A seemingly arcane change to the accounting rules has created another item on the “To-Do” list of executive compensation professionals for this fall/winter. The change may even require companies to amend their incentive stock plans.
Last week we observed that, in light of the SEC’s complete reliance on relative TSR as the basis for reporting the relationship between executive compensation and financial performance in the proposed P4P Disclosure rules, Committees that do not use relative TSR as a metric in executive pay will need to explain in the CD&A why the performance metric used to determine executive pay is preferable. We suggested that Committees discuss this issue in 2015/2016 and at least consider switching to TSR as a performance measure despite its many flaws. (See, “Pay vs. Performance Disclosure Issues for Your Upcoming Proxy”)
The change sounds simple enough: FASB slightly modified the income statement presentation requirements to replace the concept of “extraordinary items” with a new standard. If only. Below is an explanation from a Towers Watson Bulletin on the issue.
The FASB change to Generally Accepted Accounting Principles (GAAP) would simplify the income statement presentation requirements in Subtopic 225-20 (Income Statement — Extraordinary and Unusual Items) by eliminating the concept of extraordinary items and replacing it with a new standard. Before this change, extraordinary items were defined as events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Once the change is effective, companies would instead disclose items that are either of an unusual nature or of a type that indicates infrequency of occurrence as a separate component of income from continuing operations.
Companies typically include a provision specifically referencing extraordinary items in compensation plans submitted for shareholder approval, whether for 162(m) purposes or to comply with stock exchange rules regarding equity plan votes. In some circumstances, the reference is part of the laundry list of performance objectives the compensation committee would establish for a particular performance-based grant, but more often, the language permits the compensation committee to exclude extraordinary items in determining whether or not an objective performance goal has been met.
There are myriad variations on how this language is drafted, so companies must closely review if the plan makes reference to the GAAP standard or whether the reference is more generic. In some cases, the plan itself may need to be amended to reference the new standard because the existing language refers to potential adjustments that could never take place because the concept of “extraordinary item” will disappear under GAAP. Where the plan language is more general, a plan change may not be necessary.
The accounting change is effective for performance measures beginning in 2016. However, the change could also affect any performance-based awards or compensation with a performance period that includes 2016.
Many incentive stock plans give the Committee the discretion to adjust performance metrics for the impact that extraordinary items have on the performance measures under the plan. To the extent a plan uses the term “extraordinary items,” the Committee may be limited in its discretion in the future, as this standard is phased out. Companies/Committees should review the terms of their stock plans for this issue. You may need to amend the plan. An amendment this minor may not require shareholder approval, but one may need to consider the rules of Section 162(m).
Add it to your “To-Do” list for this fall/winter.