By Kateryna Kyryllova. In an effort to ensure sustainable corporate growth, companies are increasingly choosing performance-based incentives to align executive pay with performance. Companies may utilize different strategies to set performance goals, however, it is critical to keep in mind that choosing a particular metric can cause accounting complications and even unexpected costs.
Generally, performance metrics can be divided into three groups: financial, non-financial (operations-based), and market-based. Let’s take a look at the most common metrics used in each group and what companies should be aware of when considering different methods of measurement.
Financial metrics are commonly based upon profit, growth, and various capital efficiency ratios. Targets may include revenue, EPS, operating income, net income, and ROI. The popularity of using a financial metric as a primary measurement largely depends on the industry sector: for example, companies in healthcare and consumer goods tend to use revenue, financial institutions lean towards EPS, and services and technology companies are likely to use operating income.
Non-financial metrics may involve indicators such as market share, safety, innovation, compliance, or customer satisfaction. Non-financial performance measures provide other benefits, such as evaluating the company’s overall performance, including productivity, product quality, and other intangible assets that cannot be captured by accounting. They also provide employees with more specific actions they need to perform to reach the strategic goals, and reduce the risk of executives manipulating earnings to maximize the compensation.
Market-based metrics are derived from a company’s stock price and include the most commonly used metric, total shareholder return (TSR). TSR is usually used in relative terms (your TSR compared to a peer group), as there are a lot of external factors that can affect the share price. The advantages of TSR are the transparency, simplicity, and strong alignment with shareholders. On the downside, critics of this metric assert that TSR outcome is not entirely within management’s control. Different market conditions may affect stock price, and relative TSR can also fluctuate depending on the choice of peers. Some also feel that TSR and financial performance are not always strongly correlated, particularly over shorter measurement periods.
Accounting for Performance-based Awards
For accountants to report on performance-based awards in financial statements, the first challenge is to obtain up-to-date information on how the metrics are tracking against targets. Companies have to modulate expenses over time based on a subjective probability assessment of whether the performance metrics can be achieved. And with non-market-based awards, it is necessary to reverse any accrued expenses if the metric goals are not met and no shares are issued/vested.
With a fixed number of shares that vest on a particular date, after the implied service period has ended, this is relatively straightforward. However, in multiplier-model performance awards, executives may earn more or fewer than the target number of shares. That means the performance measure moves along a probability range with the added complication that the number of shares expected to vest also changes up or down from period to period. Be sure to consider this challenge when evaluating types of performance metrics.
Market-based vesting presents its own unique challenges. The most important consideration is the inability to reverse the compensation expense if the goal is not achieved. The only way this expense can be reversed is in the event of forfeiture, as is true for any share-based payment. Furthermore, awards with market-based performance metrics must be valued up front, analysis is typically performed by an outside firm. As a result, these awards cost money before they ever hit the books, and the associated expense cannot be backed out if the market-based objective is not achieved.
The graph below shows the most popular performance measures identified in the Global Equity 2015 Insights survey conducted by GEO.
Read more about key accounting considerations for performance-based compensation in our Equity Compensation in a Say-On-Pay World white paper.