Audit, Compliance and Risk Blog

On September 18 the Securities and Exchange Commission (SEC) proposed to require public companies to calculate and disclose the pay ratio between their principal executive officer (PEO) and other employees:

• PEO's "total compensation"

• Median of the annual total compensation of all employees except the PEO

• Ratio of those two numbers

The proposal would amend existing Executive Compensation reporting requirements in Item 402 of financial reporting requirements (Regulation S-K), which SEC translates into line-item requirements on a variety of reporting forms.

This rulemaking implements one of SEC's regulatory assignments under the 2002 Dodd-Frank Act (Section 953(b)). Dodd-Frank did not tell SEC how to calculate "total" compensation, or who qualifies as an "employee" for inclusion in the calculation. In issuing this proposal, the five SEC commissioners split 3:2 along partisan lines, with an angry dissent from (Republican) Commissioner Daniel Gallagher about what he sees as the folly of Dodd-Frank mandate and the majority's choices in how to implement it.

What is the PEO's "Total Compensation"?

Item 402 already requires public companies to report their PEOs' total compensation, as part of broader executive compensation reporting requirements in Regulation S-K and various reporting forms. These rules define "total compensation" as the sum of:

• Salary

• Bonus

• Stock awards

• Option awards

• Non-equity incentive plan compensation

• Change in pension value and nonqualified deferred compensation earnings

• All other compensation.

Comments in this latest rulemaking assert that many companies calculate these numbers by hand for the handful of executives presently covered, and have not created automated systems for processing such numbers for all employees.

Who Are Employees and What is Their Total Compensation?

SEC now proposes to require companies to calculate total compensation for all employees using the same items listed above for the PEO, interpreting "salary" as "wages plus overtime" for non-salaried employees.

Importantly, SEC defines "employees" as all of the following, as of the last day of the reporting company’s fiscal year:

• Full-time, part-time, seasonal or temporary worker (including officers other than the PEO)

• Employees of the reporting public company or any of its subsidiaries

SEC believes companies will be able to use existing documentation to comply with at least some provisions of this rule. For example, other SEC rules also require companies to report elements of employee compensation, on an aggregate basis as line items in their financial statements and related footnotes. These include accrued payroll and benefits amounts as current liabilities on the balance sheet, or salary and bonus amounts included in selling and administrative expenses or cost of goods sold on the income statement. Companies calculate and present some of these terms in accordance with comprehensive accounting principles incorporated in SEC rules, such as U.S. Generally Accepted Accounting Principals (US GAAP). Some items that are not subject to SEC rules may already be subject to tax or other reporting requirements that tend to require standard approaches.

Despite the likely existence of readily-useable record keeping and reporting, SEC acknowledges that it has already received many formal comments claiming that compliance costs would be substantial -- particularly for multinational companies and/or those with complex arrangements of subsidiaries and affiliates that would complicate efforts to compile information and calculate “mean” values (they might also struggle with varying national requirements for information privacy). SEC's proposal provides companies with some flexibility to reduce these problems. For example, the proposed rule allows a company to identify the median employee based on total compensation using either its full employee population or a statistical sample of that population.

Furthermore, by proposing this requirement as an amendment to Item 402, SEC effectively exempts companies not required to file reports subject to Item 402. These include "smaller reporting companies," and foreign private issuers (including those subject to the US-Canada Multijurisdictional Disclosure System (MJDS)).

What's Next?

SEC's proposal will be subject to a formal comment period for 60 days after publication in the Federal Register. Along with the proposal, SEC has also solicited comments on 60 detailed questions about methodologies, applicability, and flexibility. SEC has not forecast a date for adoption of a final version of the revisions, but is targeting a 2014 adoption and company compliance required in fiscal year 2015.

Self-Assessment Checklist

Registered companies subject to Item 402 (Executive Compensation) of SEC's financial reporting rules are presently scheduled to be subject to this Pay Ratio rule once it is adopted. Other companies may want to consider development of comparable information, in anticipation that the requirement may expand to additional companies.

Does my company compile "total compensation" information?

• For its Principal Executive Officer?

• For other senior executives?

• For all employees, or for specific groups of employees?

Does my company compute Pay Ratios between or among groups of employees?

Does my company have a formal comment to make on any of the 60 questions posed in SEC’s proposal?

Where Can I Go For More Information?

• SEC rule

• SEC Commissioner Gallagher's dissent 

STP publishes the following related publications:

• Securities Law: A Guide to the 1933 and 1934 Acts and their Amendments, including Sarbanes-Oxley and Dodd-Frank

• SEC Disclosures Checklists Including Financial Statement, MD&A, and Sarbanes-Oxley Checklists

About the Author

Jon Elliott is President of Touchstone Environmental and has been a major contributor to STP’s product range for over 25 years. He was involved in developing 16 existing products,including Workplace Violence Prevention: A Practical Guide to Security on the Job and Directors' and Officers' Liability.