The Use of Non GAAP Financial Measures – Part I

This is the Part 1 of a 2-part series. Read Part 2 here 

Introduction

Many companies, in addition to reporting earnings under U.S. generally accepted accounting principles (GAAP), report non-GAAP financial measures that they believe better reflect their results of operations, cash flows or financial position (based on their industry or specific circumstances), or that are commonly used by investors to evaluate performance. The SEC permits companies to present non-GAAP financial measures in their public disclosures as well as registration statements and periodic reports subject to compliance with Regulation G and Item 10(e) of Regulation S-K (Item 10(e)). Examples of non-GAAP financial measures would be a measure of operating income or net income that excludes one or more expense or revenue items that are identified as “non-recurring” or the commonly used measure of EBITDA that is not presented in accordance with GAAP.

Compliance with Regulation G and Item 10(e)

Regulation G contains a general requirement that any non-GAAP measure made publicly must (a) not contain an untrue material statement or (b) omit a material statement making the statement misleading. Also, if the methodology of a non-GAAP measure has itself changed over the course of the registrant’s reporting, a full disclosure of the changes may be needed to comply with Regulation G.

Further, whenever a non-GAAP financial measure is being used, these regulations require:

• A presentation, with equal or greater prominence, of the most directly comparable financial measure calculated and presented in accordance with GAAP;
• A reconciliation (by schedule or other clearly understandable method) of the differences between the non-GAAP financial measure disclosed or released with the most directly comparable financial measure calculated and presented in accordance with GAAP
• A statement disclosing the reasons why the registrant's management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the registrant's financial condition and results of operations; and

To the extent material, a statement disclosing the additional purposes, if any, for which the registrant's management uses the non-GAAP financial measure. In addition to these mandated disclosure requirements, Item 10(e) prohibits the following:

• Excluding charges or liabilities that required, or will require, cash settlement from non-GAAP liquidity measures, other than the measures EBIT and EBITDA; 
• Adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when (1) the nature of the charge or gain is such that it is reasonably likely to recur within 2 years, or (2) there was a similar charge or gain within the prior 2 years;
• Presenting non-GAAP financial measures on the face of the registrant's financial statements prepared in accordance with GAAP or in the accompanying notes, or on the face of any pro forma financial information required to be disclosed by Article 11 of Regulation S-X; and  
• Using 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.

Conclusion

Although non-GAAP measures are widely used by many registrants, companies should take great care when presenting non-GAAP financial measures to comply with Regulation G and Item 10(e) requirements related to the development, presentation and disclosure of the non-GAAP financial measures. It should be noted that Regulation G applies to all public disclosures of a registrant, including press releases, conference calls, PowerPoint presentations and other media, while Item 10(e) applies to all filings with the SEC under the Securities Act and the Exchange Act.