The Securities and Exchange Commission (SEC) recently responded to a variety of Frequently Asked Questions (FAQ) regarding Regulation G and related rules (in effect since March 28, 2003).

This Update seeks to provide practical assistance by focusing on key topics of interest addressed in the FAQ, including:

• Amending or Incorporating Pre-March 28 Reports. The effect of Regulation G on filings made prior to March 28, 2003 and registration statements that incorporate pre-effective date filings by reference.

• Eliminating "Recurring" Items. The use of non-GAAP measures that eliminate items identified as "recurring."
• "Free Cash Flow. "Whether the use of "free cash flow" in SEC filings is appropriate.
• EBIT and EBITDA. The use of EBIT and EBITDA and the GAAP financial measures to which they should be reconciled.
• Earnings Calls. How to conduct an earnings call in a manner that avoids the need to furnish a transcript of the call to the SEC on Form 8-K.
• Business Combinations. How the new rules apply to disclosures regarding business combinations.

• The FAQ addresses three related rules:

  • Regulation G generally requires that non-GAAP financial measures contained in public communications be reconciled to the most directly comparable GAAP measure.

• Item 10(e) of Regulation S-K covers only disclosures made in SEC filings and requires the same sort of reconciliation, but it also applies additional restrictions on the use of non-GAAP measures.
• Item 12 of Form 8-K requires companies to "furnish" earnings releases on Form 8-K.

• Amending Pre-March 28 Filings; Incorporating Pre-March 28 Filings by Reference

  Regulation G applies to all disclosures made after March 28, 2003, while Item 10(e) of Regulation S-K applies only to filings covering fiscal periods ending after March 28, 2003.

  Question: If a registration statement filed after March 28, 2003 incorporates by reference pre-March 28 periodic reports that contain non-GAAP financial measures, must those reports comply with Regulation G?

  Answer: Yes, they generally do.

  Question: Does this include Form S-8s?

  Answer: No. If a registration statement on Form S-8 filed after March 28 incorporates pre-March 28 filings that contain non-GAAP financial information, that information need not comply with Regulation G.

  Question: We are now filing a Form S-3 that will incorporate by reference a Form 10-K and a Form 10-Q filed before March 28, 2003. We know that the Form S-3 must comply with Regulation G, but must we also amend the Forms 10-Q and 10-K to comply with Item 10(e) of Regulation S-K?

  Answer: No, but this is a confusing issue. The filing needs to comply with Regulation G. But because Item 10(e) of Regulation S-K only applies to non-GAAP financial measures calculated for fiscal periods ended after March 28, 2003, companies do not need to bring the historical data in the pre-March 28 Form 10-Q or 10-K into compliance with Item 10(e). Two notes, however,

  • If the Form 10-Q or 10-K contained projections or other forward-looking measures for a fiscal period that ended after March 28, 2003, those projections need to comply.
  • The SEC Staff drafted Item 10(e) to codify existing SEC interpretations, so make every effort to conform the report or Form S-3 to Item 10(e)'s requirements.

  Practical Tip: How Can a Company Update Pre-March 28 Filings for Regulation G? A company can choose to: amend the previously filed document to include reconciliation; or identify the non-GAAP measure in the newly filed registration statement to provide the proper disclosure; or file a Form 8-K or periodic report that identifies and reconciles the non-GAAP measures contained in the pre-March 28 report(s) and incorporate the new report by reference into the registration statement.

  Question: Must a company comply with Regulation G if it files an amendment to a pre-March 28 Form 10-K after March 28?

  Answer: If, after March 28, 2003, a company amends a Form 10-K filed prior to that date, the amended portions must comply with Regulation G, although the unamended portions need not comply.

  Question: Does a company need to remove non-compliant non-GAAP measures posted on its Web site prior to March 28, 2003?

  Answer: No. Non-GAAP measures posted on a company's website prior to March 28, 2003 do not need to be Regulation G-compliant, unless the non-GAAP measure in question is subsequently revised or updated (in which case Regulation G requires reconciliation at that time).

  Smoothing or Eliminating Recurring Items

  Item 10(e) of Regulation S-K specifically prohibits the use of certain non-GAAP measures in SEC filings, including those that adjust a non-GAAP performance measure to "smooth" or eliminate items identified as "non-recurring, infrequent or unusual" when the nature of the charge or gain makes it reasonably likely to recur within two years or there was a similar charge or gain in the previous two years. The FAQ addresses the issue of whether companies can eliminate recurring charges, concluding that this may be possible if management reasonably believes that the financial impact of the eliminated item will disappear or become immaterial within a "near-term finite period." However, the SEC Staff is quick to point out that companies should never use a non-GAAP financial measure to smooth earnings.

  Trap for the Unwary: Be Ready to Explain the Elimination of Recurring Items If a company uses a non-GAAP measure that eliminates a recurring item, it must disclose why the non-GAAP measure is useful to investors, and that reason must be a good one. This is particularly important where the non-GAAP measure is used to evaluate performance (vs. liquidity). The FAQ states that use of such a non-GAAP measure "may be misleading" absent a discussion of the following: the manner in which management uses the non-GAAP measure to conduct or evaluate its business; the economic substance behind management's decision to use such a measure; the material limitations associated with use of the non-GAAP financial measure as compared to the use of the most directly comparable GAAP financial measure; the manner in which management compensates for these limitations when using the non-GAAP financial measure; and the substantive reasons why management believes the non-GAAP financial measure provides useful information to investors. The FAQ cautions that even such commonly used measures as EBIT and EBITDA must overcome these hurdles when used as performance measures.

  Free Cash Flow, EBIT and EBITDA

  Question: Does Item 10(e) of Regulation S-K prohibit the use of "free cash flow," which is often defined as cash flows from operating activities less capital expenditures.

  Answer: No, but any use of a measure of free cash flow should be accompanied by the following:

  • a clear description of its calculation and the requisite reconciliation and disclosure;
  • a reconciliation of free cash flow to cash flows from operating activities as presented in the statement of cash flows under GAAP; and
  • a discussion of the material limitations of the measure.

  Question: Is the presentation of "adjusted" EBIT and EBITDA measures in SEC filings allowed under Item 10(e)?

  Answer: No, unless such measures are necessary to satisfy MD&A disclosure requirements (for instance in describing a material term of credit agreement that contains an "adjusted EBITDA" financial covenant) and provided that certain explanations accompany these adjusted numbers.

  Question: Item 10(e) prohibits the presentation of non-GAAP liquidity measures that exclude changes or liabilities that must be settled in cash (or would be, absent the right to settle in another manner). There is an exception for EBIT and EBITDA. In calculating EBIT and EBITDA, should companies use net income from the statement of operations as calculated under GAAP for "earnings"?

  Answer: Yes.

  Question: What if a company calculates EBIT or EBITDA using something other than GAAP earnings as a starting point? May it include such measures in SEC filings?

  Answer: Possibly. The FAQ indicates that such measures would have to be identified by terms other than EBIT or EBITDA. Moreover, such measures would not qualify for the exception from the prohibition discussed in the previous Q&A if used as a measure of liquidity. So, any measure of this nature could only be included if used as a performance measure, and such use would need to be supported by the kind of disclosure described in the "Trap for the Unwary" above.

  Question: What should EBIT and EBITDA be reconciled to when presented as a performance measure (as opposed to a liquidity measure)?

  Answer: EBIT and EBITDA should be reconciled to net income (as opposed to operating income). If presented as a liquidity measure, EBIT and EBITDA need to be reconciled to operating cash flow from the cash flow statement.

  Regulation G-Compliant Earnings Calls; Filing Earnings Releases Under Item 12 of Form 8-K

  If a company orally discusses material nonpublic information about a completed fiscal quarter or year on its earnings call or Web cast it normally would need to furnish a transcript of that disclosure to the SEC pursuant to Item 12 of Form 8-K. However, the SEC rules contain a conditional exemption to this requirement if (1) the oral disclosure occurs within 48 hours of a related written release furnished on Form 8-K, (2) the information is broadly accessible to the public by conference call or Web cast, (3) the financial and statistical information contained in the presentation is provided on the company's Web site, and (4) the presentation was announced by a widely disseminated press release.

  Question: Is issuing a press release prior to an earnings call sufficient to avoid the need to furnish a Form 8-K with a transcript of the earnings call?

  Answer: No. A Form 8-K with the earnings press release must be on file with the SEC prior to the call to rely on the exemption.

  Question: Must a company post new material financial and other statistical information contained in the oral presentation on the company's Web site prior to the presentation?

  Answer: Yes. That information should be available on the company's Web site at the time of the oral presentation.

  Question: What should a company do if information is unexpectedly disclosed in an unscripted question and answer session?

  Answer: That information should be promptly posted on the company's Web site after the presentation.

  Practical Tip: Four Steps to Follow for Each Earnings Call Furnish within 48 hours. Furnish the earnings release under Item 12 of Form 8-K no more than 48 hours prior to the scheduled call. Post it. Post all material financial and statistical information to be discussed in the call on the company's Web site prior to the call. Follow the script. Spokespersons should know what information is in the earnings release and is posted on the Web site and go no further. If new information about a completed fiscal period is unintentionally disclosed on the call, post it on the Web site promptly. Post the audio file of the Web cast. The FAQ confirms the SEC's view that posting an audio file of the initial Web cast of the call satisfies the condition of the exemption that requires all material nonpublic earnings information to be posted on the Web site.

  Disclosures Made in Connection With Business Combinations

  Regulation G and Item 10(e) of Regulation S-K do not apply to non-GAAP financial measures contained in certain communications relating to a proposed business combination subject to the SEC's communication rules regarding business combinations, specifically Securities Act Rule 425 or Exchange Act Rule 14a-12, 14d-2(b)(2) or 14d-9(a)(2).

  Question: Does the business combination exemption from the non-GAAP disclosure rules permit the use of the same disclosures in other SEC filings that are not subject to those rules?

  Answer: No. Non-GAAP information about a business combination contained in a Form 10-K, registration statement, proxy statement or tender offer statement (none of which would usually be subject to the SEC's business combination communication rules) needs to comply with Regulation G and Item 10(e).

  Text of the FAQ

  This Update is intended only as a summary of selected topics contained in the SEC's guidance on these matters. You can find the full text of the FAQ at www.sec.gov/divisions/corpfin/faqs/nongaapfaq.htm. You can also find further discussion of the Sarbanes-Oxley Act and other recent laws, regulations and rule proposals of interest to public companies on our website.