Adjustments to GAAP financial performance measures are a perennially hot topic among compensation committees as they weigh year-end compensation decisions. Extraordinary or seemingly peripheral events can make the difference between achieving and missing a performance goal. To minimize the occurrence of arbitrary payouts, many compensation committees want to use non-GAAP results when certifying incentive payouts.
However, they know that there is a risk for blowback from shareholders and/or shareholder advisory firms if the results on a non-GAAP basis are more favorable than on a GAAP basis. Companies walk a fine line in determining what kind of adjustments should be made to GAAP results. Not all stakeholders agree on the preferred approach.
Adding to the discussion, last spring the SEC issued interpretive guidance on the use of non-GAAP financial measures in financial reporting. This guidance was not surprising given earlier comments from SEC Chairwoman Mary Jo White, who questioned whether companies were placing too much focus on non-GAAP metrics at the expense of financial statement clarity.
In this article, we walk through the rationale for adjustments and provide perspectives on which adjustments are more readily accepted and which are more controversial. We also raise some potential considerations for adjustments that are specific to annual and long-term incentive plans.
The Rationale for Non-GAAP Measures
One of the principles underlying incentive plan design is to reward management for performance that is in their control. In other words, an effective plan strives for high line of sight. GAAP performance measures can be problematic in a pay-for-performance incentive plan, as events outside management’s control can have a material impact on GAAP results. Examples include changes in accounting policy, fluctuations in exchange rates, and decisions made in prior performance periods that have current-period consequences (e.g., asset write-downs). Equally problematic is setting an incentive that later discourages decisions that are in the best interests of the business, such as M&A and restructuring actions.
From a pay-for-performance perspective, there are compelling reasons to reward based on adjusted financial performance that excludes the impact of events that were unexpected and outside of management’s control. This is consistent with analyst practices, whereby it is common to adjust as-reported GAAP results to hone in on ongoing business results.
However, a countervailing principle of incentive design is to align the interests of management with those of shareholders. While a pay-for-performance system that focuses on core results arguably achieves this objective, many shareholder advisory groups may view as-reported GAAP results as the better indicator of shareholder alignment. As a result, it is frequently controversial to determine what is in and what is out for incentive plan purposes.
Acceptable and Less Acceptable Adjustments
We don’t view this as an all-or-none decision. Not all adjustments are equal in the eyes of shareholders. If we think of it across a spectrum, we would say that the following are the most to least acceptable:
|Adjustment to As-Reported Results||Considerations|
|Essentially Necessary||Eliminating the impact of accounting standard changes||
|Most Acceptable||Eliminating the impact of changes in pension costs and discontinued operations||
|Generally Acceptable||Eliminating the impact of restructuring, mergers and acquisition-related expense, gains or loss on sale of a business, and asset write-downs||
|Most Controversial||Eliminating the impact of current economic conditions on performance (e.g., currency rates, interest rates, etc.)||
Measure Twice, Cut Once
Adjustments need to be implemented carefully to avoid accounting and tax problems. For example, failing to specify a framework for performing adjustments at the end of a performance period can result in onerous modification accounting and unexpected cost spikes. Similarly, being too vague in describing the adjustment process upfront can result in unplanned mark-to-market accounting.
Unplanned mark-to-market accounting stems from a growing area of scrutiny — how the “grant date” is defined on an equity instrument. If the terms and conditions are unclear, there isn’t a grant date, and the result is mark-to-market accounting until the terms are solidified. Consider, therefore, two ways of stating an intent to adjust as-reported GAAP results:
(Should not undermine grant date)
(May undermine grant date)
|Accounting standard changes||Operating income will be measured according to the company’s current revenue recognition policy based on the GAAP in place at the time of grant.||Operating income will be based on as-reported results in 2019, inclusive of any adjustments deemed appropriate by the Compensation Committee.|
|Currency conversion||Operating income will be measured using a constant currency conversion assumption. That is, future period results will be adjusted based on rates in place at the time of grant.||At its sole discretion, the compensation committee may adjust operating income to reflect the impact of currency fluctuations during the performance period.|
Another important feature of performance equity is its tax deductibility under Section 162(m) of the Internal Revenue Code. Failing to clearly set the adjustment parameters at the time of grant can void the tax deductibility of the instrument. But specifying upfront that performance outcomes shall be adjusted based on certain types of unforeseen events will not eliminate the deductibility of the instrument.
Have open discussions with your board and compensation committee about what items (if any) should be excluded from GAAP results.
Make adjustments on a principles basis, meaning there is symmetry in how positive and negative items are handled (e.g., a consistent approach for a tax benefit or a tax increase; for a gain on sale or a loss on sale). Clearly communicate the framework so that executives understand the intent is not to unilaterally leave them better off, but boost the line of sight in their performance incentives.
Socialize a framework upfront. We find that compensation committee members have limited appetite for adjustments to financial performance measures to reflect the impact of unanticipated changes in business conditions, unless the changes were explicitly built into the incentive design. For example, they are unlikely to accept an after-the-fact adjustment to incentive plan goals to remove the impact of changes in exchange rates. However, they may be open to a design that is established upfront with an assumption of constant currency exchange rates. The reason is that committees do not want to be viewed as making changes in management’s favor at the end of the year, particularly since it is seldom the case that management comes to the committee at the end of the year to make adjustments to GAAP earnings for favorable unanticipated factors.
Explain the framework to finance and tax teams so they understand how adjustments will be made and can validate that the approach will not trigger onerous accounting or tax consequences. For example, finance may proactively wish to explain the approach to the external auditors so that they understand why any adjustments made at the end of the performance period do not constitute plan modifications.
Make adjustments to GAAP consistent. If they are used in incentive plans, they should align with the adjustments to GAAP that are otherwise disclosed to investors in earnings releases and other shareholder communications. It may be troubling for shareholders to find a company disclosing three different versions of financial measures for use in financial statements and compensation disclosures (e.g., GAAP EPS, adjusted EPS for shareholder communications, EPS for incentive plan calculations).
Structuring incentive plans using non-GAAP measures has a place, but the devil is in the details. Formulating and socializing a thoughtful approach on the front end can avoid unnecessary surprises down the road with participants, the compensation committee, and in the financial statements.
Eric Hosken is a partner with Compensation Advisory Partners, LLC. He advises compensation committees and corporate management on executive compensation, with a focus on annual and long-term incentive design.
Takis Makridis is the president and CEO of Equity Methods, LLC. Equity Methods assists clients in the valuation and accounting of equity compensation awards, with a specialization in larger or more complex equity award vehicles.