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High non-GAAP earnings predict abnormally high CEO pay

Christian Fernsby ▼ | April 8, 2019
U.S. companies that use nonstandard numbers to calculate executive compensation are overpaying their top managers.
Company earnings
Leaders   The study is based on GAAP and non-GAAP earnings and compensation data
The working paper, “High Non-GAAP Earnings Predict Abnormally High CEO Pay,” by Nicholas Guest of Cornell University’s Samuel Curtis Johnson Graduate School of Management and S.P. Kothari and Robert Pozen at the Massachusetts Institute of Technology’s Sloan School of Management, finds that non-GAAP earnings, or those that do not conform with Generally Accepted Accounting Principles, exhibit a significantly positive relationship to CEO pay.

The study is based on GAAP and non-GAAP earnings and compensation data for 500 companies from 2010 to 2015.

“We hypothesize that large, positive differences between non-GAAP and GAAP earnings are associated with excessive CEO compensation,” the researchers wrote. ”That is, the compensation committee of the board of directors behaves as if large, positive non-GAAP adjustments to GAAP earnings warrant high levels of compensation.”

For shareholders, that’s bad news, as it means managers are being compensated at unjustifiably high levels, in some cases even when the company is losing money.

SEC rules require companies to report quarterly, annual or current financial numbers under GAAP. They are allowed to supplement those numbers with non-GAAP metrics, but they must give the standard GAAP numbers equal or greater prominence in their reporting and follow other SEC guidelines.

"Overall, our evidence suggests large non-GAAP earnings adjustments influence some boards of directors in approving a level of CEO pay that is otherwise not supported by the firm’s stock price or GAAP earnings performance.

"We also note that although excessive pay for firms reporting high non-GAAP earnings is about 16% of total pay, the bulk of the pay represents reward for performance. Still, an economically meaningful fraction of CEO pay appears to be attributable to opportunistic non-GAAP reporting."