On Tuesday, the SEC’s Division of Corporation Finance posted updated Compliance and Disclosure Interpretations (C&DIs) regarding Non-GAAP Financial Measures. A summary of the specific changes is set out below, followed by practical considerations that are worth bearing in mind as companies approach the annual reporting season.  

Summary of Changes

The changes to the C&DIs are summarized as follows:

• C&DI 100.01 (amended) –  The amendments to this C&DI note that whether or not an adjustment that is not explicitly prohibited is misleading depends on a company’s individual facts and circumstances.  The amendments also expand upon the following example of an instance when certain adjustments, though not explicitly prohibited, cause a non-GAAP measure to be misleading: “Presenting a non-GAAP performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business is one example of a measure that could be misleading.”  In this regard, the amendments add that the SEC staff “considers 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.”  Moreover, the amendments state: “The staff would view an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as recurring.”  
• C&DI 100.04 (amended) –  The update substantially overhauled the structure of this C&DI, which focuses on problematic individually tailored accounting principles (ITAPs).  Prior to the update, this C&DI mentioned adjustments that accelerate revenue as an example of an ITAP.  While the pre-amendment C&DI noted that adjustments to line items other than revenue could give rise to a problematic ITAP, the updated C&DI now provides an expanded list of ITAP examples beyond revenue adjustments that the staff may consider to be misleading, which includes, but is not limited to:
  • 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.
• C&DI 100.05 (new) – This new C&DI states that “[w]ithout an appropriate label and clear description, a non-GAAP measure and/or any adjustment made to arrive at that measure could be misleading to investors.” The C&DI provides the following list of examples that would violate Regulation G to illustrate this general principle:
  • Failure to identify and describe a measure as non-GAAP.
  • 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”;
    • 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
    • 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.
• C&DI 100.06 (new) – This new C&DI articulates “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.” No examples are offered, meaning this would be a case-by-case determination likely to evolve through the comment letter process.
• C&DI 102.10 (amended) – The update to C&DI 102.10 amends and expands the illustration of instances in which the presentation of a non-GAAP measure would violate the equal or greater prominence requirement. The updates are discussed as follows by each new subsection to this C&DI:
  • C&DI 102.10(a) – The update clarifies that the equal or greater prominence requirement applies to both (i) the presentation of and (ii) any related discussion and analysis of a non-GAAP measure. Similar language about this being a facts and circumstances determination remains, and the list of illustrative examples has been updated to include the following, many of which largely re-articulate and expand upon prior examples:
    • Presenting an income statement of non-GAAP measures. See Question 102.10(c).
      • Note: This is largely consistent with the pre-amendment C&DI, but Question 102.10(c) adds more context to the presentation of a non-GAAP income statement.
    • Presenting a non-GAAP measure before the most directly comparable GAAP measure or omitting the comparable GAAP measure altogether, including in an earnings release headline or caption that includes a non-GAAP measure.
      • Note: This largely combines two previous examples into one bulleted example.
    • Presenting 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.
    • Presenting charts, tables or graphs of a 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.
  • C&DI 102.10(b) – The update provides examples of non-GAAP disclosures that are more prominent than the presentation of comparable GAAP measures:
    • Starting the reconciliation with a non-GAAP measure.
    • Presenting a non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures. See Question 102.10(c).
    • When presenting a forward-looking non-GAAP measure, a measure would be considered more prominent than the comparable GAAP measure if it is presented without disclosing reliance upon the exception that allows exclusion of a quantitative reconciliation for forward-looking measures, identifying the information that is unavailable, and its probable significance in a location of equal or greater prominence.
  • C&DI 102.10(c) – Related to the prohibition on presenting a non-GAAP income statement, the update explains 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.”

  Practical Considerations

  Since the non-GAAP C&DIs were last significantly expanded in 2016, non-GAAP measures have continued as one of the most frequent areas of SEC comment. These latest C&DI updates formalize the SEC staff’s views as expressed in comment letters in several respects. The updates also make clear that the SEC staff will continue to assess the facts and circumstances in many instances when reviewing non-GAAP measures, suggesting that the contours around non-GAAP rules and guidance will continue to evolve through the SEC staff comment letter process.

  Companies should take a fresh look at their presentation of non-GAAP measures, taking the updated C&DI guidance into consideration, particularly as year-end reporting season approaches. As part of that review, some questions to consider based on the updated C&DIs include:

  • Does the non-GAAP performance measure exclude normal, recurring, cash operating expenses necessary to operate the business? How does the expense relate to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment? Bear in mind that the SEC staff views an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as recurring. (C&DI 100.01.)
  • Do the non-GAAP adjustments “have the effect of changing the recognition and measurement principles required to be applied in accordance with GAAP”? As an example, do the adjustments have the effect of the following:
    • 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; or
    • 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?
    (C&DI 100.04)
  • Is the non-GAAP measure properly labeled and clearly described? For instance, is the non-GAAP measure identified and described as non-GAAP? Does the label reflect the nature of the non-GAAP measure? Does the presentation involve any of the following and potentially involve the example violations described in the C&DI: “net revenue” as a “contribution margin” measure, referring to a GAAP line item but calculating it differently than under GAAP, or labeling a measure as “pro forma” that is not compliant with Article 11 of Regulation S-X? (C&DI 100.05)
  • Even with disclosure about the nature and effect of each non-GAAP adjustment, would the non-GAAP measure still potentially be viewed as misleading? (C&DI 100.06)
  • Does the presentation of the non-GAAP measure violate the applicable equal or greater prominence requirements? Does the presentation run afoul of any of the listed examples in C&DI 102.10, which the SEC staff has concluded results in the presentation of a non-GAAP measure that is more prominent than the comparable GAAP measure? Among the several examples, consider:
    • Whether the non-GAAP reconciliation is presented in a manner that constitutes the presentation of a prohibited non-GAAP income statement;
    • Whether forward-looking non-GAAP measures that exclude the quantitative reconciliation include appropriate disclosures;
    • Whether a ratio that includes a non-GAAP financial measure is accompanied by a version of the ratio using the comparable GAAP measure; and
    • Whether charts, tables or graphs that include non-GAAP measures are accompanied by charts, tables or graphs containing comparable GAAP measures and presented with equal or greater prominence.
    (C&DI 102.10)