This article was first available to subscribers of Accounting Quality Insights by Audit Analytics on Bloomberg, Eikon, FactSet, and S&P Global.
There has been considerable debate about companies that use non-GAAP metrics for executive compensation and whether these firms are manipulating metrics to boost C-suite pay. For investors who follow environmental, social and governance (ESG) investing philosophy, 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.
Corporate use of non-GAAP metrics grew so much since the 2008 financial crisis that the Securities and Exchange Commission (SEC) in 2016, and in 2018 updated its interpretation of Regulation G to clarify the agency’s position when it comes to misleading financial metrics.
The use of adjusted metrics for compensation purposes increased significantly after 2009, matching the proliferation of general non-GAAP usage. In 2018, more than two-thirds of the S&P 500 companies used non-GAAP to establish compensation targets. Notably, the SEC did not update Question 108.01 that exempts metrics used for compensation purposes from the Regulation G requirements.
The debate over non-GAAP executive pay metrics centers around two schools of thought. One argument suggests companies can use whatever metrics they want, including non-GAAP, but those metrics need to be transparently disclosed. The second school argues that certain non-GAAP metrics and adjustments are misleading and should be banned.
There are a few transparency problems when companies use non-GAAP metrics for compensation purposes. First, the figures don’t need to be reconciled to GAAP numbers. This means that investors have little visibility into how the metrics are calculated and which expenses were taken out. Second, 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&P500 companies used metrics that were double-adjusted. (Contact us for additional information.)
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. That is, metrics used for compensation purposes are exempt from the requirements of Regulation G.
There is nothing inherently wrong with using custom targets, as executive pay plans often combine GAAP, non-GAAP and operational metrics to set targets.
Non-GAAP targets seek to align executive compensation with shareholders’ long-term interests. Sometimes GAAP metrics alone can’t help a firm reach this goal. One group that believes non-GAAP measures should be allowed for executive pay is the Council of Institutional Investors (CII). However, they contend current disclosure rules regarding use of non-GAAP metrics for executive compensation aren’t enough.
CII wrote to the SEC in April 2019 about non-GAAP disclosure, asking the agency to eliminate Instruction 5 to Item 402(b) regarding permitted annualized adjustments and replace it with the requirement that companies using non-GAAP metrics in the proxy statement need to present the information in proper context in the Compensation Discussion & Analysis, and for it be subject to the requirements of Regulation G and Item 10(e) of Regulation S-K. Additionally, they want companies to include the required reconciliation in the proxy statement or make it accessible through a hyperlink in the CD&A.
Currently the SEC says that Instruction 5 to Item 402(b), “is limited to CD&A disclosure of target levels that are non-GAAP financial measures. If non-GAAP financial measures 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.”
The argument by CII to include the information in the CD&A section is because it “is the most important source used by investors in evaluating executive compensation, and in deciding how to vote on advisory votes on executive compensation mandated by the Dodd–Frank Wall Street Reform and Consumer Protection Act. The CD&A also informs investor understanding of a corporation’s governance more generally, and in voting on election of directors.”
A recent study, High Non-GAAP Earnings Predict Abnormally High CEO Pay, by Nicholas Guest of Cornell University’s Samuel Curtis Johnson Graduate School of Management and S.P. Kothari and Robert Pozen at the Massachusetts Institute of Technology’s Sloan School of Management, find companies that use non-GAAP earnings end up over paying their C-suite executives. From the executive summary:
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. 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.
However, in the executive summary, the researchers stop short of suggesting these are a sleight-of-hand by companies, and they don’t accept the argument that non-GAAP is a truer picture of business.
As in prior research, we do not find that non-GAAP earnings mislead investors, nor do we find support for managers’ typical assertion that non-GAAP earnings more accurately convey core performance. Specifically, non-GAAP earnings do not correlate more highly with contemporaneous stock returns or future performance than GAAP net income or operating income.
Those who argue against using non-GAAP metrics to set compensation targets cite potential pitfalls, such as allowing management to avoid taking responsibility for bad decisions and poor performance. Some commonly excluded items like lay-off related charges are tied to management’s performance and need to be included when calculating pay.
In an attempt to improve non-GAAP disclosures, the SEC led a powerful campaign beginning in mid-2016 primarily focused on tailored metrics disclosed in earnings releases. However, SEC staff comments related to non-GAAP metrics used exclusively for executive compensation practices are uncommon. Moreover, the SEC may permit companies to continue using certain metrics for compensation purposes that would be prohibited in other filings.
To emphasize the controversy surrounding the use of non-GAAP metrics, let’s look at a recent example of the SEC taking a hard line against the use of adjusted measures. In a November 2018 comment letter to Microchip Technology Inc. [MCHP], the agency stated that some of the adjustments could be misleading.
The SEC’s question:
The use of the term “net sales” within the title of your non-GAAP measure implies that it is derived from GAAP, when in fact, it is not a GAAP measure. Please revise the title of your “non-GAAP net sales” measure to more appropriately reflect the fact that this measure represents the sales of your product by your distributors to end customers during the period.
Microchip said it would revise the title to “end-market demand,” a customized financial metric, and that it would explain it in a future disclosure. In part, end-market demand refers to the net dollar amount of its products, licensing revenue and other services delivered to direct customers or to distributors. The firm said its GAAP net sales are based on when it finishes performance obligations and transfers inventory control to customers. The firm explained it is part of a “large and complicated supply chain” with a mix of direct customers and distributors, with distributors making up most of their sales.
As an example, during the three months ended September 30, 2018, our end-market demand exceeded our GAAP net sales by $80.8 million, primarily due to distributors reducing the amount of inventory they carried. Therefore, we believe that end-market demand is a useful metric to investors as it provides information on the consumption trends of our products in the markets we serve. In the absence of disclosure of end-market demand, we believe that financial statement users may infer inaccurate conclusions with respect to the demand for our products. We believe disclosure of end-market demand is meaningful supplemental information of our performance but is not a substitute for our GAAP results.
The SEC isn’t buying this custom metric, saying changes in distributor inventory levels don’t comply with the revised guidance about non-GAAP metrics and that it’s misleading.
The SEC asked Microchip to revise the measure to exclude the changes in distributor inventory level, but Microchip says they’ll still use this metric for executive compensation. (Emphasis is ours)
…When reporting our actual results in future periods, we plan to continue to provide a calculation of our non-GAAP gross margin, non-GAAP operating expenses, non-GAAP other expense, net and non-GAAP tax provision (benefit) and a reconciliation of these non-GAAP measures to the most directly comparable GAAP measure and will not make any adjustments to reflect the impact of changes in distributor inventory levels.
It is important to note that the Company operates and manages its business to create and fulfil end-market demand and does not have internal goals or measure itself based on GAAP net sales. The Company’s variable compensation programs for all employees, including its named executive offers, will continue to be based off of end-market demand and non-GAAP measures. In our future filings, we will include a statement that we are not able to provide GAAP guidance as doing so would require an unreasonable effort.
The SEC isn’t just issuing comment letters trying to persuade companies to change their use of non-GAAP metrics. The agency is also starting to look into adjustments made to non-GAAP metrics, including those used for executive pay, that may be potentially misleading.
When the SEC issued its updated guidance for non-GAAP metrics, the watchdog agency told companies it would look “closely and skeptically” at companies’ reasons to use non-GAAP metrics to adjust revenue. Investors must be very careful with their analysis if a company uses revenue adjustments when calculating executive pay, because these firms are modifying the top line.
In conclusion, investors and analysts should look at non-GAAP metrics when it comes to executive compensation. If a company consistently underperforms and executive pay remains high, investors and analysts should think about whether the C-suite really deserves this compensation. For ESG investors in particular, they should be mindful of companies that use non-GAAP metrics aggressively for executive compensation, and how that effects a firm’s governance score.
For more information on this article, or for subscription information, please contact us at info@auditanalytics.com or (508) 476-7007.