From Harvard Business Review
Each year most public companies issue reports on the pay packages of their top executives, describing how their compensation committees arrived at the numbers. These reports are part of the proxy statements sent to all shareholders, who vote on the packages. The votes are advisory or binding, depending on the country where a company is chartered.
More than 95% of the time, shareholders overwhelmingly approve the pay recommendations. Yet our research suggests that investors should be more skeptical. Compensation committees frequently adjust company performance numbers in complex and
even obscure ways, for a variety of reasons. Sometimes, for example, they want to focus on the performance of a company’s core or continuing operations. Whatever the motive, the upshot is all too often inflated numbers, calculated on a nonstandard basis, that rationalize overly generous compensation.
Given that reality, compensation committees need to explain the basis of their decisions more clearly in their reports. For their part, investors need to develop standards and best practices for compensation design and reporting, around which they can build a meaningful dialogue with companies. Such a dialogue is critical today in view of the public’s concerns over the rising ratio of CEO pay to the average worker’s wages and of shareholders’ growing insistence that high pay be justified by superior managerial performance.
In this article we’ll review the common shortcomings of compensation committee reports, especially the use of nonstandard accounting measures and the selection of inappropriate peer companies. We’ll also propose ways in which companies and shareholders can improve their approach to determining top management’s compensation. Let’s begin by looking at an example of the problem.
Generous to a Fault
In their reports, most compensation committees identify the criteria used to award both annual cash bonuses and longer-term stock grants—usually the two largest components of executive pay. But even at the most upstanding companies, those criteria are seldom well explained.
Take the 2015 compensation committee report of a well-known Fortune 500 company (which you’ll find summarized above in the exhibit “One CEO’s Pay Package”). Running 15 single-spaced pages, it makes a serious effort to delineate the components of the $24 million this CEO received for the year and the criteria behind them. But, like most such reports, it doesn’t provide enough information to allow the reader to make an informed judgment on the merits of the pay package without doing a lot of extra work. So we dug a bit deeper:
The cash bonus.
The committee tied 40% of this to a revenue target and 20% to a goal for the company’s product pipeline. Its report provides clear numbers for the revenue target and specific milestones for the pipeline.
But shareholders would struggle to understand the criterion for the other 40% of the bonus: non-GAAP EPS, or earnings per share calculated on a basis other than generally accepted accounting principles. Companies often use such earnings figures, arguing that GAAP numbers don’t provide a fair picture of performance.
What the report doesn’t make clear is the considerable disparity between the company’s GAAP and non-GAAP earnings. Instead, a footnote refers the reader to the company’s 10-K report. There the curious reader learns that this difference is approximately $7.5 billion, which constitutes more than 100% of this company’s GAAP earnings for 2015. In plain English, the company’s earnings under GAAP were $1.56 a share, versus $3.56 under the non-GAAP criterion used by the committee.
Why such a big difference? A review of the 10-K reveals that most of it came from eliminating charges for acquisition and divestiture costs in 2015 and earlier years. While that move may have helped the committee focus on the continuing business, the reader has no good way to evaluate whether the huge costs of these transactions were outweighed by their benefits.
Read the full post at Harvard Business Review.
Robert Pozen is a Senior Lecturer at the MIT Sloan School of Management.
S.P. Kothari is the Gordon Y Billard Professor of Accounting and Finance at the MIT Sloan School of Management.