On May 17, 2016, the Division of Corporation Finance (the “Division”) of the Securities and Exchange Commission (the “SEC”) issued new and updated Compliance and Disclosure Interpretations (“C&DIs”) of the rules and regulations on the use of non-GAAP financial measures.1 These revisions mark the Division’s most significant changes to such C&DIs since January 2010, echoing recent public statements from senior SEC officials and suggesting a renewed focus on the use and presentation of non-GAAP financial information by public companies.2
While not an official rule change, the revised C&DIs provide insight to the calculus utilized by the SEC when reviewing and commenting on public disclosures by SEC registrants with regard to the presentation of non- GAAP financial measures under Regulation G and Item 10(e) of Regulation S-K. The updated guidance potentially impacts earnings press releases, investor presentations, and required SEC filings by registrants. Mark Kronforst, chief accountant of the Division, has indicated “an uptick” soon in the number of SEC comment letters, but that the “next quarter will be a great opportunity for companies to self-correct.”3 Accordingly, public companies should consider revisiting and potentially revising the way in which they utilize non-GAAP financial information in their publicly available materials. Below is a summary of the significant changes to the C&DIs, with a comparison of the textual revisions attached hereto as Annex A. The unmarked text of the revised guidance can be found at the link in footnote 1 below.
Presentation of GAAP Measures with Equal or Greater Prominence
Perhaps the most practically significant revision to the C&DIs is revised Question 102.10. Item 10(e)(1)(i)(A) of Regulation S-K requires that whenever a non-GAAP financial measure is provided in an SEC filing or an earnings release furnished under Item 2.02 of Form 8-K, the most directly comparable GAAP measure must be presented “with equal or greater prominence.” The Division’s answer in Question 102.10 highlights eight examples where the Division staff would consider the non-GAAP measures as more prominent than the corresponding GAAP measure and, therefore, unacceptable practices, including:
- Omitting comparable GAAP financial measures from earnings release headlines that include non-GAAP financial measures;
- Using stylistic enhancements, such as bolded text or larger font, to emphasize non-GAAP measures over the comparable GAAP measure;
- Having a non-GAAP measure precede its most directly comparable GAAP measure (including headlines or captions);
- Utilizing qualitative descriptions for performance based on non-GAAP measures without providing an equally prominent descriptive characterization of the comparable GAAP measure;
- Providing tables with non-GAAP financial measures only, unless preceded by equally prominent tabular disclosure of the comparable GAAP measures (or including the comparable GAAP measure in the same table as the non-GAAP measures);
- Presenting forward-looking information on a non-GAAP basis only without explaining why the same presentation was not possible utilizing the GAAP-based metric; and
- Providing a discussion and/or analysis of a non-GAAP measure without including a similar discussion and analysis of the most directly comparable GAAP measure.
A number of the practices noted as problematic above are common in the context of earnings releases and companies should take care to evaluate whether their current formatting and presentation runs counter to the Division’s new guidance.
Potentially Misleading Non-GAAP Measures
Rule 100(b) of Regulation G requires that the presentation of non-GAAP measures not be misleading.4 In questions 100.01 through 100.04 of the revised C&DIs, the Division provides guidance and examples of when certain uses of non-GAAP measures may be misleading under the confines of Regulation G:
- Adjustments excluding normal, recurring, cash operating expenses necessary to operate a company’s business, even though such an adjustment may not be explicitly prohibited, could be deemed misleading;
- Inconsistent adjustments between periods unless the change is disclosed and explained and, if the adjustment results in significant change from prior periods, recasting of prior measures to conform to the current presentation;
- Utilizing adjustments that exclude non-recurring charges without an accompanying adjustment that excludes non-recurring gains; and
- Presenting non-GAAP performance measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP, such as the recognition of revenue for a subscription service when a customer is billed instead of ratable recognition over time in accordance with GAAP.
Per Share Non-GAAP Measures
The Division also updated several C&DIs related to the presentation of non-GAAP measures on a per share basis. Item 10(e) of Regulation S-K does not prohibit the use of per share non-GAAP financial measures and the Division recognizes that certain non-GAAP per share performance measures may be meaningful from an operational standpoint. However, the revised C&DIs emphasize that non-GAAP measures cannot be presented on a per share basis when used as a liquidity measure (even if management classifies the particular non-GAAP measure as performance-based). For example, the Division clarifies in its answer to Question 102.07 that free cash flow is a liquidity measure that must not be presented on a per share basis. Further, the Division’s answer to Question 103.02 adds explicit clarification that EBIT and EBITDA must not be presented on a per share basis.
Income Tax Effects Related to Adjustments for Non-GAAP Measures
In the revised C&DI 102.11, the Division reversed its prior standing guidance that adjustments could be presented net of tax if the effect of each reconciling item was disclosed in either a footnote or parenthetical statement providing an explanation for the calculation of such measure. The new C&DI instructs registrants 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 with an accompanying clarifying explanation.
The revised C&DIs represent the SEC’s renewed focus on the practical uses of non-GAAP financial measures by registrants, a focus which is unlikely to stop with the updated guidance released this month.5 Accordingly, companies frequently using non-GAAP financial measures would benefit from taking a fresh look at their earnings releases, other investor presentations, and SEC filings and consider proactively implementing self- corrective measures where appropriate so that future disclosures are not inconsistent with the Division’s revised interpretations of the requirements of Regulation G and Item 10(e) of Regulation S-K.