The landscape for executive pay has been tumultuous in recent years, thanks to the Dodd-Frank Act, investor pressures, and the changing preferences and protocols of proxy advisers. So now let’s throw one of the largest changes in the history of accounting standards into the mix.
In the coming months, public companies are expected to begin implementing policies to comply with the new revenue recognition standard adopted by the Financial Accounting Standards Board last year. The standard, scheduled to go into effect at the start of 2017, reconceives business transactions as a series of performance obligations, with revenue recognized as each obligation within a transaction comes to pass.
The new standard is a tectonic shift in accounting, and it will affect everything from fraud risk assessments to internal control over financial reporting to, yes, executive pay—which is often based on an executive hitting revenue goals. Change the definition of “revenue” and all your pay calculations will feel the consequence.
“To the extent your executive compensation is triggered by company performance, or if there is a clawback for any restatements or errors, the new revenue recognition standards are going to be very difficult,” says Kimberley Anderson, a partner with law firm Dorsey. “Companies are going to struggle with applying it properly.”
Clawbacks may be a particular concern as companies see revenue and earnings assessments fluctuate, perhaps greatly, from what they have been in past years and from what initial estimates assumed.
“For performance metrics that go out a few years, what do you do when you have that change in revenue recognition? Do you have to be able to modify for it? How do you adapt to it? Compensation committees will need to think seriously about the effect of the new rules, especially on performance-based pay,” Anderson says.
“To the extent your executive compensation is triggered by company performance, or if there is a clawback for any restatements or errors, the new revenue recognition standards are going to be very difficult.”
Kimberly Anderson, Partner, Dorsey
“A company's executive compensation plan definitions, calculations, and targets should be evaluated in light of impending changes to its revenue recognition practices,” says Marta Alfonso, a principal with accounting and advisory firm MBAF.
“Executive compensation plan changes should be considered to retain incentives that reward appropriate real growth in a company's revenue and net income.”
The new standard may have unintended consequences on compensation packages that are designed to encourage revenue or net income growth—particularly for companies whose revenue is generated by contracts or make commitments as part of the sales process, such as providing support services to customers, says Robert Dyson, also with MBAF.
“Under the new rules, revenue is recognized when contractual obligations are satisfied, rather than based on the type of contracts or payment terms,” he says. “As a consequence, companies may report lower current revenue if contractual income will be deferred, or less future revenue growth if contractual income will be accelerated.”
Thus far, few companies have dived into an in-depth compensation analysis of how revenue recognition affects pay programs, says Jeff London, a partner with the law firm Kaye Scholer who specializes in compensation design. Bigger concerns, such as compensation disclosure rules pending from the Securities and Exchange Commission, and immediate business, such as upcoming annual meetings, have taken precedent.
“There are things on the horizon that are much more urgent,” he says. “The accounting standards rules have been somewhat falling by the wayside because nobody thinks it’s a crisis.”
Shifts in Focus & in Strategy
London does expect a greater focus on the issue once this year’s annual meetings conclude. “Most, if not all, of the programs that are revenue-driven tend to be short-term programs and more likely to be annual bonus plans than stock compensation plans,” he says. “You have to start thinking about short-term versus long-term, and whether you want to redesign some of those compensation programs. All bonus plans and compensation agreements will need to be reexamined, at least those that are based on metrics derived from revenue.”
REVENUE RECOGNITION IN A NUTSHELL
The following is from an overview of the new revenue recognition standard by the Financial Accounting Standards Board and International Accounting Standards Board.
Revenue is a crucial number to users of financial statements in assessing an entity’s financial performance and position. However, revenue recognition requirements in U.S. generally accepted accounting principles (GAAP) differ from those in International Financial Reporting Standards (IFRSs), and both sets of requirements need improvement. U.S. GAAP comprises broad revenue recognition concepts and numerous requirements for particular industries or transactions that can result in different accounting for economically similar transactions. Although IFRSs have fewer requirements on revenue recognition, the two main revenue recognition standards, IAS 18, Revenue, and IAS 11, Construction Contracts, can be difficult to understand and apply. In addition, IAS 18 provides limited guidance on important topics such as revenue recognition for multiple-element arrangements.
Accordingly, FASB and IASB initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRSs that would:
Remove inconsistencies and weaknesses in existing revenue requirements.
Provide a more robust framework for addressing revenue issues.
Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
Provide more useful information to users of financial statements through improved disclosure requirements.
Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.
Because the new standard will record revenue differently, it may create more volatility and therefore less predictability. As a consequence, London predicts that companies will move away from long-term incentive plans with revenue-based metrics.
Another prediction, this one from Dayna Harris, a vice president with Farient Advisers, an executive pay consultant: Expect a renewed focus on “goal setting” for executive pay packages. “The pay conversations this year will increasingly focus on providing clear disclosures on performance goals and why those metrics were set the way they were,” she says. “This is going to be where the proxy advisory firms and investors will focus.”
The spotlight will be on whether targeted performance levels are sufficiently rigorous, alongside a call for greater disclosure and transparency, Harris says. Some companies may be the focus of activist investors for lowering their targets to what will be seen as more easily achievable goals.
These reviews, however, may not adequately assess performance. Companies should be prepared to provide insights on why they made specific decisions—for example, talking about why revenue is declining and goals are lower, while a competitor’s revenue is increasing, Harris says.
“Goal setting is not simply a quantitative exercise, but activist investors may treat it as such,” a recent client advisory from Farient Advisers warned. It suggests that directors develop an easy-to-understand disclosure process to manage investor and proxy adviser concerns and to explain revenue matters that require a more nuanced view of operations.
“If you set a goal that is lower than last year’s target, you want to explain that,” Harris says. “There can be some very good reasons for why you would do that, because it’s not just a quantitative thing.” She expects to see greater standardization around disclosures related to performance in 2016 and beyond.
The focus on revenue and goal setting this year prompts a longstanding concern with executive pay. Performance goals are all well and good, but how do you design a program that rewards executives for efforts to build a company, but not take excessive risk in the name of personal profit?
“It is like a tightrope you are walking when trying to figure out what the right choices are,” Harris says. “You want people to be working toward something that is harder to get, but you don’t want them betting the farm and damaging the business.”
She recommends a balanced pay program. “Some of it can be balanced in terms of the components of pay, having a mix of long- and short-term incentives, only some of which require goals. Stock options, for example, may not have to be tied to a particular performance goal,” she says.
A practical concern that relates to the new revenue recognition standard is whether it leads to additional costs for companies, London says. Not only will lawyers be called in to review executive compensation plans, “if the revenue standard changes, executive compensation consultants are going to caveat everything by saying you need to run it by your accounting firm too.”