On May 17, 2016, the Division of Corporation Finance of the Securities and Exchange Commission (“SEC”) issued guidance in the form of 12 new and revised Compliance & Disclosure Interpretations (“C&DIs”), regarding the use of non-GAAP financial measures by public companies under Regulation G and Item 10(e) of Regulation S-K. Regulation G generally applies to all public disclosure of material information by public companies that includes non-GAAP financial measures, including SEC filings, press releases, investor presentations and conference calls, whether such disclosure is made in print, orally, telephonically, by webcast or by broadcast. Item 10(e) of Regulation S-K applies to all SEC filings and earnings releases furnished under Item 2.02 of Form 8-K that include non-GAAP financial measures.
Recently, the SEC has expressed growing concern that public companies were using non-GAAP financial measures in a manner that is confusing or misleading. The C&DIs signal an increased focus by the SEC on the use of non-GAAP financial measures by public companies. Management teams and audit committees of public companies should carefully review the C&DIs in advance of their earnings releases and quarterly reports and determine whether any adjustments need to be made in their presentation of non-GAAP financial measures.
The full text of the new and revised C&DIs is available here. The new C&DIs regarding the use of non-GAAP financial measures, the substantially revised C&DI regarding the calculation and presentation of income tax effects related to adjustments and the revised C&DIs regarding “funds from operations” and per share presentation are excerpted in the Appendix linked in this Client Alert and are discussed in further detail below.
Potentially Misleading Non-GAAP Measures
Four new C&DIs pertain to the requirement in Regulation G and Item 10(e) of Regulation S-K that a public company’s use of non-GAAP measures not be misleading. According to the SEC, certain adjustments, while not explicitly prohibited by Regulation G or Item 10(e) of Regulation S-K, may violate the applicable rules and regulations because they present non-GAAP financial measures in a way that is misleading. To illustrate this point, the new C&DIs provide certain examples of adjustments to GAAP measures which the SEC believes may be misleading, including the following:
- presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a company’s business;
- presenting a non-GAAP measure inconsistently between periods (e.g., use of 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 (unless the change between periods is disclosed and the reasons for such change explained));
- presenting a non-GAAP measure that excludes charges, but does not exclude gains; or
- presenting a non-GAAP measure that substitutes individually tailored revenue recognition and measurement methods for those of GAAP (e.g., a non-GAAP measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though the company earned the revenue when customers were billed).
Presenting GAAP Measures with Equal or Greater Prominence
One new C&DI relates to the requirement in Item 10(e) of Regulation S-K that when a public company presents a non-GAAP measure, it must also present the most directly comparable GAAP measure with equal or greater prominence. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the SEC would consider the following examples to be disclosures where the non-GAAP measure is featured more prominently than the GAAP measure:
- 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) 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; or
- 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.
Income Tax Effects Related to Adjustments
Substantially revised C&DI Question 102.11 instructs companies that whether to provide disclosure regarding the income tax effects related to adjustments of non-GAAP measures depends on the nature of such 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 a measure is a performance measure, the company should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability.
In addition, the revised C&DI provides 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 and clearly explained. This is a departure from prior C&DI guidance, which permitted public companies to present an adjustment “net of tax” when reconciling a non-GAAP performance measure, provided that the tax effect of each reconciling item was disclosed parenthetically or in a footnote to the reconciliation.
Definition and Presentation of Funds from Operations
In revisions to two C&DIs, the SEC provides clarification regarding the presentation and definition of “funds from operations”, referenced in footnote 50 to Exchange Act Release No. 47226 (“FFO”), which indicates that public companies may use FFO in documents that are filed or furnished to the SEC, subject to the requirements of Regulation G and Item 10(e) of Regulation S-K. The C&DIs affirm the SEC’s prior guidance that FFO refers to the measure defined by the National Association of Real Estate Investment Trusts (“NAREIT”) and establish the definition of FFO in effect as of May 17, 2016 as a performance measure, which may be presented on a per share basis. The C&DIs also confirm that a company may present FFO on a basis other than as defined by NAREIT provided that any adjustments made to FFO comply with Item 10(e) of Regulation S-K and Regulation G.
Presentation of Non-GAAP Measures on a Per Share Basis
In revisions to the C&DIs, the SEC clarified that, pursuant to Item 10(e) of Regulation S-K, a non-GAAP measure that can be used as a liquidity measure that measures cash generated may not be presented on a per share basis in documents filed or furnished with the SEC, even if management presents the non-GAAP measure solely as a “performance measure.” In determining whether the non-GAAP measure can be used as a liquidity measure, the SEC will focus on the substance of the non-GAAP measure and not management’s characterization of the measure. The revised C&DIs make clear that free cash flow, EBIT and EBITDA must not be presented on a per share basis.