June 6, 2016
On May 17, 2016, the staff (Division of Corporation Finance) of the Securities and Exchange Commission (SEC) updated its Compliance and Disclosure Interpretations (C&DIs) of the rules and regulations on the use of non-generally accepted accounting principles (GAAP) financial measures.
These are numerical measures of a company’s historical or future financial performance, financial position or cash flows that include or exclude amounts from the most directly comparable GAAP measure. They are used by issuers in their public disclosures as well as registration statements filed under the Securities Act of 1933 and periodic reports filed under the Securities Exchange Act of 1934, subject to compliance with Regulation G and Item 10(e) of Regulation S-K (Item 10(e)) of the SEC’s Final Rule: Conditions for Use of Non-GAAP Financial Measures.1
Their primary use is to supplement the earnings reported under U.S. GAAP to offer investors and analysts information they may use to evaluate performance, often tailored to a particular industry or circumstance. The idea is to combine the two sets of complementary information as an analytical tool in understanding the underlying business.
There has been a noticeable increase in the use of non-GAAP measures and, more importantly, the differential between GAAP and non-GAAP measures is increasing. According to Factset Insight, the average difference between GAAP earnings per share (EPS) and non-GAAP EPS for the companies in the Dow Jones Industrial Average increased from 11.8 percent to 30.7 percent in fiscal years ending in 2014 and 2015, respectively.
Furthermore, the average year-over-year change between fiscal years 2014 and 2015 for these companies were declines of 12.3 percent for GAAP EPS and only 4.8 percent for non-GAAP EPS.2 The SEC has taken notice of these trends; hence, the commission issued its guidance on non-GAAP measures in May.
The SEC’s Latest Guidance
In 2003, the SEC adopted a new disclosure regulation, Regulation G, to require public companies that disclose or release non-GAAP financial measures to include, in the disclosure or release, a presentation of the most directly comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure.
In its final rule, in which the SEC defined conditions for the use of non-GAAP financial measures, it stated that these measures are “measure[s] of performance that [are] different from that presented in the financial statements, such as income or loss before taxes or net income or loss, as calculated in accordance with GAAP; or a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP.”3
Since 2003, the SEC staff has issued guidance on the proper use of non-GAAP measures, and has also commented extensively on their use in a variety of public forums. The rules, as initially issued, and the subsequent guidance have emphasized two common themes. First, non-GAAP measures must not be misleading. Second, non-GAAP measures are intended to supplement, not supplant, information disclosed in the financial statements.
The latest guidance essentially sends a warning along the lines of this continuing theme.4 The SEC staff has stated in plain English that:
- When presenting a non-GAAP measure, the most directly comparable GAAP measure must be presented with equal or greater prominence. For example, the SEC would consider the following presentation as the non-GAAP measure being more prominent: presenting a complete “income statement” of non-GAAP measures when reconciling non-GAAP measures to the most directly comparable GAAP measure.
- Certain adjustments, although not explicitly prohibited, can result in a non-GAAP measure that is misleading. For example, presenting a performance measure that excludes normal, recurring cash operating expenses necessary to operate a registrant’s business could be misleading.
- A non-GAAP measure could be misleading if it is presented inconsistently between periods. For example, a non-GAAP measure 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 could violate Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it explained. In addition, depending on the significance of the change, it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context.
- A non-GAAP measure can be misleading if the measure excludes charges but does not exclude any gains. For example, a non-GAAP measure that is adjusted only for nonrecurring charges when there were nonrecurring gains that occurred during the same period could violate Rule 100(b) of Regulation G.
This guidance reads like a primer. The SEC staff is sending a message that it will be watching. Staff members will ask the necessary questions to ensure no abuse is occurring if they sense a red flag. Additional guidance further drives home this message:
- A registrant cannot present in SEC filings a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.
The idea behind Regulation G is to ensure that, when non-GAAP measures are used, investors are provided with financial information that is fairly presented and not misleading. To that end, four questions are included in the guidance relating to the application of certain provisions in Item 10(e) of Regulation S-K to amplify the SEC staff’s concerns. These are listed below along with the staff’s responses:
- Question: Item 10(e) of Regulation S-K prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as nonrecurring, 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. Is this prohibition based on the description of the charge or gain, or is it based on the nature of the charge or gain?
SEC Staff Answer: The prohibition is based on the description of the charge or gain that is being adjusted. It would not be appropriate to state that a charge or gain is nonrecurring, infrequent or unusual unless it meets the specified criteria. The fact that a registrant cannot describe a charge or gain as nonrecurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K. See reference on the previous page to the staff’s guidance that certain adjustments, although not explicitly prohibited, can result in a non-GAAP measure that is misleading.
- Question: While Item 10(e)(1)(ii) of Regulation S-K does not prohibit the use of per share non-GAAP financial measures, the adopting release for Item 10(e), Exchange Act Release No. 47226, states that “per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission.” In light of SEC guidance, specifically Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data, and Accounting Standards Codification 230, are non-GAAP earnings per share numbers prohibited in documents filed or furnished with the Commission?
SEC Staff Answer: No. Item 10(e) recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint. Non-GAAP per share performance measures should be 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, consistent with Accounting Series Release No. 142. 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. When analyzing these questions, the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.
- Question: 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. Does Item 10(e)(1)(ii) of Regulation S-K prohibit this measure in documents filed with the Commission?
SEC Staff Answer: No. The deduction of capital expenditures from the GAAP financial measure of cash flows from operating activities would not violate the prohibitions in Item 10(e)(1)(ii). 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. Also, as noted in the previous question, free cash flow is a liquidity measure that must not be presented on a per share basis.
- Question: Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant 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 and also earnings releases furnished under Item 2.02 of Form 8-K. Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?
SEC Staff Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:
- 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.
With respect to calculation and presentation of income tax effects related to adjustments to arrive at a non-GAAP measure, the SEC staff indicates that registrants should provide income tax effects on their non-GAAP measures depending on the nature of the measures.
For example, if a non-GAAP amount disclosed is a liquidity measure that includes income taxes, it might be acceptable to adjust GAAP taxes to show taxes paid in cash. Or, if a measure is a performance measure, the registrant should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. The SEC staff also points out that 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.
One final point: If earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA) is presented as a performance measure, the SEC staff states that 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 not included in operating income. In addition, as noted earlier, these measures must not be presented on a per share basis.
The staff addresses other points relating to “funds from operations per share,” as defined by the National Association of Real Estate Investment Trusts (NAREIT), in earnings releases and materials filed with or furnished to the SEC. Subject to the requirements of Regulation G and Item 10(e) of Regulation S-K, the staff accepts NAREIT’s definition of funds from operations in effect as of May 17, 2016, as a performance measure and does not object to its presentation on a per share basis.
The staff will also accept the presentation of funds from operations on a basis other than as defined by NAREIT as of May 17, 2016, provided that any adjustments made to funds from operations (FFO) comply with Item 10(e) of Regulation S-K and the measure does not violate Rule 100(b) of Regulation G.
In a speech delivered in March of this year, SEC Chief Accountant James Schnurr noted that the “SEC staff has observed a significant and, in some respects, troubling increase over the past few years in the use of, and nature of adjustments within, non-GAAP measures by companies as well [as] prominence that the analysts and media have accorded such measures when reporting on the results of the companies they cover.” In addition, Mr. Schnurr stated:5
"I am particularly troubled by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income, and alternative measures of cash generation, as compared to the measures of liquidity or cash generation … preparers should carefully consider whether significant adjustments to profitability outside of customary measures such as EBITDA or nonrecurring items or other charges to the business, such as the sale of portions of the business in order to provide the user with an understanding of how these events impact trends and future performance, are appropriate. As it relates to cash measures, I believe those measures should be reconciled to cash flow from operations."
The above comments reinforce comments from SEC Chair Mary Jo White three months earlier:6
"[T]he use of non-GAAP measures … deserves close attention … to make sure that our current rules are being followed and to ask whether they are sufficiently robust in light of current market practices …. By some indications, such as analyst coverage and press commentary, non-GAAP measures are used extensively and, in some instances, may be a source of confusion …."
Content Contributed by:
1Final Rule: Conditions for Use of Non-GAAP Financial Measures, U.S. Securities and Exchange Commission.
2“Did DJIA Companies Report Higher Non-GAAP EPS in FY 2015?” by John Butters, March 11, 2016.
3Final Rule: Conditions for Use of Non-GAAP Financial Measures, U.S. Securities and Exchange Commission.
4Non-GAAP Financial Measures, U.S. Securities and Exchange Commission.
5“Remarks before the 12th Annual Life Sciences Accounting and Reporting Congress,” James V. Schnurr, Chief Accountant, Office of the Chief Accountant, March 22, 2016.
6"Maintaining High-Quality, Reliable Financial Reporting: A Shared and Weighty Responsibility,” Mary Jo White, SEC Chair, December 9, 2015.