The staff of the US Securities and Exchange Commission (SEC) has issued new and revised interpretations regarding the use of non-GAAP financial measures.

The staff of the US Securities and Exchange Commission (SEC) has issued new and revised interpretations regarding the use of non-GAAP financial measures. The interpretations follow a number of recent public statements by several senior SEC officials expressing some degree of concern regarding the use of non-GAAP financial measures.[1]

For many US reporting companies, the most significant SEC interpretation defines with more clarity when the SEC staff will consider a non-GAAP financial measure to be inappropriately presented in earnings releases and other SEC filings with greater prominence than the equivalent GAAP measure. Examples provided by the SEC staff where it would consider the non-GAAP measure to be more prominent include a non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption), omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures, and using a description of a non-GAAP measure (such as “exceptional” or “record performance”) without at least an equally prominent descriptive characterization of the comparable GAAP measure.

The new interpretations also clarify various adjustments and presentations that the SEC staff deem to be misleading, such as excluding normal, recurring cash operating expenses from the non-GAAP measure, presenting measures inconsistently between periods, excluding charges but not gains, and substituting individually tailored revenue recognition methods for GAAP methods. In addition, the SEC staff clarified that non-GAAP liquidity measures cannot be presented on a per share basis, including free cash flow, EBIT and EBITDA. The interpretations, described in more detail below, became effective immediately and are applicable to all US reporting companies.

Equal or greater prominence

The SEC rules have historically provided that when non-GAAP financial measures are included in SEC filings or in earnings releases furnished under Item 2.02 of Form 8-K, the filing must include the most directly comparable GAAP measure “with equal or greater prominence.” The new SEC interpretations now define with greater specificity what would cause a non-GAAP measure to be more prominent.

Stating that “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 SEC staff said that they 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.
  • Presenting 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.
  • Where a company provides a forward-looking non-GAAP measure but excludes the quantitative reconciliation because it cannot be provided without unreasonable efforts, not disclosing the fact of such omission and not identifying the information that is unavailable and its probable significance in a location of equal or greater prominence.
  • 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

In addition to the new guidance regarding what constitutes disclosure of non-GAAP measures with greater prominence, the SEC staff added four new interpretations reflecting what it views to be misleading and inappropriate non-GAAP financial measures:

  • Excluding normal recurring cash operating expenses. Certain adjustments, although not explicitly prohibited, can result in a misleading non-GAAP measure. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.
  • Inconsistency between periods. A non-GAAP measure can be misleading if 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 be prohibited 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.
  • Excluding charges but not gains. 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 non-recurring charges when there were non-recurring gains that occurred during the same period could be misleading.
  • Individually tailored revenue recognition. 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. For example, a company cannot adjust a non-GAAP performance measure to reflect earnings revenue when customers are billed where the GAAP measure would recognize revenue ratably over time in accordance with GAAP.

Other revisions

The new SEC interpretations also changed, amplified or clarified some of the SEC’s pre-existing guidance. In particular, the SEC staff confirmed that per share liquidity measures are inappropriate, and the SEC views any non-GAAP measure to be a liquidity measure if it can be used as a liquidity measure, even if the company characterizes it as a performance measure. The interpretations also provide that non-GAAP measures can no longer be presented “net of tax.” The new guidance provides as follows:

  • Earnings per share. The new guidance reiterates the SEC’s previous position that non-GAAP per share performance measures are acceptable so long as they are reconciled to GAAP earnings per share, but non-GAAP liquidity measures such as cash flow (now referred to as liquidity measures that measure cash generated) must not be presented on a per share basis. However, the new guidance adds that “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 SEC staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.”
  • Free cash flow per share. The SEC staff reiterated its previous position that allows presentation of “free cash flow” (cash flow from operating activities, less capital expenditures), so long as a clear description of how the measure is calculated and the necessary reconciliation to a GAAP measure are included. However, the new interpretations clarify that free cash flow is a liquidity measure that may not be presented on a per share basis.
  • EBIT or EBITDA per share. The SEC staff reiterated its previous position that if EBIT or EBITDA is presented as a performance measure, it must be reconciled to GAAP net income and not GAAP operating income. Significantly, the new interpretations provide that EBIT and EBITDA may not be presented on a per share basis.
  • Tax effects in reconciliation. The SEC staff’s previous interpretations provided that companies can present adjustments “net of tax” when reconciling performance measures, so long as the tax effect of each reconciling item is disclosed parenthetically or in a footnote or the tax effect is presented in one line in the reconciliation. The revised interpretations provide that adjustments cannot be presented net of tax but instead income taxes must be shown as a separate adjustment and clearly explained. Further, the new interpretation provides that for liquidity measures it may be acceptable to adjust GAAP taxes to show taxes paid in cash, and for performance measures companies should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability.
  • Funds from operations. The SEC staff previously stated that it approved the use of “funds from operations” as defined by the National Association of Real Estate Investment Trusts (NAREIT) as of January 1, 2000 and accepted its use as a performance measure on a per share basis. The new interpretations note that NAREIT has revised its definition since 2000 and the SEC staff accepts the updated definition in effect as of May 2016. The SEC staff also reiterated its previous position that companies can define FFO on a basis other than as defined by NAREIT, but noted that some adjustments may trigger the prohibition on presenting this measure on a per share basis.

Foreign private issuers

The SEC’s rules regarding non-GAAP financial measures, including the interpretations discussed above, generally apply to foreign private issuers. However, the SEC has historically provided a special set of rules applicable to foreign private issuers which result in foreign private issuers being able to avoid compliance with the SEC’s non-GAAP financial measure rules in many cases, and the new interpretations do not change these provisions:

  • For foreign private issuers whose primary financial statements are prepared in accordance with non-US GAAP, GAAP refers to the generally accepted accounting principles pursuant to which their primary financial statements are prepared. Therefore, for example, a European issuer that prepares its financial statements in accordance with IFRS but provides a non-IFRS financial measure would need to accompany the non-IFRS financial measure with a reconciliation to the nearest IFRS measure.
  • Regulation G (which applies to any public disclosure of non-GAAP financial measures) does not apply to public disclosures made by a foreign private issuer whose securities are listed or quoted on a non-US exchange, the non-GAAP measure is not derived from or based on a measure calculated in accordance with US GAAP, and the relevant disclosure is made outside the United States.
    • This rule applies even if a written communication is released both inside and outside the United States so long as it is released in the United States contemporaneously with or after release outside of the United States and is not targeted at persons in the United States, journalists and other third parties have access to it, the disclosure appears on the company’s website, or the company submits the information to the SEC on a Form 6-K following its disclosure.
  • Finally, Item 10(e) of Regulation S-K (which applies to the use of non-GAAP financial measures in SEC filings) provides that foreign private issuers can use a non-GAAP financial measure that would otherwise be prohibited if the measure relates to the GAAP used in the company’s primary financial statements included in its SEC filings, is required or expressly permitted by the applicable standard-setter, and is included in the annual report prepared by the company for use in its home jurisdiction.