On December 13, 2022, the SEC issued seven new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures, the first new C&DI on the subject since 2018. Several of the new C&DI update or replace the language of prior existing C&DI. The C&DI cover revenue recognition, misleading information and GAAP reconciliation, in some cases replacing a principles-based response with a more prescriptive approach.
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.
GAAP continues to be and has consistently been criticized by the marketplace in general, with many institutional investors publicly denouncing the usefulness of the accounting standard. 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.
My two-part blog series on non-GAAP financial measures, Regulation G and Item 10(e) of Regulation S-K can be read HERE and HERE. My blog on the 2018 C&DI updates can be read HERE and on 2017 guidance HERE.
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. A chart outlining the specific requirements of Regulation G and Item 10(e) appears at the end of this blog.
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. 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.
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 C&DI published by the SEC on May 17, 2016, even specifically allowable non-GAAP financial measures may violate Regulation G if they are misleading. This is one of the C&DI that has been expounded. In particular, Question 100.01 simply asked whether adjustments that are not explicitly prohibited can be misleading. The original answer was an equally simple statement that whether an adjustment is misleading depends on a company’s individual facts and circumstances analysis.
The SEC has now expounded on that response to specify that presenting a non-GAAP performance measure that excludes normal, recurring, cash operating expenses necessary to operate a company’s business is one example of a measure that could be misleading. When evaluating what is a normal operating expense, the SEC considers the nature and effect of the non-GAAP adjustment and how it relates to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment. The SEC would view an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as recurring.
I note that the addition to Question 100.01 is consistent with Questions 100.02 and 100.03 that was also originally adopted in 2016. Those questions provide examples of misleading charges or gains between periods.
Prior question 100.04 related to the ability to present non-GAAP revenue performance measures has been completely replaced. The prior question was written as a “Can a company…” with a “no” response. The new question is written to ask if a non-GAAP measure would violate Regulation G if the recognition and measurement principles used to calculate the measure are inconsistent with GAAP. The SEC answers in the affirmative (it would violate the rule). The SEC provides further explanation noting that by definition, a non-GAAP measure excludes or includes amounts from the most directly comparable GAAP measure. However, non-GAAP adjustments that have the effect of changing the recognition and measurement principles required to be applied in accordance with GAAP would be considered individually tailored and may cause the presentation of a non-GAAP measure to be misleading.
The SEC provides some examples of misleading information, including: (i) changing the pattern of recognition, such as including an adjustment in a non-GAAP performance measure to accelerate revenue recognized ratably over time in accordance with GAAP as though revenue was earned when customers were billed; (ii) presenting a non-GAAP measure of revenue that deducts transaction costs as if the company acted as an agent in the transaction, when gross presentation as a principal is required by GAAP, or the inverse, presenting a measure of revenue on a gross basis when net presentation is required by GAAP; and (iii) changing the basis of accounting for revenue or expenses in a non-GAAP performance measure from an accrual basis in accordance with GAAP to a cash basis.
Question 100.05, again dealing with misleading financial measurements, is new in its entirety. The question asks, “[C]an a non-GAAP measure be misleading if it, and/or any adjustment made to the GAAP measure, is not appropriately labeled and clearly described?” The SEC (obviously) answers in the affirmative. Non-GAAP measures are not always consistent across, or comparable with, non-GAAP measures disclosed by other companies. Without an appropriate label and clear description, a non-GAAP measure and/or any adjustment made to arrive at that measure could be misleading to investors.
The SEC again provides examples that would violate Regulation G including: (i) failure to identify and describe a measure as non-GAAP; (ii) presenting a non-GAAP measure with a label that does not reflect the nature of the non-GAAP measure, such as (a) a contribution margin that is calculated as GAAP revenue less certain expenses, labeled “net revenue”; (b) non-GAAP measure labeled the same as a GAAP line item or subtotal even though it is calculated differently than the similarly labeled GAAP measure, such as “Gross Profit” or “Sales”; and (c) a non-GAAP measure labeled “pro forma” that is not calculated in a manner consistent with the pro forma requirements in Article 11 of Regulation S-X.
Question 100.06, also dealing with misleading measures, is brand new. The question posed is: “[C]an a non-GAAP measure be misleading, and violate Rule 100(b) of Regulation G, even if it is accompanied by disclosure about the nature and effect of each adjustment made to the most directly comparable GAAP measure?” Not as obviously, again the SEC answers in the affirmative. The SEC explains, “[I]t is the staff’s view that a non-GAAP measure could mislead investors to such a degree that even extensive, detailed disclosure about the nature and effect of each adjustment would not prevent the non-GAAP measure from being materially misleading.”
I find this guidance troubling. Regulation G and Item 10(e) of Regulation S-K specifically allow for the use of non-GAAP measures in accordance with the rules. The premise of the rule is that when a non-GAAP measure is used it must be thoroughly explained, and generally reconciled to a GAAP number. The SEC’s blanket statement that “even extensive, detailed disclosure about the nature and effect of each adjustment” could be materially misleading, without examples or further explanation, will most certainly have a chilling effect on non-GAAP use, and motivate practitioners to fail to provide definitive advice and guardrails for clients.
Question 102.10 is a rewrite of an answer to a prior C&DI. The question is: “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?”
The prior answer was a “yes” depending on facts and circumstances with the SEC providing a few examples. Although the answer is still “yes,” the SEC has modified the wording, replaced a few and added to the examples. In particular, following the “yes,” the SEC adds, “[T]his requirement applies to the presentation of, and any related discussion and analysis of, a non-GAAP measure.” 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 to be examples of non-GAAP measures that are more prominent than the comparable GAAP measures:
- Presenting an income statement of non-GAAP measures;
- Presenting a non-GAAP measure before the most directly comparable GAAP measure or omitting the comparable GAAP measure altogether, including in an earnings release headline or caption that includes a non-GAAP measure;
- Presenting a ratio where a non-GAAP financial measure is the numerator and/or denominator without also presenting the ratio calculated using the most directly comparable GAAP measure(s) with equal or greater prominence;
- Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font, etc.) that emphasizes the non-GAAP measure over the comparable GAAP measure;
- 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;
- Presenting charts, tables or graphs of a non-GAAP financial measures without presenting charts, tables or graphs of the comparable GAAP measures with equal or greater prominence, or omitting the comparable GAAP measures altogether;
- 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 102.10(b) is new in its entirety. The question asks if there are “examples of disclosures that would cause the non-GAAP reconciliation required by Item 10(e)(1)(i)(B) of Regulation S-K to give undue prominence to a non-GAAP measure?”
Upon answering in the affirmative, the SEC provides the following examples:
- Starting the reconciliation with a non-GAAP measure;
- Presenting a non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;
- When presenting a forward-looking non-GAAP measure, a registrant may exclude the quantitative reconciliation if it is relying on the exception provided by Item 10(e)(1)(i)(B) of Regulation S-K. A measure would be considered more prominent than the comparable GAAP measure if it is presented without disclosing reliance upon the exception, identifying the information that is unavailable, and its probable significance in a location of equal or greater prominence.
Question 102.10(c) is new in its entirety. The question posed is: “The staff considers the presentation of a non-GAAP income statement, alone or as part of the required non-GAAP reconciliation, as giving undue prominence to non-GAAP measures. What is considered to be a non-GAAP income statement?”
The answer is: “[T]he staff considers a non-GAAP income statement to be one that is comprised of non-GAAP measures and includes all or most of the line items and subtotals found in a GAAP income statement.”
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.
Below is a chart explaining the Regulation G and Item 10(e) requirements, which is 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 is 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.
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