By: George M. Wilson & Carol A. Stacey
Every six months, when we do our Midyear Forums in May and June and again when we do our Annual Forums in November and December, we discuss the SEC Division of Corporation Finance’s presentation of frequent comment areas. At our recent Midyear in Dallas the staff discussed the topics below, which are not in any particular order:
- Non-GAAP Measures
- Statement of Cash Flows
- Income Taxes
- Business Combinations
- Fair Value
- Revenue Recognition
- Disclosure of Recently Issued Standards
- Internal Control over Financial Reporting
As usual the list contains many familiar topics and themes. In the next several weeks we will post about each of these topics.
For this first post, we’ve chosen non-GAAP measures which shouldn’t be a surprise. We are all likely familiar with the SEC’s focus on this area and the C&DI’s they issued in May 2016. For our review here we thought we would explore three of the more problematic C&DI’s and recent staff comments for each of them:
Question 100.01, which is about whether or not presentation of certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading,
Question 100.04, which is about attempts to build tailored accounting principles that are not in accordance with GAAP, and
Question 102.10, which discusses “equal or great prominence”.
When is an Adjustment Misleading, Even if it is Not Specifically Prohibited?
The full text of this C&DI is:
Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?
Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading. [May 17, 2016]
The idea of “normal, recurring, cash operating expenses” can be subjective. Here is an example where that C&DI is translated into a comment:
We note that you exclude pre-opening expenses as part of your calculation of Adjusted EBITDA. Please explain to us why these are not normal, recurring, cash operating expenses necessary to operate your business. In this regard, we note pre-opening expenses for all periods presented, along with your discussion throughout the Form S-1 that your growth strategy is to expand the number of your stores from 71 to 400 within the next 15 years. Please refer to Question 100.01 of the updated Non-GAAP Compliance and Disclosure Interpretations issued on May 17, 2016.
Here is another similar example:
Management’s Discussion and Analysis Earnings Before Interest, Taxes, Depreciation and Amortization (Non-GAAP measure)
Please tell us how you concluded that the amounts in the acquisition-related adjustments reconciling item were appropriately excluded from your non-GAAP measures (e.g., adjusted EBITDA, adjusted gross margin and adjusted SG&A) presented here and in your Item 2.02 Forms 8-K filed October 25, 2016 and December 8, 2016. It appears that in each period presented you may be reversing a portion of your GAAP rental expense and removing recurring cash operating expenses, like sponsor fees and other costs. Refer to Non-GAAP Financial Measures Compliance and Disclosure Interpretation, Questions 100.01 and 100.04, which can be found at:
What is a Tailored Accounting Principle?
The full text of the C&DI is:
Question: A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?
Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G. [May 17, 2016]
Here are two comments to illustrate that a company should not try to tinker with GAAP to create their own accounting principles. This first comment is an attempt to adjust revenue recognition so that a non-GAAP measure would include revenue that is deferred under GAAP:
- We note your response to prior comment 4. The adjustment “change in deferred amusement revenue and ticket liability” in arriving at your non-GAAP measure “adjusted EBITDA” appears to accelerate the recognition of revenue associated with the deferred amusement and ticket liability that otherwise would not be recognized in any of the periods for which adjusted EBITDA is presented. Accordingly, adjusted EBITDA substitutes a tailored revenue recognition method for that prescribed by GAAP and does not comply with Question 100.04 of the staff’s Compliance & Discussion Interpretations on Non-GAAP Financial Measures. Please remove this adjustment from your computation.
This second comment shows an attempt to undo business combination accounting:
Refer to the line items, ‘purchase accounting adjustments,’ and ‘purchase accounting amortization’ within the reconciliation of net income to adjusted income before income taxes. Please explain to us the basis behind these adjustments as they appear to portray tailored accounting principle under GAAP for business combination. Refer to the guidance under Questions 100.01 and 100.04 of C&DI on Non-GAAP Financial Measures.
What Does Equal or Greater Prominence Mean?
The text of this much-discussed C&DI is:
Question: Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission and also earnings releases furnished under Item 2.02 of Form 8-K. Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?
Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:
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 in Item 10(e)(1)(i)(B) 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 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. [May 17, 2016]
This C&DI created perhaps the most confusion, or maybe consternation, raising issues of what is bolded and which measure is presented first. This first example comment is about a recent earnings release:
Your headline references “Record Q1 Non-GAAP Revenues and EPS, Growing 29% and 44% Respectively Year-over-Year” but does not provide an equally prominent descriptive characterization of the comparable GAAP measure. We also note several instances where you present a non-GAAP measure without presenting the comparable GAAP measure. This is inconsistent with Question 102.10 of the updated Compliance and Disclosure Interpretations issued on May 17, 2016 (“the updated C&DI’s”). Please review this guidance when preparing your next earnings release.
This second example is from a recent MD&A:
Management’s Discussion and Analysis Non-GAAP Measures
Return on Invested Capital, page 47
Please present the comparable GAAP measure with equal or greater prominence and label the non-GAAP calculation as “adjusted” or similar. Refer to Item10(e)(1)(i)(A) and Question 102.10 of staff’s Compliance and Discussion Interpretation on Non-GAAP Financial Measures for guidance.
And this last comment is from a 2016 earnings release:
- We have the following observations regarding the non-GAAP disclosures in your fourth quarter 2016 earnings release:
- Your statement of “net sales growth across all segments” in the earnings release headline is inconsistent with the segment results table on page 3 and appears to be based on pro forma adjusted results excluding foreign currency translation impact. In this regard, we note that both the Consumer and Other segments had a decrease in the reported net sales in 2016.
- It appears that you provide earnings results discussion and analysis of only non- GAAP measures in the body of the release without providing a similar discussion and analysis of the comparable GAAP measures.
- The measure you refer to as “free cash flow” is adjusted for items in addition to what is commonly referred to as free cash flow.
Please revise future filings to use titles or descriptions for non-GAAP financial measures that accurately reflect the amounts presented or calculated, and are not the same as, or confusingly similar to, GAAP measures. Also, to the extent you continue to discuss your results based on non-GAAP measures, you should also provide the comparative measures determined according to GAAP with equal or greater prominence. Refer to Question 102.10 of the updated Compliance and Disclosure Interpretations issued on May 17, 2016.
Stay tuned for our next topic, the statement of cash flows next week, and as always, your thoughts and comments are welcome!