The SEC’s Division of Corporation Finance is cracking down on the use of non-GAAP financial measures. What is a non-GAAP measure? A non-GAAP measure is a supplemental figure that adjusts the most directly comparable measure determined in accordance with generally accepted accounting principles (GAAP). While non-GAAP measures are allowed, the rules for using them are relatively strict.
SEC rules prohibit the use of non-GAAP amounts that are misleading or give the non-GAAP measure undue prominence over the GAAP measure. SEC staff members believe that non-GAAP amounts can be both confusing and troubling. Therefore, the staff has questioned whether the use of these measures follows SEC rules. Recently, the staff updated its Compliance and Disclosure Interpretations (C&DIs) regarding non-GAAP financial measures to provide clarity. This article is the first in a two-part series that discusses the SEC’s emphasis on non-GAAP measures and the appropriate use of the measures in filings and earning releases.
The Construction of Non-GAAP Financial Measures
Why Are They Used?
Companies supplement their GAAP financial reporting (e.g., financial position, performance, cash flows, or liquidity) with non-GAAP measures to provide additional insights into the business or to bridge the divide between internal corporate reporting and the standardized reporting required by GAAP.
What Are Some Examples?
Non-GAAP financial measures may disaggregate different aspects of a company’s operations or remove the effects of large, unusual, or unique transactions, such as acquisitions or dispositions. Common non-GAAP financial measures include:
- earnings before interest, taxes, depreciation, and amortization (EBITDA),
- adjusted EBITDA,
- funds from operations (FFO),
- adjusted earnings or adjusted earnings per share, and
- net debt.
When Are They Used?
Certain non-GAAP financial measures may be more common in particular industries in which users of the financial statements expect certain non-GAAP measures in investor communications. For example, FFO is generally considered an important non-GAAP financial measure for real estate investment trusts and is, therefore, frequently disclosed by such entities. However, because companies can choose which non-GAAP financial measures to report and how to calculate those measures, their reported non-GAAP results could vary over time or differ from competitors’ reports. Simply put, non-GAAP measures may limit the comparability between reporting periods and other entities in the same industry.
Spanning the C&DIs Update
Non-GAAP figures are permissible only when presented appropriately. To that end, the SEC updated its C&DIs to clarify that about non-GAAP measures.
- A measure could be considered misleading if it:
- excludes normal, recurring cash operating expenses that are necessary to operate the business; or
- is presented inconsistently between periods without adequate disclosure of and reason(s) for the change.
- Any measure that accelerates revenue recognition is unacceptable and may not be presented publicly (including in SEC filings, in earning releases, or on company websites).
- Measures that use individually tailored recognition and measurement methods for other financial statement items may be unacceptable.
- A measure is inappropriate in SEC filings and earnings releases if it is presented more prominently than the comparable GAAP measure. Examples might include:
- presenting a full income statement of non-GAAP measures;
- omitting comparable GAAP measures from an earnings release headline;
- presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font);
- having a non-GAAP measure precede the most directly comparable GAAP measure (including in an earnings release headline);
- describing a non-GAAP measure as, for example, “record performance” or “exceptional” without an equally prominent descriptive characterization of the comparable GAAP measure;
- providing tabular disclosure of non-GAAP financial measures without an equally prominent tabular disclosure or inclusion of the comparable GAAP measures;
- excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure; and
- providing discussion and analysis of a non-GAAP measure without a similar discussion, analysis, and prominence of the comparable GAAP measure.
The C&DIs also indicate that SEC staff will focus on the substance of a non-GAAP per-share measure rather than on management’s characterization of it as a performance measure (i.e., whether a per-share measure is a performance measure or liquidity measure). Finally, the C&DIs indicate that adjustments to arrive at a non-GAAP measure should not be presented net of tax in the reconciliation to the most comparable GAAP measure.
Let CRI Help You Build Your SEC Financial Measures Compliance
In part two of this series, we will look at SEC rules regarding non-GAAP measures and how to more appropriately utilize the measures in light of the staff’s CD&Is update. If you have questions concerning the use of non-GAAP measures, then please contact the SEC professionals at CRI. We can help you cross over any challenges you may have in complying with the SEC’s rules related to non-GAAP measures.