Disclosure of Non-GAAP Financial Measures

Companies commonly supplement their reported earnings under U.S. generally accepted accounting principles (GAAP) with non-GAAP financial measures that they believe more accurately reflect their results of operations or financial position or that are commonly used by investors to evaluate performance. A non-GAAP financial measure is a numerical measure of a company’s historical or future financial performance, financial position or cash flows that includes or excludes amounts from the most directly comparable GAAP measure. Non-GAAP financial measures are used by companies to bridge the divide between corporate reporting that is standardized under GAAP and reporting that is tailored to a particular industry or circumstance.

The Securities and Exchange Commission (SEC) permits companies to present non-GAAP financial measures in their public disclosures as well as registration statements filed under the Securities Act of 1933 (Securities Act) and periodic reports filed under the Securities Exchange Act of 1934 (Exchange Act), subject to compliance with Regulation G and Item 10(e) of Regulation S-K (Item 10(e)). These regulations were adopted to ensure that investors are provided with financial information that is fulsome and not misleading.

What Disclosure Is Covered by Regulation G and Item 10(e)?

Regulation G: All public disclosures that contain non-GAAP financial measures by any registrant that has a class of securities registered under the Exchange Act or is required to file reports pursuant to the Exchange Act are subject to Regulation G, including press releases, investor presentations and conference calls, whether such disclosure is made in print, orally, telephonically, by webcast or by broadcast. Therefore, registrants must be aware of disclosure of non-GAAP financial measures in all information released to the public.

Item 10(e): Item 10(e) governs all filings with the SEC under the Securities Act and the Exchange Act and prohibits the presentation of non-GAAP financial measures on the face of a registrant’s financial statements or in the accompanying notes, as well as on the face of any pro forma financial information required to be disclosed pursuant to Regulation S-X. Item 10(e) typically applies to the Summary Financial Information, Selected Historical Financial Information, Management’s Discussion and Analysis as well as any other sections of prospectuses and periodic reports that contain non-GAAP financial measures.

Disclosures made by foreign private issuers are subject to special requirements under Regulation G and Item 10(e), which are discussed below.

A summary of Regulation G and Item 10(e) and the disclosure required under each is included in the following table:

What Constitutes a Non-GAAP Financial Measure?

The SEC defines a non-GAAP financial measure as a numerical measure of a registrant’s historical or future financial performance, financial position or cash flows that (i) excludes amounts, or is subject to adjustments that have the effect of excluding amounts, or (ii) includes amounts, or is subject to adjustments that have the effect of including amounts, that are included in or excluded from, as the case may be, the most directly comparable GAAP measure in the registrant’s statement of income, balance sheet or statement of cash flows (or equivalent statements).

The definition of a non-GAAP financial measure excludes:

• operating and other statistical measures (such as unit sales, numbers of employees, numbers of subscribers or numbers of advertisers);
• ratios or statistical measures calculated using exclusively GAAP financial measures (such as operating margin) or operating measures or other measures that do not constitute non-GAAP financial measures (such as sales per square foot and same store sales); or
• financial measures required to be disclosed by GAAP (such as segment profit or loss and segment total assets and pro forma financial information required by Regulation S-X), SEC rules or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to a registrant (such as measures of capital or reserves calculated for regulatory purposes).

Metrics used in financial covenants that constitute material terms of a credit agreement or other agreement, which are material to an investor’s understanding of its financial condition and/or liquidity, may be disclosed even if they constitute non-GAAP financial measures or if they are prepared on a basis that is not consistent with Item 10(e). For example, if a registrant’s credit agreement uses the defined term “Adjusted EBITDA” for its financial covenants, then a registrant may use that non-GAAP financial measure calculated pursuant to the credit agreement in its periodic reports. Also, target levels in executive compensation agreements discussed in Compensation Discussion and Analysis are exempt from Regulation G and Item 10(e).

Commonly used non-GAAP financial measures include EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Non-GAAP financial measures of earnings that are calculated differently from EBIT and EBITDA should also be titled differently, such as Adjusted EBITDA or Earnings Before Interest, Taxes, Depreciation, Amortization and Rent (EBITDAR), a non-GAAP financial measure commonly used by real estate companies. Similarly, where operating income is adjusted to exclude one or more expense or revenue items, the resulting non-GAAP financial measure should be distinguished from operating income, a GAAP financial measure, by referring to it as Adjusted Operating Income, Net Operating Income or a similarly titled measure.

Neither Regulation G nor Item 10(e) prohibits the presentation of non-GAAP financial measures on a per share basis where they are measures of performance (provided that they are reconciled to GAAP earnings per share); however, the presentation of non-GAAP financial measures on a per share basis where they are measures of liquidity is prohibited. Commonly used non-GAAP financial measures related to cash flow are Free Cash Flow (FCF) and Funds from Operations (FFO). The term “free cash flow” should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures, since many companies have mandatory debt service requirements or other non­discretionary expenditures that are not deducted from the measure.

How to Comply With Regulation G

While broader in scope than Item 10(e), Regulation G is more limited in its requirements regarding a registrant’s disclosure of non-GAAP financial measures. In order to comply with Regulation G, whenever a registrant makes public a non-GAAP financial measure, it must:

• present the most directly comparable financial measure calculated and presented in accordance with GAAP; and
• reconcile the differences between the non-GAAP financial measure and such comparable GAAP measure.

For historical non-GAAP financial measures, the reconciliation is required to be quantitative, while for forward-looking information, the reconciliation is only required to be quantitative to the extent available without unreasonable efforts. If the forward-looking non-GAAP financial measure is not able to be quantified without unreasonable efforts, then the registrant should describe the anticipated differences between such non-GAAP financial measure and the most directly comparable financial measure qualitatively.

How to Comply With Item 10(e)

In order to comply with Item 10(e), whenever a registrant presents a non-GAAP financial measure in SEC filings, it must, in addition to the requirements set forth above for Regulation G:

• disclose the reasons why the registrant’s management believes that the presen­tation of the non-GAAP financial measure provides useful information to investors regarding the registrant’s financial conditions and results of operations; and
• to the extent material, disclose the additional purposes, if any, for which the registrant’s management uses such non-GAAP financial measure.

The SEC has indicated that statements with respect to management’s rationale for the use of any non-GAAP financial measure should not be boilerplate, and should be clear, understandable and tailored to the measure used, the registrant itself, the nature of its business and industry, and the manner in which management assesses the measure and applies it in decision-making.

In addition, the SEC proscribes certain practices with respect to the presentation of non-GAAP financial measures. A registrant is not permitted to:

• exclude charges or liabilities that required or will require cash settlement, absent an ability to settle in another manner, from non-GAAP liquidity measures (except for EBIT and EBITDA);
• adjust a non-GAAP performance measure to eliminate or smooth a non-recurring, infrequent or unusual item where such item is reasonably likely to recur within two years or there has been a similar charge or gain within the prior two years; or
• use titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures.

Companies may adjust for recurring charges within the two-year look forward/look back window, but the adjustment may not be classified as non-recurring, infrequent or unusual. Although a registrant also is not permitted to describe a charge or gain as non-recurring, infrequent or unusual if it falls inside the two-year look-forward/look-back window, the registrant may nevertheless be permitted to adjust for the charge or gain if the registrant otherwise deems it appropriate in compliance with Regulation G and Item 10(e).

What Requirements Apply to Foreign Private Issuers?

Foreign private issuers are subject to both Regulation G and Item 10(e). For both sets of requirements, the generally accepted accounting principles applicable to a foreign private issuer are those pursuant to which its primary financial statements are prepared, if other than U.S. GAAP, whether those are accounting principles generally accepted in its home country (Local GAAP) or International Financial Reporting Standards (IFRS). Therefore, where foreign private issuers publicly disclose financial measures that deviate from the accounting principles pursuant to which they prepare financial statements (whether U.S. GAAP, Local GAAP or IFRS), they must provide the same reconciliation that other registrants are required to provide under Regulation G and Item 10(e), subject to the qualifications set forth below. In addition, under Item 10(e), where foreign private issuers prepare financial statements pursuant to Local GAAP or IFRS but use a non-GAAP financial measure derived from or based on a measure calculated in accordance with U.S. GAAP, the registrant must reconcile such non-GAAP financial measure to U.S. GAAP.

Regulation G does not apply to public disclosure of a non-GAAP financial measure made by a foreign private issuer if its securities are listed or quoted on a securities exchange or inter-dealer quotation system outside the United States, the non-GAAP financial measure is not derived from or based on a measure calculated and presented in accordance with U.S. GAAP, and such disclosure is made outside the United States or is included in a registrant’s written communication released outside the United States. If a foreign private issuer’s disclosure of a non-GAAP financial measure is made contemporaneously both inside and outside the United States, Regulation G exempts the U.S. disclosure from Regulation G so long as:

• the communication is not targeted at persons located in the United States;
• journalists and other third parties (both U.S. and foreign) have access thereto;
• the disclosure appears on the registrant’s website; and
• the registrant submits the information to the SEC on Form 6-K following its disclosure or release.

Item 10(e) permits foreign private issuers to use a non-GAAP financial measure that it is otherwise prohibited from using under Item 10(e) if the measure relates to Local GAAP or I FRS, is required or “expressly permitted” by the applicable standard-setter, and is included in the annual report prepared by the registrant for use in its home jurisdiction for distribution to securityholders. A measure is considered to be “expressly permitted” if (i) it is clearly and specifically identified as an acceptable measure by the standard-setter that is responsible for establishing the generally accepted accounting principles used in the registrant’s primary financial statements included in its filings with the SEC or (ii) there is explicit acceptance of a presentation by the primary securities regulator in the foreign private issuer’s home country jurisdiction or market, including published views of such regulator or its staff or a letter from the regulator or its staff to the foreign private issuer indicating acceptance of the presentation.

Cautionary Note as to Misleading Information

The SEC has long taken the position that the misleading presentation of financial information presented on a basis other than GAAP, whether in SEC filings or public disclosures, may subject an issuer to liability under anti-fraud provisions of the federal securities laws. Even prior to the adoption of Regulation G and Item 10(e) in 2003, the SEC cautioned registrants that:

• the anti-fraud provisions of the federal securities laws apply to a company issuing “pro forma” (i.e., non-GAAP) financial information that has been made misleading through selective editing or “cherry picking”;
• when a registrant purports to announce earnings excluding “unusual or nonrecurring transactions;’ it should describe the particular transactions and the kind of transactions that are omitted and apply the methodology described when presenting purportedly comparable information about other periods; and
• investors are likely to be deceived if a registrant uses a “pro forma” (i.e., non-GAAP) presentation to recast a loss as if it were a profit, or to obscure a material result of GAAP financial statements, without clear and comprehensible explanations of the nature and size of the omissions.

Regulation G strengthened the SEC’s hand in the enforcement of rules regarding the disclosure of misleading non-GAAP financial information by establishing a definitive rule as to the presentation of misleading non-GAAP financial measures: “A registrant … shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.”

In 2009, the SEC brought its first and only enforcement action under Regulation G against SafeNet, Inc. and certain of its senior executives for what the SEC described as an “earnings management scheme,” including the improper classification of certain ordinary operating expenses as nonrecurring expenses, which resulted in the dissemination of what the SEC characterized as false and misleading non-GAAP financial results. The action was ultimately settled, resulting in a $1 million civil penalty for the registrant and disgorgement of profits and lesser civil penalties for certain of the registrant’s senior executives. SafeNet should not be viewed as prohibiting or discouraging the use of non-GAAP financial measures that comply with Regulation G; rather, it serves as a reminder that the public disclosure of financial information, including non-GAAP financial measures, that is deemed by the SEC to be misleading, particularly if it is viewed as earnings management, may result in an enforcement action against the registrant and members of its management team.

Practical Tips for Compliance

Registrants must be thoughtful about the disclosure of financial measures in SEC filings and submissions, as well as in press releases, investor presentations and conference calls. All such measures should be evaluated by appropriate personnel who are responsible for disclosure controls and procedures to determine whether such measures constitute non-GAAP financial measures within the scope of Regulation G or Item 10(e), and, if so, whether they contain the required reconciliation and disclosure. Foreign private issuers do not have blanket exemptions from these regulations, so they must be equally vigilant to comply with the regulations or the exemptions granted to foreign private issuers.

It is important to note that even compliance with the letter of applicable federal securities laws, rules and regulations regarding the disclosure of non-GAAP financial measures will not preclude SEC inquiries or enforcement actions if the spirit of the disclosure is inconsistent with those laws, rules and regulations and with the guiding principle that such disclosure not be misleading to investors. With respect to a registrant’s public filings, particular attention should be paid to how adjustments are titled and whether charges that are identified as “one-time items” and added back to non-GAAP measures. For example, restructuring charges that are described as a one-time item should in fact represent expenses that did not occur within the past two years and are not likely to recur within the following two years. In addition, registrants should ensure that any reconciliation of a non-GAAP measure to the most directly comparable GAAP measure in SEC filings is accompanied by an explanation sufficient to permit an investor to understand the differences between the two financial measures and why such non-GAAP financial measures may provide a meaningful assessment of a registrant’s financial performance, financial position or cash flows.