This fall, the SEC celebrated its 15-year anniversary with non-GAAP financial measures by issuing numerous comment letters and enforcement inquiries on the topic. An example of a non-GAAP financial measure is adjusted EPS, which excludes charges or gains reflected in the corresponding GAAP measure in order to focus investors on results of ongoing, recurring operations.
Where It All Began
Like many sagas, this one began with the collapse of Enron in November 2001, which led to SEC guidance on misleading financial measures. In 2002, the SEC brought its first enforcement action on the topic, alleging that Trump Hotels & Casino Resorts violated antifraud provisions by using non-GAAP income and EPS measures to tout purportedly positive results of operations. The company’s disclosure was deceptive because it excluded a one-time $81.4 million charge and failed to disclose that the results were primarily attributable not to operations, but to a one-time gain recognized in the same period as the charge. Without this gain, the company’s revenues and net income would have decreased from prior years and the company would have failed to meet analysts’ expectations. The enforcement action made clear that the Securities Exchange Act does not permit cherry-picking and opaque disclosure.
Parameters for Using Customized Financial Measures
The financial reporting landscape has advanced since 2002, but SEC rules remain premised on protecting investors from misleading disclosures. In 2003, the SEC adopted Regulation G, which prohibits the use of misleading non-GAAP measures in public communications and requires any publicly-disclosed non-GAAP measures to be accompanied by the most directly comparable GAAP measure and a quantitative reconciliation. In addition, periodic reports, proxy statements, other SEC filings and any furnished earnings release must feature the GAAP measure with equal or greater prominence and state why management believes the non-GAAP measure provides useful information to investors, as well as additional purposes for which management uses the customized measure. In SEC filings, additional restrictions also prohibit eliminating performance measures from recurring items, excluding cash charges from liquidity measures and presenting non-GAAP financial measures in a confusing or prominent manner.
2016 Comment Letters and Enforcement Inquiries
The use of non-GAAP measures has proliferated since the adoption of Reg G. A December 2015 Audit Analytics study found that 88 percent of the S&P 500 use non-GAAP metrics. While non-GAAP measures can be useful to investors, skepticism also endures. Audit Analytics showed that these adjustments increase net income 82 percent of the time, with an average quarterly impact of $176 million. Perhaps in response to these findings, in May 2016 the SEC updated its guidance to clarify when a non-GAAP measure would be considered misleading and when a non-GAAP measure would be inappropriately prominent. The SEC issued over 100 comment letters throughout the late summer and fall to encourage compliance with these interpretations on a going-forward basis. We can glean the following takeaways from these comment letters:
- Adjustments can be misleading if they occur over multiple periods and relate to normal, recurring cash operating expenses necessary to operate a registrant’s business. One area of SEC focus is recurring adjustments for restructuring charges. Registrants may need to provide factual background and explain why it is not misleading to exclude these charges.
- Cherry-picking is not permitted. Non-GAAP measures should be presented consistently between periods, unless the change is disclosed and the reasons for it explained. Depending on the significance of the change, it may be necessary to recast prior measures. Non-GAAP measures should be adjusted for both charges and gains.
- A registrant cannot imply that it recognizes revenue at a different time than GAAP would allow.
- Free cash flow should be clearly defined and reconciled to cash from operating activities. Free cash flow and EBITDA should not be presented on a per-share basis.
- Prominence matters. Lead with GAAP measures in headlines, captions and narratives, and be mindful of style issues (e.g., bold, larger font) and superlative or more extensive descriptions of non-GAAP figures. Use clear labels for non-GAAP measures. With respect to forward-looking non-GAAP measures, excluding a reconciliation is permitted only if unavailable information is identified, along with its significance, in a location of equal or greater prominence.
- Non-GAAP measures should separately reflect and explain adjustments, including the corresponding income tax impact of non-GAAP adjustments.
The SEC’s guidance and comment letters should also be considered in connection with activities of the SEC’s enforcement division, which this fall contacted a number of registrants regarding whether customized financial measures are featured too prominently. The inquiries request extensive information, including all drafts, e-mails and other correspondence relating to earnings releases for the past five years and identification of other instances of Regulation G violations. While the SEC comment letter process has been focused on improving future disclosure, the enforcement inquiries examine historical disclosures and are more likely to result in penalties.
Questions For the Disclosure Team
In light of the focus on non-GAAP financial measures by the SEC, the media and investors, it is very important for registrants to maintain disclosure controls around non-GAAP calculations, definitions and narratives. Dialogue among audit committees, external reporting teams, legal counsel and auditors should include the following questions:
- Has the purpose for using and presenting non-GAAP measures been documented and disclosed? Do non-GAAP adjustments align with that stated objective?
- Is the narrative and presentation of GAAP measures at least as extensive and prominent as that for non-GAAP measures?
- Are all non-GAAP measures, including forward-looking measures, clearly labeled and reconciled to the most directly comparable GAAP measure? Are all adjustments to each non-GAAP measure separately described and reflected?
- How do the registrant’s non-GAAP measures align with its industry peers?
- Have non-GAAP measures been calculated consistently over time? For proxy statements that present a longer performance look-back than periodic reports, it may be necessary to recast any inconsistent earlier presentations.
- Do non-GAAP measures adjust for gains as well as charges?
- Do the registrant’s auditors have adequate time to review and consider non-GAAP measures, including those used in the proxy statement?
Additional helpful questions are included in the June 2016 Toolkit for Audit Committees published by the Center for Audit Quality. As always, the goals of transparent, straightforward disclosure and facilitating investor understanding can guide these discussions.
This article summarizes a presentation delivered at the November 18, 2016, meeting of the American Bar Association’s Business Law Section regarding the history and future of non-GAAP financial measures. Panelists included David Lynn (Morrison & Foerster LLP, former Chief Counsel of the SEC’s Division of Corporation Finance), John White (Cravath, Swaine & Moore LLP, former Director of the SEC’s Division of Corporation Finance), Carmen Lawrence (King & Spalding), Mark Kronforst (Chief Accountant of the SEC’s Division of Corporation Finance) and Steven Jacobs (Ernst & Young LLP).