In the last three decades or so, there has been a strong push for a pay-for-performance structure in public companies. This stems from a long period of time of people questioning whether compensation packages (pre pay-for-performance) actually incentivized executives or higher-up managers enough to keep the interests of shareholders in line with theirs. Institutional investors led this fight to tie executive pay to company performance. Many academic studies have shown that the increased habit of tying executive compensation to company performance has led to a substantial increase in shareholder returns over the past decade.
The idea of performance based compensation and tying it to performance, is and has been a hotly debated topic over the past few years. The system in theory correctly aligns managers’ goals to that of shareholders which in turn should increase the value of the economic entity. In most cases this remains true, but in poorly designed compensation packages it can be detrimental to the economic entity as the package can emphasize non-value adding goals or short-term successes rather than longevity and future prosperity of the entity. As stock-based compensation has matured over the years, options have become the most prevalent and valuable form of executive compensation. Options are meant to even more closely align the interests of executives and shareholders, but over the years we have seen that just aligning these interests doesn’t always produce the best outcome as it can push executives and other managers to take more risks, and the line of earnings management and fraud can become blurrier.
Stock-based compensation has a storied past, an interesting reputation now, and a complicated future. In this paper, we set out to see how this complicated mechanism for compensating executives is grounded in the financial statements, and to see if it’s true economic impact is able to be represented fully under current guidance.
What is Stock-Based Compensation?
Stock-based compensation is compensation that is based on the value of a company’s shares. It is typically used to compensate top level executives and managers. By tying compensation to the value of stock makes them have a vested interest in the company’s financial performance which should lead to responsible and strategic decision making in theory. This type of compensation can take different forms such as: shares, restricted share units, stock options, phantom shares, and employee share ownership plans.
Some of the key factors that are important when understanding stock-based compensation and how it is valued are whether it is equity or liability classified, the form that it takes, the grant date, the vesting period, and any conditions that are tied to the compensation package. The key difference to note when classifying these packages between equity and liability is that equity classified awards are always settled in shares, and liability classified awards are settled in cash. The more common classification and usually simpler (the basis for this paper) are equity classified awards.
Another part to look at is what form the award takes as discussed above, and generally the most common forms are stock options or stock in general. When talking about stock and stock options in terms of compensation, it is important to pay attention to the grant date and any conditions attached to the award. The grant date usually occurs when the employee and employer come to an agreed upon compensation package, the board of directors approves the package, the company has become obligated to provide the shares, and the employee has been exposed to changes in the value of stock they are set to receive. All of the conditions need to be met for the grant date to be set, and usually the grant date is equal to that of the board of directors approval. After the grant date, there is a time period over which the award matures, the vesting period, in which a certain condition has to be met. The compensation package isn’t always contingent on a certain condition but more often than not there is at least one if not more conditions that need to be met for the award to fully vest. The conditions can be a service, performance, or market condition. Service conditions are met after a predetermined number of years, set out in the compensation package, are completed. This could also be just referred to as the vesting period. Performance conditions vest after certain performance metrics are met which can be any number of things including accounting metrics or a benchmark to hit relative to a competitor. Market conditions are said to be met when the stock price of a company hits a certain level or falls in line with industry averages. It is important to note that more often than not, multiple conditions are required in compensation packages.
How companies go about expensing and paying out these stock-based compensation packages is central to this paper, but we first need to understand requirements around expensing these packages first. For awards that have a service conditions, the expense is recognized over the period of time in which the service is performed. Awards that have market or performance conditions attached to them require a different type of expensing called “graded vesting,” which is basically front loading the expenses for these awards. Performance condition awards also have another tier for expensing where there must be a trend toward the performance metric, that was set in the package, meaning that there has to be a reasonable expectation that the performance condition will be met to expense the award. These awards are able to be capitalized, if the company chooses to do so, as certain items under current GAAP guidance, and then the company will expense it over the service period.
Mechanics of Stock-based Compensation
To understand the economic impact of stock compensation on a company, we first need to understand how these awards are recorded in the financial statements. We will look at a basic entry for a stock option:
Ex. A
The mechanics of recording the compensation are actually fairly straight forward, and can only vary a little when different conditions, as discussed earlier, are set on these compensation packages. Two important things to note when looking at the mechanics of how to record compensation are what to do when a condition is not met, and a rule attributed to market conditioned awards. If a service or performance condition of the award is not met at all, no compensation cost is recognized for those awards. Compensation cost is recognized for an award that has market condition if the service period is completed no matter if the market condition is satisfied or not. The mechanism for recording this type of compensation remains pretty unchanged across companies, but the tools used by a company to execute these awards will differ which is what we have set out to study.
Problem
The problem that we have set out to study becomes prevalent when companies go to compensate their executives by “pulling different levers,” or using different tools to satisfy their part of the compensation package. We are looking to see if under the current guidance of GAAP for stock-based compensation that it truly represents the complete economic impact to the company. To help illustrate this problem, we will take a look at an example:
Ex. B
Grant Date
Company A agrees to employ Executive B on 1/15/CY in a stock options package
10,000 Shares
Co. A Stock Price 1/15/CY: $10/share
Option Price 1/15/CY: $10/share
Black Scholes Model: $3.24/sh 13.24/sh
Vesting Period of 3 Years: (3.24*10,000)/3 = 10,800 Compensation Expense per year
Executive B Exercises the option 1/15/2021: $15/sh
The part that we have denoted in yellow is where our study will focus. The typical model would tell us that this entry is correct, but as mentioned before companies have different tools at their disposal to use in completing this side of the transaction. The most apparent tool to use would be to use treasury stock in compensating executives. This opens up a whole new line of questions regarding the economic impact to the company, such as how much treasury stock is released or at what price was that treasury stock purchased at in order to compensate the executives. If this was the way the company compensated their executives, what would the mechanics of that look like, and would that ever change the expense side of the transaction. These are questions that we plan to study further and answer the overarching question of whether GAAP guidance provides adequate rules for a company to show the actual economic impact of executive compensation packages.
Tracking a Company
In order to answer this important question about GAAP Guidance on stock-based compensation, we will be looking into one company’s financial statements and supporting filings to trace where compensation is being pulled from. We will be tracking Apple Inc. (AAPL) as the company in this paper, and will be going back twenty years in financials in order to have the most complete picture possible of executive compensation over the years.