Why do Companies use Fair Value?

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Credit Suisse has released a further research note investigating organisations’ use of fair value to allocate equity under incentive plans.

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The fair value of a performance share or right 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.

We consider such values to be appropriate for expensing grants to the P&L, but not to define the number of instruments to be granted to executives under incentive plans because it inflates the number of shares executives receive. (See our discussion on the matter here, with examples.)

As mentioned in our June newsletter, Credit Suisse ‘s last research note examined how many companies were using fair value rather than market value to allocate equity – 21 of the 70 companies it examined. The new report publishes the reasons organisations provided for doing so.

The four main reasons were:

  1. Fair value appropriately reflects the value of the reward
  2. It is consistent with market practice
  3. It is consistent with the accounting standards
  4. It allows for the estimated dividend yield

Credit Suisse disagreed with these points. Our thoughts are below:

Point 1:

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 at risk and subject to future performance outcomes.

Regardless of whether performance shares, options or cash is the reward vehicle, a long term incentive award represents a maximum potential earning opportunity. An amount of money or equity is locked away in whatever instrument is deemed appropriate: the possibility that participants will not receive all of the award does not diminish the amount of the award they could receive.

After all, if an executive exceeds expectations and receives all of their long term incentive, is the incentive worth less than market value to the executive at that point?

Even disregarding the above argument, fair value does not reflect shareholder expectations of the value of the award.

Point 2:

When international organisations were collectively taking excessive risks in the lead up to the global financial crisis, it was considered normal and everyone was doing it. This mindset did not save those organisations from the eventual consequences. Even if a practice is being adopted by multiple companies, Boards must use their own moral compass and powers of reason to decide if it truly is best practice.

Point 3:

As previously stated, accounting cost to the company and value to an executive are two different things.

It is appropriate to use fair value to determine the cost of the incentive to the company. The company has to comply with accounting standards and expense STI awards to the P&L – accounting value is affected by the likelihood of the company meeting the performance hurdles.

Point 4:

This point is less contentious, but it is our opinion that until an executive has met the performance requirements and is entitled to an award, they should not be entitled to dividends. Therefore, dividends should not be considered when calculating the value of long term incentive instruments for the purpose of allocating instruments under the program.

Additional Points:

Another point that companies did not volunteer but Credit Suisse considered might come into play was that companies were intentionally applying discounts to inflate LTI awards to retain talented executives or due to executive pressure on the Board regarding remuneration. We consider it likely this is occurring in some cases.

As Credit Suisse stated, shareholders are making decisions based on the information companies disclose in their remuneration reports. Utilising fair value to allocate equity and then disclosing the fair value of grants creates a distorted impression of how much remuneration executives can receive under incentive plans. It may be that higher long term incentive levels are necessary to retain and motivate employees, but disclosure should reflect the true value of the incentive the executive can potentially receive.

We understand that changing disclosure to reflect this may cause some concern among shareholders, but improved transparency now may avoid problems at a later date. Two out of the 21 companies using fair value to allocate equity had the use of fair value enshrined in the CEO’s contract. This will make difficult any transition from using fair value. We question whether the inclusion of such terms in the contract is appropriate.

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