It’s all a matter of time—at least when it comes to recognizing revenue at public companies. The Financial Accounting Standards Boards (FASB) and the International Accounting Standards Board (IASB) in 2014 developed an accounting rule that is set to change how companies approach revenue recognition. The rules, available here, go into effect for public companies with fiscal years beginning after December 15, 2017, and will have major consequences for financial reporting in many industries.
To address the executive-compensation implications of the revenue recognition standard, NACD, executive compensation advisory firm Farient Advisors, and law firm Katten Muchin Rosenman cohosted a meeting of the Compensation Committee Chair Advisory Council on April 4, 2017. During that meeting and its related teleconference, Fortune 500 companies’ compensation committee chairs came together to discuss leading practices and key considerations related to the impact of the new revenue recognition standard. Jose R. Rodriguez, partner in charge and executive director of KPMG’s Audit Committee Institute, joined council delegates for the discussion. The meeting was held using a modified version of the Chatham House Rule, under which participants’ quotes (italicized below) are not attributed to those individuals or their organizations, with the exception of cohosts. A list of attendees’ names are available here.
About the New Standard
A 2014 press release from FASB explained the rationale behind the new standard, noting that revenue is an important metric that investors use when trying to understand how a company has performed and its potential for future performance. Previous accounting standards from the International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP), however, were somewhat at odds, according to the press release. Those inconsistencies between IFRS and GAAP meant that different industries that had very similar types of transactions were accounting for revenue in sometimes very different ways. The revenue recognition standard aims to bring more consistency to accounting done for similar types of transactions.
A key part of the new standard is that revenue can only be recognized—among other requirements—once customers actually benefit from the services or goods that the company has already provided them, as noted in the Journal of Accountancy. The Journal continues that if a company provides a customer with goods or services over time, such as a yearlong service contract, the company can recognize revenue as the customer receives benefits in the contract period. For more information on the standard, see this four-page overview and in-depth guide from KPMG.
Key Questions Directors Should Ask
While the level of disruption that the revenue recognition standard will cause varies by industry and company, four questions important for all boards emerged from the Advisory Council meeting:
- How will the new revenue recognition standard affect our company specifically?
- Does the board understand the key milestones for the revenue recognition standard and how the company is progressing in light of those milestones?
- How will compensation plans be affected?
- How will our disclosures need to change?
How will the new revenue recognition standard affect our company specifically?
Impact of the new standard will vary widely for a few reasons. First, sales and service contracts can differ significantly depending on industry—consumer products, health care, manufacturing, IT, and so on. Additionally, the types of sales contracts—and, therefore, the way revenue is recognized—can differ even within a single company, depending on the types of products and services sold. The company’s suppliers and vendors are a third factor influencing change: “Even if the standard doesn’t affect our core business, we could be working with partners and vendors that are affected,” said one director. “One of my companies has hundreds of millions of dollars in service contracts,” another delegate commented. “Our whole income statement is going to change.”
“Every company’s finance department has been looking at this,” Rodriguez said. “Ask your CFO to brief the board about the major income-statement changes that will occur for the company. What will be affected across all revenue lines? How are key reporting processes changing to accommodate the new standard?”
Does the board understand the key milestones for the revenue recognition standard and how the company is progressing in light of those milestones?
Rodriguez said that a pitfall for many companies is not investing enough time upfront in ensuring compliance with the new standard. “Some companies are finding that this is a bigger lift than they thought [to adopt the standard], so they are having to scramble to coordinate.”
Rodriguez shared several steps that companies can take to prepare:
- Forming cross-functional task forces that integrate finance, accounting, IT, legal, and HR to ensure activities are coordinated.
- Designating a revenue group to analyze contracts in different regions and locations to ensure all jurisdictions are covered.
- Devoting sufficient time and resources to make required changes and upgrades to IT and reporting systems, especially in companies that have multiple legacy systems in place.
- Developing a communication plan to explain to affected employees (especially on sales teams) how the changes will impact their work. “This is actually a huge change-management process,” one council delegate said. “You have to re-train sales people about how they design contracts and agreements.”
How will compensation plans be affected?
Council delegates agreed that compensation committees need to have a clear understanding of how the new standard will affect the key metrics that drive compensation for all levels of employees, from rank-and-file to the C-suite (For more information on incentives and risk taking, please see NACD’s brief, Incentives and Risk Taking). Changes to the way revenue is reported could have a major impact on the numbers used in annual bonus plans, as well as on long-term incentive plans that are already in place. “With multi-year incentive plans that are in mid-cycle, the effects could be quite complex,” said Dayna L. Harris, partner at Farient Advisors. “For compensation committees, it will be important to ensure incentives are paid out in a way that’s appropriate to what was originally intended to keep consistent with the compensation philosophy the board has devised.”
Compensation committees can ask the following questions:
- Is the company adopting the new standard prospectively or retrospectively, and how will that change our revenue numbers?
- Which compensation plans will be affected beyond the CEO and named executive officers (e.g., sales staff at multiple levels)?
- What do we anticipate will be the impact on the peer groups we use to benchmark executive compensation?
Rodriguez suggested that compensation committees schedule a briefing session with the external auditor, audit committee chair, CFO, and compensation consultant to discuss these and other questions. Members of the audit committee can also be invited to the briefing.
How will our disclosures need to change?
As noted in the Report of the NACD Blue Ribbon Commission on Board-Shareholder Communications (p. 17), “Directors have a general responsibility to oversee the company’s disclosure programs. They also need to take special care in reviewing certain specific disclosures—notably the company’s regular financial disclosures, such as the proxy statement, 10-Ks, 10-Qs, and 8-Ks, as well as any securities registration statements filed with the [U.S. Securities and Exchange Commission (SEC)].” A director observed, “In addition to the changes to reports, we need a strategy to communicate with our major investors. They will be asking questions about why compensation payouts appear to have ‘changed.’”
The SEC will task review teams with scrutinizing public companies’ financial disclosures, 10-Ks especially, to determine if the statements include information on the revenue recognition standard, Bloomberg BNA reports. Mark Kronforst, chief accountant of the SEC’s Division of Corporation Finance, told Bloomberg BNA, “I don’t think that we will be shy about issuing comments if we don’t see the disclosures.”
“Accounting changes should not interfere with a good business decision, performance outcomes on incentives, and appropriate incentive payouts,” said Harris. “With an accounting change in the middle of a performance period, compensation committees will need to provide full transparency into incentive payout decisions, especially if they appear larger than expected under the new accounting. There’s a whole list of ramifications if that transparency is lacking, from proxy advisors’ criticisms to activist investors’ reproach.”
And there’s no time like the present to understand those ramifications and ensure that management stays on top of key milestones.