SEC posts new and revised CDIs on non-GAAP financial measures

by Cydney Posner

The SEC’s verbal blitzkrieg on abuses of non-GAAP financial measures has finally made its way into some new and revised CDIs. As discussed in this PubCo post, in early May, SEC Deputy Chief Accountant Wesley Bricker, speaking before the 2016 Baruch College Financial Reporting Conference, emphasized that the staff continues to issue comments objecting to the use of non-GAAP measures, in particular, companies’ disclosures as to why their non-GAAP measures are useful, apparent cherry-picking of adjustments within a non-GAAP measure and adjustments to remove normal, cash operating expenses. Speaking at the same conference, Mark Kronforst, the Corp Fin chief accountant, as reported in, outlined that admonition in neon lights, cautioning that, with regard to non-GAAP financial measures, “[f]or lack of a better way to say it, we are going to crack down.” The new and revised CDIs are summarized below:

General (new)

  • Even if they are not expressly prohibited, certain adjustments that result in a non-GAAP measure can be misleading in violation of Rule 100(b) of Reg G. For example, the staff advises that “presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.”

Sidebar: The discussion in this column in Compliance Week by Scott Taub, former deputy chief accountant and former acting chief accountant at the SEC, highlights the problem with this type of measure. One way to look at the acceptability of a non-GAAP measure, he observes, is “whether the adjustment tells the reader something useful. After all, given the flexibility of a measure like ‘Adjusted EBITDA,’ we could justify anything. For example, we could conceivably just present a measure that cuts labor costs in half. But it wouldn’t be a useful disclosure, because cutting labor costs in half without affecting the rest of the income statement is not something that could reasonably have occurred. Along those lines, there are some who believe the SEC staff is uncomfortable with non-GAAP measures that appear to be measures of what the results would be if only costs were less or fulfilling contracts with customers was easier.”

  • Another way that a non-GAAP measure could be misleading is when it is presented inconsistently between periods, such as when the measure adjusts a particular charge or gain in the current period but similar charges or gains were not adjusted in prior periods. In those cases, the staff advises, the change between the periods must be disclosed and the reasons for it explained. If the change is significant, the staff suggests that “it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context.” 

SideBar: In his remarks, Kronforst expressed particular concern about companies’ increasing use of non-GAAP measures to show the financials in a more favorable light.  According to the article,  “Kronforst said that the SEC is ‘definitely’ on the lookout for companies that are prone to ‘changing the calculation of a measure depending on what happened for any particular year.’ One particular practice that would be in the SEC’s crosshairs is the so-called ‘cherry picking’ of non-GAAP results to portray a company in the best possible light. ‘That would be moving the goalposts over time to manage the non-GAAP measure,’ Kronforst said. The commission frowns on the practice of senior executives ‘changing the calculation of a measure depending on what happened for any particular year [in a way that’s] advantageous to management,’ he added, ‘particularly when there’s no disclosure of it.’”  Now the guidance will, in effect, require this disclosure.

  • A non-GAAP measure can also be misleading in violation of Reg G if it “cherry picks” the adjustments, such as making adjustments only for non-recurring charges when there were also non-recurring gains that occurred during the same period.

SideBar: Taub recommends that companies make clear what the resulting measure is because that process may help companies be more consistent: “If you can define what the non-GAAP measure actually shows (Core earnings? Free cash flow? Foreign exchange neutral results? Earnings before unusual items?), rather than simply how it is calculated, you’ll be in a position to answer the question of whether something should be adjusted in calculating the measure. The uncertainty can be remedied if the definition of the measure describes the population of the things that will be adjusted if they occur, rather than simply the items that have been adjusted in the current period. For example, ‘Core Earnings represents operating income adjusted to remove gains or losses on dispositions of businesses, goodwill impairments, and unusual items (as defined in ASC 225).’ A definition like that is helpful in deciding whether a new item that comes up should be adjusted for the non-GAAP measure. And that’s what we should be shooting for. So check the description of your non-GAAP measure—if it merely describes the adjustments you made this period, try to do better. Try to explain the universe of items you will adjust for when they happen. This will also help to mitigate the tendency to look for negative things each period and consider whether just one more adjustment could be added.”

  • Another practice that the staff views as impermissible is presenting a non-GAAP performance measure that is a replacement of an important accounting principle with an alternate accounting model that does not conform to the company’s business. For example, a company may not use a non-GAAP measure that accelerates revenue that, under GAAP, is recognized ratably over time, to make it appear that the company earned revenue when customers were billed: “Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b),” as could individually tailored recognition and measurement methods for other financial statement line items. 

SideBar:  In his remarks, Bricker provided the following example illustrating this concept: “[C]onsider a company that has a subscription-based business.  The company bills for the full subscription at the outset, but since it will deliver over time, it earns and recognizes GAAP revenue over that same period.  Now assume this company calculates non-GAAP revenue as though it had a different business.  That is, it calculates what revenue it would have had, had it not sold a subscription, but rather had sold a product. The effect of the measure is that the company accelerates revenue recognition to the billing date and proceeds to calculate earnings based on this non-GAAP revenue.  At that point, this company’s GAAP results are based on revenues recognized as the service is provided and the non-GAAP results are based on revenues that are merely billed to the customer.”

In his analysis of the issue, Bricker concludes that the non-GAAP “measure does not appear to help investors understand and analyze core operating results.  Rather, it is a replacement of an important accounting principle with an alternate accounting model that does not match the company’s subscriptions business or earnings process, which is over time. Revenue adjustments do more than just adjust from GAAP:  they change the very starting point from which other performance analyses flow.”  Bricker cautions that, in the course of monitoring implementation of the new revenue recognition standard (which is also discussed extensively in his remarks), the staff “will be looking to see if the reporting concepts within those standards are supplanted by any number of company-specific non-GAAP alternatives.  For all of these reasons, if you present adjusted revenue, you will likely get a comment; moreover, you can expect the staff to look closely, and skeptically, at the explanation as to why the revenue adjustment is appropriate.” [Emphasis added.]

Item 10(e) of Reg S-K (new and revised) 

  • (This bullet and the next were revised primarily to update for the new definition of FFO.) Footnote 50 of Exchange Act Release No. 47226, Conditions for Use of Non-GAAP Financial Measures indicates that companies may use “funds from operations per share in earnings releases and materials that are filed or furnished to the SEC, subject to the requirements of Reg G and Item 10(e). The reference to “funds from operations (FFO) refers to the measure as defined in 2000 by the National Association of Real Estate Investment Trusts (NAREIT); however, since NAREIT subsequently revised and clarified the definition, the staff indicates that it accepts NAREIT’s definition of FFO in effect as of May 17, 2016, as a performance measure and does not object to its presentation on a per-share basis.
  • A registrant may present FFO on a basis other than as defined by NAREIT as of May 17, 2016, provided that any adjustments made to FFO comply with Item 10(e) and the measure does not violate Rule 100(b) of Reg G. Any adjustments made to FFO must comply with the requirements of Item 10(e) for a performance measure or a liquidity measure, depending on the nature of the adjustments, some of which may trigger the prohibition on presenting this measure on a per-share basis (e.g., a liquidity measure). (See the fourth bullet below.)
  • Item 10(e) prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. This prohibition is based on the description of the charge or gain that is being adjusted, not the nature of the charge or gain. That is, unless the charge or gain meets the specified criteria, it should not be described as non-recurring, infrequent or unusual.  That does not mean, however, that the registrant cannot adjust for that charge or gain if it believes the adjustment to be appropriate, subject to Reg G and the other requirements of Item 10(e). The staff has revised the CDI to add a reference to the first bullet under “General” above.
  • The adopting release for Item 10(e) states that “per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission.” But not all per-share non-GAAP financial measures are prohibited under Item 10(e)(1)(ii). Which then are prohibited? Once again distinguishing between liquidity and performance measures, the staff observes that Item 10(e) recognizes that certain non-GAAP per-share performance measures “may be meaningful from an operating standpoint” and, if presented, should be reconciled to GAAP earnings per share. On the other hand, non-GAAP liquidity measures that measure cash generated should not be presented on a per-share basis in documents filed or furnished with the SEC, consistent with Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data. The revised CDI adds that “[w]hether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure.  When analyzing these questions, the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.” [Emphasis added.]
  • Item 10(e)(1)(ii) does not prohibit the use in SEC filings of a measure of “free cash flow,” which is typically calculated as cash flows from operating activities (as presented in the statement of cash flows under GAAP), less capital expenditures. However, because this measure does not have a uniform definition and its title does not indicate how it is calculated, companies should accompany the measure with a clear description of how it is calculated along with the necessary reconciliation. The staff advises that companies should also avoid inappropriate or potentially misleading inferences about its usefulness, for example, by inappropriately implying that the measure represents the residual cash flow available for discretionary expenditures (because many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure). The revision adds a reminder that free cash flow is a liquidity measure that must not be presented on a per-share basis, as discussed in the bullet above.

SideBar: Interestingly, especially in light of Bricker’s observation that “usefulness” disclosure is the subject of frequent staff comment, the new CDIs do not  provide much additional guidance on the required description of a non-GAAP measure’s usefulness.

  • Item 10(e)(1)(i)(A) requires, both in SEC filings and furnished earnings releases that include non-GAAP financial measures, that the most directly comparable GAAP measure be presented with equal or greater prominence relative to the non-GAAP measure. Whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances, and this largely new CDI provides some useful examples of the types of presentations where the non-GAAP measures would be viewed by the staff to be more prominent:
    • “Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;
    • Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;
    • Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;
    • A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);
    • Describing a non-GAAP measure as, for example, ‘record performance’ or ‘exceptional’ without at least an equally prominent descriptive characterization of the comparable GAAP measure;
    • Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;
    • Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the ‘unreasonable efforts’ exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and
    • Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.”
  • In a substantially revised CDI, the staff advises that the presentation of income tax effects related to non-GAAP measures depends on the nature of the measures: “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. If a measure is a performance measure, the registrant should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. In addition, adjustments to arrive at a non-GAAP measure should not be presented ‘net of tax.’ Rather, income taxes should be shown as a separate adjustment and clearly explained.”

EBIT and EBITDA (revised)

  • If EBIT or EBITDA is presented as a performance measure, it should be reconciled to GAAP net income as presented in the statement of operations, not to operating income (because EBIT and EBITDA make adjustments for items that are not included in operating income). The revised CDI adds that these measures must not be presented on a per-share basis, with a reference to the fourth bullet under “Item 10(e) of Reg S-K.”

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