forfeiture rate (unless

    no forfeiture rate policy)

    Forfeited shares due to

    termination

    To-date expense reversal To-date expense reversal

    Forfeited shares due to

    missed target

    To-date expense reversal No expense reversal

    Fair Value Stock Price on Grant Date Monte Carlo simulation

  • -15-

     Business Combinations & Assumed Awards

    – For assumed awards, total expense is bi-furcated between “pre-combination expense” and “post combination expense”

    – Only the post combination expense is recorded on the books of the acquiring company (pre combination expense is included in the purchase price)

    – Full cancellation of the award results in reversal of full value of the awards

    – For liability awards (marked to market quarterly), if the overall value of award dips below original purchase price, you could have negative expense to date.

    WEIRD EXPENSING Negative Expense-to-Date

  • Bizarre and Unexpected Modifications

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     Modifications that result in lower ASC 718 valuation

     Example:

    – 100 RSUs with a performance condition

    – Fair value $10; two year vesting; Grant Date fair value $1,000

    – Performance condition is unlikely to be met: to-date expense is zero

    – Modified to remove performance condition

    – On date of modification fair value is $7

    – Modification date fair value $700 ($300 less than fair value on Grant Date)

    BIZARRE MODIFICATIONS Performance Awards

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     In an acquisition, the transaction-date fair value forms the expense basis for the acquiring company

     Changes in the treatment of equity awards could result in lower fair values for the replacement awards, cre