In December 2022, the Securities and Exchange Commission (the “SEC”) released updates to its Compliance & Disclosure Interpretations (“CDIs”) with respect to the use of non-GAAP financial measures. Non-GAAP financial measures are numerical measures of performance, financial position, or cash flows that are not calculated in accordance with generally accepted accounting principles (“GAAP”). With the updates to the CDIs, the SEC continues to scrutinize the use and presentation of non-GAAP financial measures and their corresponding disclosures.
Background
Regulation G and Item 10(e) of Regulation S-K govern the use of non-GAAP financial measures. Regulation G applies to non-GAAP financial measures used both in SEC filings and other public disclosure, while Item 10(e) of Regulation S-K applies only to those used in SEC filings. Both rules require disclosure of the most directly comparable GAAP financial measure and a corresponding reconciliation. Item 10(e) also requires that the most directly comparable GAAP financial measure be of equal or greater prominence than its corresponding non-GAAP financial measure, among other things. The updated CDIs generally focus on disclosures that the SEC believes could be misleading or in violation of Item 10(e)’s “equal or greater prominence” requirement.
Updated Question 100.01
Some adjustments, while not expressly prohibited, could result in a misleading non-GAAP financial measure. For example, a performance measure that excludes normal, recurring cash operating expenses could be a misleading non-GAAP financial measure. The update clarifies that the SEC considers the nature and effect of the non-GAAP adjustment and how it relates to a company’s operations, revenue generating activities, business strategy, industry, and regulatory environment when determining what is a normal operating expense. In addition, the SEC indicated that it views expenses that occur repeatedly or occasionally (including at irregular intervals) as recurring.
Updated Question 100.04
“Individually tailored” revenue recognition and measurement methods (those that have the effect of changing the recognition and measurement principles required under GAAP) could result in a non-GAAP financial measure in violation of Regulation G if the measure is misleading. The SEC provided examples of potentially problematic adjustments that may create misleading measures, including presenting revenue on a gross basis instead of a net basis, changing the accounting basis from accrual to cash, and changing the pattern of recognition.
New Question 100.05
A non-GAAP financial measure could be misleading if it (and/or any adjustment made to the GAAP financial measure) is not appropriately labeled and clearly described. Because definitions of non-GAAP financial measures may differ among public companies, the failure to appropriately label or clearly describe the measure could be misleading for investors. Failing to identify and describe a measure as non-GAAP or presenting a non-GAAP financial measure with a label that does not reflect its nature violates Regulation G.
New Question 100.06
A non-GAAP financial measure accompanied by extensive, detailed disclosure about the nature and effect of each adjustment made to the most directly comparable GAAP financial measure could nonetheless be materially misleading and violate Regulation G. This new question suggests that even excellent disclosure can’t cleanse a materially misleading non-GAAP financial measure.
Updated Question 102.10
Item 10(e)’s “equal or greater prominence” requirement applies to both the presentation of non-GAAP financial measures and any related discussion and analysis in both SEC filings and furnished earnings releases. While the “facts and circumstances” standard still applies, the SEC expanded its list of examples where a non-GAAP financial measure is more prominent than the comparable GAAP financial measure. This includes describing a non-GAAP financial measure as “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP financial measure, presenting a non-GAAP financial measure before the most directly comparable GAAP financial 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 financial measure(s) with equal or greater prominence, and providing discussion and analysis of a non-GAAP financial measure without a similar discussion and analysis of the comparable GAAP financial measure in a location with equal or greater prominence.
The SEC also provided examples where the non-GAAP reconciliation required by Item 10(e) gives undue prominence to a non-GAAP financial measure, such as starting the reconciliation with a non-GAAP financial measure or presenting a non-GAAP income statement (an income statement comprised of non-GAAP financial measures and includes all or most of the line items and subtotals found in a GAAP income statement) when reconciling non-GAAP financial measures to the most directly comparable GAAP financial measures.
Conclusion
A redline of the SEC’s updates to its non-GAAP financial measures CDIs can be found here. The updates reflect the SEC’s continued attention on the use of non-GAAP financial measures. Public companies should carefully review their use and presentation of non-GAAP financial measures, especially those that could be viewed as potentially misleading, and should consider whether revisions to their non-GAAP disclosures are necessary in light of the updated guidance.
If you have any questions about the updates to the non-GAAP financial measures CDIs, please contact a member of Harter Secrest & Emery’s Securities and Capital Markets group.