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Shareholders need to know when CEO comp is tied to disappointing results that have been ‘adjusted’ upward.

By Robert J. Jackson Jr. and Robert C. Pozen

Op-Ed in Wall Street Journal, April 10, 2019

It’s proxy season, and shareholders will soon cast votes on executive pay at America’s public companies. To vote intelligently, investors need transparency on how pay is tied to performance. Historically, corporate performance has been measured using generally accepted accounting principles—the standard for all statements filed with the Securities and Exchange Commission. But pay practices are changing: Executives today are often paid to hit “adjusted,” non-GAAP targets. 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.

Compensation committees charged with tying pay to performance should be using the same scorecard as ordinary shareholders. If they’re not, they should have to explain that decision to investors.

Recent research co-authored by one of us shows 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—hardly a basis for outsize compensation.

Differences between GAAP and non-GAAP numbers can be dramatic, sometimes turning GAAP losses into adjusted profits. In 2015, 36 companies in the S&P 500 announced adjusted earnings that were more than 100% higher than their GAAP income, with another 57 announcing adjusted earnings 50% to 100% higher. The compensation committees of almost all those companies used a non-GAAP measure as an important criterion for awarding executive pay.

There are often good reasons to use adjusted earnings to evaluate corporate performance, like when one-time charges obscure the underlying health of a business. But because those adjustments can be significant, the SEC requires earnings releases to reconcile adjusted measures with GAAP figures. This allows investors to evaluate the difference for themselves.

Unfortunately, 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.

The SEC’s disclosure rules have not kept pace with changes in compensation practices, so investors cannot easily distinguish between high pay based on good performance and bloated pay justified by accounting gimmicks. That’s why we’re calling on the SEC to require companies to explain why non-GAAP measures are driving compensation decisions—and quantify any differences between adjusted criteria and GAAP. A few public companies already provide investors with this kind of transparency. Others can too.

Over the past decade, we’ve reformed securities laws to give shareholders a say over how companies pay top executives. But for those votes to be meaningful, investors need more insight into the decisions that produce managers’ payouts. Now that accounting adjustments to GAAP results have become pervasive, we need much more transparency on the role of those adjustments in setting executive pay. It’s time for the SEC to help investors understand exactly what performance they’re paying for.