Hypothetical Earnings Trigger Real Bonus Payments

By Curtis C. Verschoor, CMA, Editor
 
Federal income tax incentives motivate questionable compensation decisions that benefit executives at the expense of taxpayers and shareowners.
 
The Revenue Reconciliation Act of 1993 caps the deductibility of executive salaries at $1 million, but bonus payments of any amount are deductible if they result from the achievement of established performance goals. Many public companies today take advantage of the performance-based bonus payment system, using misleading bonus calculations to give "superior performance" bonuses at the expense of shareowners and taxpayers.
 
The congressional Joint Committee on Taxation reports that these tax-advantaged bonuses cost the US Treasury $3.5 billion per year. Dozens of corporations reward subpar returns to shareowners. According to the September 13, 2013, Bloomberg News article, "Companies Use IRS to Raise Bonuses with Earnings Goals," the CEOs of sixty-three large companies in the Standard & Poor's (S&P) 500 Index received cash bonuses in 2012 based on corporate performance even though their company's shares underperformed that of the Index. Bloomberg quotes Robert Reich, the secretary of labor under President Bill Clinton, who said, "Taxpayers are losing billions of dollars; shareholders are being taken for a ride."
 
Tax-deductible bonuses based on company performance were undoubtedly allowed because Congress believed it's in the best interests of shareowners: Performance-based compensation includes stock option and appreciation rights awards. At least two outside independent directors must approve the performance goals, and a majority of shareowners must approve the incentive compensation program. The company's compensation committee – composed of external, independent directors – must certify that the appropriate goals have actually been met.
 
Unfortunately for taxpayers and many shareowners, "any company can define performance 'more or less as it chooses,'" according to Michael Doran, a lawyer who served in the Treasury Department's Office of Tax Policy under presidents Clinton and George W. Bush. Now a law professor, Doran believes the IRS rules have "merely served to undermine the concept of 'performance.'" He continued, "Failure can be treated as success for purposes of exemption."
 
The cause of this divergence of the financial results reported to shareowners and those used for bonus purposes appears to be a growing emphasis on financial measures that aren't audited or based on Generally Accepted Accounting Principles (GAAP). In addition to utilizing non-GAAP measures for the calculation of bonuses, many companies provide analysts and investors with public information adjusted by management to exclude nonrecurring and other various items.
 
A search of the ProQuest database in May and June 2013 found more than 6,000 news articles and wire releases that contained non-GAAP information while announcing corporate earnings for the first quarter, giving a revenue outlook or earnings guidance for the year, or providing other information for investors and analysts.
 
In addition to the fact that non-GAAP financial information isn't audited, another difficulty with its use is that there are no accounting principles to guide its preparation. Thus the information may be subject to manipulation. Consequently, non-GAAP financial measures presented by a company may differ substantially over time and lack comparability with similar information from other companies, even when the same terms are used to identify the measures. Companies also may make unannounced adjustments to non-GAAP earnings in order to meet bonus targets or analysts' expectations.
 
Consider, for example, Exelon Corporation, a New York–based nuclear energy company. The Exelon board of directors added $85 million ($0.06 per share), which the company never actually earned, to the 2012 audited earnings report. This boosted the "performance" of the company enough so that top executives could receive tax-deductible bonuses.
 
To its credit, Exelon painstakingly provided considerable information on how unaudited, non-GAAP financial measures were used to calculate its executive incentive performance awards. Its 2013 Proxy Statement provides forty-five pages of disclosures mandated by the US Securities and Exchange Commission (SEC) concerning matters affecting compensation. Yet how many shareholders are able to fully comprehend this content?
 
The statement defines compensation as salary, annual incentive plan, nonqualified stock options, performance share unit awards, and restricted stock unit awards. Additional elements of compensation include pension, supplemental pension, savings plan, deferred compensation plan, and perquisites. It also describes the three guiding principles of Exelon's compensation program:
  1. Link compensation to performance results,
  2. Align the interests of its named executive officers and shareholders, and
  3. Provide competitive compensation opportunities.
The Proxy Statement further notes: "A majority of executive compensation is performance-based and is tied to our financial and operational performance, individual performance and Exelon stock price performance." Yet even though former Exelon CEO John Rowe's incentive bonuses grew nearly 49 percent between 2007 and 2011, Exelon shareowners haven't fared well, according to Bloomberg's analysis. The company's operating profits and market value have fallen by half in the past five years. During that period, executives still received bonuses for above-target performance in four of the five years, amounting to more than $20 million. In a February 7, 2013, press release, Exelon announced it was reducing its annual dividend on common shares from a rate of $2.10 to $1.24 per share.
 
The influence of tax deductibility on Exelon compensation is also set forth in its Proxy Statement: "The compensation committee's policy has been to seek to cause executive incentive compensation to qualify as 'performance-based' in order to preserve its deductibility for federal income tax purposes to the extent possible, without sacrificing flexibility in designing appropriate compensation programs." It also notes that "despite the challenging operating environment, the company closed the year within adjusted earnings guidance."
 
Exelon's statement presented its 2012 audited earnings per share (EPS), based on GAAP, as $1.42. To arrive at the publicly reported, adjusted non-GAAP operating EPS of $2.85, management made ten adjustments that amounted to a net increase of $1.43 per share, a little more than 100 percent. (The non-GAAP results were also included in the February press release and discussed in Exelon's earnings conference call on the same date.)
 
Adjustments that increased non-GAAP EPS included plant retirements and divestitures ($0.29), merger and integration costs ($0.31), Maryland commitments related to merger ($0.28), amortization of commodity contract intangibles ($0.93), and Federal Energy Regulatory Commission (FERC) settlement ($0.21). These adjustments increased EPS by $2.02.
 
The adjustments that decreased non-GAAP EPS included mark-to-market impact of economic hedging activities ($0.38), unrealized gains related to nuclear decommissioning trust funds ($0.07), and reassessment of state deferred income taxes ($0.14). Their total effect was a decrease of EPS by $0.59.
 
But that's not all. The EPS that was used for bonus purposes was $2.91. The additional $0.06 per share of non-GAAP earnings (approximately $85 million) the board of directors added is described in the Proxy Statement as "Adjustment by Compensation Committee." The rationale for this action, according to Gary Prescott, the company's vice president of compensation, was to offset unexpected rate decisions by Illinois regulators that cut actual earnings. The statement noted that "the outcome of these deliberations was not known at the beginning of the year when the budget was established."
 
Other companies seem to use significant discretion in setting performance goals for deductible bonus purposes and determining if they have been achieved. According to Bloomberg, Las Vegas–based gaming company Wynn Resorts Ltd. uses earnings before interest, taxes, depreciation, and amortization (EBITDA), a non-GAAP measure. For CEO Steve Wynn, the goal he needed to achieve to receive a full bonus was set at a level lower than prior-year results in both 2011 and 2012. Wynn easily exceeded the targets and collected tax-deductible bonuses of $9.1 million in 2011 and $10 million in 2012.
 
Another example of questionable logic is the case of CEO Scott Boruff of Miller Energy Resources, an oil and gas exploration company. For Boruff to earn his performance bonus, the company had to achieve "a higher percentage increase" in common stock return than its peers. Miller's shares actually fell by 5.9 percent during the year, but the board of directors decided to award a $1 million performance bonus to Boruff anyway, saying he had achieved a "lower percentage decrease" than competitors.
 
Yet another tactic that a number of companies employ, according to Bloomberg, is to set a non-GAAP EPS goal that's substantially lower than analysts' expectations – even though most analysts rely heavily on a company's guidance and outlook for the future. For example, Valero Energy set its bonus earnings goals for 2011 and 2012 "at least 37 percent below analysts' consensus estimates" of actual performance. This practice makes it easy to support the $3.7 million in incentive payments for Valero Energy's CEO Bill Klesse each year.
 
Let's hope that companies will do the right thing for their shareowners and for taxpayers at large by discontinuing the use of misleading bonus calculations and instead make performance bonuses a reward for actual superior performance. Exelon, for one, employed a new compensation consultant in 2013 and made six substantive changes to its 2013 compensation program. These moves were partially in response to feedback from shareowners, 25 percent of which voted against the company's program in the 2012 advisory "Say on Pay" vote. 
 
Read more articles by Curtis Verschoor
 
About the author:

Curtis C. Verschoor, CMA, is a member of the IMA Committee on Ethics. He is the Emeritus Ledger & Quill Research Professor at the School of Accountancy and MIS and an honorary Senior Wicklander Research Fellow in the Institute for Business and Professional Ethics, both at DePaul University, Chicago. He is also a Research Scholar in the Center for Business Ethics at Bentley University, Waltham, Massachusetts. He was selected by Trust Across America as one of North America’s Top Thought Leaders in Trustworthy Business Behavior in 2012 and 2013. His e-mail address is curtisverschoor@sbcglobal.net.

©2013 by the Institute of Management Accountants (IMA®), www.imanet.org; reprinted with permission.

For guidance in applying the IMA Statement of Ethical Professional Practice to your ethical dilemma, contact the IMA Ethics Helpline at (800) 245-1383 in the United States or Canada. In other countries, dial the AT&T USA Direct Access Number from www.usa.att.com/traveler/index.jsp, then the above number.

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