In May 2016, the SEC issued new Compliance and Disclosure Interpretations (CDI) and modified others to revise its guidance on the reporting of non-GAAP financial measures. Non-GAAP financial measures are often reported in the management’s discussion and analysis (MDA) section of a company’s quarterly (10-Q) or annual (10-K) financial report filings. They are also reported in earnings releases and other forms of communication that companies use to provide additional insight into their business beyond that found in the financial statements.
Non-GAAP financial measures are considered useful by many investors and analysts who believe that GAAP financial measures do not adequately capture a company’s value. Non-GAAP financial measures typically eliminate items deemed transitory, uncontrollable, or irrelevant by management. The SEC first provided guidance on non-GAAP financial measures in 2002, but loosened its restrictions on their reporting in 2010. The flexibility that companies have in what they report and how they report it is of growing concern, as non-GAAP financial measures may be misleading, difficult to interpret or, in the words of SEC Chair Mary Jo White, “a source of confusion” (“Maintaining High-Quality, Reliable Financial Reporting: A Shared and Weighty Responsibility,” Keynote Address at 2015 AICPA National Conference, Dec. 19, 2015, http://1.usa.gov/1XlOGKz).
Regulation of Non-GAAP Financial Measures
A non-GAAP financial measure is a numerical measure that adjusts the most directly comparable GAAP measure reported on the audited financial statements. Common non-GAAP measures include earnings before interest, taxes, depreciation and amortization (EBITDA); adjusted EBITDA; and non-GAAP income. Non-GAAP measures are not subject to audit; however, they are regulated by the SEC. Public companies must comply with Regulation G, which addresses all non-GAAP financial disclosures, as well as Item 10(e) of Regulation S-K, which addresses non-GAAP information included in SEC filings. Non-GAAP measures often separate and remove certain aspects of a company’s operations or remove the effects of large, unusual, or nonrecurring transactions. The calculation of these measures is highly subjective, and they are not necessarily comparable across companies or industries.
The SEC issued its Final Rule on the Conditions for Use of Non-GAAP Financial Measures in 2002, effective March 28, 2003. It adopted a new disclosure regulation, Regulation G, which requires public companies that disclose non-GAAP measures to include the most directly comparable GAAP measure and a reconciliation of the two. Within this rule, the SEC adopted amendments to Item 10 of Regulations S-K and S-B, as well as to Form 20-F, to provide additional guidance to public companies that report non-GAAP measures in their SEC filings. It also amended Form 8-K, which applies to earnings releases and similar announcements.
The final rule specifically defined a “non-GAAP financial measure,” in part, as one that excludes or includes amounts included in the most directly comparable GAAP measure, or is subject to adjustments that do so. It also stated that public companies must not “exclude charges or liabilities that required, or will require, a cash settlement” or “adjust a non-GAAP performance measure to eliminate or smooth items identified as nonrecurring, infrequent, or unusual” when the charge or gain is likely to recur within two years or a similar charge/gain has happened in the last two years.
Regulation G and the related amendments were intended to ensure that investors and other users of financial information are not misled by the use of non-GAAP measures, and that the reconciliation of non-GAAP measures with their most directly comparable measures will assist users in their evaluation. The SEC believes that this will provide the marketplace with value-added information to better evaluate companies’ securities, which will result in a more accurate pricing of securities.
In May 2016, the SEC issued new CDIs and amended others, reflecting the unease with the proliferation of non-GAAP measures, as well as the types of adjustments being made to GAAP financial measures.
In 2010, the SEC’s Division of Corporation Finance updated and significantly moderated its CDIs related to non-GAAP financial measures, indicating that there would be fewer objections to the disclosure of such measures in SEC filings. The SEC was concerned that companies were not providing meaningful information to investors due to the original stricter guidance; in particular, the original rule made it difficult for a company to justify and defend the disclosure of a non-GAAP measure that excluded a recurring item. The modified CDI specifically stated: “The fact that a registrant cannot describe a charge or gain as nonrecurring, infrequent, or unusual, however, does not mean the registrant cannot adjust for that charge or gain.”
This relaxation of the rule allowed companies to determine what is appropriate to exclude from GAAP income in arriving at a non-GAAP financial measure. Growing concern over the inconsistency, lack of comparability, and possible misleading effects of non-GAAP financial measures led the SEC to revisit this guidance. In May 2016, the SEC issued new CDIs and amended others, reflecting the unease with the proliferation of non-GAAP measures, as well as the types of adjustments being made to GAAP financial measures. Key provisions of the new guidance include the following:
- Certain adjustments may violate Regulation G because they cause the presentation of the non-GAAP measure to be misleading, even if they are not expressly prohibited.
- A non-GAAP measure that adjusts a particular charge or gain in the current period for which similar charges and gains were not adjusted in prior periods could violate Regulation G.
- A non-GAAP financial measure that is adjusting only for nonrecurring charges when there were also nonrecurring gains in the same period could violate Regulation G.
- A non-GAAP financial measure may not be presented with greater prominence than the most directly comparable GAAP measure. Examples of non-GAAP presentations that are more prominent and may violate Item 10(e) of Regulation SK include—
- presenting a full income statement of non-GAAP financial measures, even if the presentation is used to reconcile these non-GAAP measures to the most directly comparable GAAP measures;
- presenting a non-GAAP measure that precedes the most directly comparable GAAP measure or omitting the comparable GAAP measures from an earnings release headline or caption;
- presenting a non-GAAP measure in a manner (e.g., larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;
- describing a non-GAAP measure as “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;
- excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure using the “unreasonable efforts” exception in Item 10(e) of Regulation S-K, without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and
- providing a discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.
- The prohibition of adjusting a non-GAAP measure to eliminate or smooth items identified as nonrecurring, infrequent, or unusual is based on the description, not the nature, of the charge.
- Free cash flow is a liquidity measure and must not be presented on a per share basis. A clear description of how it is calculated, as well as any necessary reconciliation, should accompany the measure.
- Registrants should provide income tax effects of non-GAAP measures, depending on the nature of the measure (i.e., liquidity measure or performance measure). Adjustments to arrive at non-GAAP measures should not be presented net of tax; rather, the income tax adjustment should be presented separately.
An Example from Social Media Companies
The earnings releases of social media companies provide a rich source of non-GAAP financial measures. The authors examined the non-GAAP income (loss) reported by the six largest (by market capitalization) publicly traded social media companies: Facebook, Twitter, LinkedIn, Groupon, Pandora, and Yelp. There are several rationales for examining companies in the same industry, and specifically in this segment. Technology companies have garnered attention for their use of stock options as compensation, which is a prevalent adjustment of adjusted EBIDTA and non-GAAP income. In addition, the study of companies within one industry allows for a more focused comparison.
Another reason companies cite for reporting non-GAAP measures is to remove nonrecurring costs, which obscure the true meaning of GAAP measures. Such nonrecurring costs are particularly prevalent for newer companies, such as those in the social media industry. These companies provide a means to compare costs at similar points in their history and to see if their reporting of nonrecurring costs diminishes over time.
Finally, the companies examined differ dramatically in their size, ranging in market capitalization from $2.88 billion for Yelp to $355 billion for Facebook. This provides an opportunity to see if size of the company impacts the way non-GAAP income is calculated.
All of the studied companies include non-GAAP income in their 4th quarter earnings releases. Companies also reported other non-GAAP financial measures, such as adjusted EBIDTA and free cash flow, but the authors focused on the reporting of non-GAAP income. In some instances where non-GAAP income was not reported in the 4th quarter earnings release, data was obtained from the company’s 10-K (Groupon, 2011 and 2012; Yelp, 2011 and 2012) or S-1, Initial Registration Form (Twitter, 2011). Pandora changed its fiscal year-end in 2013, so the amounts reported for this year are for the 11 months ended December 31, 2013.
The graphs indicate an increasing divergence between non-GAAP and GAAP measures over time, signifying a growing emphasis on non-GAAP income.
Exhibit 1 provides a list of the non-GAAP adjustments to GAAP net income used by the companies in their annual earnings reports over the years 2011–2015. The “frequency” columns indicate the number of times each adjustment was used over these five years. Adjustments common across all companies include stock/share-based compensation, amortization, and income tax expenses; however, each company makes many other adjustments. Not obvious from the table is that the number of adjustments for each company increased over time. This reflects the effect of the 2010 CDI relaxing the restriction on repeated reporting of adjustments.
Non-GAAP Adjustments to GAAP Net Income (2011–2015) and Frequency of Reporting
Non-GAAP Adjustments Scaled by Market Value of Equity (dollars in millions)
The magnitude of such adjustments is evident in Exhibits 2and 3. The charts in Exhibit 2 show the annually reported GAAP and non-GAAP net income for each company from 2011 through 2015. The graphs indicate an increasing divergence between non-GAAP and GAAP measures over time, signifying a growing emphasis on non-GAAP income and an increase in the amount of adjustments to GAAP income in the calculation of non-GAAP income.
Exhibit 3 provides the relative magnitudes of the non-GAAP adjustments by dividing the total non-GAAP adjustments by the market value of equity. These scaled values increase over time for all companies. In decreasing order, the respective companies’ scaled values for 2015 are: Pandora, 6.31%; Twitter, 4.97%; Groupon, 3.87%; Yelp, 2.82%; LinkedIn, 1.81%; and Facebook, 0.95%.
The magnitude of non-GAAP adjustments increased over time for all the companies in this study.
A Changing Landscape
SEC regulations concerning the reporting of non-GAAP financial measures have evolved over time, vacillating between looser and tighter restrictions. This study of the reporting of non-GAAP income for the six largest U.S.-based social media companies provides some caveats for investors and analysts. First, the adjustments included in the calculation of this measure vary significantly, not only from company to company, but from year to year for the same company. Second, the SEC initially frowned upon including recurring items in non-GAAP adjustments, then seemed to permit them in 2010; it has recently returned to a stricter view, as seen in its Compliance and Disclosure Interpretations of May 16, 2017 (http://bit.ly/2qOTRJZ). During the period of this study, companies readily included recurring adjustments in their determination of non-GAAP income. Finally, the magnitude of non-GAAP adjustments increased over time for all the companies in this study. It will be interesting to see the impact, if any, that the most recent SEC guidelines will have on this behavior and the reporting of non-GAAP income in future periods.