Creative use of non-GAAP financial measures has become standard practice in public company disclosures. Management, quite correctly in most cases, often believes that the company’s dry GAAP financial statements fail to fully explain company performance and that adjustments and carve outs (sometimes extensive) are needed to paint a clear picture. For the most part, the SEC has taken a benign approach to the proliferation of non-GAAP disclosures, though there are anecdotal signs of increasing concern.

Problems can arise, however, if a company becomes too aggressive with its non-GAAP measures. In addition, “non-GAAP disclosure creep” can become an issue as more and more adjustments and exclusions are layered on year after year without revisiting regulatory and common sense limitations.

The key to avoiding such problems (whether SEC enforcement or shareholder litigation) is to be mindful of, and attentive to, the spirit of the SEC’s non-GAAP disclosure rules, which allow flexibility and discretion, but contain reasonableness limitations.

The Basics.
A non-GAAP financial measure is a numerical measure of financial performance, financial position or cash flows that:

• excludes amounts that are included in the most directly comparable GAAP measure of the company, or

• includes amounts that are excluded from the most directly comparable GAAP measure.

In essence, it is a financial measure that depicts financial performance in a manner different from the GAAP financial statement presentation. It generally does not include non-financial statistical measures (such as unit sales, number of employees, ratios calculated using GAAP numbers).

If a company uses a non-GAAP financial measure in an SEC filing (which includes proxy statements), Item 10 of Regulation S-K requires:

• Equally prominent presentation of the comparable GAAP measure,
• Reconciliation of the differences between the non-GAAP and GAAP numbers, and
• Disclosure as to why management believes the non-GAAP measure is useful to investors and, if material, the additional purposes for which management uses the non-GAAP number.

If a company discloses non-GAAP financial measures in a non-filed manner (for example, in a press release or web site or social media posting), Regulation G imposes similar requirements, absent the statement of management’s beliefs.

What’s the Problem?
Companies can become overly aggressive with the nature and scope of their non-GAAP adjustments, sometimes changing adjusted items almost quarterly to suit the most recent financial results. This can create the appearance that the company is trying to obfuscate its actual financial performance, causing confusion among investors and attracting the attention of the SEC.

It can be tempting to exclude recurring items that are fundamental to how the company does business. Examples might include carving out compensation payments, systems upgrade costs, severance payments, internal restructuring expenses, refinancing costs, asset impairment charges and asset purchase or disposition adjustments, just to name a few. While there is no specific prohibition against excluding such recurring items, the SEC is sensitive to any suggestions that such items are non-recurring, extraordinary or special. In those cases, extra care must be taken to explain the adjustments and why management believes they are appropriate and helpful to investors’ understanding of the business.

Investor relations department sometimes seek to press the disclosure envelop in their (understandable and well-intentioned) efforts to present the company in the most favorable light. For example, it has become common practice to include financial information, ratios and other data in executive or financial summary sections or CD&A sections of proxy statements in order to highlight salient aspects of prior year performance.  (See this Doug’s Note.)

Inconsistencies sometimes arise between marketing-oriented earnings and other financial releases and actual SEC periodic reports, particularly regarding the prominence and nature of non-GAAP measure presentations. Fight the urge to issue press releases whose headings and bullets tout non-GAAP measures while the GAAP numbers are buried somewhere below.

Similar problems can arise with regard to investor trade conference presentations, whose slide decks are frequently posted on company web sites and, therefore, become public disclosures subject to SEC rules. Likewise, special care must be taken if non-GAAP financial measures are posted on social media, where brevity and, therefore, creativity is at a premium. (See this Doug’s Note.)

Fundamental Principles of Non-GAAP Financial Measure Disclosures.
The SEC requires that non-GAAP disclosure, definitions and reconciliations not be so excessive or confusing that they become counterproductive, or even misleading, to investors. Yet, its rules allow companies significant discretion. It is useful, therefore, to keep certain fundamental principles in mind when fashioning and updating non-GAAP disclosures.

• Clearly identify non-GAAP financial measures as such so that there can be no confusing them with actual GAAP financials. Using “non-GAAP” or “adjusted” in the measure’s title is widely accepted practice. Beyond that, it is useful (and perhaps necessary) to include a plain English definition of the measure in close proximity to its first use, rather than merely referring the reader to a mathematical reconciliation to its nearest GAAP counterpart in a subsequent table. The definition might indicate the components included or excluded from the GAAP counterpart, along with a brief statement of the goal the company seeks to achieve by presenting it.
• Avoid using boilerplate language in management’s explanation of why the non-GAAP measure will be useful to investors and the purposes for which management uses it. This is, of course, easier said than done, and most companies use the same standard language from period to period without giving it much, if any, thought. Nevertheless, it is important to be sure that “non-GAAP disclosure creep” does not out-strip this important (in the SEC’s eyes) disclosure. Oftentimes, as new measures are adopted they simply get added to the list of such measures without corresponding additional explanation or analysis.
• Strive for consistency of presentation of non-GAAP measures from period to period. A company should adopt a standard approach to non-GAAP measures that is in sync with its overall disclosure goals and perspective on its operations.  Presumably, this approach will not vary much from period to period. If there is a change, be sure to explain clearly why that the change makes sense in light of changes in management’s strategy or the company’s operations.
• Be aware of how others in your industry are presenting and using non-GAAP measures.  Non-GAAP presentations tend to be consistent within an industry since analysts and investors tend to adopt uniform methodologies to evaluate peer performance. Strive to stay in step with your peers unless there is a specific reason not to. If so, be sure to explain an deviation in clear language that addresses the rationale for your company’s approach and notes the absence of peer-to-peer comparability.

Suggested Action Steps.
As your investor relations, public relations and other departments continue to explore the boundaries of non-GAAP creativity:

• Try to manage the process away from meaningless non-GAAP numbers that will lead to cumbersome, counterproductive reconciliations and disclosures,
• Eliminate non-GAAP measures that have become obsolete over time,
• Consider whether key personnel would benefit from a training refresher on this topic,
• Confirm that your disclosure controls and procedures function to preclude a reporting glitch, and
• Be sure to revisit from time to time, and stay within the spirit of, Item 10 of Regulation S-K and Regulation G.

The ultimate goal is to strike the right balance between providing helpful and creative additional information to enhance the reader’s understanding of the company versus so muddying the GAAP financial waters that they recede into the background.