Remuneration Value Not the Same as Accounting Cost

Credit Suisse has released a research note revealing that a large number of ASX 100 companies are understating the value of performance rights or shares they are granting to executives under long term incentive plans.

Caution required on using fair value for equity allocation

Under a typical long term incentive plan, an executive has the opportunity to receive a certain amount of money (for example 50% of their fixed remuneration) in shares if they meet certain performance conditions.

Companies will issue performance share rights to the executive reflecting the agreed remuneration value that vests to the executive if the performance conditions are met. In the past, to calculate how many performance shares to issue, the company would normally divide the value of an executives’ long term incentive opportunity by the volume weighted average share price (VWAP) – otherwise known as the face value of the shares.

However, as we noted in December last year, many organisations are using a discounted value for the performance shares instead of the current market value. This discounted value will often be lower than the market value of the shares because it takes into account factors such as the risk of not meeting performance hurdles and foregone dividends. The number of performance shares to be granted rises because of the lower accounting value used for the calculation.

Credit Suisse does not endorse this practice. Neither does Egan Associates. We also agree with Credit Suisse’s reasons for not favouring the practice:

  • There is a fault in the logic of adjusting the value of performance rights downwards to compensate for the risk of not meeting performance hurdles when long term incentives are intended to be a risk-based measure.
  • Transparency is sacrificed.
  • Because not all companies use discounted values to determine LTI awards and those that do so employ different methods to calculate the discounted values, executives’ LTI opportunities become difficult to compare.

Credit Suisse stated that 21 of the around 70 ASX 100 companies it had examined used discounted fair values when allocating equity to executives under long term incentives, with over four times as many rights being issued in one case than would have been granted using the market value of the performance rights.

This report followed another by ISS in March 2014 that also examined the ‘windfall’ to ASX 50 executives of using fair value methodologies to allocate performance shares to the executives. ISS compared the value of performance shares at grant date and vesting based on whether the performance shares had been allocated using the face value or a fair value.

It found that significantly more performance shares were allocated to executives when fair value methodologies were used to determine the number of rights, leading to awards being inflated by over $1 million in some cases.

From Egan Associates’ perspective, this is the most critical area of emerging sensitivity in relation to long term incentive plans, especially as regards its impact on transparency in disclosure to shareholders.

We note that share rights are the dominant vehicle for long term incentive plans today, excepting in emerging and growing smaller market cap companies where options remain an attractive vehicle.

It is our judgement that allocation on the basis of the prevailing share price remains the most appropriate method for LTI grants. In this context, if an executive’s fixed remuneration, for example, was $500,000 and their long term incentive was established at 50% of the fixed remuneration value (that is $250,000) and shares were trading at $10 (VWAP over the ten days prior to the LTI grant issue date), the executive would receive 25,000 rights.

In this situation there is clarity in relation to shareholders’ expectations – that the executive is receiving an incentive opportunity at the current market price of the company’s shares equivalent to 50% of their fixed remuneration, subject to meeting performance and service hurdles.

Whilst we appreciate that Boards will seek independent advice on the accounting treatment for proposed equity grants, such advice should not be adopted to calculate the number of share rights to grant to executives. The issues of allocation value (incentive opportunity to the executive) and the accounting cost to the company are separate.

Where Boards have received specific advice re adopting fair value for determining the LTI grant, they should receive a confirmatory letter to that effect from their advisor.

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