‘Misleading’ non-IAS metrics in executive remuneration

Over the past three years or thereabouts, investors, proxy advisors and investor representatives have been increasingly calling for companies to more clearly explain what performance hurdles are being used, how they reconcile to company performance and, if they are normalized/underlying earnings, why is statutory not being used.

The financial metric for STIs will always be a non-market hurdle like profit, EBIT or EPS. The second most commonly used performance hurdle for LTIs in Australia is also EPS.

Investors have become particularly concerned when STIs and LTIs are being paid on performance measures that vary from the statutory or reported earnings.

It is not surprising then to see that the concern is a global one.

The chairman of the International Accounting Standards Board (IASB), Hans Hoogervorst, has warned that the growing use of underlying financial rather than IAS measures in company reporting is producing increasingly misleading results. The warning included advice that Remuneration Committees, and others, need to be aware of the potential pitfalls of policies and decisions based on what he described as ‘sugar-coated’ adjustments.

Speaking at the annual conference of the European Accounting Association in Maastricht, the Netherlands, Hoogervorst said the difference between IAS and non-IAS numbers is widening.

He said that shareholders and Remuneration Committees need to be much more aware and critical of the role of non-GAAP measures in remuneration structures.

The IASB chairman quoted research that found more than 88% of the US S&P 500 currently disclose non-GAAP metrics in their earnings release. (It is relevant to note that approximately 74% of the ASX50 reported an alternative profit measure in addition to the statutory profit for the year ended 30 June 2015. Not surprisingly, the alternative results exceeded statutory results because of the exclusion of impairments and some other items (see HERE https://assets.kpmg.com/content/dam/kpmg/pdf/2016/04/asx50-financial-reporting-insights-july-december-2015.pdf).

Of those releases, 82% show increased net income and are clearly designed to present results in a more favourable light. One study showed that the popular metric “core earnings” was on average 30% higher than GAAP earnings.

While these are numbers for the American market, securities regulators in the world of IFRS standards are also concerned that non-GAAP numbers are getting increasingly detached from reality. Given ASIC’s 2010 review (see HERE) this may be old news for Australian investors. However, it still has relevance for the financial metrics used in executive remuneration structures.

The IASB chairman said it was ‘unnerving’ that most management remuneration packages are based on adjusted earnings. He argued that notions such as an ‘underlying profit’ mean a CEO’s remuneration could end up being almost completely insulated from factors that are said to be outside the control of management, but which shareholders actually expect to be considered when determining incentive payments.

Hoogervorst acknowledged that cutting back the use of non-IAS measures is primarily the task of securities regulators, such as ASIC. However, he said IFRS standards provide relatively little detail on the formatting of the income statement, and claimed this ‘enormous flexibility’ offers ‘an open invitation for non-GAAP to step in.’

In the Australian context, this is particularly relevant for LTIs contingent on earnings measures such as EPS growth. EPS growth is the second most popular LTI metric used to determine the extent of an LTI grant actually paid to an executive.

Many ASX listed companies use an ‘underlying’ earnings amount for this purpose, rather than the standard defined under AASB 133.

While proxy advisers and most large institutional investors are concerned about the issue, the competence applied to understand and address it varies greatly. This lack of understanding, to some extent, can be related to directors’ inability, or unwillingness, to explain their measures. The quality of analysis is often lacking, and reverts to a belief that the statutory EPS standard is best. And most times this argument is correct.

For long-term plans, management should wear the impairment costs incurred for poor investment decisions, and write-offs for acquisitions that were overpriced.

However, for some companies non-statutory measures are best. These might include, for example, high capital intensity, high growth companies where the internal rate of return utilises net cash flow as the primary return element. This is not to say that an underlying measure could not use an EBITDA measure (as a proxy for cash flow), but it could include an exception in the measure for write-downs and impairments above expected depreciation and amortisation. But in most cases, the threshold performance level should be high enough such that the cash flow is sufficient not to incur write-downs etc. This is where communications between boards and their stakeholders on LTI measures needs to be more robust, detailed and nuanced.

Other companies that might use non-statutory measures include those financial institutions with long-term investments that are marked to market. The statutory result may have little correlation with the actual result over the longer term.

STI measures should be different. Unfortunately, however, the current view of some stakeholders lacks sophistication.

STI financials are typically focused on generating the cash needed to exceed investor expectations, and provide for future investment and dividends. The measures should not discourage write-downs and impairments where they should occur for sins of prior periods. If a write-down or impairment occurs, the impact should be, and mostly is, reflected in the extent to which the LTI will vest. To include impairments and write-downs in STI measures muddies the waters, as STI outcomes are being impacted by decisions made in prior periods, for which some management personnel may not have been present.

But this is not the view of some proxy advisers and investors. That is, they do not necessarily accept the fact that an STI is for performance in the year just past, and an LTI is for a longer period longer. If there is an impairment, management should suffer in the extent the LTI that vests. It has nothing to do with their STI. If they fail to generate the cash flow on which their STI is based, they will suffer for that too.

In summary:

  • poor performance on both short-term and long-term metrics, results in management getting no incentive;
  • for good short-term or good long-term performance, management will get some reward; and finally,
  • for both good short-term and long-term performance, management should get both.

The IASB will be looking closely at potential ways to address the problem. One way is that the IASB may need to define more sub-totals in the income statement, provide a definition of operating income which does not allow for obfuscating restructuring or impairment charges and create a rigorous definition of the commonly used non-IAS metric, EBIT.

Hoogervorst did, however, reaffirm that the bottom line, profit or loss, will remain the most important performance measure over time. This is because no one can predict the extent to which seemingly extraordinary elements of income are recurring and not. That is why it is important the bottom line is as inclusive as possible and that it shows everything, ‘warts’ and all.

In his speech, Hoogervorst drew attention to particular problems with the use of other comprehensive income (OCI). He said OCI ‘should only be resorted to if it enhances the relevance of profit or loss’ and is used more sparingly than in the past.

The chairman expressed particular concerns with defined benefit pension scheme reporting, which primarily has relevance for US or British companies, although it could have a reasonable impact on the subsidiaries of Australian listed companies with significant US or British operations. While the pension liability is in full view on the balance sheet, its effect on performance is hidden in the semi-darkness of OCI. One cannot help wondering what would have happened if the pension liability were to directly hit profit or loss. It would have likely led to more realistic pension arrangements and/or more cautious distribution of dividends in many cases.

To explore the issues and to read the IASB chairman’s views on George Clooney, see HERE.

© Guerdon Associates 2024
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