Thursday, May 19, 2016

SEC updates C&DIs on non-GAAP financial measures

By Rodney F. Tonkovic, J.D.

The SEC has updated a dozen of its Compliance & Disclosure Interpretations (C&DIs) on the use of non-GAAP financial measures. Among other items, the updates concern the definition of "funds from operations," the use of per share non-GAAP financial measures, and free cash flows.

Misleading measures. The first set of updates, to Questions 100.01 through 100.04, applies generally and concerns misleading non-GAAP measures that could violate Rule 100(b) of Regulation G. For example, Question 100.01 states that certain adjustments, even if not expressly prohibited, can violate Rule 100(b) because they cause the presentation of the non-GAAP measure to be misleading. A non-GAAP measure be misleading if it is presented inconsistently between periods.

Funds from operations. Question 102.01 discusses the definition of "funds from operations" (FFO) as used in in footnote 50 to Exchange Act Release No. 47226: Conditions for Use of Non-GAAP Financial Measures. The SEC uses the definition of FFO used by the National Association of Real Estate Investment Trusts (NAREIT) in effect as of May 17, 2016. The response to Question 102.02 states that a registrant can present FFO on a basis other than this definition provided that any adjustments made to FFO comply with Item 10(e) of Regulation S-K and the measure does not violate Rule 100(b). The response to Question 102.03 notes that registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K

Per share measures. Next, Question 102.05 notes the adopting release for Item 10(e)(1)(ii) of Regulation S-K states that "per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission." The response says, however, that certain non-GAAP per share performance measures are not prohibited. Non-GAAP per share performance measures, the staff says, should be reconciled to GAAP earnings per share, but non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis.

Free cash flow. Measures of "free cash flow" are also not prohibited under Item 10(e)(1)(ii). The response to Question 102.07 cautions, however, that a clear description of how this measure is calculated, as well as the necessary reconciliation, should accompany the measure where it is used. Additionally, free cash flow is a liquidity measure that must not be presented on a per share basis.

Prominence of non-GAAP measures. In the response to Question 102.10, the staff provides several examples of how, when presenting a non-GAAP measure, to present the most directly comparable GAAP measure with equal or greater prominence, as required under Item 10(e)(1)(ii). The list shows what the staff would consider as presenting the non-GAAP measure as more prominent, including omitting comparable GAAP measures from an earnings release headline that includes non-GAAP measures and presenting a non-GAAP measure in a larger font than the comparable GAAP measure.

Income tax effects. The updates also indicate that a registrant should provide income tax effects on its non-GAAP measures depending on the nature of the measures. The response to Question 102.11 states, to illustrate, that liquidity measures including income taxes might show taxes paid in cash.

EBITDA. Finally, under Question 103.02, if EBIT or EBITDA is presented as a performance measure, that measures should be reconciled to net income as presented in the statement of operations under GAAP. Operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income, the response says. These measures also must not be presented on a per share basis.