Updated SEC Guidance Will Require Many Public Companies to Revise their Presentation of Non-GAAP Information

New and Revised C&DIs Criticize Several Common Practices Relating to Non-GAAP Disclosures

On May 17, 2016, the Securities and Exchange Commission’s (SEC’s) Division of Corporation Finance (Division) published updated Compliance & Disclosure Interpretations (C&DIs) relating to the use of non-GAAP financial measures. These C&DIs represent a significant change in the Division’s approach to non-GAAP financial measures, which will also be reflected in how the Division reviews and comments on SEC filings. In advance of their next quarterly earnings releases, companies should evaluate their use and presentation of non-GAAP financial measures in view of the new and revised C&DIs, including disclosures about the reasons why management believes that presentation of the non-GAAP financial measures provides useful information to investors. Companies should expect an increase in SEC comment letters on non-GAAP financial measures as a result of these C&DIs. The full text of the updated C&DIs is available here, and the Appendix to this Sidley Update includes a comparison highlighting the C&DIs that were added or modified.

Background

Although non-GAAP financial measures have always been subject to Exchange Act Section 10(b) liability, the SEC’s regulation of these disclosures can be said to have started in January 2002, when the SEC brought its first enforcement case addressing the abuse of non-GAAP financial measures (then called pro forma earnings figures). The respondent was Trump Hotels & Casino Resorts, Inc., and the Commission found that Trump Hotels’ third quarter 1999 earnings release used pro forma earnings figures that excluded a one-time charge to tout the company’s purportedly positive results of operations but failed to disclose that those results were primarily attributable to a one-time gain rather than to improvements in operations.

Later in 2002, the Sarbanes-Oxley Act was enacted, Section 401 of which directed the SEC to adopt rules providing that pro forma financial information included in any SEC filing or in any public disclosure must be presented in a manner that does not contain any material misstatements or omissions and be reconciled with GAAP. Accordingly, the SEC adopted Regulation G and Item 10(e) of Regulation S-K. Regulation G generally applies to all public disclosures of material information that includes non-GAAP financial measures, whether or not the information is filed or furnished with the SEC. Item 10(e) of Regulation S-K generally applies to all SEC filings and earnings releases furnished under Item 2.02 of Form 8-K that include non-GAAP financial measures. Regulation G and Item 10(e) of Regulation S-K also apply to foreign private issuers, subject to certain exceptions.

In recent years, the Division has encouraged companies using non-GAAP financial measures outside of their SEC filings, such as in presentations to investors and analysts, to include those measures in their SEC filings. The primary reason for this was the view that companies should communicate with investors in a consistent manner – the story told outside of a company’s SEC filings should be the same as the story in the company’s SEC filings. Moreover, if included in an SEC filing, the non-GAAP financial measure would be subject to the additional disclosure requirements in Item 10(e) as well as to the full panoply of liability provisions in the Securities Exchange Act of 1934 and, if incorporated by reference into a registration statement, the Securities Act of 1933.

Updates to C&DIs

In this section we highlight the most significant of the updated C&DIs.

Presentation of GAAP Measures With Equal or Greater Prominence

New C&DI Question 102.10 relates to the requirement in Item 10(e) of Regulation S-K, but not in Regulation G, that, whenever a non-GAAP financial measure is included in an SEC filing or an earnings release furnished under Item 2.02 of Form 8-K, the most directly comparable GAAP measure must be presented “with equal or greater prominence.” This C&DI marks the most dramatic shift in the Division’s approach to non-GAAP financial measures – from a permissive stance to a highly prescriptive one. In this C&DI, the Division provides examples of disclosures that it believes would cause a non-GAAP measure to be more “prominent” than its corresponding GAAP measure and therefore violate Item 10(e). A number of the examples are surprising because they label as improper several practices commonly used by public companies in the context of earnings releases. Certain material considerations relating to earnings releases in light of C&DI Question 102.10 are highlighted in the box below.

Potentially Misleading Non-GAAP Measures

New C&DI Questions 100.01 through 100.04 relate to Regulation G’s and Item 10(e)’s requirement that non-GAAP measures not be misleading. In these C&DIs, the Division states that, even when a particular non-GAAP measure includes an adjustment that is not explicitly prohibited and that is accurately and fully disclosed, the presentation of such non-GAAP measure can still be misleading. The Division provides examples of adjustments that it believes could lead to a misleading non-GAAP presentation, including:

• An adjustment excluding normal, recurring, cash operating expenses necessary to operate a company’s business. C&DI Question 100.01 indicates that, even though such an adjustment may not be explicitly prohibited, it could still be misleading.
• An adjustment that is presented inconsistently between periods. C&DI Question 100.02 indicates that such an adjustment could be misleading unless (1) the change in such adjustment between periods is disclosed, (2) the reasons for the change are explained and (3) if the change is sufficiently significant, the related non-GAAP presentation from prior periods is recast to conform to the current presentation. 
• An adjustment that excludes one-time charges without an adjustment that excludes one-time gains. C&DI Question 100.03 indicates that it could be misleading to exclude non-recurring charges when non-recurring gains during the same period were not excluded. This was the basis for the SEC’s case against Trump Hotels.
• An adjustment that substitutes individually tailored recognition and measurement methods for those required under GAAP. C&DI Question 100.04 indicates that it could be misleading to use such an adjustment for revenue (such as accelerating the recognition of revenue to have revenue earned when customers are billed rather than earned ratably over time in accordance with GAAP) or other financial statement line items.

Public companies should review their non-GAAP measures carefully to determine if they include any adjustments of the type described above and consider what actions should be taken to prevent potentially misleading presentations. Although not expressly addressed by the updates, the updated C&DIs would appear to suggest that foreign private issuers should also review their non-GAAP financial measures for potentially misleading presentations even where such measures would otherwise be permissible under the note to Item 10(e) of Regulation S-K as measures that are “expressly permitted” by the GAAP standard setter applicable to the foreign private issuer.

Presentation of Non-GAAP Measures on a Per Share Basis

The Division also updated C&DI Questions 102.02, 102.05, 102.07 and 103.02 to emphasize that a non-GAAP measure that can be used as a liquidity measure may not be presented on a per share basis. The Division noted that the determination of whether a measure is a liquidity measure depends on (1) the nature of the adjustments included in such measure (see C&DI Question 102.02) and (2) whether, based on the substance of such measure, such measure can be used as a liquidity measure, even if management characterizes such measure solely as a performance measure (see C&DI Question 102.05). In order to determine whether a particular per share presentation of a non-GAAP measure is acceptable, a public company should review such non-GAAP measure carefully to determine if it could potentially be used as a liquidity measure. CD&I Question 103.02 specifically states that EBIT and EBITDA, regardless of whether they are presented only as performance measures, must not be presented on a per share basis.

Presentation of FFO by REITs and Other Public Companies

The updates to C&DI Questions 102.01 and 102.02 continue to recognize that real estate investment trusts (REITs) and other public companies may present funds from operations (FFO) on a basis other than as defined by the National Association of Real Estate Investment Trusts (NAREIT), provided that any adjustments, among other things, comply with Item 10(e) of Regulation S-K and not violate Rule 100(b) of Regulation G. The updates, however, highlight the Division’s concern that adjustments to the NAREIT definition of FFO made by a REIT or other public company, depending upon their nature, may result in an adjusted measure that is a liquidity measure, for which per share information is prohibited. REITs and other public companies that present (or would like to present) an adjusted FFO measure on a per share basis should carefully review their FFO adjustments to determine whether such adjusted measure could potentially be used as a liquidity measure and, as a result, make such a per share presentation impermissible.

Calculation and Presentation of Income Tax Effects Related to Adjustments

In a substantially revised C&DI Question 102.11, the Division indicates that, for certain non-GAAP measures, income tax effects should be provided. For liquidity measures, the Division noted that an adjustment to GAAP taxes to show taxes paid in cash might be acceptable, and, for performance measures, the Division indicated that current and deferred income tax expense should be included. The Division further clarified that income taxes should be shown as a separate adjustment and clearly explained rather than simply indicating that an adjustment is “net of tax.” Public companies should review their non-GAAP measures carefully to determine whether their calculation or presentation of any adjustments related to income tax should be modified.

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