It is no secret that the use of non-GAAP financial measures, which are financial measures that are neither calculated nor presented in accordance with U.S. generally accepted accounting principles ("GAAP"), has been a focus of attention for the U.S. Securities and Exchange Commission ("SEC"). In December 2015, the then SEC Chair Mary Jo White called this an area that "deserves close attention, both to make sure that our current rules are being followed and to ask whether they are sufficiently robust in light of current market practices."1Wesley R. Bricker, then the SEC's chief accountant, observed in a speech in May 2016 that certain company practices related to the use of non-GAAP financial measures have raised concerns and may be potentially misleading to investors.2 On May 17, 2016, the SEC's Division of Corporation Finance (the "Staff") provided guidance on the use of non-GAAP financial measures in the form of new and updated Compliance and Disclosure Interpretations ("C&DIs").3 Since that time, the use of non-GAAP financial measures has become one of the most cited issues in Staff comment letters. In addition, since the release of said C&DIs, there have been SEC enforcement actions and a criminal action brought by the U.S. Attorney's Office for the Southern District of New York that have culminated in a securities fraud conviction relating to the use of non-GAAP financial measures.
In this guide, we discuss the nature and purpose of non-GAAP financial measures and the rules governing the use of such financial measures. We also examine recent SEC comment letters and discuss areas of concern identified by the Staff. Last, we look at recent pronouncements that provide guidance on best practices for companies and offer some practical guidance.
What is a non-GAAP financial measure?
The SEC adopted the term "non-GAAP financial measures" in order to identify information targeted by the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"), which sought to eliminate the manipulative or misleading use of what the Sarbanes-Oxley Act referred to as "pro forma financial information" and enhance the comparability with GAAP financial measures. In 2003, the SEC adopted Regulation G and Item 10(e) of Regulation S-K ("Item 10(e)"), which both define a non-GAAP financial measure as a numerical measure of a company's historical or future financial performance, financial position, or cash flows, that:
- excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with U.S. GAAP (or in the case of foreign private issuers ("FPIs") whose primary financial statements are prepared in accordance with non-U.S. generally accepted accounting principles, references to GAAP also include the principles under which those primary financial statements are prepared) in the statement of income, balance sheet, or statement of cash flows (or equivalent statements) of the issuer; or
- includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented.
In addition, the SEC's releases leading to the 2003 adoption of Regulation G and Item 10(e) (the "SEC Releases") explain that the non-GAAP financial measure definition is intended to capture all measures that have the effect of presenting:
- a measure of performance that is different from that presented in the financial statements, such as income or loss before taxes, or net income or loss as calculated in accordance with GAAP; or
- a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP.4
The following are excluded from the definition of a non-GAAP financial measure:
- operating and other statistical measures such as unit sales, number of employees, subscribers or advertisers;
- ratios or statistical measures that are calculated using exclusively one or both:
- financial measures calculated in accordance with GAAP. For example, operating margin derived from GAAP revenue divided by GAAP operating income would not be considered a non-GAAP measure; and
- operating measures or other measures that are not non-GAAP financial measures such as measures calculated in accordance with GAAP (i.e., sales per square foot or same store sales);
- financial information that does not have the effect of providing numerical measures that are different from the comparable GAAP measure such as:
- disclosure of amounts of expected indebtedness, including contracted and anticipated amounts;
- disclosure of amounts of repayments that have been planned or decided upon but not yet made;
- disclosure of estimated revenues or expenses of a new product line, so long as such amounts were estimated in the same manner as would be computed under GAAP; and
- measures of profit or loss and total assets for each segment required to be disclosed in accordance with GAAP; and
- financial measures required to be disclosed by GAAP, SEC rules, or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to the registrant such as measures of capital or reserves calculated for regulatory purposes.5
Examples of commonly used non-GAAP measures include "adjusted net income" or EBITDA. If a company takes a GAAP measure like net income and adjusts that by excluding or including one or more expense or revenue items which are "non-recurring," the resulting measure, or "adjusted net income" as it is sometimes presented, would be considered a non-GAAP measure. Companies that use EBITDA derive this non-GAAP measure by taking GAAP earnings, such as GAAP net income as presented in the statement of operations, and adjusting for interest, taxes, depreciation, and amortization components, which are elements derived from GAAP financial presentations. Other common examples of non-GAAP financial measures include variations of EBITDA, such as EBIT (earnings before interest and taxes), EBITA (earnings before interest, taxes, and amortization), EBITD (earnings before interest, taxes, and depreciation or sometimes called PBDIT or profit before depreciation, interest, and taxes), EBITDAR (earnings before interest, taxes, depreciation, amortization, and restructuring or rent costs), adjusted EBITDA, core earnings, adjusted earnings, adjusted earnings per share, adjusted revenues, free cash flow, funds from operations ("FFO"), and Adjusted FFO ("AFFO").
Do non-GAAP measures serve a purpose?
Companies usually present non-GAAP financial measures in order to supplement GAAP financial presentations and to provide investors with a better illustration of their performance, liquidity, and financial position. Non-GAAP financial measures often enable a company's management to present a company's financial condition or results of operations and provide meaningful performance measures in a manner that GAAP results alone may not properly convey. The SEC allows the presentation of non-GAAP financial measures in order to provide information to investors that a registrant believes is relevant and useful in understanding its performance or liquidity. When used, non-GAAP financial measures are typically disclosed in the "Management's Discussion and Analysis" ("MD&A") section of periodic reports, earnings releases, investor presentations, and other company communications. In addition, research analysts, rating agencies, and other financial professionals often use non-GAAP operating measures to evaluate or compare the performance of comparable companies. For example, EBITDA is commonly found in debt covenants and used in financial projections and assessments of a company's operating cash flow or cash available to service its debt. Analysts also use EBITDA in the valuation of businesses, including a company's enterprise value which is usually calculated as a multiple of EBITDA.
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1 See Mary Jo White, "Keynote Address at the 2015 AICPA National Conference: 'Maintaining High-Quality, Reliable Financial Reporting: A Shared and Weighty Responsibility,'" December 9, 2015, available at https://www.sec.gov/news/speech/keynote-2015-aicpa-white.html.
2 See Wesley R. Bricker, "Remarks before the 2016 Baruch College Financial Reporting Conference," May 5, 2016, available at http://www.legalexecutiveinstitute.com/wp-content/uploads/2016/09/22.-Bricker-May-Speech-Baruch-College-Financial-Reporting-Conference.pdf.
3 See Compliance & Disclosure Interpretations on Non-GAAP Financial Measures, available at: https://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.
4 See SEC Release No. 33-8145, Proposed Rule: Conditions for Use of Non-GAAP Financial Measures (Nov. 4, 2002), available at: https://www.sec.gov/rules/proposed/33-8145.htm (hereinafter, the "Proposing Release"), and SEC Release No. 33-8176, Final Rule: Conditions for Use of Non-GAAP Financial Measures (Jan. 22, 2003), available at: https://www.sec.gov/rules/final/33-8176.htm (hereinafter, the "Final Rule Release" and, together with the Proposing Release, the "SEC Releases")
5 Regulation G, Rule 101(a)(2) and (3); Regulation S-K, Item 10(e)(4) and (5); see also Final Rule Release.
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