In recent months, senior SEC officials have repeatedly cautioned public companies about the use of non-GAAP financial measures. These include statements by SEC Chair Mary Jo White, SEC Chief Accountant James Schnurr and SEC Deputy Chief Accountant Wesley Bricker, among others. These statements have stressed ensuring that companies do not use non-GAAP financial measures in a misleading or confusing way and cautioned companies about how they make adjustments to GAAP measures when they present non-GAAP measures, especially measures of profitability. These SEC officials have urged companies to evaluate their current disclosure practices and to engage audit committees in the process of determining how their companies present non-GAAP financial information.
On May 17, 2016, the SEC published 12 new or revised C&DIs on the use of non-GAAP financial measures. These affect both communications subject to Regulation G – which applies to all public disclosures by reporting companies that contain non-GAAP measures – and to filings subject to Item 10(e) of Regulation S-K – which applies to certain reports filed with the SEC under the Securities Act of 1933 and the Securities Exchange Act of 1934, including earnings releases furnished pursuant to Item 2.02 of Form 8-K. Several of these C&DIs either state new SEC staff disclosure interpretations or significantly revise existing interpretations. In some cases, the SEC appears to be taking aim at non-GAAP disclosure practices that have become common in recent years. Companies that disclose non-GAAP measures in their public communications, and especially in their SEC filings, should carefully review these C&DIs to assess the impact on the substance and the presentation of their non-GAAP disclosures. The new and revised C&DIs can be found on the SEC website and are tagged [May 17, 2016] to indicate the date of publication by the SEC.
Among the most significant C&DIs are several that deal with adjustments used to calculate non-GAAP measures (for example, adjustments may be misleading and violate Regulation G if the adjustments exclude normal, recurring cash operating expenses, result in a non-GAAP measure being presented inconsistently between periods, exclude non-recurring charges but include non-recurring gains during the same period, or substitute company-specific revenue recognition and measurement methods for GAAP methods). Another important C&DI provides new guidance on the requirement to present the most directly comparable GAAP measure with equal or greater prominence than a non-GAAP measure. This new C&DI contains eight examples of disclosure that the SEC staff will regard as violations of Item 10(e).
Other C&DIs clarify the circumstances under which the SEC staff will apply the prohibition against presentation of non-GAAP liquidity measures.
Finally, real estate investment trusts, or REITs, will want to review two revised C&DIs on the presentation of funds from operations, or FFO.
The following discussion summarizes the important new and revised C&DIs in the order presented on the SEC website. Companies should note that the Regulation G C&DIs apply to all public disclosures by reporting companies, including company websites, and not just SEC filings.
Regulation G C&DIs
- Presenting a non-GAAP performance measure that excludes normal, recurring, cash operating expenses necessary to operate the company’s business may be misleading and violate Regulation G. (Question 100.01)
- Presenting a non-GAAP measure that adjusts a particular charge or gain in the current period may be misleading and violate Regulation G if other, similar charges or gains were not also adjusted in prior periods. In addition, depending on the significance of the change, Regulation G may require the company to recast prior measures to conform to the current presentation and place the non-GAAP disclosure in the appropriate context. (Question 100.02)
- A non-GAAP measure that excludes charges but does not exclude gains – for example, a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains during the same period – may be misleading and violate Regulation G. (Question 100.03)
- Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for GAAP methods may violate Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Regulation G. (Question 100.04)
Item 10(e) C&DIs
- The SEC staff will not object if REITs present FFO, as defined by the National Association of Real Estate Investment Trusts, or NAREIT, in effect on May 17, 2016, as a performance measure on a per-share basis. (Question 102.01)
- REITs may present FFO on a basis other than as defined by NAREIT, provided that any adjustments comply with Regulation G. These adjustments must also comply with the requirements of Item 10(e) for performance or liquidity measures, as applicable. Depending on the nature of the adjustments, some adjustments may trigger a prohibition on presenting the measure on a per-share basis, as described in the C&DIs in Questions 100.01-100.04 (above) and Question 102.05 (below). (Question 102.02)
- Question 102.03, which provides guidance on the prohibition in Item 10(e) against adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or the company had a similar charge or gain within the prior two years, has been revised to include a reference to Question 100.01. (Question 102.03)
- Non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in SEC filings. Whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure. The SEC staff will focus on the substance of the non-GAAP measure, and not management’s characterization, when analyzing whether a non-GAAP measure is a performance measure or a liquidity measure. (Question 102.05)
- “Free cash flow,” which is typically calculated as cash flows from operating activities as presented in the GAAP statement of cash flows, less capital expenditures, is a liquidity measure that must not be presented on a per share basis. (Question 102.07)
- Item 10(e) requires companies to present the most directly comparable GAAP measure with equal or greater prominence when they present non-GAAP measures. This applies both to documents filed with the SEC and to earnings releases furnished under Form 8-K Item 2.02. This C&DI presents examples of disclosure that would violate this requirement:
- presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;
- omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;
- presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;
- a non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);
- describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;
- providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;
- excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and
- providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence. (Question 102.10)
- Companies should calculate and present the income tax effects on non-GAAP measures based on the nature of the non-GAAP measure. The C&DIs state that it might be acceptable for a company to adjust GAAP taxes to show taxes paid in cash if the measure is a liquidity measure that includes income taxes. If the measure is a performance measure, the company should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. Companies should not present adjustments to arrive at a non-GAAP measure “net of tax,” but should show income taxes as a separate adjustment with a clear explanation. (Question 102.11)
- If a company presents EBIT or EBITDA as a performance measure, it must not present that measure on a per share basis. (Question 103.02)