Updated SEC Guidance on Non-GAAP Measures

The SEC’s Division of Corporation Finance recently updated its Compliance & Disclosure Interpretations (C&DI’s) regarding the use of non-GAAP financial measures. Non-GAAP measures are numerical measures of performance, financial position or cash flows that are not calculated in accordance with generally accepted accounting principles (“GAAP”). The new interpretive guidance reflects an ongoing focus by the SEC and its staff on public companies’ use of potentially misleading non-GAAP financial measures.

Pursuant to the directives of the Sarbanes-Oxley Act, in 2003 the SEC adopted two rules regarding the use of non-GAAP financial measures: Regulation G and Item 10(e) of Regulation S-K.

• Regulation G applies whenever a company discloses a non-GAAP financial measure (including outside of SEC filings) and prohibits such use without complementary disclosure of the most directly comparable GAAP financial measure and a reconciliation of the two measures. In Rule 100(b), Regulation G also prohibits the use of materially misleading non-GAAP financial measures.
• Item 10(e) of Regulation S-K applies to non-GAAP financial measures used in SEC filings, and requires the same complementary and reconciling presentation as Regulation G. However, Item 10(e) also requires that the presentation of the most directly comparable GAAP measure be of equal or greater prominence than the corresponding non-GAAP financial measure, and that a statement be included explaining why management believes each non-GAAP financial measure is useful to investors, as well as a second statement about the additional purposes (if any) for which management uses each measure. Item 10(e) also prohibits the use of certain specific non-GAAP financial measures.

Updated Guidance

Over the years, the SEC’s Division of Corporation Finance has published a number of C&DIs regarding the use of non-GAAP financial measures. On December 13, 2022, the Division of Corporation Finance updated certain of these C&DIs, focusing on disclosures that the staff considers to be potentially misleading or in violation of the equal or greater prominence requirement of Item 10(e). The discussion below summarizes a number of key updates.

Use of Potentially Misleading Non-GAAP Financial Measures

Update to Question 100.01. This interpretation has long expressed the SEC staff’s view that certain adjustments, although not explicitly prohibited, may result in a non-GAAP financial measure that is misleading. The interpretation notes, for example, that presenting a performance measure that excludes normal, recurring cash operating expenses necessary to operate a registrant’s business could be considered misleading. The updated C&DI revises this guidance in two respects:

• The staff has clarified that an operating expense that occurs repeatedly or occasionally, including at irregular intervals, is considered recurring. This will make it more difficult to justify excluding certain cash operating expenses that may not be regular but could still be considered recurring.
• The staff has explained that when evaluating what is a normal, operating expense, it will consider the nature and effect of the non-GAAP adjustment and how it relates to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment.

Update to Question 100.04. This question addresses individually tailored revenue recognition and measurement methods. Its focus has been broadened, and now states the general principle that a non-GAAP measure could be considered misleading under Regulation G if the recognition and measurement principles used to calculate the measure are inconsistent with GAAP. In the staff’s view, non-GAAP adjustments that have the effect of changing the recognition and measurement principles required to be applied in accordance with GAAP would be considered individually tailored and may cause the presentation of a non-GAAP measure to be misleading. The updated C&DI cites several examples the staff may consider to be misleading for this reason, including:

• changing the pattern of recognition, such as including an adjustment in a non-GAAP performance measure to accelerate revenue recognized ratably over time in accordance with GAAP as though revenue was earned when customers were billed;
• presenting a non-GAAP measure of revenue that deducts transaction costs as if the company acted as an agent in the transaction, when gross presentation as a principal is required by GAAP, or the inverse, presenting a measure of revenue on a gross basis when net presentation is required by GAAP; and
• changing the basis of accounting for revenue or expenses in a non-GAAP performance measure from an accrual basis in accordance with GAAP to a cash basis.

New Question 100.05. This new C&DI says that a non-GAAP measure can be considered misleading if it, and/or any adjustment made to the GAAP measure, is not appropriately labeled and clearly described. The staff notes that non-GAAP measures are not always consistently defined and used across companies, and that appropriate labels and clear descriptions of how the non-GAAP measure is calculated can be key to preventing such disclosures from being misleading to investors. The interpretation cites the following examples of disclosures that would violate Rule 100(b) of Regulation G:

• failure to identify and describe a measure as non-GAAP; and
• presenting a non-GAAP measure with a label that does not reflect the nature of the non-GAAP measure, such as:
  • a contribution margin that is calculated as GAAP revenue less certain expenses, labeled “net revenue”;
  • a non-GAAP measure labeled the same as a GAAP line item or subtotal even though it is calculated differently than the similarly labeled GAAP measure, such as “Gross Profit” or “Sales”; and
  • a non-GAAP measure labeled “pro forma” that is not calculated in a manner consistent with the pro forma requirements in Article 11 of Regulation S-X.

New Question 100.06. This new C&DI states that a non-GAAP measure can be considered misleading, and thus violate Rule 100(b) of Regulation G, even if it is accompanied by disclosure about the nature and effect of each adjustment made to the most directly comparable GAAP measure. This interpretation does not cite any examples, and therefore leaves the staff ample room to exercise discretion in finding a particular use of a non-GAAP measure to be misleading. The interpretation notes the staff’s view that a non-GAAP measure could mislead investors to such a degree that even extensive, detailed disclosure about the nature and effect of each adjustment would not prevent the non-GAAP measure from being materially misleading.

Prominence of Non-GAAP Measures in SEC Filings

Update to Question 102.10. This C&DI addresses Item 10(e)’s requirement that when a company discloses a non-GAAP measure it must present the most directly comparable GAAP measure with equal or greater prominence, and confirms the requirement in Item 2.02 of Form 8-K that Item 10(e) applies not only to documents filed with the SEC but also earnings releases furnished under that Item. This C&DI has now been expanded and divided into sub-parts.

Question 102.10(a) states that whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made. It and the companion Question 102.10(b) give several examples of non-GAAP measures that are more prominent than the comparable GAAP measures. Certain of the examples have been updated, as follows:

• Presenting an income statement of non-GAAP measures, alone or as part of the required non-GAAP reconciliation, is an example of giving undue prominence to non-GAAP measures. Question 102.10(c) clarifies that the staff considers a non-GAAP income statement to be one that is comprised of non-GAAP measures and includes all or most of the line items and subtotals found in a GAAP income statement.
• Two existing examples that addressed earnings release headlines and captions have been combined and broadened – as revised, the example given is where a company presents a non-GAAP measure before the most directly comparable GAAP measure or omits the comparable GAAP measure altogether, including in an earnings release headline or caption that includes a non-GAAP measure.
• The existing example that discusses forward-looking non-GAAP financial measures has been clarified. The updated C&DI makes clear that when presenting a forward-looking non-GAAP measure without an accompanying quantitative reconciliation (because one is not available without unreasonable efforts), a measure would be considered more prominent than the comparable GAAP measure if it is presented without disclosing reliance upon the exemption, identifying the information that is unavailable, and its probable significance in a location of equal or greater prominence
• The existing example of tabular disclosure of non-GAAP measures has been expanded to refer to disclosure of charts, tables or graphs of non-GAAP financial measures without presenting charts, tables or graphs of the comparable GAAP measures with equal or greater prominence, or omitting the comparable GAAP measures altogether.
• As a new example, the staff cites when a company presents 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 measure(s) with equal or greater prominence.
• As another new example, the staff cites starting the required non-GAAP reconciliation with a non-GAAP measure (as opposed to starting from the comparable GAAP metric).

We expect the SEC staff to continue its heightened focus on non-GAAP financial measure disclosures, and it is reasonable to expect SEC staff scrutiny and comments on earnings releases and other public disclosures highlighting performance using non-GAAP measures. Non-GAAP measures may also continue to be a focus area for the Division of Enforcement and for potential shareholder litigation.

Public companies that make use of non-GAAP measures should continue to pay close attention to non-GAAP measure disclosures that could be viewed as potentially misleading under the updated guidance. Companies that exclude cash operating expenses in calculating non-GAAP financial measures should review the appropriateness of such exclusions in light of the updated guidance on what constitutes a recurring expense. Companies should also consider whether revisions to their non-GAAP disclosures are needed, in light of the new guidance, to ensure non-GAAP measures are appropriately labeled and clearly described. Finally, companies should review their non-GAAP presentations and reconciliations to ensure that non-GAAP measures are not more prominent than comparable GAAP metrics and that reconciliations begin with the most directly comparable GAAP measure.

If you have any questions concerning the material discussed in this client alert, please contact the members of our Securities and Capital Markets practice.