The SEC recently issued guidance for the disclosure of non-GAAP financial measures through 12 new Compliance & Disclosure Interpretations (C&DIs). Of the C&DIs released, four are new and eight are revisions of previous interpretations. The SEC’s guidance aims to tighten the use of non-GAAP financial measures. The SEC emphasized, among other things, that non-GAAP financial measures:
- should not be presented more prominently than the most directly comparable GAAP measure, and
- should not be used in a misleading or inconsistent manner.
Prominence of Non-GAAP Financial Measures
For earnings releases furnished under Item 2.02 of Form 8-K and documents filed with the SEC, Item 10(e) of Regulation S-K requires a company that presents a non-GAAP financial measure to present the most directly comparable GAAP measure with equal or greater prominence. The SEC provided the following examples of non-compliant disclosures of non-GAAP measures because they are “more prominent” than GAAP measures:
- disclosing a non-GAAP measure before the most directly comparable GAAP measure (including in an earnings release headline or caption);
- omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;
- presenting a non-GAAP measure using a style of presentation (e.g., in bold or in a larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;
- providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;
- presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;
- describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;
- 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; and
- providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.
The SEC reiterated that a determination of whether the non-GAAP measure is given greater prominence will generally depend on the facts and circumstances in which the disclosure is made, but the examples above provide useful benchmarks for common situations in which no further analysis should be required.
Misleading Non-GAAP Measures
Four of the C&DIs clarify that certain practices may cause non-GAAP measures to be misleading, resulting in a violation of Rule 100(b) of Regulation G. The SEC provided the following examples of misleading practices:
- presenting a performance measure that excludes normal, recurring cash operating expenses necessary to operate a business;
- presenting a non-GAAP measure inconsistently period to period;
- presenting a non-GAAP measure that excludes charges but not gains;
- replacement of GAAP revenue recognition and measurement methods with individually tailored methods for revenue recognition or other financial statement line items.
Per Share Measures
The SEC recognizes that for certain non-GAAP performance measures, per share measures may be meaningful from an operating standpoint and are therefore not prohibited in documents filed with the SEC. Non-GAAP liquidity measures that measure cash generated, however, may not be presented on a per share basis in documents filed with the SEC. The SEC will determine whether a non-GAAP measure constitutes a liquidity measure rather than deferring to management’s characterization of the measure. The SEC provided specific guidance regarding the presentation of the following measures on a per share basis:
- Funds from operations (FFO) is recognized as a performance measure for REITs, and the SEC does not object to its presentation on a per share basis so long as it complies with Item 10(e) of Regulation S-K and is not misleading. After noting that the National Association of Real Estate Investment Trusts (NAREIT) had defined FFO, the SEC staff stated that it accepts NAREIT’s definition of FFO in effect as of May 17, 2016.
- “Free cash flow” is a liquidity measure that must not be presented on a per share basis. The SEC further cautioned that when this measure is used other than on a per share basis, the company must provide a clear description of how the measure is calculated and must include the necessary reconciliation.
- If a company presents EBIT or EBITDA as a performance measure, the measure (a) must not be presented on a per share basis and (b) should be reconciled with net income (rather than operating income) as presented in the statement of operations under GAAP.
Adjustments for Income Tax Effects
The SEC advised that whether a discussion of income tax effects on a non-GAAP measure is necessary depends on the nature of the measure, i.e., whether it is a liquidity measure or a performance measure. If a measure is a liquidity measure that includes income taxes, it might be acceptable to adjust GAAP taxes to show taxes paid in cash. If a measure is a performance measure, the registrant should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. Additionally, adjustments to arrive at a non-GAAP measure should be presented as a separate adjustment that is clearly explained, not individual line items that are “net of tax.”