The SEC staff demonstrated its continued focus on companies’ use of non-GAAP financial measures by issuing new guidance on the topic. The new and revised Compliance and Disclosure Interpretations, or CDIs, follow a period of increased scrutiny of companies’ use of non-GAAP financial measures by the SEC staff through speeches and comment letters. Companies should carefully review the revised CDIs against their non-GAAP disclosure practices. The new CDIs provide useful guidance and signal that the SEC staff intends to continue to scrutinize companies’ filings for compliance with the rules regarding non-GAAP financial measures. A marked copy of the CDIs as revised on May 17, 2016 is in PDF form at the bottom of this page.
More Clarity on Presentation with “Equal or Greater Prominence”
The new CDIs provide clarification regarding the requirement that companies present the most directly comparable GAAP measure with equal or greater prominence when presenting a non-GAAP financial measure. When preparing earnings releases and other disclosures, companies should consider the following guidance:
- Provide the GAAP measure before the non-GAAP measure, both in disclosure and tabular presentations.
- Include the appropriate GAAP measure in any headline or caption that presents a non-GAAP measure.
- Use the same size or style of font for both the GAAP and non-GAAP measures to avoid overemphasizing the non-GAAP measure.
- Use equally prominent descriptions for the GAAP measures when emphasizing “record” or “exceptional” performance with respect to the non-GAAP measure presented.
- Present similar discussion and analysis of GAAP measures when providing discussion and analysis of non-GAAP measures.
- Do not use a full income statement of non-GAAP measures or a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measure.
- When using a forward-looking non-GAAP measure, include a quantitative reconciliation of the most directly comparable GAAP measure, or be sure explain why the company cannot do so while identifying the information that is unavailable and its probable significance in a location of equal or greater prominence.
Per Share Presentation of Non-GAAP Measures
While the SEC staff recognizes that non-GAAP per share performance measures may be meaningful, the guidance provides that non-GAAP liquidity measures, such as free cash flow, may not be presented on a per share basis. This prohibition stands even if the company presents the liquidity measure solely as a performance measure. In seeming recognition that EBIT and EBITDA can be used as liquidity measures, the CDIs indicate that these measures should not be presented on a per share basis.
Problematic Revenue Measures
Question 100.04 of the non-GAAP CDIs indicates that a company may not use a non-GAAP financial measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers were billed, or that otherwise substitutes individually tailored revenue recognition and measurement methods for those of GAAP. Labeling metrics as “adjusted revenue” or otherwise to be used as a substitute for GAAP revenue will likely draw SEC scrutiny.
Income Tax Effects on Non-GAAP Measures
Companies’ treatment of income tax effects on non-GAAP measures will depend on the nature of the measures. For example, the CDIs indicate that if a measure is a liquidity measure that includes income taxes, it might be acceptable to adjust GAAP taxes to show taxes paid in cash. Performance measures should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. The guidance indicates that adjustments to arrive at non-GAAP measures should not be presented “net of tax.” Instead, income taxes should be shown as a separate adjustment and clearly explained.
Some of the new CDIs, while not surprising, serve as helpful reminders for companies to consider when preparing disclosure:
- Certain adjustments, while not explicitly prohibited, can result in a non-GAAP financial measure that is misleading. For instance, presenting a measure that excludes normal, recurring, cash operating expenses necessary to operate a company’s business could be misleading.
- A non-GAAP measure can be misleading if it excludes charges, but does not exclude gains.
- Non-GAAP financial measures can be misleading if presented inconsistently across periods.
In addition to the new CDIs, the SEC staff has also focused on the requirement that companies disclose the reasons why management believes that presentation of a non-GAAP financial measure provides useful information to investors and has expressed concern that company disclosures in this area are often comprised of boilerplate explanations that do little to explain to investor the significance of non-GAAP financial measures.
What to do Now
We expect that the SEC staff will continue to comment frequently on companies’ use of non-GAAP financial measures and will begin to focus particularly on the examples covered by the CDIs. When preparing upcoming disclosures, companies should review the new guidance carefully to determine whether any changes need to be made to the disclosure of or use of non-GAAP financial measures in investor presentations, earnings releases and scripts, and Form 10-K and Form 10-Q reports. Companies should be prepared for greater scrutiny of non-GAAP financial measures by auditors and audit committee members.