After he became chair of the SEC in April, Gary Gensler put 49 rulemaking items to the commission’s near-term agenda, which reflects rules that he wants the commission to advance to the next stage of rulemaking process over the next 12 months.
Many of the SEC rulemaking plans align with priorities of the Council of Institutional Investors (CII), but the investor group wants Gensler to add one more item: improving non-GAAP measure presentation in the proxy statement’s Compensation Discussion and Analysis (CD&A).
“CII believes that the CD&A is the most important source of information used by investors in evaluating executive compensation,” CII General Counsel Jeffrey Mahoney wrote to the SEC on August 19, 2021. “Investors often struggle to make sense of how companies assess performance when approving large compensation package.”
Mahoney said shareholders cast say-on-pay advisory votes on executive compensation. Moreover, the CD&A helps investors to better understand a company’s governance in general and in voting for board of directors.
The influential investor group, which represents pension funds, endowments, and foundations that collectively manage more than $4 trillion in assets, said it wants companies, among other things, to comply with the rules that govern non-GAAP measures when they determine CEO pay to make sure that the metrics are not misleading. And CII petitioned the SEC for rulemaking in April 2019 when Jay Clayton was chairman of the regulatory agency. This went ignored at the time under a more business-friendly agenda set by Clayton.
“CII believes it is imperative that the SEC require, at a minimum, that companies include a hyperlink to a GAAP reconciliation for any non-GAAP pay targets contained in their CD&A,” Mahoney wrote. “We, therefore, request, that the Commission promptly add to its regulatory agenda proposed rules along the lines set forth in the 2019 Petition.”
Rationale for Rulemaking Request
Companies say they use non-GAAP figures because they provide a better representation of how they manage their business than many U.S. GAAP metrics do. And many investors find that it is useful to get management’s perspective on the company’s operations. However, the use of adjusted earnings has been increasing in the past several years because non-GAAP financial metrics tend to show higher figures than comparable GAAP numbers. This would in turn boost the company’s stock prices.
CII’s Mahoney wrote in the letter that about 95 percent of S&P index companies disclose adjusted earnings that do not follow GAAP. And such non-GAAP measures often exclude certain costs, including stock option expenses, acquired intangible write-offs, and restructuring charges.
The COVID-19 pandemic appears to have further increased non-GAAP metrics. More significantly, Mahoney said the pandemic appears to have increased the gap between GAAP and non-GAAP earnings.
“Thus, while non-GAAP financial measures may be useful in understanding a company’s performance, they also may be misused to ‘opportunistically report higher profits,’” Mahoney wrote.
He cited an analysis that showed more than two-thirds of S&P 500 companies used non-GAAP financial measures to set compensation targets in the CD&A in 2018. That analysis indicated that about 30 percent of S&P 500 companies that used non-GAAP metrics in the CD&A used non-GAAP measures that were labeled identically in their earnings releases but calculated the measures differently.
Moreover, he cited other research that indicated that non-GAAP metrics determined a significant portion of CEO’s cash bonuses, stock awards, or both.
Non-GAAP Metric Rules and Suggested Changes
Regulation G and Item 10(e) of Regulation S-K provide rules on the use of non-GAAP measures. Reg S-K lays out the reporting requirements for various filings with the commission.
Reg G says that companies cannot present their non-GAAP numbers more prominently than their audited GAAP numbers. The rule requires companies to reconcile the differences between the non-GAAP financial measure with the most directly comparable financial measurement from GAAP. The regulation also requires a statement about why management believes that presenting non-GAAP financial measures provides useful information to investors regarding the company’s financial condition and results of operations, among other requirements.
CII wants the SEC to amend Item 402(b) of Reg S-K.
In particular, the group wants the SEC to require companies in their proxy statements to explain why they are using metrics other than GAAP in their CD&A for setting executive compensation and provide a quantitative reconciliation of such metrics to their GAAP financials, or hyperlink to the reconciliation in another document.
“Since 2003 the SEC has generally required companies to give equal prominence to GAAP and non-GAAP financial measures, and explanation of why non-GAAP measures are better than GAAP, as well as provide a quantitative reconciliation of the numbers,” Mahoney wrote. ”Yet an anomaly exists in that the SEC rules currently do not apply to the target measures for compensation contained in” the CD&A.
This article originally appeared in the August 26, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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