In recent months, the Securities and Exchange Commission (the “SEC”) has signaled that the use of non-GAAP measures will be scrutinized closely. Chair Mary Jo White has discussed non-GAAP disclosures in speeches, urging registrants to review their disclosures and noting that this is an area of concern for the SEC. Several high-level SEC staffers have also focused on non-GAAP disclosures in public appearances, sending a clear message that this is a priority for the SEC. The Division of Corporation Finance (the “Division”) continued this theme on May 17, 2016 by making significant updates to its Non-GAAP Financial Measures Compliance & Disclosure Interpretations (“C&DIs”) published on the SEC’s website. The updates include several new interpretations and revisions to existing C&DIs that we believe will require meaningful changes to market practices. The C&DIs can be found here.
The use of non-GAAP financial measures is governed by Regulation G, which applies to all public disclosures of non-GAAP financial measures made by reporting companies, and Item 10(e) of Regulation S-K, which applies to non-GAAP financial measures used in filings with the SEC, with some portions also applicable to earnings releases that are furnished under Item 2.02 of Form 8-K. These rules generally require public companies, when disclosing non-GAAP financial measures, to present the most directly comparable GAAP financial measure with equal or greater prominence and reconcile the non-GAAP measure to the GAAP measure. Additionally, in most cases, companies are required to disclose the reasons why the non-GAAP measure provides useful information to investors and what management uses the measure for, if applicable. Certain non-GAAP measures are prohibited in filings and, in all cases, the use of the non-GAAP measure must not be misleading.
Misleading Disclosures – Several new C&DIs address when non-GAAP disclosures could be considered misleading. For example:
- Even adjustments that are not explicitly prohibited could be misleading, such as by excluding normal, recurring, cash operating expenses necessary to operate the registrant’s business;
- Inconsistent presentations between periods without adequate explanation of the changes could be misleading (and it may be necessary to recast prior measures); and
- Excluding nonrecurring charges, but not nonrecurring gains, could be misleading.
These C&DIs are presented as examples of disclosures that could be misleading. It is not surprising that the Division would consider any of these things as potentially misleading depending on the circumstances and accompanying disclosures. However, by highlighting these examples, we believe the Division has raised the bar in terms of the quality of disclosures that must accompany non-GAAP measures that could fall into any of the above or similar categories. It will be very important to explain clearly how non-GAAP measures are calculated and the rationale for the chosen adjustments. Even though Regulation G does not explicitly require disclosure of the reasons for using a non-GAAP measure, the practical implication of these new C&DIs may be that many non-GAAP measures, regardless of where presented, should be accompanied by meaningful explanatory disclosure.
In some cases, no level of accompanying disclosure may suffice to prevent a measure from being considered misleading. In new C&DI 100.04, the Division raises the possibility that some non-GAAP measures, even though not explicitly prohibited, could be inherently misleading regardless of how they are presented, such as a non-GAAP measure that accelerates revenue that is recognized over time in accordance with GAAP.
Prominence – Regulation S-K Item 10(e)(1)(i)(A) requires that when a non-GAAP measure is presented in a filing or earnings release, the most directly comparable GAAP measure must be presented with “equal or greater prominence.” C&DI 102.10 provides examples of disclosures the Division would consider noncompliant with this requirement, including:
- Presenting a full non-GAAP income statement, whether as part of a reconciliation or otherwise;
- Omitting the GAAP measure from a headline or caption that includes a non-GAAP measure;
- Presenting a non-GAAP measure using a more prominent style (e.g., bold or larger font);
- Presenting a non-GAAP measure that precedes the GAAP measure;
- Characterizing a non-GAAP measure (e.g., “record performance” or “exceptional”) without an equally prominent characterization of the GAAP measure;
- Presenting a tabular non-GAAP disclosure without preceding it with a tabular GAAP disclosure; and
- Providing a discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the GAAP measure.
These examples illustrate a strict interpretation of the equal prominence rule that does not align with current market practices. Many registrants will have to reconsider their practices accordingly, particularly in earnings releases.
Forward-Looking Statements – Both Regulation G and Regulation S-K require a quantitative reconciliation for forward-looking non-GAAP measures “to the extent available without unreasonable efforts.” New C&DI 102.10 indicates that in order to exclude a quantitative forward-looking reconciliation in reliance on the “unreasonable efforts” exception, it is necessary to disclose the unavailable information and its probable significance. Our experience is that this exception is frequently relied on when providing earnings guidance and similar forward-looking information, and complying with this interpretation will result in additional disclosures for many registrants.
Prohibitions on Per Share Liquidity Measures – It has long been the Division’s position that non-GAAP liquidity measures should not be presented on a per share basis in documents filed with or furnished to the SEC. A revision to C&DI 102.05 notes that this position applies to any liquidity measure that measures cash generated, and also notes that the prohibition depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it as a performance measure. In the past, the Division staff may have deferred to management’s characterization of a measure, but it appears that this will not be the case going forward. In C&DIs 102.07 and 103.02, free cash flow, EBIT and EBITDA are given as example measures that cannot be presented on a per share basis.
It remains to be seen how strictly these non-GAAP disclosure positions will be enforced, but all signs point to this being a continuing priority for the SEC. In light of the renewed SEC focus and the revised C&DIs providing detailed insight into presentations that might be considered misleading, registrants should carefully review and update their disclosure practices, even long-standing practices that have survived staff review and comment in the past or that have been consistent with market and peer practices.