The Impact of the New Accounting Standard on Incentive Compensation

As a compensation professional, I am always interested in any changes (legal, regulatory, economic, societal, etc.) that may influence the way incentive programs are designed, implemented and maintained. Back in 2014, Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) introduced new rules for revenue recognition. The new revenue recognition rules will take effect soon and this new standard will have impacts beyond financial statement preparation.

Given that many incentive plan arrangements are in some way related to revenue, or metrics and ratios derived from revenue, this topic has certainly piqued my interest. I recently had the opportunity to sit down with Scott Ehrlich of Mind the GAAP, an expert in U.S. generally accepted accounting principles, to ask questions so I can better assist clients with incentive redesign efforts as they navigate the new revenue recognition rules. Here is the Q&A from our meeting.

1) Why did FASB and IASB create this new standard?

The purpose of the new revenue recognition rule is to create greater consistency and comparability for global capital markets. The new regulations will result in all companies across all industries in all countries using one model to recognize revenue from their customer contracts.

2) What is the new standard?

The revenue standard’s core principle is built on the contract between a vendor and a customer for the provision of goods and services. It utilizes the transfer of control between the parties to determine when to recognize revenue. The amount of revenue recorded is based on the consideration to which the vendor is entitled. To accomplish this objective, the standard requires five basic steps:

3) What industries will be impacted the most?

Although the effects of the new rule will vary for each company, industries likely to experience the most change include: Aerospace, Asset Management, Construction, Healthcare, Real Estate, Software and Telecommunications.

4) When will the new standards be effective?

Public Companies – For calendar year-end public companies, the new guidance must be applied beginning in 2018, starting with the first 10-Q filing for the quarter ended March 31, 2018.

Private Companies – For private companies and not-for-profit organizations, the new guidance will become effective in 2019.

Early Adoption – Public and Private companies and not-for-profit organizations may elect early application starting this year. A few companies, such as Microsoft, Raytheon and General Dynamics, have announced plans to adopt the new rules early.

5) Are companies ready?

Per a survey by PricewaterhouseCoopers (PwC) and Financial Executives Research Foundation (FERF) in August 2016, only 17% of public companies had begun implementing new policies, controls and processes in support of the new revenue recognition rule.  Also, only about half of the private companies had started assessing the impact of the new revenue recognition rule.  I’m sure companies are further along by now, but time is running short.

6) What are the adoption methods for companies?

There are 2 available adoption methods – full retrospective and modified retrospective.  Each has pros and cons associated with them.

The full retrospective method requires the standard to be applied to each period presented in the financial statements (e.g., 2016, 2017 and 2018).

The modified retrospective method requires the standard to be applied from the effective date, with additional disclosure of financial statement line items that are different under the new standard versus what would have been recorded under legacy guidance.

Even if companies are not adopting the full retrospective method, they may want to estimate the impact of the new revenue recognition rules on historical incentive plans. Companies that do the work needed to report on a full retrospective basis will be in a better position to assess the historical impact to current incentive plans.  This can prove useful when assessing the impact on their incentive plans, and, if necessary, deciding on a new incentive plan design.  Even though companies are not required to go further back than 2016 when using the full retrospective method, they may wish to do so if understanding the historical impact of the new rules on their incentive plans is deemed important.

7) As the effective dates approach, what should companies be doing to prepare?

Between now and the revised effective dates of the new standard, companies should focus on:

  • Contracts – review contracts to determine if the new standard applies by identifying the performance obligations and if contracts clearly state when/how those performance obligations are met
  • Adoption Method – decide on an adoption method
  • Information Systems – review systems changes needed to adopt and support new standard
  • Internal Controls – develop and implement internal controls to support new standard
  • Tax Consequences – understand and plan for any related tax implications to adopt new standard
  • Financial Results – understand the likely impact on financial results to:
    • Develop internal/external communication plans so interested parties can understand trends considering the new standard
    • Analyze and implement any changes in sales or pricing strategies
    • Analyze (and revise, if necessary) corporate policies/programs tied to revenue

8) Are companies focusing on the compensation program impacts related to the new standard?

Based on my experiences so far, they are not. Most of the focus has been on readying the organization for the adoption of the new revenue recognition standard as it relates to polices, processes, controls and systems.  At a minimum, organizations should be inventorying incentive plan arrangements that are currently in place to assess if any are impacted by changes in revenue recognition.

9) For your clients that are focusing on the incentive plan impacts, how did they go about the inventory process?

Clients that have assessed the impact on incentive plans have involved their HR departments (specifically, the compensation group). Typically, I suggest that they use the following tables to determine the compensation program impacts within their organizations.

Table 1 – Determine Compensation Impacts

To make sure no employee group is missed, I also recommend the following grid that can be used as a starting point for the inventory process. Specific plans would need to be reviewed to determine if they include revenue (directly or indirectly) as a performance metric or goal.

Table 2 – Inventory Grid

 

10) What if the inventory indicates there could be an impact?

If the company answers “yes” to even one item in the Tables above, I suggest that they engage an experienced incentive design professional to assess who is impacted, the magnitude of the impact and how incentive plan(s) should be modified going forward.

 

What is your company doing to prepare for the new revenue recognition rule? Have you started assessing the impact of the new rule on current incentive plans? We’d love to hear your thoughts on this topic.  Please comment on LinkedIn at https://lnkd.in/dUTJ6KB.

 

 

Scott Ehrlich is President of Mind the GAAP (www.mindthegaap.com), an organization that helps companies interpret and apply complex accounting standards with consultancy, advisory and training services.  He can be reached at sehrlich@mindthegaap.com.



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