SEC Issues New Interpretations on Use of Non-GAAP Financial Measures
May 19, 2016
On May 17, 2016, the staff of the Securities and Exchange Commission’s (“SEC”) Division of Corporation Finance issued certain new interpretations on the use of non-GAAP financial measures by a public company that is required to file reports under Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended.
The new guidance updates the Division’s Compliance & Disclosure Interpretations (“CD&Is”) on the use of such financial measures by adding 12 new CD&Is.
Although there is no requirement to do so, public companies frequently use non-GAAP financial measures to provide additional insight into the company’s business and operations. Such measures adjust reported GAAP results with a view to enhancing information regarding performance and are frequently tailored to a particular industry.
A non-GAAP financial measure is a numerical measure of a company’s historical or future performance, financial position or cash flows that:
excludes amounts, or is subject to adjustments that have the effect of excluding amounts
includes amounts, or is subject to adjustments that have the effect of including amounts, that are included in or excluded from the most directly comparable GAAP measure in the company’s statement of income, balance sheets or statements of cash flows
Non-GAAP financial measures exclude:
operating and other statistical measures, such as unit sales, numbers of employees, numbers of subscribers or advertisers
ratios or statistical measures calculated using exclusively GAAP financial measures or operating measures or other measures that do not constitute non-GAAP financial measures
financial measures required to be disclosed by GAAP, such as segment profit or loss and segment total assets, pro forma financial information required by Regulation S-X, SEC rules or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to the company
The non-GAAP financial information most commonly used by companies includes EBITDA, “funds from operations,” adjusted earnings or adjusted earnings per share, and net debt.
Non-GAAP financial measures may not be included in financial statements and accompanying notes and required pro forma financial information, but may be included in Management’s Discussion and Analysis and other investor communications, including press releases, investor presentations and conference calls.
Disclosures by foreign private issuers are subject to certain special requirements under the rules and regulations.
In 2003, the SEC adopted Regulation G and Item 10(e) of Regulation S-K pursuant to the Sarbanes-Oxley Act of 2002 to address public companies’ disclosure or release of non-GAAP financial information or measures.
Regulation G requires public companies that use non-GAAP financial measures to include in that disclosure or release:
a presentation of the most directly comparable GAAP financial measure
a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure
a statement disclosing the reasons the non-GAAP financial measure provides useful information to investors, and
to the extent material, a statement disclosing the additional purposes, if any, for which the company’s management uses the non-GAAP financial measure that are not otherwise disclosed
New Guidance on Non-GAAP Financial Measures
Equal Prominence of GAAP Measure
Item 10(e)(1)(i)(A) of Regulation S-K requires that, when a registrant presents a non-GAAP measure, it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the SEC and also earnings releases furnished under Item 2.02 of the Current Report on Form 8-K. 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, however, in the new CD&Is the staff stated that it considers the following examples of disclosure of non-GAAP measures as more prominent:
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) 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
Certain Adjustments or Non-GAAP Measures Misleading
Certain adjustments to GAAP numbers, although not explicitly prohibited by SEC rules and regulations, can cause the presentation of a non-GAAP measure to be misleading. The staff provides the following examples:
presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading
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 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
a non-GAAP measure that substitutes individually tailored revenue recognition and measurement methods for those of GAAP
Item 10(e) of Regulation S-K prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. The CD&Is state that it would not be appropriate to state that a charge or gain is non-recurring, infrequent or unusual unless it meets the specified criteria. The fact that a company cannot describe a charge or gain as non-recurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K.
Use of Per Share Non-GAAP Measures
Item 10(e) of Regulation S-K recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint. Non-GAAP per share performance measures should be reconciled to GAAP earnings per share. On the other hand, 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.
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 CD&I make it clear that the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.
Presentation of “Free Cash Flow”
The measure "free cash flow" is typically calculated by companies disclosing such measure as cash flows from operating activities as presented in the statement of cash flows under GAAP, less capital expenditures. The deduction of capital expenditures from the GAAP financial measure of cash flows from operating activities would not violate the prohibitions in the regulations. However, companies should be aware that this measure does not have a uniform definition and its title does not describe how it is calculated. Accordingly, a clear description of how this measure is calculated, as well as the necessary reconciliation, should accompany the measure where it is used. Companies should also avoid inappropriate or potentially misleading inferences about its usefulness. For example, "free cash flow" should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures, since many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure. The staff noted that free cash flow is a liquidity measure that must not be presented on a per share basis.
Income Tax Effects Related to Non-GAAP Adjustments
A company should provide income tax effects on its non-GAAP measures depending 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 a measure is a performance measure, the registrant 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.
Presenting EBIT OR EBITDA as Performance Measure
If a company presents EBIT or EBITDA as a performance measure, such measures should be reconciled to net income as presented in the statement of operations under GAAP. Operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income. In addition, these measures must not be presented on a per share basis.
Non-GAAP financial measures are an effective means for public companies to provide more information about financial performance and operations and how management views such operations. However, non-GAAP financial measures are most effective when accompanied by clear and transparent disclosure of how the measures are calculated, together with a discussion of how management uses such measures, and the context in which they should be considered. Companies should assure that they carefully consider compliance with applicable regulations and SEC guidance and avoid using non-GAAP information in a manner that is more prominent than comparable GAAP information. Moreover, management and a company’s audit committee should assure that the information is not misleading.
For more information, please contact:
Neil R.E. Carr Direct Dial: +1 202 587 2983 firstname.lastname@example.org
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