Audit, Compliance and Risk Blog

CEO/Worker Pay Ratio—SEC Proposes Controversial and Costly Statistic

Posted by Ron Pippin on Wed, Oct 02, 2013 September 18, 2013, the Securities and Exchange Commission (SEC) issued a proposal that would require many public entities subject to its oversight to disclose the ratio of chief executive officer (CEO) annual pay to the median annual compensation of all other employees. A registrant could effectively satisfy this disclosure requirement using just 28 words as follows: “We calculated that our CEO in 20XX received compensation of $2,500,000 whereas the median company employee received compensation of $50,000, resulting in a ratio of 50 to 1.”

The SEC estimates that this disclosure requirement for all companies affected (approximately 3,900) would require 545,292 internal company hours and another $72,772,200 in outside consultant fees. Assuming an internal hourly cost of $100 per hour, that would be $54,529,200, and when added to the outside consulting fees, the total would be $127,301,400, or let’s say $125 million for convenience. That is the incremental cost per year—and the SEC believes it has provided significant flexibility on how the pay ratio calculation is made.

As proposed, the disclosure requirement would not apply to smaller reporting companies, emerging growth companies, or foreign private issuers—all as defined in the SEC literature.

The deadline for comments on this proposal is expected to be December 2, 2013.

Background—How Dodd-Frank Mandates the Proposed SEC Rule

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was signed into law. Included in section 953(b) of that legislation was the requirement for the SEC to amend Item 402 of Regulation S-K, to require the aforementioned disclosure. Currently, disclosure of the compensation paid by a company to its CEO is already required by existing SEC rules. The proposed incremental disclosure requires stating the compensation received by the median worker together with a ratio of how that amount compares to that received by the CEO. Among the stated purposes of the Dodd-Frank Act was to increase awareness of the type of CEO pay that may have contributed to the 2008 financial crisis. Further, many believe that such disclosure is good corporate governance.

When the U.S. Congress enacts legislation, it can do so by specifically amending certain federal statutes or by directing an existing regulatory body to follow the intent of Congress and amend the various laws. In this case, Congress delegated its responsibility for this portion of the legislation to the SEC. Sometimes Congress sets a deadline for its designated agency to develop rules and regulations and sometimes, as was the case for the disclosure required by Dodd-Frank section 953(b), it does not.

The SEC has five commissioners, all appointed by the U.S. President with the advice and consent of the U.S. Senate. The President cannot appoint more than three of the commissioners from the political party that he or she represents. The SEC proposal on CEO-to-worker pay ratio disclosure was approved by a 3 to 2 vote following party lines. Commissioner Daniel M. Gallagher, one of the two dissenting votes, made this public statement about this proposal:

The pay ratio computation that the proposed rules would require is sure to cost a lot and teach very little. Its only conceivable purpose is to name and, presumably in the view of its proponents, shame U.S. issuers and their executives. This political wish-list mandate represents another page of the Dodd-Frank playbook for special interest groups who seem intent on turning the notion of materiality-based disclosure on its head. There are no—count them, zero—benefits that our staff have been able to discern. [Emphasis retained.]

Computational Complexity

The compensation of a company’s CEO is already required to be disclosed to investors in various ways, including in the annual Form 10-K or proxy statement. Probably the biggest problem the SEC struggled with when developing its proposed new rule is how to determine “a median employee’s pay” such that the disclosure could be made. Answers are needed to questions like, how do you treat full time employees vs. part time employees—and how about employees on disability leave? What about employees outside the United States? And how do you account for contract employees?

That is why the proposal is 162 pages in length—it provides guidance on how to address these questions. Since this is just a proposed rule, the SEC is seeking comments from companies, accountants, and other stakeholders on whether the SEC guidance is workable and appropriately considers the issues.

In short, the SEC concluded that a company should use its fiscal year-end for the calculation and should consider all employees, both full time and part time, irrespective of where the employees are located. The SEC also concluded that contract employees should be excluded from the calculation. The SEC proposal describes how statistical samples might be used to assist registrants with the calculation.

Preparing for Implementation and Offering Comments

The SEC is proposing that this disclosure should be made in the first fiscal year beginning after the stated effective date in the final rule. Due to the complexity and length of time it will likely take the SEC to consider comments received, a final rule is unlikely to be issued in 2013. So, assuming a final rule is issued in, say, February 2014, and the stated effective date is March 1, 2014, a calendar year-end company would not have to make this disclosure until finalizing its 2015 financial statements.

While this timeframe seems long, a public company that anticipates that it would be subject to this rule should take the time to study the proposal and engage the appropriate parties—internal legal, finance, and human resources departments together with those outside consultants that assist the company with compensation issues.

While the SEC attempted to provide reasonable computational flexibility for affected registrants in its proposal, a well thought out comment letter to the SEC might be useful to communicate specific nuances or issues that companies might have concerning, for example, foreign exchange transactions, derivatives, and other abnormalities. Anything a company can do to reduce its cost under this pending disclosure requirement would be well received by investors!

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About the Author Pippin is an experienced CPA based in Wheaton, IL. His 40 plus year career includes being an audit partner in Arthur Andersen, a member of Andersen’s Professional Standards Group (“national office”) in Chicago, the Director of Financial Reporting for a Fortune 50 company and most recently, the editorial director of CCH’s Accounting Research Manager. Currently, Ron does independent writing and analysis together with accounting consultation on a variety of topics.



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Tags: Corporate Governance, SEC, Accounting & Tax, Accountants