On December 13, 2022, the staff of the Division of Corporation Finance (the “staff”) of the Securities and Exchange Commission (the “SEC”) published seven new or revised Compliance and Disclosure Interpretations (“C&DIs”) stating the views of the staff on several disclosure issues involving non-GAAP financial measures. Although many of these C&DIs clarify prior interpretive positions taken by the staff, these C&DIs include a variety of specific examples of disclosure that the staff views as potential or actual violations of applicable SEC rules, and some of these examples involve disclosures that some companies have been including in earnings releases and SEC filings in the absence of specific staff interpretive guidance. The timing is noteworthy. With fourth quarter and full-year 2022 earnings releases and Form 10-K annual reports approaching, companies should review these C&DIs and evaluate the potential impact of these C&DIs on their upcoming earnings releases and Form 10-K annual reports.
Impact and Timing of the New C&DIs
The new C&DIs are important because they clarify existing guidance or provide new guidance on a variety of common non-GAAP financial measure disclosure practices and presentations. The new C&DIs provide an expanded discussion of the staff’s views on how a company must meet the requirements of Item 10(e)(1)(i)(A) of Regulation S-K to present, with equal or greater prominence, the most directly comparable GAAP financial measure. They also stress the importance of clear labels and accurate descriptions when companies disclose non-GAAP financial measures.
The timing of publication is also significant for companies. Starting next month, companies that have a December 31 fiscal year end will begin filing earnings releases and Form 10-K reports, and companies should expect that the staff will be reviewing these for compliance with the C&DIs.
The new and revised C&DIs are discussed below. Some of the C&DIs set forth new positions while others clarify or revise previous guidance. The C&DIs include staff views relating to disclosures of non-GAAP financial measures that must satisfy the “equal or greater prominence” requirement of Item 10(e)(1)(i)(A) of Regulation S-K, which applies to earnings releases submitted with an Item 2.02 report on Form 8-K and to SEC filings, including Form 10-K and Form 10-Q. Other C&DIs reflect staff views relating to all public disclosures of non-GAAP financial measures, which are subject to Regulation G.
Non-GAAP Financial Measures Subject to “Equal or Greater Prominence” Requirement
The new C&DIs relating to the “equal or greater prominence” requirement retain the specific examples previously included, with modifications in some cases, in addition to adding new specific examples.
For REITs: The “equal or greater prominence” requirement applies to all exhibits furnished under Item 2.02 of Form 8-K, which may include the quarterly supplemental financial package in addition to the earnings release. Item 2.02 requires companies to furnish as an exhibit the text of any announcement or release disclosing material non-public information regarding the company’s results or operation or financial condition for a completed quarterly or fiscal period.
- Ratios that include a non-GAAP financial measure in the numerator and/or denominator must be accompanied by an equally or more prominent presentation of the comparable GAAP ratio. This example had not previously been included in the C&DIs and may represent a change in practice for some companies. The adopting release from 2003 relating to the non-GAAP rules had indicated, in a footnote, that presenting the comparable GAAP ratio was required as part of the reconciliation requirement. However, as many ratios using non-GAAP financial measures (e.g., debt/EBITDA ratios, interest coverage ratios, and payout ratios) do not have a meaningful GAAP counterpart, some disclosures have evolved away from the view expressed in this footnote (Question 102.10(a)).
For REITs: REITs commonly include ratios using non-GAAP financial measures in earnings releases and quarterly supplemental financial packages that do not have meaningful GAAP counterparts. Given the new staff guidance, many REITs may need to reconsider how and where they are including these ratios.
- Charts, tables, and graphs that show a non-GAAP financial measure must be accompanied by an equally or more prominent presentation of charts, tables, or graphs that show the comparable GAAP financial measure. Previously, the C&DI had included this example as it related to non-GAAP financial measures in tables, but had not specifically addressed presentation in charts or graphs (Question 102.10(a)).
- Headlines and captions, as well as other disclosure, that include a non-GAAP financial measure must not present the non-GAAP financial measure before, or omit, the comparable GAAP financial measure. This example is consistent with prior C&DIs (Question 102.10(a)).
- Forward-looking non-GAAP financial measures that exclude a quantitative reconciliation as permitted by Item 10(e)(1)(1)(B) would be considered more prominent than the comparable GAAP financial measure by the staff unless the company discloses its reliance on that exception, identifies the information that is unavailable, and discloses the probable significance of that information in a location of equal or greater prominence. This example is consistent with prior C&DIs (Question 102.10(b)).
For REITs: While this guidance is not new, REITs may want to use year-end reporting to reconsider their use of this exception. The focal point of guidance for many REITs is FFO or an adjusted FFO metric, such as Core FFO, and future net income may be subject to impacts from factors that cannot be estimated with a reasonable degree of accuracy without unreasonable efforts. REITs that choose to rely on the unreasonable efforts exception should understand the additional disclosure expected by the staff.
- Reconciliations that begin with a non-GAAP financial measure would be considered by the staff to give greater prominence to the non-GAAP financial measure than the comparable GAAP measure. This example had not previously been included in the C&DIs (Question 102.10(b)).
For REITs: REITs should review reconciliations for compliance with this staff guidance. The staff guidance does not appear to prohibit companies from providing alternative quantitative reconciliations of non-GAAP financial measures that are preceded by the formal reconciliation that begins with the most directly comparable GAAP number (e.g., NOI presentations showing rental and other applicable revenue less rental and other applicable expenses).
- Discussion and analysis of a non-GAAP financial measure without similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence does not comply with the equal or greater prominence requirement. This example is consistent with prior C&DIs (Question 102.10(a)).
- Use of a presentation style or format (for example, bold or larger fonts) that emphasizes a non-GAAP financial measure over the comparable GAAP measure does not comply with the equal or greater prominence requirement. This example is consistent with prior C&DIs (Question 102.10(a)).
- Use of descriptive characterizations, such as “record performance” or “exceptional” for a non-GAAP financial measure without at least an equally prominent descriptive characterization of the comparable GAAP measure does not comply with the equal or greater prominence requirement. This example is consistent with prior C&DIs (Question 102.10(a)).
- A non-GAAP income statement, presented either alone or as part of a required non-GAAP reconciliation, is considered by the staff to give undue prominence to a non-GAAP financial measure regardless of how prominently it appears. This position is consistent with prior C&DIs. In the new C&DIs, the staff indicated that it considers an income statement comprised of non-GAAP financial measures that includes all or most of the line items and subtotals found in a GAAP income statement to be a non-GAAP income statement (Questions 102.10(a) and (c)).
For REITs: This new staff guidance does not appear to modify the previous understanding that had been reached, after extensive interactions, between the staff and the REIT industry regarding the presentation of “pro rata” or “at share” financial metrics.
All Non-GAAP Financial Measures
- Operating expenses that occur only occasionally, including at irregular intervals, will be viewed by the staff as “recurring.” In this C&DI, the staff states its view that adjustments that exclude normal recurring cash operating costs may be misleading, which is consistent with prior C&DIs, but adds the staff’s view that operating expenses that occur repeatedly or occasionally, including at irregular intervals, are “recurring.” Further, although not stated in this C&DI, the staff’s view on “recurring” may mean that identifying these types of operating expenses as non-recurring (or using a similar characterization) may be viewed as misleading in violation of Regulation G, even if the disclosure was not subject to the requirements of Item 10(e)(1)(ii)(B), which specifically prohibits adjustments that eliminate or smooth items identified as non-recurring, infrequent, or unusual when the nature of a charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. This C&DI may also be intended to further restrict what can be identified as non-recurring, infrequent, or unusual beyond what is explicitly noted in Item 10(e)(1)(ii)(B) (Question 100.01).
- Adjustments that change GAAP recognition and measurement principles, change the treatment of transaction costs, or change accrual basis accounting to a cash basis may be misleading. Previously, this C&DI had indicated that (i) a non-GAAP performance measure adjusted to accelerate revenue recognized over time in accordance with GAAP as though it earned revenue when customers are billed would violate Regulation G, (ii) non-GAAP financial measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Regulation G, and (iii) other measures that use individually tailored revenue recognition and measurement methods for financial line items other than revenue may also violate Regulation G. The revised C&DI eliminates the distinctions among these three categories, and instead states that non-GAAP adjustments that have the effect of changing the recognition and measurement principles required to be applied in accordance with GAAP would be considered to be individually tailored and may cause the presentation of the non-GAAP measure to be misleading. The C&DI then indicates that examples the staff may consider to be misleading include, but are not limited to:
- Changing the pattern of recognition, such as including an adjustment in a non-GAAP performance measure to accelerate revenue recognized ratably over time in accordance with GAAP as though revenue was earned when customers were billed
- Presenting a non-GAAP measure of revenue that deducts transaction costs as if the company acted as an agent in the transaction, when gross presentation as a principal is required by GAAP, or the inverse, presenting a measure of revenue on a gross basis when net presentation is required by GAAP
- Changing the basis of accounting for revenue or expenses in a non-GAAP performance measure from an accrual basis in accordance with GAAP to a cash basis (Question 100.04)
For REITs: This new guidance does not specifically modify prior staff positions regarding “pro rata” or “at share” financial metrics or other non-GAAP financial measures commonly used in the REIT industry, such as cash NOI, that fit within the types of adjustments that the staff indicates it may consider to be misleading.
- Use of inappropriate labels or lack of clear descriptions may result in a non-GAAP financial measure or adjustment being misleading. This C&DI includes several examples of labels that do not clearly identify the nature of a non-GAAP financial measure that the staff says would — not may — violate the prohibition of Rule 100(b) of Regulation G against misleading disclosure of non-GAAP financial measures. The examples include:
- Failing to identify and describe a measure as non-GAAP
- Presenting a non-GAAP financial measure with a label that does not reflect the nature of the non-GAAP measure, such as:
- A contribution margin that is calculated as GAAP revenue less certain expenses, labeled “net revenue”
- A non-GAAP financial measure labeled the same as a GAAP line item or subtotal even though it is calculated differently than the similarly labeled GAAP measure, such as “gross profit” or “sales”
- A non-GAAP financial measure labeled “pro forma” that is not calculated in a manner consistent with the pro forma requirements in Article 11 of Regulation S-X (Question 100.05)
For REITs: REITs should review labels being used for non-GAAP financial measures in light of this new staff guidance. We would not expect this new guidance to apply to common industry-wide metrics, such as net operating income or NOI, to which the staff had not previously objected and are not specifically identified in the new C&DI, but there may be a renewed focus on the labels given to more individualized metrics.
- Extensive, detailed disclosure about the nature and effect of non-GAAP adjustments may not prevent a non-GAAP financial measure from being materially misleading, in the staff’s view. The staff views some non-GAAP financial measures as misleading investors to such a degree that no amount of disclosure regarding the adjustments made can prevent them from being materially misleading (Question 100.06).
What Companies Can Do Now
Review 2022 Earnings Release and Form 10-K Disclosures. As companies begin to prepare earnings releases and Form 10-K annual reports for fiscal year 2022, companies should review their disclosures of non-GAAP financial measures and their related disclosure controls and procedures in light of the new C&DIs. As they do so, they should consider the possibility that disclosure that is inconsistent with these C&DIs may result in more than a staff comment letter on the earnings release or Form 10-K report.
For REITs: Particular attention should also be given to the quarterly supplemental financial package for REITs, which may contain disclosure of non-GAAP financial measures to which the new C&DIs may apply.
Focus On “Equal or Greater Prominence.” In 2019, the SEC settled enforcement proceedings involving alleged violations of the equal or greater prominence requirement that were contained in a company’s earnings releases, including the headlines of these earnings releases, following the staff’s publication of C&DIs addressing this topic. Because several of the new C&DIs provide specific examples of disclosures that the staff describes as failing to comply with the equal or greater prominence requirement, and in light of the fact that the SEC has initiated enforcement proceedings where companies have not heeded the staff in similar circumstances in the past, companies should give particular attention to Questions 102.10(a), (b) and (c).
Communicate With Audit Committee. In addition to reviewing upcoming disclosures and their disclosure controls and procedures, companies should consider communicating with the audit committee of the company’s board of directors about the new C&DIs, particularly to the extent they result in changes in the company’s typical disclosures. The SEC views oversight of a company’s use of non-GAAP financial measures as part of the responsibilities of the audit committee. For example, in December 2019, then SEC Chairman Jay Clayton, SEC Chief Accountant Sagar Teotia, and Director, Division of Corporation Finance, William Hinman, stated that “It is important that audit committees understand whether — and how and why — management uses non-GAAP measures and performance metrics, and how those measures are used in addition to GAAP financial statements in the company’s financial reporting and in connection with internal decision making. We encourage audit committees to be actively engaged in the review and presentation of non-GAAP measures and metrics to understand how management uses them to evaluate performance, whether they are consistently prepared and presented from period to period, and the company’s related policies and disclosure controls and procedures.”
SEC Regulation of Non-GAAP Financial Measures
Non-GAAP financial measures — financial measures of a company’s historical or future financial performance, financial position, or cash flow that reflect adjustments that are not in accordance with US generally accepted accounting procedures (“GAAP”) — have been a subject of SEC written guidance since 1973. The Sarbanes-Oxley Act of 2002 required the SEC to adopt rules governing the disclosure of non-GAAP financial information. In response, the SEC adopted Regulation G and amended Regulation S-K to add Item 10(e).
Regulation G. Regulation G, which applies to any public disclosure by or on behalf of a public company of material information that includes a non-GAAP financial measure, prohibits misleading disclosure of non-GAAP financial measures and requires that any public disclosure of a non-GAAP financial measure be accompanied by (1) presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP and (2) a reconciliation of the differences between the non-GAAP financial measure and the comparable GAAP financial measure.
Item 10(e). Item 10(e) applies to non-GAAP financial measures contained in registration statements, Form 10-K and Form 20-F annual reports, Form 10-Q quarterly reports, and other documents filed with the SEC. Item 10(e) includes both a series of disclosures required when a company includes a non-GAAP financial measure in an SEC filing (Item 10(e)(1)(i)) and a series of prohibited adjustments and presentation that apply to disclosure of non-GAAP financial statements.
Item 10(e)(1)(i) requires that non-GAAP financial measures in an SEC filing must be accompanied by:
- A presentation, with equal or greater prominence, of the most directly comparable GAAP financial measure
- A reconciliation of the differences between the non-GAAP financial measure and the comparable GAAP financial measure
- A statement of the reasons why the company’s management believes that the non-GAAP financial measure provides useful information to investors about the company’s financial condition and results of operations
- A statement disclosing any additional purposes for which management uses the non-GAAP financial measure, to the extent material
In addition, Item 10(e)(1)(ii) provides that companies must not:
- Exclude charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures, other than the measures earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA)
- Adjust 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 there was a similar charge or gain within the prior two years
- Present non-GAAP financial measures on the face of the company’s financial statements prepared in accordance with GAAP or in the accompanying notes
- Present non-GAAP financial measures on the face of any pro forma financial information required to be disclosed by Article 11 of Regulation S-X
- Use titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures
Item 2.02 of Form 8-K. Item 2.02 of Form 8-K requires companies to submit a Form 8-K report if a company or any person acting on its behalf makes any public announcement or release that discloses material non-public information about the company’s results of operations or financial condition for a completed quarterly or annual fiscal period. Item 2.02 clearly applies to quarterly and annual earnings releases that precede the filing of the Form 10-Q or Form 10-K for the applicable period, and it can also apply to other disclosures. Item 2.02 requires the company to include the text of the announcement or release as an exhibit to the Form 8-K. This report is treated as furnished, rather than filed, and would therefore not be subject to Item 10(e), but Instruction 2 to Item 2.02 provides that the requirements of Item 10(e)(1)(i), listed above, apply to Item 2.02 disclosures. This means that the text of earnings releases furnished as an exhibit to an Item 2.02 Form 8-K must comply with Item 10(e)(1)(i), including the requirement that disclosures of non-GAAP financial measures must be accompanied by equally or more prominent presentation of the comparable GAAP financial measures. As discussed above, this requirement is the focus of several of the new C&DIs, which emphasizes the importance of those C&DIs as companies begin to prepare the 2022 year-end earnings releases.
Staff Guidance. There are two leading sources for SEC staff guidance on compliance with Regulation G and Item 10(e). The first is the Compliance and Disclosure Interpretations on non-GAAP financial measures, which the new C&DIs have updated. The second is the Division of Corporation Finance Financial Reporting Manual, which includes a section titled “Topic 8 – Non-GAAP Measures of Financial Performance, Liquidity, and Net Worth.