What just happened?
On May 17, 2016, the Division of Corporation Finance of the Securities and Exchange Commission issued important updates to its Compliance and Disclosure Interpretations (“C&DIs”) regarding the use of non-GAAP financial measures. The full text of the revised C&DIs can be found here. The new interpretations represent a significant shift in the Staff's historical views on non-GAAP disclosures. In light of the revised interpretations, public companies will need to carefully review and may need to revise their presentation of non-GAAP financial measures in SEC filings and earnings releases.
How did we get here?
To understand the reasons behind the SEC’s renewed focus on non-GAAP reporting, it may be helpful to recall some prior history. In early January 2002, the Staff brought an enforcement action against Trump Hotels & Casino Resorts Inc. focused on “the abuse of pro forma earnings figures.”1 This case took place in the midst of the Enron scandal and was the first enforcement action aimed at abusive non-GAAP measures. The highly-publicized Enron case also centered around the use of what the SEC considered to be misleading non-GAAP accounting measures. The SEC attempted to combat these reporting practices by issuing Regulation G in 2003, which restricted companies from deviating too far from GAAP by requiring, among other things, that public companies that disclose non-GAAP financial measures include, in that disclosure, a presentation of the most directly comparable GAAP financial measure and an accompanying reconciliation to that GAAP measure. The SEC loosened these restrictions slightly in 2010 following findings that Regulation G apparently led to “unintended consequences.”2 Given the Staff’s recent guidance, it appears that the pendulum has swung back, and we expect a period of heightened scrutiny once again.
The release of the new C&DIs follows a series of recent speeches by SEC staff members in which they expressed concerns over the use of customized accounting metrics, including concerns expressed by SEC Chair Mary Jo White, SEC Chief Accountant James Schnurr, SEC Deputy Chief Accountant Wesley Bricker and other senior SEC officials, as well as PCAOB Chair James Doty.3 Chief Accountant Schnurr recently stated, “The SEC staff has observed a significant and, in some respects, troubling increase over the past few years in the use of, and the nature of adjustments within, non-GAAP measures by companies.”4 The Staff’s remarks and the use of non-GAAP financial measures also received attention from the media. Bloomberg reported on a recent study that surveyed 380 S&P 500 firms reporting on a non-GAAP net income basis and found that, while all-inclusive GAAP income declined over the surveyed period, the reported non-GAAP income increased over the same period, due in large part to significant amounts of excluded expenses.5
What do the new C&DIs mean for your disclosure?
The changes to the C&DIs that we find most interesting include the following:
What you thought was equal prominence may not be
Perhaps the most significant C&DI included in the new guidance is the Staff’s clarification of the requirement that an issuer presenting a non-GAAP measure must present the most directly comparable GAAP measure with equal or greater prominence. Although the determination of whether a non-GAAP financial measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances of each disclosure, the Staff clarified that the following examples of non-GAAP disclosures would be considered more prominent and, therefore, impermissible:
- 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;
- 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., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;
- A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);
- 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;
- 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;
- 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) of Regulation S-K 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 (See C&DI 102.10).
What does this mean for you? All companies should take a fresh look at their earnings presentations to ensure that they comply with the SEC’s new guidance. We expect to see companies whose presentations were not strictly within the new guidelines adopting changes in Q2 earnings releases, such as including net income prior to Adjusted EBITDA in the headline or highlights section and adding disclosure around the reconciliation of forward looking non-GAAP financial measures. MLPs in particular will have to be careful about the placement of their disclosure of Distributable Cash Flow, Cash Available for Distribution and Adjusted EBITDA, metrics that are often presented in headlines and near, but not following, the corresponding GAAP metrics, such as statements of cash flow from operations and net income. Additionally, using superlatives or similar descriptions to characterize non-GAAP financial measures is not permissible without accompanying such disclosures with a similar evaluation of the comparable GAAP metric.
Be careful what you adjust for
Rule 100(b) of Regulation G prohibits the use of a non-GAAP financial measure that is misleading when viewed in context with the information accompanying that measure and any other accompanying discussion of that measure. C&DIs 100.01 through 100.04 prohibit the use of non-GAAP information in a manner that may be misleading to investors. The Staff has clarified that while certain adjustments to GAAP numbers may not be expressly prohibited, such adjustments may nonetheless be misleading and impermissible. Some examples of misleading non-GAAP adjustments and metrics include the following:
- Presenting a non-GAAP performance measure with certain adjustments, including one that excludes normal, recurring cash operating expenses that are necessary to operate a registrant’s business (See C&DI 100.01);
- Presenting a non-GAAP measure inconsistently between periods, such as adjusting for a particular charge or gain in the current period and not adjusting for similar charges or gains in prior periods, unless the change between periods is disclosed and the reasons for it explained (See C&DI 100.02);
- Presenting a non-GAAP measure that excludes only non-recurring charges when there were also non-recurring gains that occurred in the same period that were not excluded (See C&DI 100.03); and
- Presenting a non-GAAP measure that substitutes individually tailored revenue recognition and measurement methods for those of GAAP, such as adjustments to accelerate revenue recognized ratably over time in accordance with GAAP as though such revenue was earned when customers are billed (See C&DI 100.04).
It should be noted that the Staff’s revised guidance does not indicate whether the inclusion of accompanying disclosures highlighting the nature of any non-GAAP adjustments would resolve the Staff’s concern that a non-GAAP measure may be misleading.6
What does this mean for you? Registrants cannot assume that their adjustments to GAAP metrics are permissible solely because there is not a specific rule expressly prohibiting those particular adjustments. Rather, registrants must carefully evaluate all non-GAAP financial information they present to ensure that their adjustments would not be misleading, even when the reconciliation and other disclosure requirements are met. Moreover, the SEC’s guidance applies to non-GAAP metrics presented in any public disclosure by a registrant (including on the registrant’s website) and not just in SEC filings and earnings releases, particularly with respect to non-GAAP adjustments to revenue recognition.
Do not present non-GAAP liquidity measures on a per share basis
The Staff recognizes that certain non-GAAP per share performance measures may be meaningful to investors from an operating standpoint, so long as such non-GAAP per share performance measures are reconciled to GAAP earnings per share. That being said, the Staff has emphasized that non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the SEC. Moreover, the new interpretations clarify that the Staff will determine whether per share data should be characterized as a liquidity or a performance measure based on the substance of the measure, regardless of whether management categorizes such data as a performance measure (See C&DI 102.05). Further, the Staff has clarified that EBIT and EBITDA must not be presented on a per share basis and has maintained its position that, when used as a performance measure, EBIT and EBITDA should be reconciled to net income as presented in the statement of operations under GAAP, as opposed to operating income or cash flows (See C&DI 103.02).
What does this mean for you? Registrants must be careful when presenting per share data in their earnings releases and SEC filings and pay particular attention to whether it is used as a performance measure or a liquidity measure. Additionally, registrants may not present EBIT or EBITDA on a per share basis. Similarly, other non-GAAP measures such as Distributable Cash Flow and Cash Available for Distribution, when used as liquidity measures, should not be presented on a per share or per unit basis.
Use caution with income tax adjustments
The revised C&DIs instruct that companies should provide income tax effects on non-GAAP measures depending on the nature of those non-GAAP measures. For instance, if a non-GAAP measure is a liquidity measure that includes income taxes, it may be acceptable to adjust GAAP taxes to show taxes paid in cash. Similarly, if a measure is a performance measure, the company should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. Additionally, adjustments to derive non-GAAP measures should not be presented “net of tax.” Rather, income taxes should be shown as a separate adjustment and clearly explained (See C&DI 102.11).
What does this mean for you? Registrants should appropriately tailor any tax adjustments based on the nature of the non-GAAP financial information presented. A registrant’s evaluation of the composition of appropriate tax adjustments has become even more important, since the SEC now requires any income tax adjustments to be shown as a separate line item.
Non-GAAP financial information can be extremely useful for investors and is used by many companies that believe that non-GAAP metrics more accurately reflect their results of operations or financial position. However, management and audit committees must take care to comply with the applicable regulations and Staff guidance and avoid using non-GAAP measures in a manner that is misleading or more prominent than corresponding GAAP measures. Given the Staff’s recent focus on the issue, a registrant should carefully review not only its presentation of any non-GAAP information, but also its rationale behind using such information and the appropriateness of any adjustments being made. The Staff will closely scrutinize such disclosures in the near future. “We are sending a message and we are going to continue talking about it,” said Mark Kronforst, chief accountant of the SEC’s Division of Corporation Finance. Mr. Kronforst indicated at a meeting of an advisory group to the PCAOB that there will be “an uptick” soon in the number of SEC comments to companies, as concerns have mounted that non-GAAP metrics could mislead investors and the SEC has devoted more attention to them.