ISS has released a report to its subscribers regarding the use of fair value for the allocation of equity in incentive plans, referencing our discussion on the matter in our December 2013 newsletter.
(Australian Accounting Standards Board (AASB) Standard 2 – Share-based Payment (AASB 2) requires companies to expense the value of equity-settled share-based payments to the P&L “by reference to the fair value of the equity instruments granted” as at the date of grant. The use of this valuation technique has been extended by some companies to the allocation of equity to executives for incentive plans.)
In December, we noted that using fair value for this purpose can result in substantially higher equity grants to executives than if the face value of the equity were used.
We used an example where an executive’s LTI potential is set at $1,000,000. With a share price of $10 at grant date, the number of share rights to be granted using face value would be $1,000,000/$10 = 100,000.
The fair value of the share at grant date might only be $5, discounting for the possibility that the performance hurdle and tenure requirement is not met and deducting forecast dividends for the period. If this fair value is used to allocate shares, the executive would receive 200,000 shares instead of 100,000.
We raised the concern that shareholders may not understand this.
In its report, ISS tested the effects of using fair value for equity allocation, analysing performance right grants for S&P/ASX 50 companies.
Of the companies in the index, 36 applied fair value methodologies when allocating equity to executives and one used the face value. The other 14 were excluded for a number of reasons including lack of information on plans.
ISS analysed performance right grants to the lead executive for 17 of the 36 fair value companies.
At grant date, it found that the difference between the face value and fair value of the grants made to the executive was over $1 million for six of the 17 companies. The median discount of fair value valuations compared with the prevailing share price at the grant date was 31.3%.
ISS then calculated how many shares would have been granted if the face value of the equity had been used for allocation and compared those shares’ value at vesting with the value of the shares actually granted using the fair value. For eight of the 17 companies, the value of the latter was close to or over $1 million more than the value of the equity allocated using face value. ISS also noted that in some cases, this inflation of reward to the executive had occurred parallel to low or negative shareholder returns.
Following its analysis, ISS formed a similar conclusion to ours:
Fair value valuation techniques are not entirely transparent as they have the capability to over-remunerate executives when compared with their targeted long-term incentive entitlement. This has the potential to mislead shareholders who are not cognisant of the available treatments for equity incentive awards.
If a Board believes an executive needs a higher equity grant to be retained and rewarded, then we accept they should be granted that amount. However, the value of the grant needs to be clearly disclosed and not hidden via accounting methodologies. Obscuring real grant values risks further regulation, which we do not believe would be in the interests of organisations or their shareholders.