From The Wall Street Journal
Every year, shareholders of U.S. companies weigh in on executive pay by casting advisory votes on the reports of compensation committees. The committees are appointed by corporate boards to make recommendations about appropriate pay levels. Shareholders tend to take their reports at face value, voting to approve them in over 97% of cases. But their confidence is undermined by a lack of awareness about the often flawed methods compensation committees use to determine pay.
The trouble is that compensation committees frequently rely on faulty performance metrics that inflate executive pay. But the committee reports do not provide a sufficient explanation of these metrics to shareholders.
First, their reports routinely use “adjusted” earnings that are much higher than the figures calculated under Generally Accepted Accounting Principles. While many companies tout adjusted numbers in their press releases on earnings, regulations require these releases to give their GAAP figures equal prominence. By contrast, there is no similar rule for compensation reports, which may use only the adjusted numbers without quantifying their differences from GAAP.
Take Merck & Co., whose CEO had a bonus goal for 2015 of $3.40 in adjusted earnings per share. The compensation committee concluded that he had met that target, since the company’s adjusted earnings were $3.56 per share. But the committee’s report failed to mention that GAAP earnings were only $1.56 per share.
This example is not unique.
In 2015, 93 companies in the S&P 500 announced adjusted earnings that were more than 50% above their GAAP earnings. At most of these firms, the compensation committees set executive pay using the adjusted earnings without quantifying how they differed from GAAP metrics.
There are valid reasons for excluding certain expenses from the GAAP figures. The costs of one-time events like layoffs might reasonably be omitted when calculating CEO pay. But most compensation reports don’t provide sufficient justifications for these omissions. For example, they may write off “one-time” restructurings that their companies actually undergo almost every year.
More broadly, compensation reports often leave out expenses that truly ought to factor into executive pay, such as litigation settlements for alleged financial misstatements by management. Depreciation and amortization are excluded on the grounds that they are not core operating expenses. Yet they represent wear and tear on the plant and equipment that generate operating income. Committees also exclude taxes, although tax management is clearly relevant to financial performance.
Read the full post at The Wall Street Journal.
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.