While the potential for tax reform dominates the headlines, we note that significant new accounting rules are nearly upon us and need to command our attention. A newly converged revenue recognition standard that the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued on May 28, 2014 generally becomes effective in 2018 (i.e., for U.S. companies, annual reporting periods beginning after December 15, 2017). This raises some important considerations for compensation professionals.
- Most incentive plan measures are potentially impacted by this change. Plans that measure revenue, earnings, cash flow and returns on capital are all potentially directly impacted, while relative total shareholder return is potentially indirectly impacted. Operating metrics like production volume, quality, and safety, as well as individual results, would not seem to be impacted.
- Outstanding, multi-year incentive plans tied to financial results measured in 2018 and thereafter will be affected by a change in accounting standards.
- Incentive plan goals and ranges for 2018 and beyond will be set in a new regime, in many cases with limited understanding of how past performance and volatility might have differed under the new regime.
Varying degrees of impact
There’s work to be done to gauge the extent to which your company can anticipate the impact of the new revenue recognition rules and the extent to which the compensation committee can make adjustments at the conclusion of the performance cycle. Importantly, under the new rules, the timing of revenue recognition may create more revenue and earnings volatility than under current rules.
- The rules are likely to affect different industries in different ways, although some industries may not be affected greatly at all.
- We expect that companies in industries where the new rules will create a timing difference in the recognition of revenue may make changes to their contracts to offset some of the impact to financial statements.
Incentive plan implications
Many shareholder approved incentive plans provide broad language suggesting that the compensation committee has the ability to ignore changes in accounting standards that occur during the performance period. Whether there’s an impact on outstanding incentive plans may be a function of the precise language in the plan, and whether ignoring these changes is required or merely permissible. Because companies already may have altered their contracts with customers and vendors to take better advantage of the new rules’ changes, this issue is more difficult to manage.
Some plans provide that the company “shall exclude” the impact of a change in accounting standards when determining the degree of goal achievement. For existing performance measurement periods that began before 2018, it appears they would be obligated to continue under the prior revenue recognition standard, keeping in mind that their contracting language may already have been changed. This could create a disconnect between expected results under the prior rules and whether contract language changes have had a material impact. For performance periods starting in 2018, counsel should confirm whether they would be required to apply the new standards since those are effective for 2018 fiscal years.
Other plans include permissive language stating that the company “may exclude” the impact of accounting rule changes for purposes of measuring plan performance against goals. For existing performance measurement periods that began before 2018, compensation committees will then need to determine, at the end of the performance period, whether the impact of the new standard is material and if they wish to exclude its impact. If this right is exercised, the impact of the change may be a modification of the award that potentially triggers additional expense. For plans commencing in 2018 and thereafter, we presume companies would adopt the new standard in setting goals for future performance periods.
Looking ahead, companies should consider whether and how incentive plan metrics and goals for plans commencing in or after 2018 should evolve from past practice. For those companies anticipating a material impact from the change in revenue recognition, it may be that a different goal-setting framework is required, i.e., wider ranges around the target goal if revenues and earnings are likely to be more volatile. And in some cases, it may be that different measure(s) are preferable.
- Coordinate with finance to understand whether the new revenue recognition rule is likely to have a material impact on the company’s financial results. Understand how the changes to revenues cascade into different results in performance measures used by incentive plans. For some companies, the answer may be that they don’t yet know, which makes this transition much trickier.
- Review incentive plan documents and award agreements to determine whether changes in accounting standards are automatically excluded (“shall exclude”) or at the committee’s discretion (“may exclude”). Determine whether there would be an accounting charge associated with modifying the award, if permissible, and estimate the potential expense.
- Consider whether and how incentive plan goals and ranges for new performance periods may need to evolve based on different forecasts and volatility under the new revenue recognition rule. Investigate what the historical financial statements would have looked like, including the volatility of results, to have a sound basis for setting 2018 incentive plan goals with a better historical perspective about performance.
Steve Kline, CFA, is a director in the Pittsburgh office who leads Willis Towers Watson’s efforts to develop innovative approaches to pay-for-performance measurement and analysis. Steve Seelig is a regulatory advisor specializing in executive compensation in Willis Towers Watson’s Research and Innovation Center. Email firstname.lastname@example.org, email@example.com or firstname.lastname@example.org.