Non-GAAP Measurements and Executive Compensation: Domino Effect

Last week, Michael Rapoport had an interesting article in the WSJ (based on Audit Analytics data) concerning the use of non-GAAP metrics to determine executive compensation. He wrote, “U.S. companies increasingly are using unconventional earnings measures in determining bonuses, making it easier for them to appear more profitable when they reward executives with big paydays.”

According to the analysis, it appears the number of proponents of non-GAAP benchmarks is growing. The number of large accelerated filers that used non-GAAP metrics in determining executive compensation grew from 249 in 2009 to 542 in 2013 (14% and 28% of all large accelerated filers in the respective years).

This has some parties concerned, and the opinions on the use of non-GAAP are quite divergent. Non-GAAP income is virtually always higher than GAAP income. Some believe that the only use for non-GAAP is to hide losses and/or poor performance. Others argue that the non-GAAP measures are more reflective of the underlying business health of the company.

Either way, based on those figures, fewer than one in three companies are using non-GAAP measures. If we assume that these remaining companies do not use non-GAAP measurements to determine executive compensation, can we conclude that the effect is limited to the companies noted? Well, not exactly. You see, the most common method of setting executive compensation is to benchmark against a company’s peers.

If you ask an average employee of Buy N Large Inc. how much the company’s CEO made in total compensation last year, the answer might be, “a lot more than I did, I can tell you that”. If you asked on a Friday afternoon after a round or two of beers, the employee may also mutter “and way more than he deserves”, cautiously looking around to make sure nobody is listening.

This conversation could be had with employees of virtually all large US corporations, since CEOs are paid based on… what other CEOs are paid. The most common way to determine top executive compensation is (and has been for a while) to benchmark compensation against peer companies.

So, if the companies that don’t use non-GAAP measures benchmark against those that do, we have sort of a domino effect on our hands.

Back in November, Audit Analytics published a list of companies that were selected the most frequently as benchmarking peer companies in 2013. Johnson and Johnson (JNJ), General Mills (GIS), and Eaton Corp. (ETN) rounded out the top three most commonly cited peers, among the Russell 3000.

Out of the top benchmarking companies Audit Analytics cited, most use Non-GAAP metrics to determine their executive compensations. This suggests that the use of non-GAAP measures by a relatively small number of companies could affect the executive compensation of a much larger group of companies.