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Impact of COVID-19 on performance-based incentives accounting, disclosures

System og strategi for kompensasjon |Executive Compensation|Health and Benefits
COVID 19 Coronavirus

By Tom Kelly and Steve Seelig | August 11, 2020

Employers considering adjusting compensation plan targets in light of COVID-19 face potential accounting and disclosure implications.

A recent Willis Towers Watson pulse survey of nearly 300 companies found that most respondents are currently maintaining their previously approved incentive compensation plan goals. However, in light of COVID-19’s impact on executives’ annual and long-term incentives, many companies are considering adjusting plan targets and using discretion to determine any earned awards after the performance period. Before taking action, employers should be aware of the potential accounting and disclosure implications of these changes by consulting with audit firms and legal counsel.

Mid-course changes could bring added scrutiny from investors, proxy advisors and the press. And alternatives such as modifying performance goals have limited appeal with so much uncertainty about how long the pandemic will affect business operations.

Companies waiting to exercise discretion until the end of the performance period should consider the related complications for performance-contingent equity grants and cash-based annual bonus plans, as outlined below.

Annual bonus plans

Until the repeal of the performance-based exception for Internal Revenue Code Section 162(m),1 many annual bonus programs used negative discretion2 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 of the Summary Compensation Table (SCT).3

With many companies no longer utilizing negative discretion plans, a discretionary payment relating to a cash incentive program may simply require reporting the paid amount in the SCT'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 (unlike for equity grants, as discussed below), how a company accounts for bonus accruals must be considered if discretion may be used to increase the bonus at period end. The rules of the Financial Accounting Standards Board 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 should consult with their auditors to understand what actions they must take to make the likelihood of payment as probable for accrual purposes during interim quarters when the objective plan goals established at the start of the year will not be met. Any difference between the actual earned bonus for the year and the amount previously accrued is a change in accounting estimate, something the company may wish to avoid. Auditors will look to board minutes, internal and external communications, and other documentation to discern whether they agree with the bonus accrual to be recorded.

Performance-based equity awards

Performance-based equity 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.
  • Other award agreements reference that discretion can be used to adjust performance goals at the end of the cycle in recognition of unusual or nonrecurring events or transactions affecting the company or its financial statements pursuant to old section 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.

After determining what is legally permissible, companies will then need to focus on whether or not discretion will be used in determining the earned awards and how it might be applied. Companies should understand how the timing of using discretion on performance share awards may affect accounting treatment and proxy disclosure.

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.

Particularly for performance cycles ending in 2020, grant date timing will be an important consideration based on when the company can best tolerate the additional expense and, perhaps more importantly, when it wants the expense disclosed on the SCT. 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 adjustments for unusual or nonrecurring events

Not all plans have these provisions, and how they are phrased may be very different for plans in different industries. Where these provisions exist, there will be interpretational questions about whether the onset of COVID-19 would meet the specific plan definitions. If yes, the next challenge will be to interpolate what corporate financial results might have been for the business had the pandemic never hit. This will be an incredibly time-consuming exercise for many companies, with the goal being to establish a level of bonus funding from which the compensation committee will then exercise negative discretion in settling the shares, much the same way that companies used umbrella plans and negative discretion to meet the performance-based exception of 162(m) for their annual plans.

The plan and grant agreements permit discretion

The following example illustrates applying the ASC 718 rules relating to using discretion on equity awards where financial performance conditions are in place (not those related to stock price or shareholder returns).

Suppose 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 to 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 (attainment is “improbable” in accounting terms). 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, which otherwise would have been forfeited because results were not achieved, is recognized as an 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.

In the example, the disclosure of the modified grants would be made in the 2021 SCT, which may or may not be a desired result. Had the compensation committee taken that action in 2020, some or all of the disclosed value would have moved into the 2020 SCT.

It is uncertain how auditors will view, under the above example, whether the entire $100,000 expense must be reversed during the second quarter of 2020. Clearly, if the plan did not permit the use of discretion, that expense would have been reversed during that quarter. However, if the compensation committee makes clear it will exercise its discretion to allow some grants to vest at the end of the performance period, perhaps at least some portion of the expense would not be reversed. This question will become a case of first impression for many audit firms, and the answer will be very fact dependent. Of course, since disclosure will follow accounting, it is important to nail down this issue before any compensation committee decisions are made.

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 for the original grants are not reversed in subsequent periods when the possibility of attaining performance goals becomes improbable.

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. The plan and grant agreements may require that this exercise of discretion come with plan participant agreement.

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, although this may not become an issue given the current unprecedented circumstances.

Depending on the answer, 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. 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. Because the tax deduction can influence cash on hand, assuming the company will be paying taxes during 2020, it must be factored into these decisions.


1 See “Changes to 162(m) prompt revisiting pay plans and proxy disclosures,” Insider, July 2019.

2 The ability to exercise negative discretion was permissible under the prior 162(m) rules for companies seeking to meet the performance-based exception to permit a compensation committee to reduce or eliminate the amount of an award at the end of the performance cycle.

3 Pursuant to Question 119.02 of the Compliance & Disclosure Interpretations issued by the Securities and Exchange Commission Corporate Finance Division's interpretations of Regulation S-K

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