On May 17, 2016, the SEC’s Division of Corporate Finance issued new Compliance & Disclosure Interpretations (“C&DIs”) regarding the use of non-GAAP financial information by public companies. This attempt to reset the guardrails for use of non-GAAP information follows numerous recent studies and press reports to the effect that the focus on non-GAAP financial information has largely eclipsed GAAP results in the media and financial markets, and related concerns and warnings expressed by SEC Chair White and ranking members of the SEC Staff in various speeches and panels.
The Staff added 12 new C&DIs to its body of existing interpretations relating to the SEC’s regulations governing the use of non-GAAP financial information—Regulation G and Item 10(e) of Regulation S-K. The complete C&DIs can be found here and the new C&DIs are dated May 17, 2016. While accepting the premise that non-GAAP financial information can provide useful information to investors, the Staff sent a very clear message that issuers must be very careful not to use it in a way that is either more prominent than GAAP information or misleading. The C&DIs also provide specific guidance for certain types of non-GAAP financial information.
In addition to assuring technical compliance with this new SEC guidance, management and audit committees should take this opportunity to re-examine their companies’ use of non-GAAP financial measures in SEC filings and other public disclosures, including the amount, prominence and type of such measures and the related required disclosures, the justification for using such measures, and the applicable disclosure controls and procedures. The SEC has moved with clarity and a sense of urgency to respond to recent concerns raised about non-GAAP information, and it can be expected that the Staff will be reviewing disclosures carefully in the days and months ahead and will bring enforcement actions where appropriate to drive the point home.
The C&DIs that are likely to have the biggest effect on current disclosure practices are those that squarely address the “prominence” of non-GAAP measures in relation to GAAP measures. Item 10(e)(1)(i)(A) of Regulation S-K requires that when an issuer presents a non-GAAP measure, it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission, as well as earnings releases furnished under Item 2.02 of Form 8-K. Whether a non-GAAP measure is more prominent than the most directly comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, but the C&DIs now make it clear that the following disclosures of non-GAAP measures are more prominent and therefore noncompliant:
- omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;
- a non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);
- 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;
- 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;
- 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;
- 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.
Misleading Non-GAAP Measures
The C&DIs also make it clear that certain adjustments to GAAP numbers, although not explicitly prohibited in the rules and regulations, can result in a non-GAAP measure that is misleading. Examples include:
- presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a company’s business;
- a non-GAAP measure that is presented inconsistently between periods, such as one that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods, unless the change between periods is disclosed and the reasons for it explained;
- a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period; and
- a non-GAAP performance measure that substitutes individually tailored revenue recognition and measurement methods for those of GAAP.
Per Share Non-GAAP Measures
The Staff recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint, as long as they are reconciled to GAAP earnings per share. On the other hand, non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission. 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 Staff made it clear that they will focus on the substance of the measure rather than on management’s characterization.
Non-recurring Charges and Gains
Item 10(e) of Regulation S-K prohibits adjusting a non-GAAP financial 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. The C&DIs clarify, however, that when a company cannot describe a charge or gain as non-recurring, infrequent or unusual, it does not mean that the company cannot adjust for that charge or gain. Rather, companies can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K.
Free Cash Flow
Some companies present a measure of “free cash flow,” which is typically calculated as cash flows from operating activities as presented in the statement of cash flows under GAAP, less capital expenditures. The Staff takes the position that the deduction of capital expenditures from the GAAP financial measure of cash flows from operating activities does not violate the rules. However, companies should be aware that this measure does not have a uniform definition and its title does not describe how it is calculated. Accordingly, a clear description of how this measure is calculated, as well as the necessary reconciliation, should accompany the measure where it is used. Companies should also avoid inappropriate or potentially misleading inferences about its usefulness. For example, free cash flow should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures, since many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure. The Staff also notes that free cash flow is a liquidity measure that must not be presented on a per share basis.
Adjustments for Income Tax Effects
Companies are instructed that providing for the income tax effects on non-GAAP measures should depend on the nature of the measures. If a measure is a liquidity measure that includes income taxes, it might be acceptable to adjust GAAP taxes to show taxes paid in cash. If a measure is a performance measure, the company should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. In addition, adjustments to arrive at a non-GAAP measure should not be presented “net of tax.” Rather, income taxes should be shown as a separate adjustment and clearly explained.
EBIT and EBITDA
If a company presents EBIT or EBITDA as a performance measure, such measures should be reconciled to net income as presented in the statement of operations under GAAP. Operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income. In addition, these measures must not be presented on a per share basis.
Non-GAAP financial information is here to stay. Among other things, appropriate adjustments made to GAAP information can provide investors with important insights into the core operations of a company’s ongoing business and how management views the results of these operations. But companies must be careful to comply with the applicable regulations and guidance and not to use non-GAAP information in a way that is more prominent than GAAP information or that is misleading. In addition, management and audit committees should review now and going forward their companies’ use of non-GAAP financial measures in SEC filings and other public disclosures, the justification for using such measures and the applicable disclosure controls and procedures.