Non-GAAP Financial Measures
An essential step toward becoming a public company is filing with the SEC for the first time. The first mandatory statement that your company must file with the SEC is Form S-11 (the “S-1”), which is the beginning of a long list of filings required of public companies. SEC filings must adhere to a strict set of rules governing what a company can include. One particularly important rule that must be followed is the requirement for financial statements to be created according to the United States Generally Accepted Accounting Principals (“GAAP”). The SEC, however, allows companies to include non-GAAP financial measures in their statements if they follow specific SEC rules regarding non-GAAP financial measures outlined in Regulation G (Reg G). While the majority of the SEC guidance around non-GAAP financial measures applies to various public disclosures, such as annual public company filings and formal public disclosures of financial information beyond SEC filings, this article will address non-GAAP financial measures solely in the context of the S-1.
Understanding Non-GAAP financial measures is especially important considering the current agenda of the SEC, which includes the enforcement of Reg G with respect to non-GAAP measures. As part of a keynote speech by SEC Chairman Jay Clayton at the International Corporate Governance Network Annual Conference, Chairman Clayton said “We are watching [Non-GAAP measures] very closely and are poised to act through the filing review process, enforcement and further rulemaking if necessary to achieve the optimal disclosures for investors and the markets.” Since this speech, the SEC has followed through with their claim by increasing focus on non-GAAP measures. During 2017, non-GAAP measures were one of the most frequent issues highlighted in SEC comment letters related to registration statements.
Non-GAAP Financial Measures Defined
A non-GAAP financial measure is a performance metric that departs from GAAP because it excludes earnings components that are required under GAAP. A common example of a non-GAAP measure is EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA is a non-GAAP financial measure because it excludes interest, tax, depreciation, and amortization expenses, all of which are included in the standard calculation of net income (the closest comparable measure to EBITDA) under GAAP. The most common non-GAAP performance measure found in S-1 filings is “adjusted EBITDA,” which backs out interest, taxes, depreciation, amortization, and other items.
While GAAP measures are very informative and can provide the majority of the information investors will need, interested parties may at times require additional non-GAAP financial measures to create an accurate picture of the company’s performance. In practice, many companies feel they need to disclose non-GAAP financial measures to accurately depict their core financial performance. According to a study published by Audit Analytics, “approximately 88 percent of S&P 500 component companies use non-GAAP measures.” Additionally, a study published by FactSet states that “over two-thirds of registration statements related to IPOs that were declared effective in 2015 included disclosures of non-GAAP information.”
Registrants often claim that non-GAAP measures are meaningful to investors and provide insights into their true operating performance. For example, many management teams feel that GAAP measures alone do not sufficiently reflect their company’s performance or cash-flow-generating potential, thus requiring the disclosure of additional non-GAAP measures to accurately depict the company’s true performance. There are many additional reasons registrants provide non-GAAP measures in their statements. A few of those reasons are as follows:
- Management compensation and incentive plans may be based on non-GAAP measures.
- Debt covenants or other requirements may be based on non-GAAP measures.
- Investors, analysts, and others may find non-GAAP information useful (e.g., the information may provide meaningful insight into items affecting a company’s performance and comparability of results).
- Certain non-GAAP measures, such as EBITDA, may be used for assessing business valuations in analyses of either earnings multiples or comparable transactions2.
There are a wide variety of non-GAAP financial measures. The following list includes some of the most common measures:
- Operating income that excludes one or more expense items
- Adjusted net income and adjusted earnings per share
- Earnings before income and taxes (“EBIT”) and earnings before interest, taxes, depreciation, and amortization (“EBITDA”), and adjusted EBIT and EBITDA3
- Core earnings
- Free cash flow
- Funds from operations (“FFO”)
- Net debt, which could be calculated as borrowings less cash and cash equivalents, or borrowings less derivative assets used to hedge the borrowings
- Measures presented on a constant-currency basis4, such as revenues and operating expenses
- System-wide sales
Non-GAAP Financial Measure Rules and Implementation Guidance
You must follow many SEC rules in order to include non-GAAP financial measures in your registration statements. The remainder of this article will focus on these rules. First, we will outline the rules you should be aware of when including non-GAAP financial measures in your registration statements. After outlining these rules, we will provide an explanation of and implementation guidance for the various rules.
The important, overarching rules relating to non-GAAP financial measures in registration statements are as follows:
- Whenever a registrant includes a non-GAAP financial measure, the registrant must accompany that non-GAAP financial measure with:
- A presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP; and
- A reconciliation (by schedule or other clearly understandable method), which shall be quantitative for historical non-GAAP measures presented, and quantitative, to the extent available without unreasonable efforts, for forward-looking information, of the differences between the non-GAAP financial measure disclosed or released with the most comparable financial measure or measures calculated and presented in accordance with GAAP identified in the above requirement.
- A registrant, or a person acting on its behalf, 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 misleading5.
Additionally, the SEC also requires that when presenting non-GAAP measures:
- The most directly comparable GAAP measure presented be with equal or greater prominence than that of the non-GAAP measure.
- The registrant include a statement indicating how the non-GAAP measure provides useful information to investors about the registrant’s financial condition and results of operations.
- To the extent material, a statement disclosing the additional purposes, if any, for which the registrant uses the non-GAAP measure, be included6.
Implementation of the Rules
Reconciliation of Non-GAAP Financial Measures
As stated by the SEC, non-GAAP financial measures must be accompanied by a presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP, and a reconciliation between the two measures. The first step in the reconciliation process is determining the most comparable GAAP financial measure. To this end, the SEC has provided the most appropriate GAAP measures for certain non-GAAP measures. For example, EBIT and EBITDA should be reconciled to net income and not operating income7. The SEC has not provided specific guidance on the majority of customized non-GAAP measures. However, the majority of adjusted income statement measures should be reconciled with GAAP income or earnings per share. For other customized measures, you will have to use judgment to determine the most comparable GAAP measure.
In order to determine what GAAP measure should be compared to the non-GAAP financial measure, you should first determine if the non-GAAP measure is assessing your company’s performance or liquidity. Answering this question will affect which GAAP measure is most comparable and will lead to rules that are specific to each type of measure (performance or liquidity). Generally, non-GAAP performance measures should be reconciled to items on the income statement, and non-GAAP liquidity measures should be reconciled to items on the statement of cash flows. Additionally, per-share measures should be reconciled to GAAP earnings per share.
After deciding on the appropriate comparable GAAP measure, you should reconcile the two measures. While the reconciliation may be presented in any understandable format, it is most often presented in a table. The reconciliation should begin with the comparable GAAP financial measure which should then be adjusted via the addition or subtraction of specific items, to arrive at the non-GAAP financial measure. To illustrate these adjusting items, Figure 1 shows that interest expense, tax expense, and depreciation expense are all added to net income (the GAAP comparable measure) to arrive at EBITDA (the non-GAAP measure).
Misleading Non-GAAP Measures
One of the main purposes of the SEC is to ensure that investors receive accurate information (i.e., to protect investors from being mislead). Non-GAAP financial measures are an area of particular concern to the SEC, since they can be a potentially high risk method of misleading stakeholders. Therefore, part of the SEC regulations around non-GAAP measures are focused specifically on the issue of transparency and truthfulness. As part of this focus, the SEC has provided examples of non-GAAP measures that could be considered misleading, including measures that:
- Exclude normal, recurring cash operating expenses necessary for business operations
- Are presented inconsistently between periods. For example, by adjusting an item in the current reporting period, but not a similar item in the prior period, without appropriate disclosure about the change and an explanation of the reasons for it
- Exclude certain nonrecurring charges but do not exclude nonrecurring gains
- Are based on individually tailored accounting principles, including certain adjusted revenue measures
- Exclude certain marketing expenses that were considered normal recurring operating cash expenditures
- Used a “price normalized cash margin” that included higher oil and commodity prices from earlier periods8
Equal or Greater Prominence
As stated previously, non-GAAP measures should never be presented with greater prominence than the comparable GAAP measure. You should use judgment when deciding whether a non-GAAP measure is presented with greater prominence, since there is little formal guidance on this topic. The SEC staff has, however, provided the following list of examples they feel constitute non-GAAP measures being presented with greater prominence than their GAAP counterparts:
- Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures
- Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures
- Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure
- A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption)
- Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure
- Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table
- Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception… without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence
- Providing 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 prominence9
Explaining the Necessity of the Non-GAAP Measure
In addition to a reconciliation, the SEC requires that non-GAAP measures be accompanied with a disclosure stating why the non-GAAP measure was included. This explanation should include a discussion of how the non-GAAP measure is useful to investors and the different ways the measure is used by management. Examples of the use of non-GAAP measure by management include decisions regarding employee bonuses, debt covenants, financing decisions, and other management decisions. You should avoid being vague and generic when explaining why you included certain non-GAAP measures. Your explanation should be specific to the non-GAAP measure, your company, and the way the non-GAAP measure is used. The fact that a non-GAAP measure is useful to analysts cannot be the sole reason you cite for including a certain measure.
Labeling Non-GAAP Measures
The SEC pays careful attention to the presentation of non-GAAP measures in registration statements, including the labels and descriptions of the measures. If you include non-GAAP measures in your statements, it is important that you plainly label and describe the non-GAAP measure and use correct accounting terminology. You should also avoid using items in your reconciliation that include the word “other;” rather, you should break the item into its specific parts. For example, if you are using the income statement line item “other expenses” in your reconciliation, you should break out the expenses contained within the catchall phrase “other” so that users are able to see the actual expenses, such as depreciation. Additionally, you should not label the non-GAAP measures that you use with names that could be mistaken for, or are similar to, the names of GAAP measures. For example, a non-GAAP measure labeled “operating earnings” could be easily mistaken for “operating income.”
Per-share Non-GAAP Measures
While there is little specific SEC guidance regarding the presentation or use of non-GAAP per-share measures, the SEC has prohibited certain per-share measures. You may not use non-GAAP per-share measures regarding liquidity or any cash flow per-share measures. You are also prohibited from using per-share measures that are derived from prohibited non-GAAP measures. If you include a non-GAAP per-share measure, it should always be reconciled to GAAP earnings per share.
Non-GAAP Measures in Financial Statements
The SEC strictly prohibits the presentation of non-GAAP measures in any financial statements prepared in accordance with GAAP. Therefore, you may not include any non-GAAP measures in the face of any financial statements or within the footnotes to financial statements. Non-GAAP measures should only be included in certain disclosures and in portions of your registration statements that are discussion based.
Non-GAAP financial measures can add real value to your registration statements. They allow you to communicate the performance of your business in ways that some GAAP measures may not, allowing investors to receive a more complete vision of your company. However, it is important to remember that non-GAAP measures have the potential to be misleading and are scrutinized by the SEC. This article has outlined many of the important rules regarding non-GAAP measures that we feel you should be aware of when preparing your registration statement. If you follow these rules as well as the SEC guidance on non-GAAP financial measures, you will be better prepared to effectively communicate with your investors without SEC pushback.
- Legal Information Institute
- Deloitte: A Roadmap to Non-GAAP Financial Measures
- EY Trends in US IPO Registration Statements
- S-1 is the form used to register your securities with the SEC for public trading on a stock exchange. For more information on S-1s see our article Drafting an S-1.
- Deloitte Roadmap to Non-GAAP Financial Measures
- Adjusted EBIT and adjusted EBITDA differ from EBIT and EBIDTA in that they normalize income and expenses that are characterized differently by different companies. Essentially income and expenses are adjusted in order to make them more comparable between companies.
- Constant-currency basis is used to eliminate fluctuations due to exchange rates. This allows financial information to be free of significant differences that are caused solely by exchange rate fluctuations, rather than actual company operations.
- Regulation G, § 244.100
- Regulation S-K, Item 10(e)
- Securities and Exchange Commission Compliance and Disclosure Interpretations 103.02
- Securities and Exchange Commission Compliance and Disclosure Interpretations 100.01-.04
- Securities and Exchange Commission Compliance and Disclosure Interpretations 102.10