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Reporting non-GAAP financial measures under SEC rules

by contributors Bruce Czachor and Stephen Ashley, Orrick | Published May 7, 2012 at 3:00 PM

The use and presentation of financial metrics that do not conform to generally accepted accounting principles has long been a thorn in the side of the Securities and Exchange Commission. While the SEC toes the party line that all financial presentations must conform to GAAP, it acknowledges the tension that market participants prefer and use non-GAAP financial metrics to assess their investment opportunities. In its last significant update of its Compliance and Disclosure Interpretations regarding non-GAAP financial measures in January 2010, the SEC made it clear that it wants consistency in how public companies communicate financial measures to investors.

As part of the regulatory changes adopted in the post-Enron and WorldCom era, the SEC's rules on the use of non-GAAP financial measures were adopted in January 2003 pursuant to the Sarbanes-Oxley Act. The two rules that regulate the use of non-GAAP financial measures are Regulation G and Item 10(e) of Regulation S-K. Regulation G applies to all public disclosures made by a company, which covers not only SEC filings but also other information made available to the public, including through earnings releases, investor and analyst calls, as well as the Internet. Item 10(e) of Regulation S-K, on the other hand, applies only to disclosure documents filed with the SEC, such as quarterly reports, annual reports and registration statements, but does not apply to Form 8-K disclosures that are merely furnished to (as opposed to filed with) the SEC.

This difference in the application of these two rules often resulted in inconsistencies in financial disclosures made by companies in their SEC filings and in other information made available to the public. In addition, while statutory liabilities under both the U.S. Securities Act of 1933 and the Securities Exchange Act of 1934 apply to documents that are filed with the SEC, information that is not filed is subject only to general anti-fraud liability. These issues are considered the driving factors for the SEC staff to release new interpretations in 2010 that encourage companies using non-GAAP financial measures to include them in their SEC filings.

Regulation G and Item 10(e) define a "non-GAAP financial measure" as a numerical measure of financial performance, financial positions or cash flows that excludes (or includes) amounts that are otherwise included in (or excluded from) the most directly comparable measure calculated and presented in the financial statements under GAAP. Examples include Ebitda, adjusted Ebitda, Oibitda and free cash flow. Non-GAAP financial measures are often presented in securities offering documents as measures of performance or liquidity and are often used in covenants to measure financial performance or approximate cash generated from operations that would be available to pay interest on debt.

Regulation G applies whenever an SEC registrant, or a person acting on its behalf, "publicly discloses material information" that includes a non-GAAP financial measure. Regulation G requires that non-GAAP financial measures be accompanied by (a) a presentation of the most directly comparable financial measure calculated in accordance with GAAP and (b) a reconciliation of the differences between such measures. In addition, Regulation G prohibits a registrant from making any non-GAAP financial measure public if it contains a material misstatement or fails to include information needed to make the included measure not misleading.

Item 10(e) of Regulation S-K applies to non-GAAP financial measures included in SEC filings. In addition to the requirements of Regulation G, Item 10(e) requires (1) a presentation of the most directly comparable GAAP financial measure that is at least equally prominent; (2) disclosure why management believes the non-GAAP financial measure provides useful information for investors; and (3) to the extent material, a statement of any additional purposes for which management uses the measure. Item 10(e) prohibits (1) non-GAAP measures of liquidity that exclude items requiring cash settlement (other than Ebit and Ebitda); (2) the use of titles used for (or confusingly similar to) GAAP financial measures to describe non-GAAP measures; and (3) making adjustments characterized as "non-recurring, infrequent or unusual" if a similar charge/gain occurred within the last two years or is reasonably likely to recur within two years.

There were several significant changes in the SEC's position reflected in the 2010 interpretations. First, the 2010 guidance clarified that companies may in fact present non-GAAP performance measures that exclude the impact of recurring items, so long as the recurring items are not labeled as "non-recurring, infrequent or unusual." The updated guidance allows an SEC registrant to make such adjustments if it believes they are appropriate, subject to Regulation G and the other requirements of Item 10(e).

Second, the 2010 guidance makes clear that companies may present non-GAAP financial measures in their public disclosures and SEC filings even where management does not use those measures in managing its business. Although Item 10(e) never explicitly required that a company actually use a non-GAAP financial measure in managing its business in order to be able to disclose it, practitioners generally had treated it as a requirement. Companies must still satisfy the other requirements of Item 10(e) discussed above.

And third, the staff explicitly acknowledged that companies may present adjusted Ebitda in their SEC filings and public disclosures as long as they comply with Item 10(e). The 2010 guidance also includes a number of helpful clarifications, including that (1) Item 10(e) applies to free-writing prospectuses included in or incorporated by reference into a registration statement or other Securities Exchange Act filing (but does not apply to any other free-writing prospectus); (2) it is generally not appropriate to present a full non-GAAP income statement for purposes of reconciling non-GAAP financial measures; and (3) when reconciling a non-GAAP performance measure, a company may present an adjustment "net of tax" so long as it discloses both the tax effect of each reconciling item (parenthetically or in a footnote) and how the tax effect was calculated.

The interpretations also included those relevant to foreign private issuers. For example, the staff clarified that a non-GAAP financial measure that is permitted under a foreign private issuer's home country accounting rules through "explicit acceptance of a presentation," such as a published regulatory position or letter from the regulator to the issuer, constitutes an "expressly permitted" measure that a foreign private issuer may use pursuant to an exemption under Item 10(e). The 2010 guidance makes clear that such an issuer may incorporate into a Securities Act registration statement only those portions of a furnished press release on Form 6-K that do not include non-GAAP financial measures. In addition, a foreign private issuer that takes advantage of Rule 100(c), which exempts them from complying with Regulation G for non-GAAP disclosures made outside the U.S., and then furnishes non-Regulation G-compliant information in a report on Form 6-K, must still comply with Item 10(e) with respect to that information if it chooses to incorporate the Form 6-K into a Securities Act registration statement (with certain exceptions for Canadian companies).

In guidance relevant for domestic and foreign companies, the staff made clear that an issuer may present financial information in a constant currency to eliminate the effects of currency fluctuations and still comply with Item 10(e) by presenting historical results together with disclosure on how to calculate the constant currency amounts and the basis for presentation. The 2010 guidance no longer requires that amounts of revenue by product be set forth in a table aggregating to "total revenue" as reflected in the financial statements so long as the revenue amounts for each product are calculated in accordance with GAAP.

Except as discussed above, the staff reaffirmed its prior guidance regarding non-GAAP financial measures in the 2010 interpretations. Certain key principles that remained intact are that Ebit and Ebitda are limited to precise definitions, and per-share non-GAAP performance measures, including "funds from operations" for REITs, are permitted, subject to Item 10(e) compliance.

Bruce Czachor, a partner in the New York office of Orrick, Herrington & Sutcliffe LLP, is a member of the corporate group. Stephen Ashley is a senior associate in Orrick's New York office and a member of the banking and debt capital markets group and corporate group.

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