Cash bonus plans may also include performance or market conditions (see
SC 2.5). Cash bonus plans that include performance conditions are subject to the guidance in
ASC 710—i.e., the cost of those benefits should be accrued over the period of service when management determines that it is probable that the performance condition will be achieved. In this context, the meaning of probable is consistent with its definition in
ASC 450. When the performance condition is not considered probable, no cost is accrued, or previously accrued cost is reversed. If a performance condition is initially considered not probable and the assessment of the probability changes, we believe there are two approaches to account for any adjustments made to the estimated incentive payout.
In the first approach, the reporting entity can increase the accrual to reflect the amount that cumulatively would have been accrued by the end of the reporting period had the performance condition been assessed as probable from the inception of the service period. The remaining balance, thereafter, should be accrued as future services are rendered. The second approach would be for the reporting entity to account for the increased compensation prospectively (i.e., accrue the total estimated compensation assessed as probable over the remaining period with no immediate adjustment to the accrual). Under this approach, the reporting entity would still need to ensure that the accrual recorded at the balance sheet date reflects at least the portion of the bonus in which participants have vested.
Plans that include a market condition that is based, at least in part, on the price of the entity's shares or other equity instruments should be accounted for in accordance with
ASC 718. See SC, PwC's
Stock-based compensation guide, regarding the accounting for awards subject to
ASC 718.
Example PEB 6-1 illustrates the accounting for changes in the incentive payout due to reassessment of the probable outcome of the performance condition.
EXAMPLE PEB 6-1
Accounting for changes in the probability assessment of a performance condition
On June 30, 20X1, PEB Corporation set up a long-term incentive plan for certain of its key executives. PEB Corporation has a calendar year end. The plan has a performance condition based on achieving targeted net income levels calculated on a cumulative basis for the two-year period ending June 30, 20X3. Participants vest in the bonus on June 30, 20X3. The estimated payouts are based on reaching the targeted cumulative net income levels are as follows:
- Cumulative income of at least $25 million but less than $30 million: payout is $3 million
- Cumulative income is $30 million or more: payout is $5 million
PEB Corporation is accounting for the long-term incentive plan by recognizing the anticipated payout using straight-line attribution over the 24-month vesting period. Bonuses under the incentive plan will be paid out in July 20X3, once results for the cumulative two-year performance period have been determined.
On June 30, 20X1, PEB Corporation anticipates that the cumulative net income will reach $27 million by June 30, 20X3 and, therefore, the payout will be $3 million. PEB Corporation accrues $375,000 in each of the third and fourth quarters of 20X3. Absent a change in facts and circumstance, PEB Corporation would accrue another $375,000 in the first quarter of 20X2 for a cumulative total of $1,125,000 as of March 31, 20X2.
On March 31, 20X2, when the performance measurements are reassessed, management estimates that cumulative net income will be at least $30 million and, therefore, the estimated payout is projected to be $5 million.
How should PEB Corporation account for the change in the probable incentive payout from $3 million to $5 million?
Analysis
If PEB Corporation had estimated the probable payout to be $5,000,000 from inception of the plan, it would have accrued $1,250,000 in the second half of 20X1 ($625,000 per quarter for two quarters) and another $625,000 in 20X2 for a total accrual by March 31, 20X2 of $1,875,000.
Based on the updated assessment of the award at March 31, 20X2, PEB Corporation needs to increase its accrual. It has two options:
- Cumulative catch-up—increase the accrual to the amount it would be if the amount determined upon reassessment had been used all along. To get the current accrual of $1,125,000 to the new assessment of $1,875,000, PEB Corporation would record a true-up of $750,000. Assuming no other changes in expectations in the ensuing periods, PEB Corporation would accrue $625,000 per quarter for the remaining 5 quarters of the performance period.
- Prospective—accrue the remaining $4,250,000 ($5 million less the $750,000 accrued as of December 31, 20X1) prospectively over the remaining period from January 1, 20X2 until June 30, 20X3. This would be acceptable under the guidance in ASC 710-10-25-9, which states that the cost of such benefits should be accrued for over the period of the employee's service in a manner that is "systematic and rational." This would result in an accrual of $708,333 in the remaining quarters of 20X2 compared to the original expectation of $375,000.
Whichever method is chosen would constitute an accounting policy election that should be applied consistently to similar arrangements.
Example PEB 6-2 illustrates accounting for an additional cash bonus to be paid in a subsequent year.
EXAMPLE PEB 6-2
Accounting for a discretionary cash bonus to be paid in a subsequent year
PEB Corporation had a particularly good year in 20X0 and decides in early 20X1 to set aside an additional amount of bonus money for key executives. The bonuses will be paid out in January 20X2 and require continued employment through that date in order for the executives to be eligible to receive their bonus.
PEB Corporation has an existing annual bonus plan that allows the compensation committee discretion in increasing or decreasing the amount of the final bonus. Such amounts are determined and paid in late January of each year.
When should the amount of the additional bonus be accrued as an expense?
Analysis
The additional bonus expense should be accrued over the period from February 20X1, when the plan is established, through January 20X2, when the amounts become payable to specific executives (i.e., the implied service period for the award). The rationale for this conclusion is as follows:
- The bonus is not part of PEB Corporation's established bonus plan (which employees were familiar with and knew they were working towards throughout 20X0); instead, the plan was established in 20X1.
- Payment of the additional bonus, unlike the 20X0 bonus payable in January 20X1, requires continued employment of the specific employees through January 20X2. This is a substantive employment requirement, not merely an “administrative period” necessary to finalize year-end bonuses pursuant to the plan's normal terms.
If PEB Corporation believes the bonus is attributable to employee service in 20X0, and accrued as an expense in the 20X0 financial statements, we believe those amounts would need to be finalized and paid out concurrent with any other 20X0 annual bonus payments (i.e., as part of the compensation committee's discretionary authority). Accrual of the bonus in 20X0 would also be acceptable if the decision was made in January 20X1 as part of finalizing the 20X0 bonus and the amounts became fixed obligations (notes payable) to be paid in January 20X2 without regard to continued employment.
Example PEB 6-3 illustrates attribution of expense for a cash bonus funded using a trust.
EXAMPLE PEB 6-3
Attribution of expense for a cash bonus funded using a trust
PEB Corporation commits to fund a Retention Trust with $15 million for the purposes of an annual bonus payout. PEB Corporation will fund the trust in $5 million increments over the next three years. PEB Corporation will determine the amount of the bonus on an annual basis and that amount will be distributed to employees from the trust annually. The amount paid each year may be more or less than the annual $5 million in trust funding; however, PEB Corporation is required to distribute the entire $15 million by the end of the third year. This arrangement is communicated to employees who may participate in the bonus program.
How should compensation cost be attributed over the three-year period?
Analysis
As PEB Corporation is required to distribute the total $15 million over the three years, regardless of the annual allocation to employees, recognition of compensation cost on a straight-line basis over the three-year period may be an appropriate approach.
PEB Corporation’s ability to pay out an amount greater or less than the current year trust contribution is not the predominant factor in the determination of the attribution method. However, if it is probable that PEB Corporation will pay out more than the amount of straight-line compensation expense cumulatively recognized, then PEB Corporation should adjust the amount recognized as compensation to equal the estimated bonus payment that is going to be made. The cumulative compensation expense recognized should not be less than the actual compensation cost paid. That is, delayed recognition of the compensation cost actually paid, with no clawback features, would not be appropriate.
If PEB Corporation did not pay out an annual bonus in the first two years, recognition of the entire $15 million of compensation expense in year 3 would not be appropriate as the recipients of the bonus were providing service (i.e., earning the bonus) throughout the entire period. Thus, this approach would not be considered "systematic and rational."