Continuing the SEC’s recent focus on companies’ use of non-GAAP financial measures, the staff of the SEC Division of Corporation Finance issued updated guidance on May 17, 2016 that addresses compliance issues under Regulation G and Item 10(e) of Regulation S-K.  The four new and eight updated Compliance & Disclosure Interpretations (C&DIs) address non-GAAP disclosure practices that have become more commonplace in recent years, and about which the SEC staff have repeatedly raised concerns.  The new guidance pointedly addresses practices that the SEC staff consider misleading, including inconsistencies in the calculations of non-GAAP measures, individually tailored revenue recognition methods, per share presentation of non-GAAP liquidity measures, and presentation of non-GAAP measures net of tax without clearly identifying the adjustments. 

This update summarizes the new and updated C&DIs and suggests practical steps that public companies can take in preparation for their next earnings announcements and periodic reports.

Background

Regulation G and Item 10(e) of Regulation S-K, the rules that govern the use of non-GAAP financial measures in public companies’ external communications and SEC filings, were first adopted in 2003.  The rules were intended to ensure that companies’ presentation of such financial measures, which are commonly used by analysts and company management, are clearly explained and do not overshadow companies’ GAAP results or otherwise mislead investors. 

Specifically, when a company chooses to include a non-GAAP measure in its public disclosures and filings with the SEC, the rules require the company to present the most directly comparable GAAP measure and to reconcile (by schedule or other clearly understandable method) the non-GAAP financial measure to the most comparable GAAP measure.  When presenting a non-GAAP measure in a document filed with the SEC, the most comparable GAAP measure must be presented with “equal or greater prominence” and additional disclosures must be provided, such as the reasons why a non-GAAP measure provides useful information to investors and, if material, how else the measure is used by management.  The C&DIs that were updated on May 17th  provide staff interpretive guidance on the application of these rules.

Prior to the release of the new C&DIs, SEC leaders had signaled in recent speeches that reforms relating to non-GAAP financial measure disclosures were on the horizon, discussing concerns that such measures can be confusing and misleading for investors.  The financial press and other commentators have also reported concerns that companies may be taking greater liberties with non-GAAP financial measures. A FactSet report from March 2016 showed that, on average, companies in the Dow Jones Industrial Average that report non-GAAP earnings per share (EPS) had non-GAAP EPS for fiscal 2015 that exceeded GAAP EPS by 30%, compared to a disparity of only 12% in fiscal 2014.    

Updated Guidance

Below is a summary of the new C&DIs and material updates to existing C&DIs.

• Question 100.01 (new): Even if not explicitly prohibited, some adjustments may nevertheless result in a non-GAAP measure that is misleading; for example, a performance measure that excludes normal, recurring, cash operating expenses necessary to operate the company’s business could be misleading.
• Question 100.02 (new): A non-GAAP measure that adjusts a charge or gain for which other similar charges or gains were not also adjusted in prior periods could be misleading if the change between periods is not disclosed.  For a significant change, prior periods may need to be recast.
• Question 100.03 (new): Inconsistent practice regarding the impact of non-recurring charges and non-recurring gains on the calculation of non-GAAP measures may be misleading; for example, excluding non-recurring charges while including non-recurring gains in the same period.
• Question 100.04 (new): Measures that use individually tailored non-GAAP revenue recognition and measurement methods could be misleading; for example, a non-GAAP measure that accelerates revenue recognized ratably over time under GAAP as though it was earned in its entirety when the customer was billed.
• Question 102.01 (updated): This question was updated to clarify that the staff accepts the current National Association of Real Estate Investment Trusts (NAREIT) definition of “funds from operations” (FFO), which had been updated since Regulation G was first adopted, as a performance measure, and does not object to its presentation on a per share basis.
• Question 102.02 (updated): This question was updated to clarify that presentation of FFO on a basis other than as defined by NAREIT must not be misleading under Rule 100(b) of Regulation G.
• Question 102.05 (updated): This question was updated to clarify that non-GAAP performance measures are not permitted to be presented on a per share basis where the measure can be used as a liquidity measure, even if management presents it solely as a performance measure.  In reviewing such measures, SEC staff will focus on the substance of the measure and not on management’s characterization of the measure.
• Question 102.07 (updated): This question was updated to clarify that non-GAAP “free cash flow” measures (typically cash flows from operating activities less capital expenditures) cannot be presented on a per share basis because they are liquidity measures.
• Question 102.10 (updated):This question was updated to list several additional examples of non-GAAP measures being presented with greater prominence than the comparable GAAP measure that would not be acceptable, including:
  • presenting a full non-GAAP income statement, including in reconciling non-GAAP measures;
  • omitting comparable GAAP measures from a headline or caption containing non-GAAP measures;
  • emphasizing non-GAAP measures over comparable GAAP measures through use of bold type or larger font size;
  • a non-GAAP measure that precedes the comparable GAAP measure;
  • describing a non-GAAP measure as “record performance” or “exceptional,” without an equally prominent characterization of the comparable GAAP measure;
  • using tabular disclosure where the non-GAAP table precedes the GAAP table or both are not included in the same table;
  • not disclosing that a quantitative reconciliation for a forward-looking non-GAAP measure has been excluded in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) of Reg. S-K or not disclosing, with equal or greater prominence, the type of unavailable information that precludes preparation of such a reconciliation and its probable significance; and
  • providing discussion and analysis of a non-GAAP measure without, or more prominently than, discussion and analysis of the comparable GAAP measure.

Previously, this question addressed only the possibility that presentation of a full non-GAAP income statement may present the non-GAAP measures with greater prominence than the comparable GAAP measures.

• Question 102.11 (updated): This question was updated to clarify that requirements for income tax effects related to adjustments depend on the type of non-GAAP measure.  For a liquidity measure, it may be acceptable to adjust GAAP taxes to show taxes paid in cash.  For a performance measure, current and deferred tax expenses should be included commensurate with the measure of profitability.  Tax adjustments to arrive at a non-GAAP measure must be shown as a separate adjustment and clearly explained.
• Question 103.02 (updated): This question, regarding EBIT or EBITDA presented as a performance measure, was updated to clarify that such measures may not be presented on a per share basis.

Practical Tips

Many of the practices that are addressed by the new and updated C&DIs are common for many companies.  As legal and financial teams and audit committees prepare for the next quarterly earnings announcement and periodic filing, they will need to carefully examine and reconsider disclosure practices in connection with the presentation of non-GAAP measures.  Applicable teams, including company disclosure committees, should consider getting a head start by reviewing past practices now.  Below are several important issues to consider. 

• Review the company’s disclosure of non-GAAP measures to ensure that the measures are calculated consistently between periods and that the company does not adjust for non-recurring losses without making similar adjustments for non-recurring gains.
• Ensure that non-GAAP measures do not use individually tailored revenue recognition methods.
• Review all non-GAAP measures that are presented on a per share basis to ensure that none are performance measures that could be liquidity measures, such as EBITDA or free cash flow.
• Scrub earnings releases and related communications to eliminate the presentation of a non-GAAP measure with greater prominence than the comparable GAAP measure.
• Review any non-GAAP measures that are presented as “net of tax” for compliance with the updated guidance.
• Consider whether any changes that the company makes to its non-GAAP measures to comply with the new guidance will require recasting of prior periods, and be sure that disclosures regarding non-GAAP measures that are updated clearly explain the changes between periods.
• Review explanations of how and why the company uses non-GAAP measures to ensure they are complete.
• Consider implementing specific controls around the use of non-GAAP measures or reexamining existing controls in the light of the updated SEC guidance.

Read the full text of the SEC’s recently updated C&DIs regarding non-GAAP financial measures. 

© 2016 Perkins Coie LLP