It’s not the adjustments to GAAP numbers in setting executive compensation that bother investors. It’s the lack of clarity about how those non-GAAP measures are calculated.
That’s what prompted the Council of Institutional Investors to petition the Securities and Exchange Commission for a change to the rules about the use of non-GAAP measures in proxy statements’ Compensation Discussion and Analysis. “There can be legitimate reasons for excluding certain non-GAAP items when computing executive pay,” said Robert Pozen, senior lecturer at MIT and former president of Fidelity Investments. “We’re just asking for much better disclosure.”
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Public companies are required under SEC rules to provide financial information following Generally Accepted Accounting Principles, or GAAP, and to take care when using non-GAAP measures to assure they won’t confuse investors to appear more prominently than GAAP measures. Where companies use any non-GAAP metrics in their communications with investors, they are required to reconcile the figure to its nearest GAAP counterpart so investors will understand how the number was computed.
Use of non-GAAP metrics has jumped considerably in recent years. Companies generally use the metrics to remove the effects of one-time events or to try to arrive at numbers that they believe better represent the operating performance of the core business. The SEC has cracked down on misuses of non-GAAP metrics, concerned about instances where companies may be using non-GAAP numbers to obscure actual results.
Compensation disclosure in the proxy, however, is one area of SEC reporting where reconciliation of non-GAAP metrics to GAAP is not required, says Mark Borges, principal at compensation consultancy Compensia.
“This has been the rule since executive compensation disclosures changed in 2006,” said Borges. “It was always thought that it was a concession to the desire to not interfere with the design of incentive compensation arrangements that companies were using that weren’t necessarily intended to provide information for the marketplace as a whole on the financial condition or health of the company but were related to metrics used to determine executive compensation.”
As executive compensation has grown more complex over the past several years, so has CD&A in proxy statements, which investors now rely on to cast their votes under the say-on-pay provisions of Dodd Frank to approve or disapprove of executive compensation programs.
The California State Teachers’ Retirement System, for example, votes on more than 3,000 proxies each year, roughly three-fourths of which occur in April and May, says Aeisha Mastagni, CII board member and portfolio manager at CalSTRS. “Sometimes we’re getting 100 proxies a day,” she says. “If it’s not clearly laid out in the CD&A portion of the proxy, it’s very difficult for us to go and research what types of adjustments were made.”
Generally, companies are adjusting GAAP numbers in arriving at executive compensation plans in the same way they already disclose or reconcile elsewhere in their form 10-K filings, says Richard Harris, a partner at human resources consulting firm Aon Hewitt. “Most companies would say if you’ve read a few CD&As, which are already long, complex, and involved, you have tons of information to help investors understand how pay gets delivered to executives teams,” he says. “While it might be marginally easier to have some sort of link or appendix, this is not information that’s unavailable to investors today.”
“Most companies would say if you’ve read a few CD&As, which are already long, complex, and involved, you have tons of information to help investors understand how pay gets delivered to executives teams. While it might be marginally easier to have some sort of link or appendix, this is not information that’s unavailable to investors today.”
Richard Harris, Partner, Aon Hewitt
Geography of information aside, CII is also raising concerns about whether companies in fact are making the same adjustments for CD&A purposes that they’re making for other investor communication. Sometimes, it’s impossible to determine, says Ken Bertsch, executive director of CII.
“My sense is that some companies do not reconcile because it is not required and they have not thought more about it and that others are making this more difficult to understand because they know the adjustments would be viewed skeptically by investors,” says Bertsch.
In its petition to the SEC, CII provides examples of disclosures it believes to be instructive and helpful in terms of explaining how GAAP numbers were adjusted for compensation purposes as well as others that are confusing. Blackbaud, for example, includes a table in its 2019 proxy statement that begins with year-end GAAP revenue and income for its two more recent years and lists adjustments related to business combinations, stock-based compensation, employee severance, restructuring costs.
Blackbaud’s disclosure illustrates how the company arrived at metrics like “non-GAAP revenue,” “non-GAAP income from operations,” and “non-GAAP operating margins.” CII cites a number of other disclosures that use terms like “adjusted EBITDA,” (that refers to earnings before interest, taxes, depreciation and amortization) “adjusted non-GAAP net income,” “adjusted EBITDA growth,” “non-GAAP pretax profit,” and “certain adjusted EBITDA targets” without adequately explaining or cross-referencing them.
“I don’t think its really malfeasance,” says Steve Kline, director and senior executive compensation consultant at Willis Towers Watson. “When you look at 10-Ks and proxies, there’s a pretty big effort to produce those and a range of practices. Some are readily transparent, and there are different ways to be transparent.”
In light of growing interest on greater corporate transparency, Harris says companies should take a look at their disclosure and consider how investors will view it. “The real issue is having investors understand — whether through proxy or something else — truly understand what is in and out of the number,” he says.
It’s important for companies to have a set of principles to define what kinds of non-GAAP metrics they will use and then stick to it, says Harris. “Have a good governance process to deal with this,” he says.