Reconsidering Realization-Based Accounting for Equity Compensation

The U.S. equity compensation landscape continues to evolve. Recent innovations have improved the linkage between pay and firm-specific performance, but have added complexity. Against that backdrop, this Article urges reconsideration of the accounting rules for equity pay. Under current rules, most equity pay awards are expensed based on grant date valuation with no updating for changes in value post grant. This Article advocates the adoption of a mark-to-market or realization-based approach under which the expense recorded for all equity pay awards would ultimately be trued to the value received by employees. Increasingly, equity pay awards are more analogous to commissions than to arm’s length investments, and the tighter link between pay and firm-specific performance suggests that including post-grant changes in equity pay award values in compensation expense tends to improve accuracy, not just add noise. In addition, increased complexity leads to greater ex ante valuation uncertainty and gaming opportunities, suggesting de-emphasizing reliance on ex ante measurement to the extent possible. Realization-based accounting also produces book/tax conformity for equity pay, which further combats gaming, and it levels the accounting playing field for equity instruments, minimizing accounting-induced distortions in pay design. The Article also argues that concerns that realization-based accounting will add an unacceptable level of uncertainty or volatility into compensation expense can be mitigated.