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.

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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

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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, creating “destruction of value”. Example:

– Original award terms: vested options will be assumed by the acquirer

Fair value = intrinsic value + time value

– Merger agreement terms: vested options will be paid out in cash

Fair value = intrinsic value only

As the modification was made for the acquirer’s benefit, it seems counterintuitive to allocate expense based on the lower value of the replacement awards

– Common approach: apply a “floor” based on the premodification fair value

BIZARRE MODIFICATIONS Value Destruction in M&A Transactions

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Modifying the target for a performance RSU award with scaled payout levels may change the expected multiplier as of the modification date

Example:

– Expected payout for current target : 70%

– Expected payout for modified target: 120%

Two modification frameworks may apply for this award:

– Type I (probable-to-probable) modification on 70% of the shares

Expense based on grant date fair value + any incremental cost as of modification

– Type III (improbable-to-probable) modification on 50% of the shares that would have forfeited otherwise

Expense based on modification date fair value

BIZARRE MODIFICATIONS Resetting Performance Targets

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Grant date fair values are determined at start of offering period for each of the purchase periods

Modification accounting when

– Employee increases contribution %

– Plan automatically resets to a decreased purchase price at beginning of new purchase period

No change in accounting expense if employee

– Decreases contribution % during offering period

Reversal of to-date expense if employee

– Terminates employment during offering period (forfeiture)

No Reversal of to-date expense if employee

– Terminates employment during offering period (withdrawal)

UNEXPECTED MODIFICATIONS Cadillac ESPP with Look Back

Peculiar EPS Issues

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ASC 718: Expense multiplier drives expense calculations

ASC 260: # of shares to pay out at period end drive dilution

– Example:

– 100 Performance RSUs; $10 fair value; 75% into vesting period

– Estimation is that achievement will be at 150% multiplier; i.e. 150 shares

– Currently met performance for 50 shares

INCONSISTENT ACCOUNTING EPS - Contingently Issuable Shares

Expense at 150% Shares at 50%

Expense to date (100 shares * $10 * 150%)

* 75% = $1,125

Not Calculated

Unrecognized Expense (100 shares * $10 * 150%)

* 25% = $375

Not Calculated

Weighted Shares

Outstanding

Not Calculated

(100 shares * 50%) = 50

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ASC 260 requires computation of a YTD average of dilutive shares by quarter vs. independent YTD computation based on updated period assumptions

Differences in method would occur when:

– Options that were underwater on a QTD basis but not on a YTD basis

– Changing performance payout factors in interim quarterly periods

– ESPP awards where the average market price in interim periods is lower than enrollment price

– Interim quarterly net loss which turns to profit in the YTD period

ASC 260-10-55-3:

EPS – YEAR TO DATE VS AVERAGE OF 4Q’S

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Inclusion of unsettled RSU’s where the requisite service

is met in basic as opposed to dilutive EPS

Per ASC 260

– Include all share options and nonvested shares in dilutive calculation

– If issuance is no longer contingent upon future service requirements, shares should be included in basic EPS as of the date that all necessary conditions have been satisfied

ASC 260-10-45-13:

EPS & RETIREMENT ELIGIBLE RS

Additional Oddities

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Performance target date is before vest end date

– Service period ends on vest end date

– Included in EPS Dilution when performance target is met

– Example:

Performance period ends December 31st - Target is met

Service period ends March 31st

Expense amortization thru March 31st

EPS Dilution: include dilution impact of awards as of beginning of Q4 (qtrly EPS)

Performance target end December 31st but shares are not released until target has been board certified

– Service period ends on certification date

– Include in EPS Dilution when performance target is met, if board certification is perfunctory

Example: Annual cash bonus deferral program

CHALLENGING VEST END DATES Contingently Issuable Shares

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WHACKY WINDFALLS AND SHORTFALLS

[A] Grant

Date Fair

Value

[B] Settlement

Intrinsic Value

[C] Settlement

Intrinsic Value

• GAAP expense based on grant date

fair value; IRS tax based on

settlement value (“temporary

difference”)

• Tax windfall: B > A

• Tax shortfall: C < A

• Where should this be recorded?

Prior Guidance New Guidance

Record windfalls (excess benefits) and shortfalls

(deficiencies) to additional paid-in-capital (APIC) –

balance sheet

Track cumulative windfalls through off balance sheet

“APIC pool” account

Record to P&L only if APIC pool reaches 0

Record windfalls and shortfalls directly to the P&L

(income statement as tax expense or benefit)

Eliminate APIC pool

B

C

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PROBLEMATIC TAX DEFICIENCIES

2012 2013 2014 2015 2016

R

R

R

R

O

Pre ASU 2016-09 Amended Guidance % Change

Pre-tax income $1,600 $1,600

Provision for income taxes $400 $475 -12.5%

Net income $1,200 $1,125 4.17%

Effective tax rate 25% 29.69% -12.5%

Basic EPS $0.60 $0.57 4.17%

Diluted EPS $0.59 $0.56 3.96%

Dilutive shares 2,020 2,024 0.20%

Settlement produces

excess tax benefit

Settlement produces

tax deficiency

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TRICKY TAX SETTLEMENT FORECASTING

2012 2013 2014 2015 2016 2017 2018 2019

2012 annual grant (Sg = $30 / Ss = $40)

2012 off-cycle grant (Sg = $34 / Ss = $40)

2013 annual grant (Sg = $38 / Ss = $25)

2014 annual grant (Sg = $44 / Ss = $39)

2008 option

(Sg = $50) Settlement event

2015 annual grant (Sg = $47 / Ss = $51)

Sg = stock price at

grant

Ss = stock price at

settlement

Forecasting and scenario analysis are useful when there are a range of potential outcomes

They reduce surprises and create insight into the drivers capable of influencing a result

Some companies have always performed tax settlement forecasting

FASB’s impending revisions will likely make tax settlement forecasting an essential staple

The basics: form assumptions related to (1) option settlement timing, (2) future stock prices, (3) future hypothetical grants,

(4) performance outcomes, and (5) tax rates

Questions?

Parting Thoughts

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WEIRD & CHALLENGING ACCOUNTING Contact Information

Steve Tamsula, CEP VP, Equity & Executive Compensation Finance

Direct: (412) 762-5006 E-mail: steve.tamsula@pnc.com

www.pnc.com

Rado Kanev Manager, Financial Reporting Services

Direct: (480) 428-3334 E-mail: radostin.kanev@equitymethods.com

www.equitymethods.com

Nathan O’Connor Managing Director

Direct: (480) 428-1205 E-mail: nathan.oconnor@equitymethods.com

www.equitymethods.com