Non-GAAP Performance Measures For Executive Compensation Plans

September 26, 2016

The U.S. Securities and Exchange Commission (SEC) recently released new and revised guidance on the use of non-GAAP financial measures. According to a recent Audit Analytics study, non-GAAP metrics have increased in prevalence among S&P 500 company earnings releases (approximately 88% of S&P 500 companies favored using non-GAAP metrics over standard GAAP metrics). While non-GAAP financial measures are widely used, there are few rules governing their construction and disclosure. This guidance serves as a tool to help mitigate any potential consequences of material errors and omissions or misleading non-GAAP presentations.

Entangled in the debate over the use of non-GAAP metrics versus standard GAAP metrics is the notion that non-GAAP financial measures invariably trend toward presenting company performance in a more favorable light. The same Audit Analytics study found that:

Non-GAAP adjustments increase net income 82% of the time; and
The average quarterly impact of non-GAAP income adjustments was an increase of $176 million.

Findings like these naturally prompt pay critics and the press to question the overall impact that non-GAAP metrics have in executive compensation.

Impact of Non-GAAP Measures on Incentive Payouts

A recent study by Willis Towers Watson examined the relationship between GAAP and non-GAAP performance measures, and CEO annual incentive payouts for fiscal year 2015. The study compared company annual incentive payouts relative to target based on the type of measures used (non-GAAP vs. GAAP), among a sample of 369 S&P 1500 companies. As illustrated in the graph below, no discernible difference was found based on the type of measures used, suggesting that incentive compensation is not the motivating factor driving companies to use non-GAAP metrics.

Use of Non-GAAP Metrics in Performance Plans

The use of non-GAAP measures in performance plans is often a subject of debate for compensation committees. Arguments made in favor of management adopting non-GAAP financial measures typically include:

More focus on line-of-sight performance and disregard of one-time nonrecurring items (e.g., legal settlements, M&A accounting, etc.);
Better company operational effectiveness and avoidance of disincentives for decisions and actions that are in the best interest of the company; and
Less management distraction on items outside their operational control (e.g., currency exchange fluctuations, etc.).

Popular incentive plan measures such as revenue, operating income and net income often include multiple adjustments or exclusions such as acquisitions/reorganizations, extraodinary or nonrecurring items and foreign currency fluctuations. From a compensation standpoint, these adjustments or exclusions serve a valuable purpose by creating direct line of sight to what executives have the ability to manage or control. The table below outlines the most common adjustments found in incentive plan performance measures:

Non-GAAP Metric Best Practices

Given the SEC’s renewed focus of non-GAAP performance metrics, it is important for compensation committees and management to be mindful should they decide to adopt these metrics in their executive pay programs. Some common best practices include:

Benchmarking: Understanding what metrics are commonly used may help management determine which metrics are useful for investors. Enhanced disclosure may also be needed should there be any differences in metric calculations between companies or industries;
Transparency: Clearly labeling each non-GAAP financial measure, and providing transparent disclosures of how each measure is calculated will help avoid confusion, and better convey the nature of each measure. Clear identification of components included in determining the measure and where such components are reflected in the GAAP financial statements can also aid in the overall understanding of the metric;
Predefined performance conditions: Performance measures should be defined and clearly established at the beginning of the performance cycle. To avoid any confusion or criticism, needed adjustments such as acquisitions, nonrecurring items, and foreign currency fluctuations should be built in to the definition of each measure from the outset;
Consistency: Companies should maintain a certain level of consistency in their calculations and presentations of non-GAAP information from period to period. In instances where a company changes how it determines a non-GAAP measure, transparent disclosure of the changes and rationale should be included. Consistency across reporting mediums such as investor presentations, or press releases should also be taken into consideration; and
Process Improvement: In light of the heightened scrutiny of non-GAAP disclosure practices, compensation committees should be fully aware of company performance as it relates to both GAAP and non-GAAP measures. Initial compensation committee meetings should outline year-over-year performance under both metrics, with actual year-to-date performance updates at subsequent meetings throughout the year. These should also include any pending adjustments, potential impact and rationale for inclusion or exclusion in the reported financial results.

Veritas Executive Compensation Consultants, ("Veritas") is a truly independent executive compensation consulting firm.

We are independently owned, and have no entangling relationships that may create potential conflict of interest scenarios, or may attract the unwanted scrutiny of regulators, shareholders, the media, or create public outcry. Veritas goes above and beyond to provide unbiased executive compensation counsel. Since we are independently owned, we do our job with utmost objectivity - without any entangling business relationships.

Following stringent best practice guidelines, Veritas works directly with boards and compensation committees, while maintaining outstanding levels of appropriate communication with senior management. Veritas promises no compromises in presenting the innovative solutions at your command in the complicated arena of executive compensation.

We deliver the advice that you need to hear, with unprecedented levels of responsive client service and attention.

Visit us online at www.veritasecc.com, or contact our CEO Frank Glassner personally via phone at (415) 618-6060, or via email at fglassner@veritasecc.com. He'll gladly answer any questions you might have.

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