Pro Forma Compensation: Useful Insight Or Window Dressing?
Stanford University – Graduate School of Business
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Stanford University – Graduate School of Business
Stanford Graduate School of Business
July 28, 2015
Rock Center for Corporate Governance at Stanford University Closer Look Series: Topics, Issues and Controversies in Corporate Governance No. CGRP-50
Stanford University Graduate School of Business Research Paper No. 15-46
In recent years, companies have begun to voluntarily disclose alternative measures of CEO compensation. These figures differ — sometimes significantly — from those reported in the summary compensation tables of the annual proxy. The motivation to report this information, however, is not entirely clear. A company might disclose adjusted compensation because it believes this measure to be more informative about executive incentives than SEC-designated calculations. Alternatively, it might do so to make its compensation practices and payouts appear more favorable than under SEC rules.
We examine this practice in detail, and ask: Are alternative measures of compensation useful in assessing CEO compensation? Does their prevalence indicate shortcomings in SEC standards, or a desire to mislead investors? Are alternative pay calculations beneficial in helping investors understand the relationship between CEO pay and performance?
The Closer Look series is a collection of short case studies through which we explore topics, issues, and controversies in corporate governance and executive leadership. In each study, we take a targeted look at a specific issue that is relevant to the current debate on governance and explain why it is so important. Larcker and Tayan are co-authors of the books Corporate Governance Matters and A Real Look at Real World Corporate Governance.
Pro Forma Compensation: Useful Insight Or Window Dressing? – Introduction
It has become commonplace for companies to issue supplementary disclosure about their financial results in addition to those required under “generally accepted accounting principles” (GAAP). Approximately one-third of companies issue so-called non-GAAP or pro forma earnings.1 Academics and professionals have engaged in considerable debate about the motivation underlying the decision to issue non-GAAP earnings. On the one hand, a company might issue non-GAAP earnings to improve investor understanding of financial results by stripping away transitory charges to focus attention on underlying performance. On the other, a company might report non-GAAP figures to mislead investors by inflating perceptions of underlying results. Evidence exists to support both of these claims.
CEO compensation is another metric widely tracked by shareholders and stakeholders. Just as GAAP accounting standards are regulated by the Financial Accounting Standards Board (FASB), corporate disclosure of executive compensation is regulated by the Securities and Exchange Commission and is reported in the proxy statement Compensation Discussion & Analysis (CD&A) section and various summary compensation tables. The summary compensation figures reported in proxies are widely cited (and often criticized) by corporate observers, and journalists rely on these figures to compile annual rankings of the most highly paid CEOs. Critics of executive compensation rely on SEC-designated calculations of compensation to allege that CEO compensation contracts are “too high” and uncorrelated with performance.
However, shortcomings exist with SEC-designated calculations that may make reported compensation figures misleading or incomplete. Compensation packages include a variety of risky pay elements awarded in a given year that vest across multiple years and whose ultimate value—contingent upon the achievement of performance targets or stock price changes – can only be estimated at the time that they are reported. More than one method for calculating compensation exists, and the most appropriate compensation metric will depend on what one is trying to measure: An analysis of the “pay-for-performance” of executive pay will rely on the value of compensation that has been earned or realized, while an analysis of the “incentives” inherent in the compensation program will rely on the expected value and mix of compensation currently held by the CEO. The summary compensation figures required by the SEC do not make this distinction clearly.
Alternative Pay Disclosures
In recent years, some companies have begun to voluntarily disclose what might be called “pro forma compensation.” Their motivation for doing so is not entirely clear. As with pro forma financial statements, a company might disclose adjusted compensation figures because they are more informative about executive incentives than SEC-designated calculations. Alternatively, they might do so to make their compensation practices and payouts appear more favorable than under SEC rules and mitigate criticism by journalists and shareholders. Because this type of disclosure is relatively new, appropriate approaches for calculating adjusted compensation have not yet been established.
One approach that companies use is to disclose the amount of compensation that the CEO has realized in a current year through the sale of equity awards (stock options, restricted stock, and performance units) that were granted in previous years. For example, Cincinnati Financial calculates that its CEO realized total compensation of $2.43 million in 2014, taking into account the values of annual salary, bonus, and the proceeds received through the exercise of stock options and vesting of performancebased restricted stock units. This figure is lower than the total pay reported in the summary compensation table of $2.62 million. Over a three-year period, Cincinnati Financial calculates that its CEO realized cumulative compensation of $6.92 million, 15 percent lower than the $8.19 million reported in the summary compensation tables over these same years.6 The company compares this figure to its performance relative to peers, which it estimates in the 60th percentile measured both in terms of change in book value and total shareholder return.
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