On May 17, the SEC’s Division of Corporation Finance published additional Compliance and Disclosure Interpretations (CDIs) relating to the use of Non-GAAP financial measures in documents filed with or furnished to (for example earnings releases) the SEC. The new interpretations add additional CDIs to those previously issued and last updated in 2011.
The publication of these additional CDIs follows a number of public statements made by SEC officials where they expressed concern over how Non-GAAP financial measures are currently being used by public companies. This Alert identifies interpretations in the new CDIs that we believe are most relevant to technology and life science companies in their use of Non-GAAP measures.
Prominence of Non-GAAP Financial Measures
Item 10(e)(i)(A) of Regulation S-K prohibits the presentation of a Non-GAAP financial measure more prominently than the most directly comparable GAAP measure. In the new CDIs, the SEC provides examples of disclosure practices that it views as disclosing Non-GAAP financial measures more prominently than the comparable GAAP measure:
Headlines in Earnings Releases. Presenting only a Non-GAAP financial measure in a headline of an earnings release, without also presenting the comparable GAAP measure.
Presentation Style. The use of bold or larger fonts for Non-GAAP financial measures than for GAAP measures.
Non-GAAP Financial Measures Preceding GAAP Measures. Presenting Non-GAAP financial measures prior to the comparable GAAP measures, including in earnings release headlines and captions.
Non-GAAP Tables. Tables consisting only of Non-GAAP financial measures that are not preceded by a table of comparable GAAP measures.
Discussion of Non-GAAP Financial Measures. Characterizing Non-GAAP financial measures as, for example, a “record performance” or “exceptional” without a similar characterization of GAAP results.
The CDIs retain the guidance first formally provided in 2010 to the effect that it is inappropriate to present a full income statement consisting of Non-GAAP financial measures, or to present a full non-GAAP income statement in a table reconciling Non-GAAP financial measures to the comparable GAAP financial measure.
Problematic Adjustments used for Non-GAAP Financial Measures
The SEC noted that even if an adjustment may not be specifically prohibited, it could nevertheless cause a non-GAAP financial measure to be misleading, such as by excluding normal, recurring, cash operating expenses necessary to operate the business. Other observations regarding problematic adjustments include:
Inconsistent Presentation of Non-GAAP Financial Measures. If a company excludes a particular charge (or gain) in one period, but does not exclude similar items in prior periods, the Staff would expect the change between periods to be disclosed as well as the reasons for the change. The Staff also noted that if the change was significant, companies may need to recast presentations for prior periods to be consistent.
“One-Sided” Adjustments. If Non-GAAP financial measures adjust for non-recurring expenses, the Non-GAAP measures should similarly adjust for non-recurring gains.
Acceleration of Revenue. Non-GAAP measures that substitute individually-tailored revenue recognition criteria and measurement methods would be problematic. For example, if a company recognizes revenue with respect to the sale of a subscription service over time, it would not be able to present a non-GAAP performance measure as though the revenue was instead recognized when billed. Measures other than revenue (such as costs or expenses) that substitute individually tailored recognition and measurement methods would also be problematic.
Tax Effects of Adjustments. To the extent a Non-GAAP financial measure reflects the tax effects related to the adjustments and is a performance measure, the current and deferred income tax expense should be reflected as adjustments, instead of simply presenting the measure as “net of tax.”
EBIT and EBITDA. Depending upon the context,EBIT and EBITDA may be presented either as performance measures, to be reconciled to net income (loss), or as liquidity measures, to be reconciled to the statement of cash flows. The CDIs in particular reiterate that it is not appropriate to present liquidity measures on a per share basis, while it is acceptable to present per share performance measures. The somewhat subjective determination of whether EBIT or EBITDA or another similar measure is presented as a performance measure or a liquidity measure creates the potential for confusion regarding the appropriateness of the presentation of the measure on a per share basis.
With the release of these additional CDIs, we believe that the Staff will begin to issue comment letters related to Non-GAAP financial measures, with these comment letters providing an additional view into the interpretation of Regulation G and Item 10 of Regulation S-K and the related CDIs.