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Article | Executive Pay Memo North America

Beware accounting, disclosure impact of changes to incentive comp plan goals 

Governance Advisory Services |Executive Compensation
COVID 19 Coronavirus

By Steve Seelig and Tom Kelly | June 4, 2020

The considerations for performance shares may differ significantly from those for annual bonuses.

As companies struggle to determine the potential impact of COVID-19 on their executives’ annual and long-term incentives, an important concern should be the potential accounting and disclosure implications of adjusting plan targets. As with most accounting-driven rules, the form and timing of these adjustments matters greatly. Now is the time to consider those implications by consulting with audit firms and counsel before action is taken.

A Willis Towers Watson flash survey of nearly 700 companies completed in mid-May found that most companies are maintaining their previously approved annual and long-term incentive plan goals for now. But, due to COVID-19’s impact, many companies are considering using discretion to determine any earned awards following the end of the performance period, which is not that surprising.

Other alternatives such as modifying performance goals have limited appeal with so much uncertainty about how long the pandemic will affect business operations. Another consideration would be that mid-course changes will tend to bring added scrutiny from investors, proxy advisors and the press, not all of it favorable. On the other hand, companies should be mindful that waiting to exercise discretion until the end of the performance period brings more complications for performance-contingent equity grants as compared to cash-based annual bonus plans.

Annual bonus plans and discretion

Until the repeal of the performance-based exception for Code Section 162(m), many companies had annual bonus programs that may have used the “negative discretion” permitted to fund bonus plans at maximum for attaining threshold performance levels. This meant that disclosure of most company annual bonus plans was included in the “Non-Equity Incentive Plan Compensation” column, per Question 119.02 of the Compliance & Disclosure Interpretations ("C&DIs") issued by the Securities and Exchange Commission Corporate Finance Division's interpretations of Regulation S-K.

With many negative discretion plans having been scrapped, this now means a discretionary payment relating to a cash incentive program may simply require reporting the paid amount in the Summary Compensation Table’s “Bonus” column. This would be the case if such bonus is earned for services provided (and performance results attained) during the previous fiscal year (even if the decision to make such a bonus is not made until early the following year). It would also be the case even if a cash bonus payment is deferred until some later year.

Although accounting rules do not impact the proxy disclosure treatment of cash bonuses, how a company accounts for bonus accruals is relevant for consideration if it is contemplated that discretion may be used to increase the bonus at period end. The rules of ASC 450-20 require companies to estimate the amount of a bonus whose payment is probable. For annual bonuses, determining the accruals for each quarter would then be apportioned to each period to reflect the reasonable portion of the expense recognized for each period.

Companies that intend to exercise positive discretion at year end must consult with their auditors to understand actions necessary to make the likelihood of payment as probable for accrual purposes during interim quarters when it becomes clear the objective plan goals established at the start of the year will not be met. Any difference between the actual bonus that is earned for the year and the amount previously accrued is a change in accounting estimate, something the company may wish to avoid.

Equity-based awards and discretion

Equity-based grants are usually made under a legally enforceable award agreement between the company and employee, governed by terms of a shareholder-approved plan document. Some award agreements and equity plans may not even consider the potential application of discretion in determining the number of shares earned at the end of a measurement period.

Others reference that discretion can be used to adjust performance goals in recognition of unusual or nonrecurring events or transactions affecting the company or its financial statements — a vestige of old 162(m) and current accounting rules. Others still provide even more flexibility for Compensation Committees, including explicit use of discretion to determine the number of shares earned. Determining what the plan and agreements permit, as a legal matter, is the first step in determining whether discretionary adjustments are permitted and whether the participant must agree to those changes.

The plan and grant agreements foreclose discretion: Where discretion to make changes is not permitted, the only way to apply discretion effectively is to make a new grant for the number of shares that otherwise might have been considered “earned.” In this situation, the fair value of the new grant being made will be accounted for under ASC 718 over the vesting period.

Fully vested grants will be expensed immediately. Grant date timing will be an important consideration based on when the company can best tolerate the additional expense and, perhaps more importantly, when they want the expense disclosed on the Summary Compensation Table. Thus, some companies may wish to make the new grant before the end of fiscal year 2020, while others will want to wait until early 2021 on the anniversary of the grant date.

The plan and grant agreements permit discretion: At first glance, the accounting treatment under ASC 718 relating to using discretion on equity awards with performance conditions appears simple. The following example illustrates application of these rules where financial performance conditions are in place, not those related to stock price or shareholder returns.


In early 2018, a company makes a performance-contingent equity award of 6,000 shares if a performance goal relating to cumulative operating income during the three-year period of 2018-2020 is achieved. The stock price on the grant date is $20 per share and the performance goal is considered likely to be achieved. The grant date fair value is $120,000 and the company begins recognizing the expense over the three-year period ($40,000 each year).

During the second quarter of 2020, the company determines that the performance goal is not likely to be achieved, so it reverses the expense previously recognized ($100,000) and accrues no future expense during 2020 for this grant. In early 2021, the compensation committee determines that the operating performance goal has not been achieved, but also decides that it will exercise its discretion and allow 3,000 of the shares to be earned and paid on a fully vested basis. The stock price on the date of that decision is $30, so the company must recognize expense of $90,000 immediately (3,000 shares multiplied by $30 stock price).

This example illustrates the principle that the fair value of any shares earned that otherwise would have been forfeited based on results achieved is recognized as expense over any remaining service period, although in this example grants are fully vested. Fair value of those shares earned based on discretion is the stock price on the date the terms of the award are modified in early 2021. The expense on the forfeited shares was already reversed earlier in 2020.

In the example, the disclosure of the modified grants would be made in the 2021 Summary Compensation Table, which may or may not be a desired result. It is certainly possible to consider taking that action in 2020, which would move some or all of the disclosed value into 2020.

This accounting treatment is the same as if the original award was forfeited on the measurement date, but the compensation committee decided to make a “new grant” of fully vested shares in consideration of the reasons why the performance goal was not achieved, which would suggest that either approach would be equally justifiable, except that the decision to use discretion to “override” the original terms of an equity award with performance conditions MAY have other consequences.

Note that where equity awards are earned based on performance conditions that are related to stock price or shareholder return (market conditions), the accounting would be similar to the above except that expenses are not reversed in subsequent periods when attainment of goals is no longer probable.

Using discretion could trigger variable accounting, for all performance share grants. Many companies structure their award agreements to restrict or otherwise limit the use of discretion in determining the number of earned shares. This allows the company to recognize expense on the awards based on the stock price on the original grant date, rather than reflecting any changes in stock price between the original grant date and the settlement date.

A key principle that permits the original grant date value to be used is that there must be a mutual understanding of the terms and conditions of the award when granted, with any performance conditions being objectively determinable and measurable.

Performance equity award agreements may provide compensation committees with some flexibility in how performance results will be calculated including any adjustments that will be made or considered. But this type of “discretion” relating to performance results achieved is quite different from a situation where a committee uses discretion to increase the number of shares earned regardless of the performance results achieved. This exercise of discretion may come with the agreement of the plan participants, if the plan and grant agreements so require.

The concern would be that the auditors would look to an exercise of discretion to indicate that the plan itself does not cause there to be a mutual understanding of the terms of any future grants made under the plan. The consequence could be that all outstanding and future equity awards with performance conditions will need to be expensed reflecting changes in share price between the original award date and settlement date.

For some companies, the impact of COVID-19 may result in “no earned awards” for not only the measurement period ending this year but also those ending in subsequent years where goals have already been established and communicated. A determination to use discretion on equity awards with performance conditions for a single year may be viewed differently from a situation where discretion is used several years in a row. For this reason, it is critical for companies to consult with their auditors now to understand the potential accounting impact.

Depending on the answer, this could mean that companies may determine that a “new grant” is preferable to using discretion on a previous award. However, many stock plans now include a minimum vesting requirement of at least one year, so any new grants would not deliver any value to participants until the following year when they vest. Unfortunately, even a grant of unvested shares would be shown in the SCT when granted, although the additional service condition may be view somewhat more favorably by investors and proxy advisors.

Tax deduction issues could be affected based on the decisions made above. Moving the exercise of discretion into 2020 would likely fix the deduction in that year for fully-vested grants, rather than in 2021 under the typical grant cycle for performance share grants made early in the year. The tax deduction can influence cash on hand, assuming the company will be paying taxes during 2020, so it must be factored into these decisions.

The prevalence of companies making equity grants with performance conditions is much higher today as compared to the financial crisis of 2008-2009, so many companies and their compensation committees likely are addressing this issue for the first time. As potential alternatives for addressing outstanding performance equity awards are discussed, we encourage companies to evaluate the potential impact on all necessary areas including accounting treatment, tax effects, disclosure and legal/regulatory requirements.


Senior Director, Executive Compensation and Board Advisory (Arlington)

Senior Director, Executive Compensation (Charlotte)

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