Overview
On May 17, 2016, the Division of Corporation Finance of the U.S. Securities and Exchange Commission (the “SEC Staff”) revised existing interpretive guidance contained in its Compliance and Disclosure Interpretations relating to the use of non-GAAP financial measures (“C&DIs”). [1]  As discussed in more detail below, companies should revisit their use of non-GAAP financial measures in SEC filings and other public communications in light of the SEC Staff’s views on related problematic practices.

Since the adoption of the requirements regarding non-GAAP financial measures through the promulgation of Item 10(e) of Regulation S-K and Regulation G in 2003, the SEC Staff has, as a general matter, vacillated on the strictness of its interpretive positions relating to the use of non-GAAP financial measures.  In June 2003, the SEC Staff published Frequently Asked Questions (June 13, 2003) (the “FAQs”) relating to non-GAAP financial measures and took what were generally viewed as restrictive positions on certain uses of non-GAAP financial measures. [2]  In 2010, the SEC Staff published Compliance and Disclosure Interpretations that scaled back some of the more restrictive positions taken in the FAQs, partly to encourage companies to include non-GAAP financial measures in SEC filings (which would thus be subject to Item 10(e) of Regulation S-K). [3]  While the newly revised C&DIs generally address different areas relative to the C&DIs issued in 2010, it appears that the SEC Staff has reverted to a stricter philosophy on non-GAAP financial measures based on the view that issuers have become too aggressive in the use of non-GAAP financial measures.

The issuance of the revised C&DIs by the SEC Staff does not come as a surprise in light of recent remarks regarding the use of non-GAAP financial measures in speeches by SEC Chair Mary Jo White, SEC commissioners and SEC staff, including the SEC’s Chief Accountant, James Schnurr.  In a speech delivered at the 2015 AICPA National Conference, SEC Chair White noted that the use of non-GAAP financial measures was an area that deserved close attention and that non-GAAP financial measures were being used extensively and sometimes were a source of confusion. [4]  SEC Chair White also remarked that companies and their audit committees should “carefully attend to the use of [non-GAAP financial measures] and consider questions such as: Why are you using the non-GAAP measure, and how does it provide investors with useful information?  Are you giving non-GAAP measures no greater prominence than the GAAP measures, as required under the rules?  Are your explanations of how you are using the non-GAAP measures—and why they are useful for your investors—accurate and complete, drafted without boilerplate?  Are there appropriate controls over the calculation of non-GAAP measures?”  In a similar vein, SEC Chief Accountant, James Schnurr, delivered a speech in March 2016 noting that the SEC staff had “observed a significant and, in some respects, troubling increase over the past few years in the use of, and nature of adjustments within, non-GAAP measures by companies as well [as the]prominence that the analysts and media have accorded such measures when reporting on the results of the companies they cover” and that he was “particularly troubled by the extent and nature of the adjustments to arrive at alternative measures of cash generation, as compared to the measures of liquidity or cash generation.” [5]

Background of Item 10(e) and Regulation G
Item 10(e) requires companies that include a non-GAAP financial measure in a filing with the SEC, and Regulation G requires companies, or persons acting on their behalf, that publicly disclose material information that includes a non-GAAP financial measure, to comply with specified requirements.  Among other things, companies are required to accompany the non-GAAP financial measure with the most directly comparable financial measure calculated and presented in accordance with generally accepted accounting principles (“GAAP”) and a reconciliation (by schedule or other clearly understandable method) that is quantitative for historical non-GAAP financial measures and quantitative, to the extent available without unreasonable efforts, for forward-looking information, of the differences between the non-GAAP financial measure with the most directly comparable GAAP financial measure. 

For non-GAAP financial measures that are included in (1) SEC filings or (2) earnings releases and other public announcements or releases disclosing material nonpublic information regarding the company’s results of operations or financial condition for a completed quarterly or annual fiscal period (which earnings releases and other public announcements/releases trigger a requirement to be furnished under Item 2.02 of Form 8-K), companies are also required to present the most directly comparable GAAP financial measures with “equal or greater prominence” as compared to the non-GAAP financial measure.  The equal-or-greater-prominence requirement is based on a concern that investors and other market participants may not be aware of the comparable GAAP financial measure and that the non-GAAP financial measure may be inappropriately emphasized over the comparable GAAP financial measure.

Regulation G also provides that companies, or persons acting on their behalf, shall not make public a non-GAAP financial measure that, taken together with information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.

Revised Compliance and Disclosure Interpretations
The revised C&DIs address the equal-or-greater-prominence requirement relating to non-GAAP financial measures and specific types of presentations that the SEC Staff views as misleading for purposes of Rule 100(b) of Regulation G.  In addition, the revised C&DIs cover funds from operations, per-share liquidity measures, and income tax adjustments.

Equal-or-Greater-Prominence Presentation of GAAP Financial Measure
As noted above, non-GAAP financial measures that are included in SEC filings or in public announcements or releases that are required to be furnished under Item 2.02 of Form 8-K, e.g., earnings releases, must be accompanied by the most directly comparable GAAP financial measures “with equal or greater prominence.”  The revised C&DIs indicate that whether a non-GAAP financial measure is more prominent than the most directly comparable GAAP financial measure is a facts–and-circumstances determination; however, C&DI 102.10 provides the following specific types of presentations that the SEC Staff considers noncompliant with Item 10(e)(1)(i)(A)’s equal-or-greater-prominence requirement:

1. Presentation of a full income statement of non-GAAP financial measures, or presentation of a full non-GAAP income statement when reconciling non-GAAP financial measures to the most directly comparable GAAP financial measures.
2. Omission of the comparable GAAP financial measures from earnings release headlines or captions that include non-GAAP financial measures.
3. Presentation of non-GAAP financial measures using a style of presentation that emphasizes the non-GAAP financial measures over the comparable GAAP financial measures, e.g., a bold, larger font.
4. Non-GAAP financial measures that precede the most directly comparable GAAP financial measures, including in earnings release headlines or captions.
5. Descriptions of non-GAAP financial measures as, e.g., “record performance” or “exceptional” without, at a minimum, including equally prominent descriptive characterizations of the comparable GAAP financial measures.
6. Inclusion of tabular disclosure of non-GAAP financial measures without preceding such disclosure with equally prominent tabular disclosure of the comparable GAAP financial measures or including the comparable GAAP financial measures in the same table.
7. Exclusion of quantitative reconciliations with respect to forward-looking non-GAAP financial measures in reliance on the unreasonable-efforts exception provided 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.
8. Inclusion of a discussion and analysis of non-GAAP financial measures without a similar discussion and analysis of the comparable GAAP financial measures in a location with equal or greater prominence.

In the case of the SEC Staff’s position that the non-GAAP financial measure must not precede the comparable GAAP financial measure (#4 above), the SEC Staff appears to read the equal-or-greater-prominence language to require that the GAAP financial measure precede, in all cases, the applicable non-GAAP financial measure.  Companies can thus no longer introduce the GAAP financial measure later in the document that discusses the non-GAAP financial measure (or even later in the paragraph) without running afoul of this interpretive position.  In the case of the SEC Staff’s position that there must be a discussion and analysis of the comparable GAAP financial measure if there is a discussion and analysis of the applicable non-GAAP financial measure (#8 above), to date, companies have not generally provided such a discussion and analysis of the comparable GAAP financial measure.  It remains to be seen whether companies will continue to provide certain non-GAAP financial measures in light of this requirement.

Misleading Non-GAAP Financial Measures
The revised C&DIs provide that specific types of non-GAAP financial measures could result in misleading non-GAAP financial measures and thus potentially violate Rule 100(b) of Regulation G:

1. C&DI 100.01 provides that certain adjustments, even if they are not expressly prohibited, may result in misleading non-GAAP financial measures.  An example of such a misleading measure could be where the non-GAAP financial measure excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business. 
2. C&DI 100.02 provides that a non-GAAP financial measure can be misleading if it is presented inconsistently between periods.  In particular, a non-GAAP financial measure that adjusts a particular charge or gain in the current period and for which other similar charges or gains were not also adjusted in prior periods could result in a violation of Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it are explained.  Moreover, depending on the significance of the change, it may be necessary to recast prior non-GAAP financial measures to conform to the current presentation and for the purpose of placing the disclosure in appropriate context. [6]
3. C&DI 100.03 provides that a non-GAAP financial measure can be misleading if the non-GAAP financial measure excludes charges but does not exclude any gains.  An example of such a potentially violative measure is where the non-GAAP financial measure is adjusted only for nonrecurring charges when there are nonrecurring gains that occurred during the same period. 
4. C&DI 100.04 provides that a non-GAAP financial measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though the company earned revenue when customers are billed may violate Rule 100(b) of Regulation G on the basis that non-GAAP financial measures that use individually tailored revenue recognition and measurement methods instead of GAAP could violate Rule 100(b) of Regulation G.  In addition, other measures that use individually tailored recognition and measurements methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G. 

Although the revised C&DIs are phrased as the above types of non-GAAP financial measures that “may” or “could” violate Rule 100(b) of Regulation G, companies should assume that there is a very high burden to convince the SEC Staff (and, if applicable, the enforcement division of the SEC) that the non-GAAP financial measures covered by these particular C&DIs are not misleading.  In addition, as a general matter, characterization of any disclosure as potentially “misleading” should cause companies to proceed with caution prior to issuing any such disclosure due to liability concerns, whether they relate to potential SEC enforcement actions or private rights of action.

C&DIs Relating to FFO, Per-Share Liquidity Measures, and Income Taxes
In addition to addressing the equal-or-greater-prominence requirements and Rule 100(b) of Regulation G, the revised C&DIs address the following:

1. Funds from Operations.  The “funds from operations” (“FFO”) reference in footnote 50 of the Adopting Release is the funds from operations measure as defined by the National Association of Real Estate Investment Trusts (“NAREIT”) in effect as of May 17, 2016, which is the date the revised C&DIs were issued.  In addition, companies may present FFO on a basis other than as defined by NAREIT if the relevant adjustments made to FFO comply with Item 10(e) and such measure does not violate Rule 100(b) of Regulation G.  Measures that adjust FFO must also comply with the requirements of Item 10(e) regarding performance measures or liquidity measures, depending on the nature of the adjustments, some of which may be prohibited from being presented on a per-share basis.  See C&DIs 102.01 and 102.02.
2. Per-Share Liquidity Measures.  With respect to per-share presentations, the Adopting Release provides that per-share measures that are prohibited specifically under GAAP or SEC rules continue to be prohibited in SEC filings.  The prior C&DIs indicated, and the revised C&DIs continue to indicate, that certain non-GAAP per-share performance measures may be meaningful from an operating perspective, and that non-GAAP per-share performance measures should be reconciled to GAAP earnings per share but that non-GAAP liquidity measures that measure generated cash should not be presented on a per-share basis in SEC filings, consistent with Accounting Series Release No. 142.  The revised C&DIs indicate that whether per-share data is prohibited depends on whether the non-GAAP financial measure can be used as a liquidity measure, even if management presents such non-GAAP financial measure solely as a performance measure.  In this regard, the SEC Staff will focus on the substance of the non-GAAP financial measure rather than management’s characterization of the measure.  See C&DI 102.05.  The revised C&DIs also indicate that free cash flow is a liquidity measure that must not be presented on a per-share basis. See C&DI 102.07.  In addition, the revised C&DIs indicate that earnings before interest and taxes (“EBIT”) and earnings before interest, taxes, depreciation and amortization (“EBITDA”) must not be presented on a per-share basis.  See C&DI 103.02.
3. Income Tax Effects.  With respect to non-GAAP financial measures that adjust for income tax effects, the revised C&DIs provide that with respect to a liquidity measure that includes income taxes, it may be acceptable to adjust GAAP taxes to show taxes paid in cash; however, with respect to a performance measure, current and deferred income tax expense commensurate with the non-GAAP measure of profitability should be included.  The revised C&DIs also indicate that adjustments should not be presented “net of tax.”  Rather, companies should present income taxes as separate adjustments, with clear explanations.

What Companies Should Be Doing in Light of the New C&DIs
In light of the fact that non-GAAP financial measures disclosure has been the subject of recent attention by top officials at the SEC, including its Chair and its Chief Accountant, and now with specific guidance in the form of the revised C&DIs, companies should carefully analyze the revised C&DIs and consider whether any non-GAAP financial measures that they intend to include in SEC filings and other public communications require revisions.  Moreover, with the additional clarity from the SEC Staff and the high level of attention from top officials of the SEC, companies are under fair warning, particularly as it relates to potential enforcement action by the SEC.  In this regard, in a speech given on June 27, 2016 after the issuance of the revised C&DIs, Chair White noted that the SEC is “watching [non-GAAP financial measures] very closely and [is] poised to act through the filing review process, enforcement and further rulemaking if necessary to achieve the optimal disclosures for investors and the markets.” [7]  Accordingly, companies should carefully evaluate their non-GAAP financial measure disclosures and should consider the following:

1. Assess whether the use of each of the company’s non-GAAP financial measures is appropriate and desirable in light of the SEC’s and SEC Staff’s current views, including reevaluating the usefulness of such non-GAAP financial measures to investors and why they are an appropriate way to measure the company’s performance.
2. Review non-GAAP financial measures from a presentation perspective (i.e., equal or greater prominence) and consider whether the presentation of the non-GAAP financial measure is different in any manner, such as order and style, as compared to the presentation of the directly comparable GAAP financial measure.  A large number of companies will likely need to change their presentation approach in earnings releases due to the SEC Staff’s positions in the revised C&DIs.  Unless any differences in presentation are due to the GAAP financial measures being more prominent than the applicable non-GAAP financial measure, the SEC Staff may ask whether the equal-or-greater-prominence requirement has been met if GAAP financial measures and non-GAAP financial measures are presented differently.  As noted specifically in the revised C&DIs, if non-GAAP financial measures are included in earnings release headlines and/or captions, the directly comparable GAAP financial measures should also be included, and the GAAP financial measures should precede the applicable non-GAAP financial measures.
3. In light of the SEC Staff’s position that there must be a discussion and analysis of the comparable GAAP financial measure if there is a discussion and analysis of the applicable non-GAAP financial measure, consider whether such a discussion and analysis of the comparable GAAP financial measure causes a rethinking of whether the applicable non-GAAP financial measure is presented/discussed.
4. Consider whether, in addition to the specific presentations that the SEC Staff considers misleading, the proposed non-GAAP financial measure is potentially misleading because it excludes something that should not be excluded, e.g., normal recurring cash operating expenses for performance measures, or includes something that should not be included, e.g., nonrecurring gains when nonrecurring charges were excluded from the measure. 
5. Involve the Audit Committee in reviewing all publicly disclosed non-GAAP financial measures.

Notes:
[1] The revised C&DIs are available at https://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.

[2] For example, the SEC Staff took the position in the FAQs that companies that eliminated recurring restructuring charges or other recurring items but did not label them as “nonrecurring” faced a difficult burden of demonstrating the usefulness of such measures.  See Question 9 of the FAQs.

[3] The SEC Staff’s position in Question 9 of the FAQs changed in the C&DIs with respect to the exclusion of recurring items, as reflected in C&DI 102.03.  This position indicated that the prohibition in Item 10(e) to adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as nonrecurring, 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 two prior years, was based on the description of the charge or gain that is being adjusted and not the nature of the charge or gain.  This interpretation permitted companies more flexibility in presenting such non-GAAP financial measures, as the SEC Staff had previously required companies to justify such disclosure from a usefulness perspective, which was a difficult burden to meet.

[4] Keynote Address at the 2015 AICPA National Conference: “Maintaining High-Quality, Reliable Financial Reporting: A Shared and Weighty Responsibility” (available at https://www.sec.gov/news/speech/keynote-2015-aicpa-white.html).

[5] Remarks before the 12th Annual Life Sciences Accounting and Reporting Congress (available at https://www.sec.gov/news/speech/schnurr-remarks-12th-life-sciences-accounting-congress.html).

[6] The concern regarding inconsistent presentation of non-GAAP financial measures between periods was a concern that was expressed at the time Item 10(e) and Regulation G were adopted.  See footnote 23 to the SEC adopting release (Securities Exchange Act Release No. 47226 (January 22, 2003)) (the “Adopting Release”) (indicating that the Association for Investment Management and Research expressed concern regarding the presentation of non-GAAP financial measures that appear to have been calculated and presented in a manner consistent with prior presentations of such measures but where the method of calculation and presentation had been changed.  The SEC noted that companies should consider whether the change in the method of calculation or presentation from one period to another, without a complete description of the methodology change, complies with Rule 100(b) of Regulation G.)

[7] Keynote Address, International Corporate Governance Network Annual Conference: Focusing the Lens of Disclosure to Set the Path Forward on Board Diversity, Non-GAAP, and Sustainability (available at https://www.sec.gov/news/speech/chair-white-icgn-speech.html#_ftn39).