Non-GAAP Financial Measures: 10 Recommendations for Compliance and Reducing the Risk of SEC Staff Comments

The regulations regarding non-GAAP (Regulation G and Item 10(e) of Regulation S-X) were issued over 20 years ago. Since their adoption, non-GAAP has been one of the most frequent areas of comment by the SEC staff in connection with their review of filings, with the volume of comments increasing in recent years. This continued area of focus is attributable, in part, to:

• The growing number of companies presenting non-GAAP information in their filings with the SEC and other communications; and
• The increase in both the volume and complexity of the various adjustments used to present non-GAAP information.

The SEC staff has issued Compliance & Disclosure Interpretations (CDIs) on non-GAAP to provide interpretive guidance to companies. This guidance was issued in 2010 and has been frequently updated with new and expanded guidance. Companies should periodically read this guidance, which is available on the SEC’s website.

Not only is non-GAAP presentation one of the most frequent sources of comments issued by the Division of Corporation Finance staff, but there have also been a number of matters brought by the Division of Enforcement against companies for violating the non-GAAP regulations.

The regulations regarding non-GAAP depend on the location of the non-GAAP information. Regulation G applies to all disclosure of non-GAAP by SEC registrants. Item 10(e) of Regulation S-K applies to the disclosure in SEC filings such as Form 10-K, Form 10-Q, Form S-1, etc. Regulation G and part (1)(i) of Item 10(e) apply to press releases that are furnished under Item 2.02 of Form 8-K. Companies should understand the distinction in the requirements. While most of the points below will be applicable regardless of location unless otherwise indicated, this discussion assumes that the company is providing the non-GAAP information in a filed document.

Presented below are ten recommendations that companies should consider, as applicable, when preparing non-GAAP information.

Number 10

Do not present non-GAAP information more prominently than the directly comparable GAAP information. Sequence of financial information impacts prominence. The discussion of GAAP information must come before the discussion of non-GAAP information. For example, in an earnings release and management’s discussion and analysis, a company should discuss its GAAP results before it discusses its non-GAAP results. Additionally, the required reconciliation should start with the GAAP amounts and reconcile to the non-GAAP amounts.

Number 9

Consider the tax implications of the reconciling adjustments. Companies need to consider the tax effect of non-GAAP adjustments. The adjustment for the tax effect should be presented as gross and not netted against the various other adjustments. Companies that report pretax losses in their GAAP results will frequently have little or no tax provision or benefit. If the company is presenting a non-GAAP net income measure and, as a result of the adjustments, would report pretax income, it will be necessary to include a tax provision commensurate with the non-GAAP measure of profitability. The company should explain its methodology in determining the applicable reconciling adjustment for income taxes.

Number 8

Consider how reconciling adjustments would impact the denominator in the earnings per share (EPS) calculation. Non-GAAP adjustments not only affect the numerator in the presentation of non-GAAP EPS, but the adjustments can also impact the denominator. Companies exclude items that would be considered anti-dilutive in the determination of EPS. As a result of the various reconciling adjustments, anti-dilutive securities based on GAAP income may be dilutive when presenting non-GAAP income.

Number 7

Do not exclude normal, recurring cash operating expenses from a non-GAAP performance measure. The SEC staff has indicated that they will consider a performance measure misleading if it excludes the normal cash operating expenses necessary to operate the business. While the concept is judgmental, the SEC staff will consider 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. Accordingly, excluding a particular expense may be acceptable for one company and not for another. While the SEC staff’s interpretive guidance addresses only cash expenses, the SEC staff have also issued comments challenging the exclusion of certain non-cash operating expenses from a non-GAAP performance measure. Some of the items they have objected to being excluded from a non-GAAP performance measure include:

• Certain legal and regulatory expenses;
• Impairment charges for inventory;
• Pre-opening and closing costs;
• Cash-based compensation; and
• Costs to be a public company.

Restructuring charges are usually not considered normal recurring expenses. However, the SEC staff could still challenge the exclusion of restructuring charges from the non-GAAP performance measure if the company has frequent restructuring charges over successive quarters or years.

Number 6

Avoid using individually tailored measurements. The SEC staff have issued a CDI and have indicated in many conferences that companies should not use individually tailored accounting principles. As non-GAAP amounts are, by definition, individually “made up” amounts, the SEC staff has highlighted some areas of concern where they are likely to ask questions regarding this concept, including:

• The reconciling adjustment shifts GAAP results from an accrual basis of accounting to a cash or modified basis of accounting;
• The reconciling adjustment adds in transactions that are also reportable in the company’s financial statements;
• The reconciling adjustment reflects parts, but not all, of an accounting concept; and
• The reconciling adjustment renders the measure inconsistent with the economics of the transaction or agreement.

Examples of measures that the staff has objected to include:

• Change an item from gross to net;
• Adjust the fair value of assets purchased and/or liabilities assumed in purchase accounting;
• Normalize effective tax rates;
• Accelerate the recognition of deferred revenue;
• Eliminate the amortization of only a portion of acquired intangibles;
• Combine consolidated and unconsolidated results.

Number 5

Use proper labeling and description of the non-GAAP financial measure. Item 10(e) of Regulation S-K prohibits registrants from using titles or descriptions of non-GAAP financial measures that are the same or confusingly similar to titles or descriptions used for GAAP measures. Improper labeling can make the presentation of a measure that would otherwise be acceptable unacceptable. For example, if a company uses the term “revenue,” that term should be consistent with revenue as determined in accordance with GAAP. If a company uses the term “EBITDA” it needs to be determined in a manner consistent with the accepted definition. If a company includes adjustments in addition to interest, taxes, depreciation, and amortization, a different term needs to be used.

Number 4

Determine the most directly comparable GAAP measure for the reconciliation. Both Regulation G and Item 10(e) of Regulation S-K require a reconciliation from the most directly comparable GAAP measure to the non-GAAP measure. The SEC staff has indicated that if a company presents EBITDA as a non-GAAP performance measure, it should be reconciled with net income/loss. EBITDA should not be reconciled from pretax income or operating income. Additionally, if the company presents a non-GAAP margin, it should be reconciled with the GAAP gross margin even if the GAAP gross margin is not presented in the financial statements.

Number 3

Explain the usefulness and purpose of the disclosure. Item 10(e) of Regulation S-X requires companies to disclose why management believes a non-GAAP measure provides useful information. Additionally, if management uses this information, the disclosure should indicate how it is being used. This is a frequent comment when the company provides boilerplate disclosure – e.g., “This adjusted net income measure is being provided because management believes it is useful to investors.” The disclosure needs to explain the information the non-GAAP measure conveys and why it is useful to an investor.

Number 2

Segment information may require compliance with Item 10(e) of Regulation S-K. By definition, a measure required by GAAP or the SEC is not a “non-GAAP” measure. Historically, this included information that was determined in accordance with ASC 280 on Segment Reporting. In ASU 2023-07, companies are permitted, but not required, to present multiple measures of a segment’s profit or loss used by the chief operating decision maker. The SEC staff has indicated that they will not object to the disclosure of multiple measures of profitability. Still, if these additional measures are presented and not prepared per GAAP, the measures would be considered non-GAAP. Accordingly, the company will need to comply with the applicable preparation and disclosure requirements regarding non-GAAP measurements. The incremental disclosure can be included within or outside of the financial statements.

Number 1

Do not omit a material fact or information that is necessary to prevent the disclosure from being misleading. The omission of information can be as misleading as an improper presentation. To illustrate, assume a company has several unusual and nonrecurring expenses that are reconciled with adjustments that decreased GAAP earnings and are excluded when presenting a non-GAAP performance measure. The presentation could be misleading if the company omitted reconciling adjustments for unusual and nonrecurring income or gains that increased GAAP earnings when presenting a non-GAAP performance measure.

Adhering to SEC regulations, ensuring transparency, and following the outlined recommendations are crucial for handling non-GAAP financial measures. This enhances compliance, aligns financial disclosures with regulatory expectations, and fosters investor confidence.

Have questions about non-GAAP presentations? Contact Marcum for advice and guidance today.