On May 17, 2016, the staff of the Division of Corporation Finance of the Securities and Exchange Commission (SEC) issued 12 new Compliance & Disclosure Interpretations (C&DIs) regarding the use of non-GAAP financial information. The new C&DIs have been greatly anticipated following recent comments from SEC officials, including SEC Chair Mary Jo White, concerned about the sharp rise in the use of non-GAAP financial measures by issuers. A recent study published by FactSet determined that for 2015, 67 percent of the companies in the Dow Jones Industrial Average reported non-GAAP earnings per share and, on average, the difference between GAAP and non-GAAP earnings per share for these companies was approximately 30 percent, representing a significant increase from approximately 12 percent in 2014. The new C&DIs reinforce the SEC’s view that non-GAAP measures are intended to supplement, and not supplant, the information in an issuer’s GAAP financial statements.
In issuing the new C&DIs, the staff is sending a clear message that issuers must be careful not to use non-GAAP financial information in a way that is either misleading or more prominent than the comparable GAAP information, and to ensure that the non-GAAP financial measures disclosed comply with the SEC’s rules under Regulation G and Item 10(e) of Regulation S-K.
The new C&DIs can be found here.
Misleading Non-GAAP Measures
The C&DIs provide that certain adjustments to a GAAP number, although not explicitly prohibited in the SEC’s rules and regulations, can result in a non-GAAP measure that is misleading. Specific examples include:
- Presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a company’s business;
- A non-GAAP measure that is presented inconsistently between periods, such as one 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, unless the change between periods is disclosed and the reasons for it explained;
- A non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period; and
- A non-GAAP performance measure that substitutes individually tailored revenue recognition and measurement methods for those of GAAP.
Prominence of Non-GAAP Financial Measures
Item 10(e)(1)(i)(A) of Regulation S-K requires an issuer that presents a non-GAAP financial measure to present the most directly comparable GAAP measure with “equal or greater prominence.” Generally, this means that the GAAP measure must precede the non-GAAP measure. Whether a non-GAAP financial measure is more prominent than the most directly comparable GAAP measure depends on the facts and circumstances in which the disclosure is made, but the C&DIs provide the following specific examples of disclosures in which a non-GAAP financial measure is more prominent than the comparable GAAP measure, and therefore noncompliant:
- 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;
- Presenting 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), 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 C&DIs also provide specific guidance for certain types of non-GAAP financial information:
- Non-recurring Charges and Gains: The C&DIs clarify that an issuer may be able to adjust a non-GAAP financial performance measure to eliminate a charge or gain that is non-recurring, infrequent or unusual, if the issuer believes the adjustment is appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K. However, the C&DIs note that it would not be appropriate for the issuer to state that such a charge or gain is non-recurring, infrequent or unusual, unless it meets the specific criteria of Item 10(e) of Regulation S-K.
- Per Share Non-GAAP Measures: With respect to non-GAAP per share performance measures, the C&DIs recognize that certain non-GAAP per share performance measures may be meaningful from an operating standpoint, but should be reconciled to GAAP earnings per share. However, the C&DIs make it clear 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. The staff will focus on the substance of a particular non-GAAP financial measure in analyzing whether it is prohibited as a liquidity measure, rather than simply defer to management’s characterization. The staff also revised existing C&DIs to make clear that free cash flow, EBIT and EBITDA are liquidity measures and may not be presented on a per share basis.
- Adjustments for Income Tax Effects: The C&DIs provide that whether an issuer should reflect the income tax effects on its non-GAAP financial measures depends on the nature of the measures. 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, however, a measure is a performance measure, issuers should include current and deferred income tax expense “commensurate with the non-GAAP measure of profitability.” In addition, 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.
Based on the new C&DIs, issuers should expect that the SEC staff will be proactive in carefully reviewing the use of non-GAAP financial measures, and will bring enforcement actions where appropriate. Issuers should take this opportunity to review their use of non-GAAP financial measures in SEC filings, press releases and websites, including descriptions of the measures and the language accompanying them, in light of the C&DIs, and consider whether their non-GAAP presentations should be modified, enhanced, or eliminated.