In an effort promote greater transparency, the Securities and Exchange Commission (SEC) adopted rules requiring public companies to demonstrate the relationship between executive compensation paid and a company’s financial performance. Companies should work on preparing the required disclosures far in advance. Collaboration across different departments of a company, such as human resources, finance, accounting, legal, and investor relations, will be important to ensuring complete and accurate disclosures.

Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires tabular and narrative disclosure of the relationship between pay and performance in a company’s annual proxy statement filed with the SEC. The pay versus performance rules are codified in Item 402(v) of Regulation S-K. Regulation S-K sets forth the qualitative disclosure requirements for SEC filings and Item 402 covers various executive compensation topics.

The disclosure rules require companies to provide a summary compensation table for the five most recently completed fiscal years. The table must contain the total compensation and the compensation actually paid in each reported year to the company’s principal executive officers. With respect to financial performance, a company is required to report its total shareholder return, or TSR. In addition, the TSR of the company’s peer group will have to be provided in the table. Finally, the table will have to report net income and a financial performance metric selected by the company.

The calculation of “executive compensation actually paid” involves a complex formula that requires addition and subtraction of items relating to equity awards and pension values. For example, the adjustments for pension benefits include subtracting the aggregate change in the present value of all defined benefit pension plans and adding service costs.

Total shareholder return, or TSR, is calculated based on the appreciation in a company’s stock plus any dividends paid during the relevant measurement period. It is expressed as a percentage. The TSR provides an indication of the long-term value of an investment. The peer group TSR gauges the company’s performance against its peers. It provides the average cumulative total shareholder return of the identified peer group companies.

The company’s net income is calculated as total revenues minus total expenses, and must be calculated in accordance with U.S. Generally Accepted Accounting Principles (GAAP). The company-selected financial measure is the measure that the company deems to most closely illustrate the relationship between executive compensation actually paid and the company’s performance. Examples include gross profit, income from continuing operations, and earnings per share.

In addition to the required summary compensation table, new Item 402(v) of Regulation S-K requires a company to provide a list of the 3-7 most important financial performance measures that link executive compensation actually paid to financial performance. The company-selected performance metric in the summary compensation table should be one of these listed measures.

The new “pay versus performance” rules mandate clear narrative descriptions of the relationship between executive compensation actually paid and the company’s TSR over the past five years. The new rules also require clear narrative descriptions of the link between the company’s TSR and peer group TSR over the past five years.