Public company incentive plans that are designed to comply with the "performance-based compensation" rules under Section 162(m) of the Internal Revenue Code often include language that permit the exclusion of certain events, including "extraordinary items," in determining whether or not an objective performance goal has been achieved. FASB recently eliminated the concept of extraordinary items, and substituted a more flexible standard. Companies should review their incentive plans now to understand the implications of the new FASB rule and make adjustments where necessary to preserve flexibility.
Extraordinary Items Under FASB
FASB recently eliminated the concept of extraordinary items from GAAP, noting that the concept causes great uncertainty in application and that it has been extremely rare for an event to meet the requirements necessary to be classified as an extraordinary item. Under the old FASB standard, an event was classified as extraordinary only if, taking into account the environment in which the entity operates, the underlying event or transaction both (1) possessed a high degree of abnormality and is of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, and (2) was of a type that would not reasonably be expected to recur in the foreseeable future. Where an event or transaction satisfied the criteria for extraordinary classification, an entity was required to segregate the extraordinary item from the results of ordinary operations and to show the item separately in its income statement.
Under the new revised FASB rules, a material event or transaction that is of an unusual nature, or of a type that indicates infrequency, or both, must be reported as a separate component of income from continuing operations. The key takeaway is that because items no longer have to be both unusual and infrequent, the standard is substantially relaxed. This new rule is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. However, companies may apply the new rule retrospectively to prior periods.
How does this FASB Change Impact Section 162(m) Compensation Plans?
Public company incentive plans that are designed to comply with the performance-based compensation rules under Code Section 162(m) often include language that allow the compensation committee to exclude certain events, including extraordinary items, in determining whether or not an objective performance goal has been achieved. Where a Section 162(m) plan refers to the old FASB standard, the plan may need to be amended to make reference to the new FASB standard; otherwise, a plan provision which excludes the impact of extraordinary items may not be given effect since it references a now-obsolete standard. On the other hand, where a Section 162(m) plan does not make any reference to the FASB standard, the plan may not need amendment. For example, the change should not have any impact on a Section 162(m) plan designed as "negative discretion" plan. Because the committee could exclude the impact of anything it chooses, these types of plans would not require an amendment (as long as the extraordinary item results in a reduction of payments).
In determining whether and when changes need to be made, consideration should be given to the types of events that could be considered unusual or infrequent under the new FASB rule. A company may not want to exclude the consequences of such events to the extent they would otherwise increase the amount payable under the plan. In addition, where awards have multi-year performance periods that end after the December 15, 2015, companies should exercise caution about changing the FASB standard during the performance period; such changes could result in changes to the objective performance standards, resulting in the award not qualifying as performance-based compensation.
Companies should review their compensation plans now to understand the implications of the new FASB rule and make adjustments where necessary to take advantage of the broader circumstances under which adjustments in determining whether performance goals have been satisfied can be made. King & Spalding would be pleased to assist with a review of your compensation plans and the impact of the FASB change.