Making Changes to Pay Plans? Don't Forget the Accounting

Changes to pay plans often come with substantial accounting consequences.

As public companies gravitate toward performance-based executive compensation plans, for example, they face more mark-to-market accounting. Now some accounting experts are advising companies to make it easier for themselves on the accounting side by considering more objective criteria.

“It certainly must not be accountants designing these plans,” says Doug Reynolds, a partner at Grant Thornton. “The people charged with governance are running a business and trying to maximize shareholder value, so they're really trying to find a way to reward the best behavior. But the accountants are saying, ‘My goodness, this adds complication.'”

According to the latest analysis from Towers Watson, a human resources consulting firm, one of the most noteworthy shifts in executive compensation in the past few years is the continued growth in performance-based long-term incentive plans. At least 44 percent of the Standard & Poor's 1500 now have long-term performance plans in place for top executives, with more than one-in-four companies measuring performance based on total return to shareholders. Only 18 percent of those companies based compensation on that performance metric in 2008, says Towers Watson. Meanwhile, companies are abandoning other measures: earnings per share, which once stood as the gold standard of performance metrics, is now the top pay metric for only 40 percent of companies.

Companies are shifting their compensation strategies in part because the credit crisis exposed numerous cases where executives raked in generous salaries and bonuses even as companies were deteriorating, says Ken Stoler, a partner with PwC. Proxy advisory firms are pressuring companies to base compensation on measures of profitability, such as total shareholder return, says Randy Ramirez, senior director with the compensation and benefits practice at BDO USA. “The proxy advisory firms have exerted an enormous amount of influence in the past proxy season,” he says.

Many companies are getting the message and doing a better job of tying pay to performance.  As the market has floundered, executive compensation has followed, Towers Watson's analysis shows. Annual bonuses for executives dropped 16 percent from 2011 to 2012, just as companies experienced significant slowdowns in sales and earnings, the firm says.

Many companies are moving toward what Reynolds describes as “blended plans,” or plans where executives earn some equity-based awards that vest based on service and others that are awarded only if or when the company meets some performance metric, such as earnings target or stock-price appreciation. That means the accounting staff must make some judgments about the probability of meeting those targets, and therefore the likelihood that the company will pay certain amounts to executives. Those estimates are revisited and adjusted each quarter, then can be reported with certainty when results are known at year-end.

Based on market conditions and recent trends, some companies are making or considering modifications to equity-based compensation, giving rise to further accounting considerations, says Stoler. “There are so many different types of equity restructurings,” he says. Among those are modifications due to non-recurring dividends and spinoffs, which are both on the rise and tend to drive the price of the stock down. Many companies paid big, one-time dividends at the end of 2012 to beat an anticipated tax increase with the start of 2013, which had an immediate effect on stock price. Companies also take a hit when a subsidiary or division is spun out of the parent company.

TOWERS WATSON SUMMARY

Below is an excerpt from the Towers Watson release relating to its CEO compensation analysis.

Growth in compensation for chief executive officers (CEOs) at the nation's largest corporations slowed considerably in 2012, reflecting weakening company financial performance last year, according to a new analysis of proxies by global professional services company Towers Watson.

The Towers Watson analysis found that total pay for CEOs increased just 1.2 percent in 2012, down from the 6.7 percent median increase CEOs received in 2011. Total pay, as reported in the Summary Compensation Table in company proxy statements, includes base salary, actual annual and long-term cash bonuses, and the grant-date value of long-term incentives including stock options, restricted stock and long-term performance shares. The smaller increase in total pay was driven largely by a steep decline in annual bonuses. While salary increases declined slightly last year—from 3.0 percent in 2011 to 2.8 percent in 2012—annual bonuses paid to CEOs dropped by 16 percent at the median, compared to 2011, when bonuses were relatively flat. Target long-term incentives, the largest component of executive pay in major companies, were up 5.6 percent at the median in 2012.

The analysis, based on 270 S&P 1500 companies that filed proxies disclosing 2012 pay by late March, also revealed that the percentage of CEOs who received bonuses that were at or below target levels increased from 47 percent in 2011 to 58 percent last year. This can be mostly attributed to a significant slowdown in sales and earnings that companies experienced in 2012.

“The fact that many CEOs saw their bonuses take a significant hit and Summary Compensation Table pay was relatively flat suggests the companies and their boards took a conservative approach to pay in 2012,” said Todd Lippincott, leader of Executive Compensation consulting at Towers Watson for the Americas.

One of the most noteworthy shifts in executive compensation is the continuing growth in performance-based long-term incentive plans. Almost half (44 percent) of S&P 1500 companies now have long-term performance plans in place, according to the Towers Watson analysis. Total return to shareholders is now the most prevalent performance metric that companies use to base long-term incentive plan awards. More than four in 10 companies (41 percent) now use this measure, compared with just 18 percent that used this metric in 2008. Earnings per share, historically the most prevalent measure, is now used by 40 percent of companies.

Strong shareholder support for say on pay in its third year

The analysis also found that in the third year for mandatory say-on-pay votes, 160 of the Russell 3000 companies that have disclosed their shareholder voting results so far reported average support of 90 percent of the votes cast this year. This is consistent with last year's voting results. Only three companies in this sample failed to win majority support for their say-on-pay resolution so far this year.

“While the say-on-pay experience has been positive for most companies, we continue to see a small number of cases in which shareholders use the vote to send companies a message about pay and performance,” Lippincott said. “Our research shows that companies with poor shareholder returns were five times as likely as other companies to receive low say-on-pay support, while those with high CEO pay opportunities were eight times as likely.”

Other findings from the Towers Watson proxy analysis include:

One in four (26 percent) companies provided supplemental charts describing the relationship between pay and performance in their 2013 proxies. That's an increase from 17 percent in 2012 and 9 percent in 2011.

More companies are disclosing alternative measures of pay in their proxy statements. Of those that included a pay-for-performance summary, almost three-quarters use a definition other than Summary Compensation Table pay in their analyses.

Source: Towers Watson.

When such actions lower the stock price, they also cause outstanding stock option awards to decline. If a one-time dividend, spinoff, or other action pushes the stock price below the grant date price, the holder is “under water,” or holding a worthless benefit. Companies may modify stock option awards in such situations, but they also need to consider the accounting consequences, which might include the need to recognize more expense, Stoler says.

At audit firm EisnerAmper, partner Jim Hatch says companies are moving away from stock options toward more restricted stock awards, partly due to such concerns. “Under a stock option, you only have value if the share price goes up from the grant date,” he says. “Under restricted stock, whether the price goes up or down, the executive has some value.” An often underestimated bonus is that the accounting is easier. Stock options must be valued using complicated models, but restricted stock is easily priced based on trading. “You just look at the value of a share and expense it as it vests,” he says.

Attack of the Clawback

Companies are also wrestling with new requirements of the Dodd-Frank Act to add clawback provisions to executive contracts, but they still don't have guidance from the Securities and Exchange Commission on how to craft such provisions. Many companies aren't waiting for the guidance, and it's leading to a wide variety of approaches to such provisions, says Hatch. “The clawback provisions we are seeing are all over the place,” he says.

Stoler explains that accounting literature tells accountants not to account for clawback provisions, which are understood to enable companies to recapture executive compensation where there is clear evidence of wrongdoing that harms the company materially, such as a fraud or a restatement. Accountants can assume executives are doing the right thing and need not consider a probability for such disaster to strike.

As some companies daft their clawback provisions, however, they are starting to use language that goes beyond the boundaries of wrongdoing and using criteria that could be viewed as performance related. Accountants and auditors should pay attention to such language and consider whether it adds uncertainty to compensation awards that must be considered in the accounting, Stoler says. “If you put too much discretion into determining what will trigger a clawback, that has the potential to cause mark-to-market accounting,” he says.

Reynolds also cautions companies against including too much discretionary language in contract provisions. Objective criteria leads to much more straightforward accounting and auditing, he says. “It's the ‘may' or ‘might' as opposed to ‘shall' or ‘will,” Reynolds says. “The more objective it is, the better it is from an auditor's perspective.”

Chris Wright, managing director at consulting firm Protiviti, says companies have grown more accustomed to dealing with uncertainty in accounting. “The market conditions of the past few years have added a degree of difficulty to the estimation of value of a given stock option or stock award,” he says. “But the rules do provide fair value that allows companies to comply with those regulations. The challenge for those companies is to have a robust estimation process and a robust documentation process, so they are able to contemporaneously document what they were thinking at the time and survive the benefit of hindsight at a later date.”