Compensation clawback provisions under IFRS® Accounting Standards

From the IFRS Institute – December 6, 2024

Authors: Michael Kraehnke and Emili Tzror

Compensation clawback provisions serve as important mechanisms for companies to reclaim previously awarded compensation based on performance metrics, safeguarding financial integrity and ensuring accountability among employees. Under the 2023 SEC Clawback Rules, US listed companies are now required to implement robust clawback policies linked to financial restatements. In the backdrop of the growing use of clawback provisions, the article examines the accounting approaches used in practice due to the lack of explicit accounting guidance in IFRS Accounting Standards.

What is a clawback provision?

A clawback provision is a contractual clause that allows a company to recover previously earned compensation or benefits due to specific circumstances such as fraud or financial restatements. In the current US labor market, clawback provisions are often found in executive compensation agreements and are typically non-negotiable by employees. These provisions ensure that bonuses or share-based compensation awards are retained only when certain conditions are met, serving as a mechanism to hold employees accountable and protect the company's financial integrity.

In some cases, clawback provisions can be applied partially, allowing for a more equitable recovery of compensation. For instance, if an employee's bonus is contingent on achieving specific EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) targets and it’s later determined, subsequent to a clawback circumstance, that only 60% of those targets were met, the company reclaims only 40% of the bonus. This approach acknowledges the employee’s efforts while still enforcing accountability for performance outcomes, helping maintain morale and motivation by linking compensation to actual performance without being overly punitive.

A historical overview of clawback provisions and their significance in modern employment agreements

The clawback provisions have evolved significantly over the years. They initially served to protect a company’s interests by restricting employees from sharing sensitive information or joining competitors after leaving the company. Over time, the scope of clawback provisions has expanded to allow companies to reclaim bonuses or other incentives that are often triggered by misrepresented performance on departure in certain circumstances. The primary purpose of including these clawback provisions in employment agreements is to safeguard the company’s financial integrity and ensure accountability among employees, particularly those in leadership positions.

By enabling firms to recoup compensation tied to misrepresented performance, clawback provisions discourage unethical behavior and promote greater transparency in financial reporting. This alignment of interests between employees and the organization fosters a culture of responsibility, encouraging employees to act in the company’s best interests and consider the long-term implications of their actions. In sum, clawback provisions intend to serve as a deterrent against potential fraud or misrepresentation, help protect the company’s reputation, and incentivize employees to meet or exceed their performance goals responsibly.

The regulatory landscape surrounding clawback provisions has also undergone significant changes over the years. Section 304 of the Sarbanes-Oxley Act of 2002 represented a pivotal moment in this evolution, as it became the first federal statute mandating companies to reclaim certain executives’ pay in response to financial misconduct. This legislative shift highlighted the need for greater accountability in corporate governance. Following the financial crisis of 2008, clawback provisions gained even more prominence as companies sought to reinforce accountability and restore public trust in their financial practices. This trend has continued, fueled by ongoing regulatory changes.

Most recently, the 2023 SEC Clawback Rules established requirements for SEC registrants (including foreign filers), mandating that companies implement clawback policies for erroneously awarded executive compensation. Under the new regulations, public companies must disclose their clawback policies in their annual proxy statements, outlining how they will recover erroneously awarded compensation due to financial misstatements. Specifically, the rules require companies to claw back excess incentive-based compensation awarded to executives when a company restates its financial statements due to material noncompliance with financial reporting requirements, as defined in the rules. This applies to both current and former executives during a ‘recovery period’, which is the three most recently completed fiscal years immediately preceding the date the company determines it is required to prepare an accounting restatement. This ongoing evolution of rules related to clawback provisions over the years reflects the growing recognition of the need for robust accountability mechanisms in corporate governance.

Companies accounting policies for clawback provisions under IFRS Accounting Standards

IFRS Accounting Standards do not provide guidance on accounting for clawback provisions. This lack of clarity can lead to varying interpretations and accounting methods, which may result in diversity in practice for companies that include clawback provisions in their compensation agreements. As a result, organizations must carefully create their own accounting policy for clawback provisions to ensure compliance while also maintaining transparency in their financial statements.

There are at least three accounting methods applied in practice under IFRS Accounting Standards when accounting for clawback provisions. The appropriate method depends on a company’s facts and circumstances.

1. Incorporate the potential for clawback events into the fair value of the compensation award
   
   This approach treats a clawback provision as a nonvesting condition under the share-based payment guidance in IFRS 2¹. That guidance defines a nonvesting condition as a condition that does not meet the definition of a vesting condition and requires that nonvesting conditions be reflected in measuring the initial fair value of an award. By treating clawback provisions as nonvesting conditions, the fair value of the compensation award, when measured, reflects the probability that a clawback event will occur. Typically, that probability at inception is low, and therefore the impact on the initial fair value of the award is likely minimal. Under this approach, consistent with the treatment for a market condition when a nonvesting condition is not met, the cost of the award is not reversed. Instead, the recovery of the shares or receipt of cash is accounted for separately when the clawback event occurs.
   
   
2. Account for clawback provisions when triggered through a current-period adjustment
   
   Under this approach, the probability of the clawback event is not included in the fair value of the award. Instead, clawback provisions are treated as separate transactions that fall outside the scope of IFRS 2. This method is consistent with Topic 718² under US GAAP (see below), where the recognition of a clawback provision is viewed as distinct from the original award granted. By treating it as a separate transaction, the clawback is more akin to a penalty that occurs based on contingent event. When a clawback event occurs, the recovery is accounted for in the period when the claim is made. If the recovery is in the form of shares, there is no profit or loss impact because it represents a treasury share transaction. However, if the recovery is in the form of cash or another asset, a gain or loss is recognized in profit or loss.
   
   
3. Account for clawback provisions when triggered through a retrospective adjustment
   
   Under this approach, like in Approach 2, the probability of the clawback event is not included in the fair value of the award. However, unlike Approach 2, the triggering of a clawback results in a retrospective adjustment, as the initial assumption regarding the award’s vesting was incorrect. This approach is consistent with updating the financial statements for other corrections of errors. 

Comparison to US GAAP

In 2003, the FASB issued FAS 123R³ (now codified in Topic 718), which provided comprehensive guidance on the accounting treatment of stock-based compensation. Topic 718 provides that clawback provisions are not considered in determining the grant-date fair value of the award. Instead, these features are accounted for if and when the contingent event occurs by recognizing:

The amount of consideration recognized is equal to the lesser of (1) the recognized compensation cost related to the share-based payment arrangement that contains the contingent feature or (2) the fair value of the consideration received.

As clawback provisions become more common, companies may face greater scrutiny from regulators and stakeholders regarding their accounting practices and disclosures. In this evolving environment, it is essential for companies to navigate the complexities of clawback provisions by establishing clear, well-documented policies that align with regulatory requirements and best practices. Given the lack of guidance under IFRS Accounting Standards and the potential diversity in practice, companies must develop their own accounting policies for clawback provisions and apply those consistently across all such provisions. The chosen method impacts how clawback provisions influence financial statements, necessitating careful consideration to ensure compliance and transparency.