Sunday, June 05, 2011

Proposed Regulations on Incentive-Based Compensation Raise Corporate Governance and Accounting Concerns Says Big Four Firm

Proposed regulations implementing Dodd-Frank incentive- based compensation arrangement provisions would have unintended corporate governance consequences and significant accounting consequences, said a Big Four accounting firm. In a letter to the SEC and federal banking regulators, KPMG LLP also noted that the proposal does not provide transition guidance for existing compensation arrangements. Based on Section 956 of Dodd-Frank, the proposal would establish a general rule that a covered financial institution may not establish or maintain any incentive-based compensation arrangement that exposes the institution to inappropriate risks.

The proposed regulations would require covered financial institutions to retain the ability to claw back awards during the deferral period to reflect actual losses or other measures or aspects of performance that are realized or become better known during the deferral period. According to KPMG, the way a firm implements this provision may impact the grant date for its share-based compensation arrangements.

Current U.S. accounting standards require entities to measure compensation for equity-classified share-based compensation arrangements based on the fair value of the awards on the grant date with no adjustment for subsequent changes in fair value. A necessary condition for a grant date is a mutual understanding between the employer and employee about the significant terms and conditions of the award. To have a grant date for awards that would be subject to a deferral period after vesting or a claw back provision, noted KPMG, it would be necessary to specify and communicate to the employee the terms and conditions of the deferral or claw back provisions including, for example, the length of the deferral period and the rate at which units of the award will be released during the deferral period.

If the terms of an award of share-based compensation are not adequately described so that a mutual understanding between the employer and the employee exists, or if the firm’s governing body designs the plan to retain significant discretion about when it might claw back an award, there would not be a grant date until the end of the deferral period. In this circumstance, the fair value of the award would be measured at the end of each period and any adjustment for the change in fair value (up or down) since the last measurement and additional service rendered would be recorded in earnings. The fair value of the award would be updated each period until the earlier of a grant date or the resolution of the claw back provision, observed KPMG, which would potentially introduce significant volatility to a covered institution’s financial results.

Current U.S. accounting standards require modification accounting for any change to an award’s terms. If the fair value of an award immediately after a modification is greater than the fair value of the award immediately prior to the modification, the difference is measured as incremental compensation cost and is recorded over the remaining service period. If the fair value immediately after a modification is equal or lower, then no change is recorded to the previously-measured compensation cost. A modification to add a three-year deferral period with objectively determinable criteria to an existing award would generally be expected to reduce the fair value of the existing award, noted KPMG, in which case the modification would have no accounting consequence. If subjective claw back provisions are added to the terms of an award, there may no longer be a grant date and the award would be accounted for based on its fair value each period until the end of the deferral period. However, when an equity-classified award is modified, the fair value of the award at the original grant date would be the minimum amount of compensation that should be recognized.

When share-based payment arrangements are modified, there also may be significant income tax consequences for a financial institution or its employees. Even when there are no accounting consequences for modifications, the tax effects could include the disallowance of the deductibility of an award, the disqualification of an award as an incentive stock option, or excise taxes being assessed to the holder of the award

In order to alleviate these concerns, KPMG urged the regulators to modify the proposed regulations to provide that, to the extent compliance would result in substantial adverse tax or accounting consequences, the firm’s governing body may limit its claw back authority to the extent necessary to avoid such consequences. KPMG noted that a similar provision was incorporated into the recommended standards for compensation policies that the Office of the Special Master for TARP Executive Compensation released in July 2010.

The accounting firm also urged the SEC and bank regulators to require that any assessment of whether an incentive compensation arrangement encourages excessive risks be made only as of the date the arrangement is first awarded and not also over the award’s performance period. Doing so would alleviate concerns that the company would have to eliminate the incentive arrangement or reduce the incentive targets if a post-award evaluation revealed that the firm was so far behind achieving the performance target that continuing to maintain the incentive compensation arrangement could expose the firm to an inappropriate risk as management attempts to make up lost ground.

In addition, modifying the program to reduce the incentive targets, and thereby potentially rewarding executives that fail to achieve the original performance objectives, would risk the possibility of changing a compensation arrangement that shareholders may have previously approved in a say on pay vote, as well as losing the ability to report a tax deduction for awards granted to the most senior executives if the revised targets are met.