Governance Advocates Looking to Close GAAP in CEO Pay Calculations

Governance Advocates Looking to Close GAAP in CEO Pay Calculations

A company underperforms. Its stock price tanks. The CEO collects a big payday.

It’s far from a unique story in Corporate America. Some stakeholders, including a commissioner on the Securities and Exchange Commission, appear to be tiring of seeing executives collect A-plus pay for failing work. Their executive-compensation exasperation is leading to calls for more transparency around chief executives’ lavish pay packages.

For financial wonks, “adjusted” earnings lie at the heart of the problem. In a Wall Street Journal editorial last month, SEC Commissioner Robert Jackson and co-author Robert Pozen, a former president of Fidelity Investments now with MIT, called out companies for tossing aside generally accepted accounting principles (GAAP) in favor of adjusted earnings when creating executive compensation standards.

“These adjustments can be significant, and their effects on executive pay are poorly understood by shareholders—raising the risk that non-GAAP numbers will be used to justify outsize compensation for disappointing results,” Jackson and Pozen wrote.

Companies use adjusted accounting metrics to paint a more complete picture of their performance when they believe one-off events can skew their operating results. For instance, a company might spotlight adjusted earnings that exclude the impact of an organizational restructuring or litigation costs. According to SEC guidelines, companies must reconcile adjusted earnings with GAAP in their financial statements for the benefit of investors.

Jackson and Pozen noted that compensation reports produced by boards of directors aren’t subject to the same requirements for reconciling adjusted earnings with GAAP numbers. Nor do boards have to justify why they used one set of figures versus the other for calculating executive pay. The Council of Institutional Investors (CII), a corporate-governance advocate, echoed the sentiments of Jackson and Pozen last month in a petition for rulemaking submitted to the SEC.

The push for more transparency behind CEO pay comes on the heels of research released earlier this year by Pozen and two academic colleagues on the impact of non-GAAP earnings on compensation packages. They found that S&P 500 companies reporting higher adjusted earnings relative to GAAP numbers offer “excessive CEO pay” in the ballpark of $2 million per year, on average. “Overall, our evidence suggests large non-GAAP earnings adjustments influence some boards of directors in approving a level of CEO pay that is otherwise not supported by the firm’s stock price or GAAP earnings performance,” the researchers wrote.

Can the issue gain traction with the SEC? The regulatory agency has made an apparent effort to ramp up its oversight of non-GAAP metrics in financial reporting. Specifically, the Division of Corporation Finance continues to revamp its non-GAAP Compliance & Disclosure Interpretations while staffers target perceived bad actors. Meanwhile, a handful of SEC comment letters from 2017 and 2018 have probed the inclusion of non-GAAP metrics in compensation plans, including communications with Consolidated-Tomoka Land Co., Automatic Data Processing Inc. and Altice USA Inc. Perhaps not coincidentally, Altice’s proxy statement is one of seven filings targeted in CII’s petition.

It seems premature to predict the SEC will implement a policy requiring greater transparency on the use of adjusted earnings in CEO compensation packages. However, it does appear as though the commission has laid the groundwork to do so.

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