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.
This is the second part in a two-part blog series on the use of non-GAAP financial information. In the first blog I summarized the new C&DI, and in this blog I am reviewing Regulation G and Item 10(e) of Regulation S-K. The first blog in the series can be read HERE.
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 discussed in Part I of this blog series, 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.
Regulation G and Item 10(e) of Regulation S-K
Regulation G was adopted January 22, 2003 pursuant to Section 401(b) of the Sarbanes-Oxley Act of 2002 and applies to all companies that have a class of securities registered under the Securities Exchange Act of 1934 (“Exchange Act”) or that are required to file reports under the Exchange Act. 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 governs the use of non-GAAP financial measures in any public disclosures including registration statements filed under the Securities Act of 1933 (“Securities Act”), registration statement or reports filed under the Exchange Act or other communications by companies including press releases, investor presentations and conference calls. Regulation G applies to print, oral, telephonic, electronic, webcast and any and all forms of communication with the public.
Item 10(e) of Regulation S-K governs all filings made with the SEC under the Securities Act or the Exchange Act and specifically prohibits the use of non-GAAP financial measures in financial statements or accompanying notes prepared and filed pursuant to Regulation S-X. Item 10(e) also applies to summary financial information in Securities Act and Exchange Act filings such as in MD&A.
Definition of non-GAAP financial measure and exclusions
A non-GAAP financial measure is any numerical measure of a company’s current, historical or projected future financial performance, position, earnings, or cash flows that includes, excludes, or uses any calculation not in accordance with U.S. GAAP.
Specifically, not included in non-GAAP financial measures for purposes of Regulation G and Item 10(e) are: (i) operating and statistical measures such as the number of employees, number of subscribers, number of app downloads, etc.; (ii) Ratios and statistics calculated based on GAAP numbers are not considered “non-GAAP”; and (iii) financial measures required to be disclosed by GAAP (such as segment profit and loss) or by SEC or other governmental or self-regulatory organization rules and regulations (such as measures of net capital or reserves for a broker-dealer).
Non-GAAP financial measures do not include those that would not provide a measure different from a comparable GAAP measure. For example, the following would not be considered a non-GAAP financial measure: (i) disclosure of amounts of expected indebtedness over time; (ii) disclosure of repayments on debt that are planned or reserved for but not yet made; and (iii) disclosure of estimated revenues and expenses such as pro forma financial statements as long as they are prepared and computed under GAAP.
Neither Regulation G nor Item 10(e) applies to non-GAAP financial measures included in a communication related to a proposed business combination, the entity resulting from the business combination or an entity that is a party to the business combination as long as the communication is subject to and complies with SEC rules on communications related to business combination transactions. This exclusion only applies to communications made in accordance with specific business combination communications, such as those in Section 14 of the Exchange Act and the rules promulgated thereunder. As clarified in SEC C&DI on the subject, if the same non-GAAP financial measure that was included in a communication filed under one of those rules is also disclosed in a Securities Act registration statement or a proxy statement or tender offer statement, no exemption from Regulation G and Item 10(e) of Regulation S-K would be available for that non-GAAP financial measure.
Regulation G and Item 10(e) requirements
Together, Regulation G and Item 10(e) require disclosure of and a reconciliation to the most 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.
As with any and all communications, non-GAAP financial measures are subject to the state and federal anti-fraud prohibitions. In addition to the standard federal anti-fraud provisions, Regulation G imposes its own targeted anti-fraud provision. Rule 100(b) of Regulation G provides that a company, or person acting on its behalf, “shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.” As clarified in the new C&DI published by the SEC on May 17, 2016, even specifically allowable non-GAAP financial measures may violate Regulation G if it is misleading.
As is generally the case with SEC reporting, companies are advised to be consistent over time. Special rules apply to foreign private issuers, which rules are not discussed in this blog.
Below is a chart explaining the Regulation G and Item 10(e) requirements, which I based on a chart posted in the Harvard Law School Forum on Corporate Governance and Financial Regulation on May 23, 2013 and authored by David Goldschmidt of Skadden, Arps, Meagher & Flom, LLP. I made several additions to the original chart created by Skadden.
|Regulation G||Item 10(e)|
|Scope||All public disclosures by Exchange Act registrants of information that contains non-GAAP financial measures, including:
Limited exclusion for business combination communications.
|All filings with the SEC under the Securities Act and the Exchange Act, including:
Does not apply to registered investment companies. Special rules apply to foreign private issues. Limited exclusion for business combination communications.
|Required Disclosure||Whenever a registrant makes public a non-GAAP financial measure, it must:
||Whenever a registrant presents a non-GAAP financial measure, it must (in addition to the requirements for Regulation G):
|Earnings Releases||A registrant must:
||Subsection (1)(i) of Item 10(e) applies to a registrant’s Item 2.02 Form 8-K (pursuant to which earnings releases are required to be furnished to the SEC). Registrants must either include in the body of the Current Report or in the earnings release itself:
|SEC Non-GAAP Measure Prohibitions||A registrant is not permitted to make any non-GAAP financial measure public if it contains a material misstatement or omits information needed to make the measure not misleading.
Measures of performance may be presented on a per-share basis; however, per-share presentation of measures of liquidity are prohibited.
A full non-GAAP income statement may not be used as it places undue prominence on the non-GAAP information.
|A registrant is not permitted to:
Companies may adjust for recurring charges within the two-year look-forward/look-back window, but the adjustment may not be classified as non-recurring, infrequent or unusual.
Click Here To Print- PDF Printout SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 2
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