United States: Use Of Non-GAAP Financial Metrics Increases In Executive Comp—Will The SEC Increase Its Scrutiny?

Last Updated: June 24 2019
Article by Cydney Posner

You might recall that, in April of this year, SEC Commissioner Robert Jackson co-authored an op-ed (with Robert Pozen, MIT senior lecturer and former president of Fidelity) that lambasted the use of non-GAAP financial metrics in determining executive pay, absent more transparent disclosure. The pair argued that, although historically, performance targets were based on GAAP, in recent years, there has been a shift to using non-GAAP pay targets, sometimes involving significant adjustments that can "be used to justify outsize compensation for disappointing results." On the heels of that op-ed came a rulemaking petition submitted by the Council of Institutional Investors requesting, in light of this increased prevalence, that the SEC amend the rules and guidance to provide that all non-GAAP financial measures (NGFMs) used in the CD&A of proxy statements be subject to the reconciliation and other requirements of Reg G and Item 10(e) of Reg S-K. But how pervasive is the use of NGFMs in executive comp? This article from Audit Analytics puts some additional data behind the brewing controversy about the use of non-GAAP financial measures in executive comp—and the level of increase is substantial.

The op-ed pointed to 36 companies in the S&P 500 that, in 2015, announced non-GAAP earnings more than 100% higher than the GAAP equivalent, and 57 more companies that reported non-GAAP earnings that were 50% to 100% higher than GAAP. What's more, the "compensation committees of almost all those companies used a non-GAAP measure as an important criterion for awarding executive pay." In its analysis, Audit Analytics found that, among the S&P 500 in 2018, out of an aggregate of 420 proxy statements, 285, or 68%, used non-GAAP metrics in determining executive comp, compared to only 80 proxy statements (out of a total of 440), or 18%, in 2009. This increase, said Audit Analytics, was consistent with the general proliferation in the use of NGFMs beginning around the same time—shortly after the 2008 financial meltdown.

In the wake of the significant increase in the use of NGFMs, in 2016, the SEC made a big push—through a series of staff oral admonitions, comment letters and written guidance, as well as enforcement actions (including one in 2019 as discussed in this PubCo post)—toward requiring issuers to be more transparent and more consistent in the use of non-GAAP financial measures and to avoid altogether non-GAAP measures that were misleading. Significantly, however, the staff did not change its guidance that excepted from much of this regulation and interpretation the use of NGFMs in CD&A to disclose comp target levels. (See, e.g., this PubCo post, this PubCo post and this PubCo post.)

Currently, in most cases, under Reg G and Item 10(e), the SEC requires that companies, among other things, reconcile NGFMs to the comparable GAAP measures, display the GAAP measures with equal prominence and provide statements of NGFM purpose and utility, and prohibits the use of certain custom or "tailored" accounting measures that may be misleading. "Unfortunately," the op-ed observed, "those requirements do not apply to the reports that compensation committees of corporate boards disclose to investors each year. Thus, committees choosing to use adjustments when deciding on payouts need not explain why an adjusted version of earnings is the right way to determine incentive pay for the company's top managers. This increases the risk that adjustments will be used to justify windfalls to underperforming managers." In light of the pervasiveness of the use of non-GAAP comp targets, the op-ed authors advocated changes in the SEC's rules and interpretations to aid investors to "easily distinguish between high pay based on good performance and bloated pay justified by accounting gimmicks." (See this PubCo post.)


The op-ed was premised on recent research co-authored by Pozen, which showed "that firms in the S&P 500 announced adjusted earnings that were, on average, 23% higher than GAAP earnings. At the same time, those firms reporting the largest differences between their adjusted and GAAP earnings awarded higher pay packages to their CEOs than predicted by the standard academic model of normal CEO compensation. Yet those firms with the largest differences, on average, experienced lower stock returns and subpar operating performance...." While the research did not agree with either of the well-worn assertions that NGFMs are necessarily misleading to investors or that NGFMs more accurately depict corporate performance, "overall," the evidence from the research suggested that "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. We also note that although excessive pay for firms reporting high non-GAAP earnings is about 16% of total pay, the bulk of the pay represents reward for performance. Still, an economically meaningful fraction of CEO pay appears to be attributable to opportunistic non-GAAP reporting."

With regard to recommended reforms to address these issues, the research suggested that "the SEC may want to require that compensation committee reports give GAAP metrics 'equal prominence' with non-GAAP metrics, as in earnings press releases. In particular, the SEC might consider requiring compensation committee reports of all public companies to (i) prominently disclose the amount of difference between the non-GAAP criteria used by the committee and the relevant GAAP numbers; and (ii) provide a justification for why the committee chose to use non-GAAP criteria in setting executive compensation."

Audit Analytics contends that the concern regarding whether non-GAAP metrics may be manipulated "to boost C-suite pay" is even more pronounced for ESG-focused investors because "a significant component of the governance factor is executive compensation and the metrics used to justify that pay. These investors and analysts need to be aware of non-GAAP metrics surrounding the debate, as excessive use of non-GAAP metrics and the aggressive adjustments done to reach compensation targets can suggest these firms are self-dealing and is a sign of poor governance."

Audit Analytics identifies two schools of thought regarding the use of non-GAAP comp metrics: one school argues simply for more transparency, regardless of the type of non-GAAP metric used. Audit Analytics adds that the lack of transparency is actually more disconcerting than is immediately apparent: "some firms will double-adjust executive compensation metrics by identically labeling metrics in both earnings releases and executive pay but calculating the metrics differently. There is limited transparency for investors and analysts when metrics are double-adjusted, and this is especially troubling if companies wouldn't be able to reach their C-suite compensation targets without double-adjusting the numbers. In 2018, about 30% of the S&P 500 companies used metrics that were double-adjusted. Investors face many of the same issues while evaluating custom metrics in earnings releases, but the problems for compensation are exaggerated because of the lower regulatory requirements applicable to proxies" (i.e., the absence of the reconciliation and other requirements of Reg G and Item 10(e)).

The other school of thought advocates prohibiting the use of certain non-GAAP metrics and adjustments because they are misleading (so-called "tailored accounting") or inappropriate. For example, Audit Analytics notes, one potential "pitfall" that some NGFM opponents identify is that some adjustments to a GAAP measure may be inappropriate because they could allow "management to avoid taking responsibility for bad decisions and poor performance." Similarly, this article in the WSJ observes that "there is an argument to be made for sometimes excluding items from results for compensation purposes. If, say, a natural disaster hits a company with expensive repairs, perhaps an adjustment is in order. But other items that often get excluded in pro forma results, such as layoff-related charges, do seem like a reflection of management's performance." (See this PubCo post.)

As noted above, the SEC has increasingly called out some tailored accounting measures as potentially misleading. As revealed in this earlier analysis from Audit Analytics, the incidence of comments on individually tailored recognition and measurement methods nearly doubled from the last six months of 2016 to the first six months of 2018, from 6.5% to 12.3%. The 2016 CDIs make clear that certain adjustments that result in a non-GAAP measure can be misleading, such as adjustments excluding normal recurring charges, "cherry picking" of adjustments or inconsistent presentation of measures between periods (such as when a measure adjusts a particular charge or gain in the current period but similar charges or gains were not adjusted in prior periods). For example, in one CDI, the staff indicated that non-GAAP measures that substituted individually tailored recognition and measurement methods for those of GAAP could violate Rule 100(b) of Reg G. The illustration provided described a company that improperly used a non-GAAP measure that accelerated revenue—which, under GAAP, would be recognized ratably over time—to make it appear that the company earned revenue when customers were billed. The staff viewed as impermissible the replacement of an important accounting principle with an alternate accounting model that did not conform to the company's business. In that regard the then-Deputy Chief Accountant had observed that, "if you present adjusted revenue, you will likely get a comment; moreover, you can expect the staff to look closely, and skeptically, at the explanation as to why the revenue adjustment is appropriate."

However, Audit Analytics maintains, so far, SEC staff comments related to the use of NGFMs exclusively for executive comp practices are "uncommon. Moreover, the SEC may permit companies to continue using certain metrics for compensation purposes that would be prohibited in other filings." Will SEC staff scrutiny of tailored accounting measures in CD&A increase? Although currently, CDI 108.01 provides that CD&A disclosure of NGFM target levels are not subject to Reg G and Item 10(e), it also states that, if NGFMs are "presented in CD&A or in any other part of the proxy statement for any other purpose, such as to explain the relationship between pay and performance or to justify certain levels or amounts of pay, then those non-GAAP financial measures are subject to the requirements of Regulation G and Item 10(e) of Regulation S-K." Accordingly, even in the absence of rule changes, the staff is empowered to examine NGFMs based on tailored accounting in CD&A in contexts other than target levels. Whether the SEC goes further and acts on the recommendations of Commissioner Jackson or CII to apply these requirements to NGFM target levels remains to be seen.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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