& Securities

Recently the Division of Corporation Finance (“Corp Fin”) of the U.S. Securities and Exchange Commission issued new and revised Compliance & Disclosure Interpretations (“C&DIs”) on the use of non-GAAP financial measures (available here). Companies should pay close attention to this latest update from the staff.  Non-GAAP financial measures are at the top of the list of most frequent topics in Corp Fin staff comment letters directed at companies.  Non-GAAP financial measures also have been the target of SEC enforcement actions with some company settlements reaching into the millions of dollars.  Aside from the SEC, plaintiff law firms have been reviewing company disclosures and sending stockholder demand letters to companies when these firms detect arguable noncompliance.

Below are some of the key features from the newly updated C&DIs (with a full redline of the changes available here):

• Question 100.01 notes that certain adjustments, although not expressly prohibited, 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 non-GAAP performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.  The SEC staff embellished that when evaluating what is a normal, operating expense, the staff 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. Furthermore, the staff would view an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as recurring.
• Question 100.04 has been reframed to more broadly address the concept of “individually tailored” measures.  A non-GAAP measure can violate Rule 100(b) of Regulation G if the recognition and measurement principles used to calculate the measurement are inconsistent with GAAP. By definition, a non-GAAP measure excludes or includes amounts from the most directly comparable GAAP measure. However, if a non-GAAP adjustment has the effect of changing the recognition and measurement principles required to be applied in accordance with GAAP, it would be considered individually tailored and may cause the presentation of a non-GAAP measure to be misleading. This updated C&DI provides the following examples of adjustments that the staff may consider to be misleading:
  • 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;
  • 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
  • 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 is a new C&DI, which notes that non-GAAP measures are not always consistent across, or comparable with, non-GAAP measures disclosed by other companies and therefore, without an appropriate label and clear description, may be considered misleading to investors.  The following examples are provided of non-GAAP measures that would violate Rule 100(b) of Regulation G:
  • Failure to identify and describe a measure as non-GAAP.
  • Presenting a non-GAAP measure with a label that does not reflect the nature of the non-GAAP measure, such as:
    • a contribution margin that is calculated as GAAP revenue less certain expenses, labeled “net revenue”;
    • a 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
    • 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 is a new C&DI and confirms that a non-GAAP financial measure could be misleading 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. This C&DI does not provide any examples from which to draw from in terms of what the SEC staff would find to be so misleading.
• Question 102.10 has always addressed the need for GAAP measures to be equally or more prominent than non-GAAP financial measures, but the C&DI question is now divided into parts (a) through (c), with additions and revisions as follows:
  • Question 102.10(a) clarifies that the prominence requirement applies not only to the presentation of a non-GAAP measure but also to any related discussion and analysis.  The staff made clear that a non-GAAP income statement would be too prominent anywhere it appear .  While not new requirements, the staff also added two new or expanded examples of non-GAAP measures that are more prominent than the comparable 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 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.
  • Question 102.10(b) addresses undue prominence in the non-GAAP reconciliation, including a non-GAAP income statement and a new reference to starting the reconciliation with a non-GAAP measure.  With respect to exclusion of a quantitative reconciliation for a forward-looking non-GAAP measure in reliance on the exception provided in the rule, the non-GAAP measure would be considered unduly prominent 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) notes that the SEC 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.

What to Do Now:

Compliance with non-GAAP financial reporting requirements should be a priority for companies.  Consider using this recent update from Corp Fin guidance as a reason for reviewing your practices.  In that regard:

• Consider any Adjustments to Presentation or Recognition of Non-GAAP Measures. Evaluate any adjustments to the presentation or recognition and measurement principles of non-GAAP measures to ensure they are not misleading. Specifically, evaluate the frequency of particular operating expense adjustments, the nature and effects of any such adjustments and how they relate to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment.

• Adequately Label and Describe your Non-GAAP Measures. Review how you have labeled your non-GAAP measures to ensure the nature of the measure is accurately reflected. Make sure to include a clear description to appropriately explain each non-GAAP measure so as to not mislead investors.  However, be forewarned that the SEC staff is of the view that some measures may be so misleading that even a detailed label and description may not be sufficient.

• Ensure No Undue Prominence of Non-GAAP measures. Review the presentation, related discussion and reconciliation of each non-GAAP measure, including any ratios and charts, tables or graphs that involve non-GAAP measures, to ensure that undue emphasis is not placed on the measures such that they would violate the prominence requirements under Item 10(e) of Regulation S-K.