Impact of Non-GAAP Earnings and Adjustments on Incentive Plan Payouts: Heightened Scrutiny Ahead?
The reporting of “non-GAAP” (Generally Accepted Accounting Principles) financial metrics is a common practice among companies. These adjusted metrics are useful to investors and other stakeholders in understanding a company’s core operating results and facilitating year-over-year business performance comparisons. A number of these adjustments are considered outside of management’s control or non-recurring in nature. Common examples include a loss on the sale of an asset or the effect of changes in foreign exchange rates.
In many cases, the same or similar non-GAAP metrics are used in executive compensation incentive programs where the same philosophy holds — reward management for performance that reflects “true” operating results that is within their control. Proxy advisory firms and investors have increased their scrutiny of some adjustments, particularly when adjusted performance leads to incentive payouts that are misaligned with the shareholders’ experience.
In this Viewpoint, we cover the basics of incentive plan performance adjustments, the issues important to management and shareholders, and some “best practices” for using adjustments and adjusted metrics for incentive plan purposes. We will then follow up with a second Viewpoint covering more complex issues with adjustments related to the effects of acquisitions and asset divestitures as well as other issues as they affect both short- and long-term incentive arrangements.
What are Some of the Common Non-GAAP Adjustments Used for Incentive Compensation Purposes?
The use of adjusted financial results for incentive plan purposes is generally intended to compensate management based on the financial results for which they are being held accountable. In our experience, common financial adjustments that may be used by companies to determine incentive plan payouts include the following:
✓ Restructuring charges, including severance
✓ Impact of acquisitions and divestitures
✓ Legal settlements and related legal fees
✓ Gains / losses related to asset sales
✓ Product liability / warranty charges
✓ Acquisition due diligence costs
✓ Pension income / expense
✓ Substantial changes in capital structure
✓ Impact of foreign currency translation
✓ Impact of share buybacks
✓ Gains / losses on extinguishment of debt
✓ Impact of changes in accounting standards
It is worth noting that changes to Section 162(m) of the tax code (the $1 million deduction limit) under the 2017 tax reform legislation have made it easier to adjust or change performance targets, as the legislation eliminated the performance-based tax deduction exception for qualified incentive compensation. As a result, many companies have eliminated the umbrella plan design that facilitated greater use of discretion under 162(m) for this reason.
Is There a Difference Between Adjustments Used to Determine Non-GAAP Metrics Used in Financial Reports and Those Used for Incentive Purposes?
There are a variety of reasons why non-GAAP adjustments used for incentive compensation purposes may differ from those used for financial reporting purposes. Some of these discrepancies are due to:
- Threshold amounts that seek to limit the number of adjustments to only those that are materially above a certain dollar amount (i.e., expenses or benefits above $5.0 million)
- Expenses or benefits that are included in the annual business plan used to establish incentive targets (further adjusting actual performance would result in double counting)
- Expenses or benefits that may be non-recurring and excluded for financial reporting purposes but still deemed within the control of management for incentive purposes
- Optics and materiality where omitting a significantly large expense could lead to a severe misalignment due to an above target incentive payout and poor share price performance
- Matter of importance — for example, foreign currency exchange rates that are used to adjust earnings for year-over-year comparability purposes but are not as important for incentive purposes
Best Practices / Potential Pitfalls
Given the potential for heightened scrutiny of non-GAAP adjustments and their potential impact on incentive plan payouts, there are best practices companies may want to consider, including:
- Approve a list of potential adjustments the management team and compensation committee might want to consider when calculating incentive payouts at the beginning of the performance period
- Determine if the list of adjustments should be limited to those used in the company’s regulatory filings and earnings releases
- Assess if the adjustments should be automatic / formulaic or should remain subject to compensation committee discretion
- Adopt a materiality standard, such as more than $5 million or at least equal to 10% of the target incentive plan payout, in order to reduce the number of adjustments each period
- Require a provision that adjustments should be “unplanned” and not already included in the annual budget if the budget is used to set incentive targets (eliminates double counting)
- Include the CFO or a finance group representative to discuss the rationale for the adjustments and in some cases how they were calculated, as needed
- Keep a running list of adjustments and their impact on incentive plan payouts over the last 5-7 years to evaluate if the company is applying the adjustments in an even-handed manner
- Review adjustments and their impact on incentive plan payouts throughout the performance period
- Consider the impact of the adjustments on incentive plan payouts to determine if the overall result is fair to incentive plan participants and shareholders
- Disclose a robust and compelling rationale for using adjusted financial results in the proxy when calculating incentives
There are also a few potential pitfalls companies may want to avoid, including:
- Approving adjustments of significant value that result in incentive plan payouts that far exceed target during a year in which the company experienced a significant decline in shareholder value / stock price without a strong rationale
- Making discretionary adjustments when determining long-term incentive plan payouts, as such adjustments could result in liability accounting for the award (grant date not properly established as all the key terms of the award were not established)
- Adjusting for items that shareholders might consider part of management’s regular operating responsibilities, such as the loss of a large customer
- Lacking documentation, which can lead to poor governance and inconsistent use of adjustments among comparable periods
Proxy Advisory Firms’ Perspective / Guidance
Institutional Shareholder Services (ISS) conducted its annual policy survey earlier this year and asked if companies should be required to include a line-by-line reconciliation of GAAP to non-GAAP results used to calculate incentive plan payouts in the proxy. According to ISS, 60% of investors responded that such a reconciliation should be mandatory compared to only 25% of companies. There was some common ground between investors and companies (approximately 35%) that such adjustments should be subject to a line-by-line reconciliation when the adjustments were material to the determination of the payouts. [i]
While ISS did not formally update its 2024 proxy voting policy to require this reconciliation, they did add a frequently asked question, which noted the sizable impact such adjustments can have on incentive plan payouts, recommended detailed disclosure of the adjustment(s) and the rationale for such adjustments, and stated the inclusion of a line-by-line reconciliation is a best practice. They also advised:
“The absence of these disclosures would be viewed negatively, as would adjustments that appear to insulate executives from performance failures – particularly for companies that exhibit a quantitative pay-for-performance misalignment.”[ii]
Glass Lewis updated its 2024 proxy voting guidance to include an expectation that companies provide “thorough and transparent disclosure in the proxy” especially for such adjustments that materially impact incentive plan payouts. Glass Lewis further notes the lack of such disclosure “may be a factor in our recommendation for say-on-pay.” [iii]
The use of non-GAAP adjustments to determine incentive plan payouts is a common practice among companies of all sizes and industry sectors. At times they can be scrutinized as being lenient on management’s performance when shareholders are not afforded the same treatment. As with many things related to executive compensation, companies will benefit from adopting rigorous governance and disclosure practices as it relates to the use of adjustments. Adopting a structure at the beginning of each performance period identifying the type of adjustments to be considered, a provision requiring only unplanned amounts be included in the adjustment, and the use of potential threshold levels to reduce the number of adjustments are considered best practices. Adjustments should be reviewed by the Compensation Committee as they arise throughout the year as part of its overall review of interim incentive performance. The disclosure of this process as well as the rationale for why adjustments were made will allow shareholders to fully understand the Compensation Committee’s decisions. While we have identified common practice regarding the use of adjustments, the facts and circumstances of each situation can be different, and therefore may influence decisions accordingly.