How Accounting Standard Changes Affect Metric Setting

We have published extensively on FASB’s upcoming revisions to ASC 718. You can read about the proposed revisions to the stock compensation accounting guidelines and what they are likely to mean to you here. A related issue is how accounting standard changes affect the way award performance metrics are determined for stock-based compensation While companies issuing total shareholder return awards need not worry about the effects of accounting policy changes, more than 50 percent of companies still rely on non-TSR financial metrics such as earnings per share and return on invested capital. For these organizations, it’s inevitable that they will set metrics now that will have performance determined after accounting policy changes go into effect.

A number of major accounting policy changes will go into effect soon. Revisions to the revenue recognition guidance in Accounting Standards Update No. 2014-09 will have far-reaching consequences for many companies. ASU 2016-01 will change the accounting for financial instruments. FASB’s revisions to ASC 718 will introduce more volatility to earnings and cause the treasury stock method of ASC 260 to produce a bleaker picture of future dilution. And this is just the beginning.

Questions From the Industry

At a time when picking the right performance metrics and setting the right targets and payout scales is already very difficult, trying to hypothesize the effect of future accounting standard changes and take that hypothesis into account when setting targets will take the problem from bad to worse. Our clients and friends of the firm are asking a number of questions:

• Should we specify in award agreements that performance measurement assessments will be adjusted to exclude the effect of standard changes?
• If a target is set and we adjust for accounting standard changes that occur after the target is set, will this trigger modification accounting?
• Will it be necessary to maintain two sets of books (GAAP books that reflect the accounting standard change and non-GAAP books that exclude the effect of standard changes)?
• If the accounting standard change happens near the grant of an award, should the award agreement specify that the particular accounting change will not be excluded or adjusted out of the performance measurement calculation?
• Should the performance metrics just be set saying something akin to “determined using GAAP standard in effect on the date of grant”?

Boiled down, these questions amount to: How should we design grant agreements today so that we meet our primary goal of having incentive compensation that drives performance without externally modified standards artificially changing the results while avoiding stressful conversations with executives and unfavorable modifications down the road?

Our Thoughts

1. As a general rule, unless the effect of a future accounting standard change is clearly known when a performance target is established, that change should be factored out of a performance measurement calculation. A performance-based award issued in March 2016 will have a performance period of Jan. 1, 2016, to Dec. 31, 2018. When the compensation committee is certifying the performance outcome in early 2019, the effect of standard changes during the performance period should most likely be stripped out. The only reason to do otherwise is if the impact of that accounting change can be precisely quantified today and factored into the metric-setting process.

2. If an accounting standard change is going into effect in 2016, then the effect of that change should probably be included in the performance measurement assessment that occurs in 2019. In that event, the issuer should set the metrics using its best available information regarding how the metrics will change as a result of the accounting standard change.

3. Whatever decision is made (adjusting or not adjusting for the accounting standard change), the grant agreement and compensation committee actions granting the awards should be specific so that modification accounting is not triggered. A modification occurs whenever there is a change to the terms or framework of the award, and the result is often an adverse accounting impact and negative proxy disclosure (if the affected party is a named executive officer). To avoid this, the award agreement language should be drafted to be explicit enough that subsequent calculation adjustments are not construed as deviations.

4. If your award agreements are silent on whether accounting standard changes are included or excluded from the final performance measurement assessment, there are a few potential approaches. First, is there precedent for including or excluding the effect of the change? If so, then acting under precedent is relatively easy and should not trigger a modification, whereas deviating from precedent well could. Second, if an award agreement is silent on too many fronts, an auditor could argue there is not a meeting of the minds upon issuance and therefore it is not possible to establish an ASC 718 grant date.

5. Many companies have told us they are concerned with the prospects of maintaining both their regular GAAP books and non-GAAP books specifically for performance measurement purposes. The difficulty will vary based on that accounting standard change. The revisions to ASC 718 that will cause excess tax benefits and deficiencies flowing through earnings should be easy to adjust: A very specific change is easy to isolate in a single place.A much more holistic standard change that affects multiple systems and processes, such as revenue recognition, may be tougher to back out. Once systems change to handle the new revenue recognition rules, a performance measurement calculation that backs out the effect may not be doable within a system. Instead, a model may need to be created that applies high-level assumptions to the formal GAAP results. When ambiguity cannot be bridged, it may often make sense to assume that the model is favorable toward the executive. To reduce the risk of disagreement with award recipients, the award agreement should create ample room for the compensation committee (and, by extension, those charged with performing the calculations) to make such assumptions.

6. A key nonaccounting consideration is the potential impact on whether an award qualifies as performance-based under Section 162(m). It is important when setting performance metrics that they be locked down during the first 25 percent of the performance period (or within 90 days of the start of the performance period if shorter). When thinking about setting targets or making determinations to include or exclude accounting standard changes, be sure to check with your attorneys or tax advisers if the awards in question are intended to qualify as performance-based compensation under Section 162(m).

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