On May 17, 2016, the Securities and Exchange Commission (SEC) Division of Corporation Finance (the Staff) issued new, and revised existing, Compliance and Disclosure Interpretations (collectively, the Revised C&DIs) regarding the use of non-GAAP financial measures.[1]  Most straightforward among the changes, the Revised C&DIs (1) provide new interpretations related to the calculation and presentation of non-GAAP measures that the Staff believes are or could be misleading and therefore could violate Rule 100(b) of Regulation G, (2) clarify the “equal or greater prominence” requirement of Item 10(e) of Regulation S-K, (3) reflect a shift in the SEC’s position regarding the presentation of income tax effects related to adjustments resulting in non-GAAP measures, and (4) provide further guidance related to the prohibition on presenting non-GAAP liquidity measures on a per-share basis in documents filed or furnished with the SEC.  That said, companies should also consider the more nuanced issues raised by these revisions related to, for example, (A) the use of accelerated revenue recognition measures, (B) adjustments for non-recurring restructuring costs, (C) whether to recast prior measures to conform to their current non-GAAP presentations, and (D) the forms of disclosure the SEC will likely be looking at most closely.

The New, the Revised and the Rewritten

The Revised C&DIs added a new Section 100 with four new interpretations that emphasize the fact that certain adjustments to arrive at non-GAAP measures, as well as the presentation of those measures, may be  misleading and therefore violate Rule 100(b) of Regulation G even where these adjustments and presentations are not expressly prohibited by any other rules or regulations.[2]  In particular, the new interpretations warn against (1) presenting non-GAAP figures inconsistently between periods,[3] (2) calculating non-GAAP measures by excluding non-recurring charges while retaining non-recurring gains,[4] and (3) presenting non-GAAP performance measures that substitute individually tailored revenue recognition and measurement methods for those required by GAAP (e.g., measures that are adjusted to accelerate the recognition of revenue that under GAAP should be recognized ratably over time).[5]

As to the Item 10(e) requirement that a registrant present the most directly comparable GAAP measure with  equal or greater prominence whenever it presents a non-GAAP measure,[6] C&DI 102.10 previously stated only that presenting a full non-GAAP income statement for purposes of reconciling non-GAAP measures to the most directly comparable GAAP measures “generally” would violate this requirement.  Revised C&DI 102.10 has  been expanded, however, with seven additional examples of presentation methods that might violate the “equal  or greater prominence” requirement.  The new examples include, among other things, (1) providing a non-GAAP measure that precedes the most directly comparable GAAP measure, (2) describing a non-GAAP measure as “record performance” or “exceptional” without an at least equally prominent descriptive characterization of the comparable GAAP measure, and (3) excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence.

The Revised C&DIs also clarify the SEC’s prohibition on per-share presentation of non-GAAP liquidity measures through revisions to C&DIs 102.01, 102.02, 102.05, 102.07, and 103.02.  Moreover, whereas the Staff had previously given great deference to management’s characterization of performance measures, C&DI 102.05  now explains 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 Staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.”  In this vein, revised C&DIs 102.07 and 103.02 make clear a company must not present “free cash flow,” EBIT, or EBITDA on a per share basis, even if management characterizes such measures as performance measures.  That said, in a recent webcast interview, Mark Kronforst, the chief accountant of the SEC’s corporate finance division, acknowledged that certain measures exist on a spectrum between “performance” and “liquidity.”  Kronforst indicated that, for now, the Staff will primarily be concerned  with only those measures that clearly fall on the liquidity side of that spectrum and explained that, “If a company has to put twelve adjustments in to get from net income to [the non-GAAP measure], but yet it takes one very simple adjustment to get from operating cash flow to [the non-GAAP measure], that’s an indicator that [the Staff] may have to ask some additional questions.”[7]

As to the calculation and presentation of income tax effects related to non-GAAP adjustments, C&DI 102.11 was rewritten to require that, among other things, “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 and clearly explained.” C&DI 102.11 previously condoned the presentation of adjustments “net of tax” when reconciling non-GAAP performance measures to the most directly comparable GAAP measure, provided that the tax effect of each reconciling item was disclosed parenthetically or in a footnote to the reconciliation.

Thorny Questions to Consider

In addition to providing some clear and straightforward guidance regarding presentation of non-GAAP measures, the Revised C&DIs also give rise to some potentially thorny questions.  For example . . .

Are Accelerated Revenue Recognition Measures Now Prohibited Without Exception?

New C&DI 100.04, relating to individually tailored revenue recognition and measurement methods, raises at least two issues.  First, the C&DI makes clear that a registrant may not present a non-GAAP performance measure that is adjusted to accelerate the recognition of revenue that under GAAP should be recognized ratably over  time; however, the reason given for this blanket prohibition is that such measures “could violate Rule 100(b) of Regulation G.”  Given that the Revised C&DIs do not themselves have the force and effect of law,[8] it is unclear how the SEC might enforce this prohibition if the non-GAAP measure is accompanied by sufficient disclosure  and reconciliation to make it not misleading and otherwise compliant with the requirements of Regulation G and Item 10(e) of Regulation S-K.  Second, the C&DIs did not previously prohibit the use of such non-GAAP measures, and so this guidance, if construed as a blanket prohibition, may be especially problematic for companies that earn revenue from, for example, subscriptions that are paid up front for services that will be provided over time and, as such, have relied for years on such non-GAAP measures in their communications  with shareholders.

Indeed, a number of such companies have already contacted the Staff concerning their revenue recognition disclosures “and so far, [the Staff] haven’t heard anything to move [them] from this position.”  According to Kronforst, when it comes to presenting accelerated revenue measures “the bar is quite high . . . and [the Staff] have yet to hear anything to change that.”  That said, Kronforst has explained that companies remain free to report measures such as “billings” and “bookings” so long as they are not presented as revenue or form the basis of a profitability measure.  Moreover, in order to allow companies that previously relied on accelerated revenue measures to transition their reporting, the Staff likely will not object to the use of such measures one last time, in reports for Q2 of 2016 accompanied by additional disclosure that provides investors and analysts with a roadmap for how they are transitioning from the accelerated revenue measure to some other acceptable measure, if any.[9]

Can Companies Still Adjust for Non-recurring Restructuring Charges?

In its 2003 FAQ regarding non-GAAP financial measures, the SEC stated that:

Whether a company can present a non-GAAP financial measure that eliminates recurring restructuring charges will depend on all the facts and circumstances.  However, if there is a past pattern of restructuring charges, no articulated demonstration that such charges will not continue and no other unusual reason that a company can substantiate to identify the special nature of the restructuring charges, it would be difficult for a company to meet the burden of disclosing why such a non-GAAP financial measure is useful to investors. In such circumstances, Item 10(e) of Regulation S-K would not permit the use of the non-GAAP financial measure. Similar considerations may apply under Item 12 of Form 8-K.[10]

This 2003 FAQ was superseded by the more recent (and more relaxed) C&DIs on non-GAAP financial measures, but the Revised C&DIs do not contain any guidance specific to acquisition or restructuring costs. The revised C&DIs did not remove or revise the statement that, even where registrants cannot describe a charge or gain as non-recurring, they nevertheless “can make adjustments [for those charges or gains] they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K.” However, the Staff added to this statement a citation to new interpretation 100.01, which states: “Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.”  As such, Registrants should carefully consider all adjustments and should be consistent from period to period in the use of adjustments or provide a detailed explanation of such adjustments, as discussed below.

Of course, there is an argument to be made that recurring restructuring charges are not “normal . . . cash operating expenses necessary to operate a registrant’s business” but the prior treatment, particularly of  recurring restructuring charges, provides some cause for concern.  If a company does choose to adjust for such  charges, especially where the charges do not meet the specified criteria for non-recurring, the disclosure around  that adjustment should be very clear to mitigate the risk of any argument that the resulting measure was  misleading. Additionally, disclosure regarding why management believes the measure is useful to investors  could help support the use of the measure.

Must Prior Non-GAAP Measures be Recast?

C&DI 100.02 states that “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 violate Rule 100(b) of Regulation G[, which relates to making statements not misleading,] unless the change between periods is disclosed and the reasons for it explained.”  As such, at the very least, any changes to a company’s non-GAAP calculations, and the reasons therefore, should be adequately disclosed.  Kronforst previously warned that if the Staff finds that a company is changing its non-GAAP calculations without disclosing it, the Staff “will issue a comment that we know that a company is doing that and not talking about it.”[11]  Additionally, C&DI 100.02 states that “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.”  The C&DIs provide no additional guidance as to what measures might need to be recast; however, Kronforst, has stated that the Staff is “definitely” on the lookout for companies that are prone to “changing the calculation of a measure depending on what happened for any particular year.”[12]

What About Non-GAAP Measures in Disclosures not Filed or Furnished with the SEC?

All of the non-GAAP guidance in the C&DIs is applicable to filings made with the SEC.  This includes the earnings releases attached as exhibits to Form 8-K, as well as the MD&A and other portions of Forms 10-K and 10-Q, etc.  However, disclosure (whether written or oral) not included in an SEC filing (for example, published only on a company’s website), is subject to only the Regulation G guidance.  Generally, Regulation G requires that non-GAAP measures be accompanied by a presentation of the directly comparable GAAP measure and a reconciliation thereto and also prohibits the use of non-GAAP measures that contain untrue statements of material fact or omit a material fact necessary to make the measure not misleading.[13]  The Item 10(e) requirements, on the other hand (regarding, e.g., prominence of non-GAAP vs. GAAP measures, discussion of why management believes the non-GAAP measure is useful to investors, and a disclosure of the additional purposes for which management uses the non-GAAP measure), are not required in disclosures not filed or furnished with the SEC.  That said, the Staff’s heavy reliance on Rule 100(b) of Regulation G in, for example, new Section 100 of the Revised C&DIs, could mean that the Staff will be looking closely at those non-GAAP measures companies disclose outside of documents filed and furnished with the SEC as well.

Disclosure Controls

As companies grapple with the effects the Revised C&DIs will have on their calculation and presentation of non- GAAP measures, they may also want to revisit their disclosure controls related to such measures.  SEC Chair Mary Jo White and SEC Chief Accountant James V. Schnurr have both emphasized in recent speeches that companies, along with their audit committees, must exercise appropriate controls over their calculation of, and determination to use, non-GAAP financial measures.  Specifically, Chair White has stated that audit committees “must . . . be able to adequately review how management . . . is using non-GAAP measures.”[14]  Similarly, Chief Accountant Schnurr has stated that companies should ensure that their non-GAAP measures are “prepared in a manner that includes appropriate controls and oversight procedures.”[15]  As a result, companies may want to consider utilizing the same process of disclosure controls and procedures for their non-GAAP measures as for their GAAP measures[16] and ensure that their audit committees understand (1) why management is using the non-GAAP measures, (2) how the non-GAAP measures are calculated and (3) any changes in how non-GAAP measures are calculated.  Additionally, companies should consider assessing, as a general matter, whether their audit committee believes their non-GAAP measures are appropriate.

Closing Considerations

The SEC chose to forego any notice and comment rulemaking when issuing these revisions.  As such, the Revised C&DIs simply reflect the Staff’s positions rather than formal SEC rule amendments.  That said, companies would do well to conform their reporting practices to the revised C&DIs as closely as possible and as soon as practicable, especially given the SEC’s increasing concerns about, and scrutiny of, non-GAAP measures.  As Kronforst has advised, there will soon be “an uptick” in the number of SEC comments to companies regarding non-GAAP measures, and “this next quarter will be a great opportunity for companies to self-correct.”[17]