In several of our previous posts we have been exploring the guidance for the use of non-GAAP measures along with some areas where the SEC finds problems and hence writes non-GAAP measure comments.
This next chapter is about removing items considered unusual or infrequent. Many companies use such measures in order to present what they believe is a more “normal” or “recurring” earnings number and trend.
This is not a simple issue in any way shape or form. It is clear investors place significant value on this information. It is also clear that some companies push this presentation too far.
As an example, suppose a company has recorded a restructuring charge in the current quarter and in their earnings release and MD&A in Form 10-Q management wants to present a picture of earnings without this restructuring charge.
What are the SEC’s rules about such measures? Reg G of course applies to the earnings release, and does not prohibit such an adjustment. As we reviewed in our earlier posts, Regulation S-K Item 10(e) is the source of the SEC’s guidance about the use of non-GAAP measures in filed documents:
(e)(ii) A registrant must not:
(A) ———Omitted————-
(B) Adjust a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years;
You can read the complete Item in our post of June 5, 2015 or at:
When S-K Item 10(e) was originally created as part of the SOX regulatory revisions the language in this paragraph was interpreted as essentially prohibiting performance measures with adjustments for unusual or infrequent items in filed documents. While many companies would include such adjustments in non-GAAP measures in earnings releases, because the SEC was very active with comments in this area, rarely would they appear in MD&A in filed documents.
(Note: You can check our post of May 7, 2015 to review the difference between filed and furnished.)
To clarify their position about this issue the SEC has issued several Compliance and Disclosure Interpretations about the use of non-GAAP measures:
www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm
Here is the relevant C&DI:
Question 102.03
Question: Item 10(e) of Regulation S-K prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. Is this prohibition based on the description of the charge or gain, or is it based on the nature of the charge or gain?
Answer: The prohibition is based on the description of the charge or gain that is being adjusted. It would not be appropriate to state that a charge or gain is non-recurring, infrequent or unusual unless it meets the specified criteria. The fact that a registrant cannot describe a charge or gain as non-recurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K. [Jan. 11, 2010]
So, lets go back to our example company where management wants to add this charge back to show operations on a more “recurring” basis. Management could add the restructuring charge back to net income in the company’s earnings release and the MD&A of the related 10-Q. In the 10-Q Regulation S-K Item 10 would apply, and the company would have to consider how to describe the restructuring change. If the company had such a charge in the last two years or reasonably expected such a charge in the next two years then they could still adjust for it in the non-GAAP measure, but they could not describe it as non-recurring, infrequent or unusual.
Do companies always follow this guidance? Unfortunately NOT! Here is an example:
In the fourth bullet point of the second paragraph of this section you present a non-GAAP measure of the increase in SG&A adjusted for “one-time unusual items” as a percentage of net sales. You indicate that the one-time unusual items are acquisition, integration, spin-off and restructuring related costs, but we note that you have recorded similar costs in the last three fiscal years. Item 10(e)(1)(ii) of Regulation S-K prohibits adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. Please explain why you believe these adjustments are non-recurring in nature or revise similar presentations in future filings to refrain from characterizing these adjustments as “non-recurring.” Please refer to question 102.03 of our Non-GAAP Financial Measures Compliance and Disclosure Interpretation, available at http://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.