On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.
The new C&DI follows a period of controversy, press and speeches on the subject. In the last couple of months SEC Chair Mary Jo White, SEC Deputy Chief Accountant Wesley Bricker, Chief Accountant James Schnurr and Corp Fin Director Keith Higgins have all given speeches at various venues across the company admonishing public companies for their increased use of non-GAAP financial measures. Mary Jo White suggested new rule making may be on the horizon, Corp Fin has been issuing a slew of comment letters, and there has even been word of enforcement proceedings on the matter.
In recent years management has used MD&A and other areas of its disclosure to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number.
However, where EBITDA may not be controversial, the SEC has seen a slippery slope in the use of these non-GAAP measures. The comments letters, and objections by the SEC, relate to failure to abide by Regulation G in providing non-GAAP information, disclosures related to why non-GAAP measures are useful, and cherry-picking of adjustments within a non-GAAP measure. Corp Fin has expressed a particular concern regarding “the use of individually tailored accounting principles to calculate non-GAAP earnings; providing per share data for non-GAAP performance measures that look like liquidity measures; and non-GAAP tax expense.”
The “non-GAAP earnings” issue is really revenue recognition. Public companies are under constant pressure to increase revenues and have become creative in figuring out ways that GAAP revenue recognition standards can be adjusted to increase revenues. Where the elimination of a non-cash GAAP expense item, such as depreciation or derivative liability, seems relatively harmless, and in fact is presented in the statement of cash flows, the inclusion of unearned revenue is much more questionable. Another controversial item affecting revenue is the couching of recurring cash expenses as non-recurring to justify eliminating that item in a non-GAAP presentation. Many of the new C&DI focus on revenue recognition.
Although I understand the SEC concern, I wonder about the continued and increasing proliferation of non-GAAP measures precipitating the controversy. If 90% of companies use non-GAAP numbers to explain their financial operations, perhaps the GAAP rules themselves needs some adjustment. If, on the other hand, the increase is due to greater economic factors, such as the fact that the US economy has been stagnant for six straight years with zero or near-zero interest rates and no real “boom” following the recession “bust” of 2008, then the SEC may be right in its recent hard-line stance. The pressure on public companies to display consistent growth and improved performance continues regardless of the state of the economy. More on that topic another day.
In this two-part blog I will start with the new and circle back to the old. Part I will summarize the new C&DI, and Part II will review Regulation G and Item 10(e) of Regulation S-K.
On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. Some of the C&DI are brand-new and some are revisions of existing guidance. Prior to this, the last published C&DI on non-GAAP financial measures was in July 2011.
Related to Revenue Recognition
The SEC issued four brand-new C&DI related to revenue recognition and, going directly to the issue of “misleading” information, the underpinning of fraud claims.
Question (100.01): Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?
Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.
Question (100.02): Can a non-GAAP measure be misleading if it is presented inconsistently between periods?
Answer: Yes. For example, 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 could violate Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it explained. In addition, depending on the significance of the change, it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context.
Question (100.03): Can a non-GAAP measure be misleading if the measure excludes charges, but does not exclude any gains?
Answer: Yes. For example, a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Rule 100(b) of Regulation G.
Question (100.04): A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?
Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.
To be sure the point is being made that adjustments may violate rules and be considered misleading and thus add risk of enforcement proceedings, the SEC has added a reference to new Question 100.01 to an existing C&DI allowing adjustments. In particular:
Question (102.03): 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. Is this prohibition based on the description of the charge or gain, or is it based on the nature of the charge or gain?
Answer: The prohibition is based on the description of the charge or gain that is being adjusted. 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 registrant 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. See Question 100.01.
Three of the C&DI are amendments related to the use of “funds from operations” or “FFO” as defined by the National Association of Real Estate Investment Trusts (NAREIT). The SEC accepts the NAREIT’s definition of FFO and allows the presentation of FFO as a performance measure including FFO on a per share basis. However, the amended C&DI clarify that any adjustments to the standard FFO as defined by NAREIT must comply with Regulation G and that such adjustments “may trigger the prohibition on presenting this measure.” In other words, any adjustments will be scrutinized as possibly being misleading.
Related to earnings per share and liquidity measures
Further related to per share measures of performance, the SEC reiterates the rule that non-GAAP measures may not be used to present liquidity on a per share basis. In particular:
Question (102.05): While Item 10(e)(1)(ii) of Regulation S-K does not prohibit the use of per share non-GAAP financial measures, the adopting release for Item 10(e), Exchange Act Release No. 47226, states that “per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission.” In light of Commission guidance, specifically Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data, and Accounting Standards Codification 230, are non-GAAP earnings per share numbers prohibited in documents filed or furnished with the Commission?
Answer: No. Item 10(e) 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 Commission, consistent with Accounting Series Release No. 142. 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 staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.
Similarly, the SEC adds a clarification to an existing C&DI (Question 102.07) to confirm that “free cash flow” is a liquidity measure that must not be presented on a per share basis.
The SEC also confirms that the generally non-controversial EBITDA may not be presented on a per share basis (Question 103.02).
Related to presentation including reconciliation and prominence
The new C&DI add completely new language, amend prior guidance and eliminate and replace other prior guidance. The new guidance provides:
Question (102.10): 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 Commission and also earnings releases furnished under Item 2.02 of Form 8-K. Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?
Answer: Yes. 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 staff would consider 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.
Question (102.11): How should income tax effects related to adjustments to arrive at a non-GAAP measure be calculated and presented?
Answer: A registrant 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.
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