Highlights from the 25th Annual NASPP Conference

Our professionals stayed busy at this year’s annual NASPP conference in Washington, DC, hosting a number of interesting presentations and roundtables. Here’s a summary of the talks we gave over the course of the week.

Performance Awards

Takis Makridis and AmyLynn Flood facilitated a session during the pre-conference workshop, focusing on advanced accounting issues related to performance awards. Performance awards are becoming more complex as multiple metrics gain favor.

The panel discussed some common flavors of performance equity. The most notable of these is the popular “hybrid award,” which combines a market metric like total shareholder return (TSR) with one or more financial or operational metrics. Metrics can be combined in an independent (additive) capacity. They can also be interdependent whereby one metric modifies the others. In either case, the accounting becomes tricky since performance conditions and market conditions are handled very differently under ASC 718.

A few areas tend to trip companies up. One is determining whether there are one or multiple grant dates. Another is handling performance awards converted in M&A or spinout transactions. And then there’s figuring out how to set up awards in the plan administration system.

Because performance awards now come in so many shapes and sizes, it’s important to know how to bridge terms in a grant agreement with the theoretical constructs in ASC 718. Also critical: making sure the reporting process is robust to the accounting policy, since small nuances in how the awards are set up in a system can wreak havoc on the accounting. Finally, companies should test the accounting all the way through EPS, deferred taxes, and disclosure.

Hot Topics of 2017

Takis, Mike Melbinger, and Art Meyer discussed the year’s hottest topics. First up? CEO pay ratio, which is set to go live in 2018.

The SEC’s September 2017 guidance helped to clarify whether the calculation should include independent contractors. In other guidance, the SEC indicated that while it isn’t looking to second-guess every assumption going into the calculation, it does expect the assumptions to be reasonable and the calculation to be carried out in a thoughtful way.

The speakers also reviewed the limitations of statistical sampling, considerations in selecting a consistently applied compensation measure (CACM), pros and cons of supplementary disclosures, and internal communication strategies.

After wrapping up pay ratio, the panel shifted to a variety of other industry happenings. On the accounting side, ASU 2016-09 is causing consternation among tax departments as they deal with tax rate and tax expense volatility. ASU 2017-09 aimed to simplify modification accounting, but really did very little to change the overall framework and practices in place.

In the compensation space, plan for considerable goal-setting difficulty as the new revenue recognition standard goes live in 2018. ISS policy changes are also likely to shake up the 2018 proxy season, leading to further evolutions in design strategy.

Non-GAAP Metrics

Takis, Kelly Malafis, and Dave Thomas ran a session on the use of non-GAAP metrics in long-term incentive plans (LTIPs).

An effective LTIP not only links executive pay to shareholder return, but also helps executives believe they have some influence over their pay. The use of as-reported GAAP numbers may interfere with that line of sight. As a result, more companies are turning to non-GAAP metrics to alleviate line-of-sight difficulties.

Non-GAAP adjustments range from the well-accepted (e.g., adjusting for the effect of accounting standard changes) to the somewhat controversial (e.g., backing out foreign exchange or interest rate gains and losses). Whatever the approach, it’s important to document a series of principles that will be applied consistently. The principles may lead to a higher payout or a lower payout, showing that management is not trying to cherry-pick its results.

A final takeaway is to socialize the approach among the finance leadership, compensation committee, and other stakeholders. Finance may need to run the language by the external audit firm so they don’t inadvertently create accounting grant date or modification issues. The compensation committee needs to know how much discretion will be exercised so that they can defend the approach.

Tour de Stock Ownership Guidelines

Nathan O’Connor, Michelle Tomasetti, and David Lanka of Bank of America Merrill Lynch provided a tour of stock ownership guidelines. These are policies that establish the level of company stock ownership that executives or outside directors are expected to maintain. Companies put them in place to align the financial interests of executives with those of shareholders, and to build an ownership mentality among executives. Proxy advisors and institutional shareholders consider stock ownership guidelines a sign of good corporate governance.

There are a number of different ways to structure ownership guidelines. Companies can base them on a multiple of the executive’s salary, a fixed number of shares, a fixed dollar value, or some combination of these approaches. If the company incorporates a post-vest holding restriction that requires shares received to be held for a certain amount of time, this will benefit the company on its ISS Equity Plan Scorecard. Sometimes, the presence of this holding restriction can also lead to a discount in the fair value of the stock award, enabling the company to grant more awards to its executives. However, there are potential drawbacks that should be thought through before implementing these kinds of restrictions.

Ownership guidelines can be tricky to track and maintain. Companies must determine which department will be responsible for tracking compliance with the policy. They also have to consider how it will be tracked, addressing issues such as integration of the company’s systems with the broker’s. Finally, firms should be communicating the policy so that people understand its purpose, how and when ownership will be measured, and the minimum requirements and timeframe for compliance.

Behavioral Biases in Performance Award Metric Setting

Josh Schaeffer gave a talk on common psychological biases and their effects on award setting.

The increasing complexity of performance award designs makes it all the more critical to keep payouts consistent with the award’s intent. Therefore, companies should watch out for cognitive biases such as overconfidence (failing to properly calibrate probabilities) and anchoring (relying too much on recent data). Either of these can cause range forecasts to veer significantly from what a rigorous analysis of data would suggest. Another common bias is to overweight improbable events (like plane crashes) against more probable but less dramatic events (like car crashes). This can skew the forecasting of critical business conclusions. Understanding these biases and their potential impact can be tremendously helpful for optimizing a company’s grant program.

People also have biases in the way they respond to incentives. One is idiosyncratic fit, or the fact that people will do more to satisfy incentives they feel are tailored to them (such as number of units sold) instead of those that are general (such as revenues). Another bias is framing. That’s where people work harder to avoid perceived losses than to generate perceived gains.

Financial Reporting Practices of Best-in-Class Companies

Raenelle James, Fatou Ba, and Carolina Koch discussed how equity compensation financial reporting can become a trusted function to support everyday decision-making.

Best-in-class corporate functions have strong upward reporting capabilities. Beyond that, they have a commitment to controls that minimizes reliance on manual processes. This enables them to focus on data and the nuances of their award design.

This means best-in-class functions do more than mitigate the inherent risk in their processes. They also have analytics capabilities that put the information they have to use. For example, they might forecast two or three years’ worth of expenses, the dilution impact of stock-based compensation, or the P&L impact of settlements. Other key competencies include variance analysis and flux analysis. Granularity—such as forecasting down to the employee level—is challenging to carry out but a valuable boost to decision support.

Collaboration is another attribute of a best-in-class equity compensation function. Solid relationships with the tax and HR functions are particularly important to reducing information asymmetry in the organization.

The takeaway? Accuracy is important, but the end goal is to enable and support senior-level decision-making. Achieving this level of maturity requires more analytics and a concentration on management accounting.