Weil Gotshal provides Practical Tips for “Self-Correcting” Non-GAAP Disclosure in Light of the SEC’s Updated Guidance

In the wake of its release on May 17, 2016 of updated Compliance and Disclosure Interpretations (“CDIs”) relating to the disclosure of non-GAAP financial measures, the SEC’s Division of Corporation Finance has indicated in no uncertain terms that now is the time for companies to review their non-GAAP measures and make any revisions called for by the new guidance.

With the new and revised CDIs, the SEC has delivered the latest in a series of increasingly strong warnings – previously made in remarks by the SEC Chair and senior Staff accountants – about the perceived misuse of non-GAAP measures. Commenting on the updated CDIs at a public PCAOB advisory group meeting held the day after their publication, the Division’s Chief Accountant Mark Kronforst encouraged companies to take the opportunity presented by the imminent close of the second fiscal quarter to review their disclosure practices in light of the latest set of non-GAAP CDIs and, if necessary, to “self-correct” before the anticipated “uptick” in critical Division comment letters directing companies to “curb some of the practices that [they are] seeing.”

While most, if not all, of the changes made to the non-GAAP CDIs were previewed in recent comment letters issued by the Division[1] and recent public remarks by the SEC Chair and senior Staff members, the prescriptive nature of some of the updated CDIs has taken observers by surprise. According to Mr. Kronforst, the “fairly strong language” of the amended interpretive guidance is “intentional.” It appears that companies have one last clear chance this quarter to reconsider their earnings disclosure practices and make any necessary modifications before the impending “uptick” in Division comment letters. Left unstated by Mr. Kronforst, but equally clear from his observations, is the prospect of referrals to the Division of Enforcement in the event of persistent use of non-GAAP measures identified in the updated CDIs as actually or potentially misleading.

In preparing the upcoming earnings releases and management presentations to investors and analysts as well as periodic reports, we recommend that companies follow the Staff’s suggestion to review their non-GAAP disclosure practices carefully and take the opportunity to “self-correct.” We suggest applying the four basic questions outlined by the SEC Chair in her keynote address at the December 2015 AICPA conference to determine whether any changes are needed:

  • Why are you using the non-GAAP measure, and how does it provide investors with useful information?
  • Are you giving non-GAAP measures no greater prominence than the GAAP measures, as required under the rules?
  • Are your explanations of how you are using the non-GAAP measures – and why they are useful for your investors – accurate and complete, drafted without boilerplate?
  • Are there appropriate controls over the calculation of non-GAAP measures?

Given recurring reminders from the Chair and senior accounting staff of the importance of Audit Committee oversight in this area, we also recommend that the Audit Committee be briefed on the results of this review and any management-recommended changes.

Self-Correcting Impermissibly Prominent Non-GAAP Measures

Below is mark-up of an excerpt of a company’s earnings press release:

Beware non-GAAP measures in headlines and executive quotes – non-GAAP measure must be included and must come first.  Also beware descriptive words for non-GAAP, but not GAAP measures:

XYZ Corp Reports Solid Second Quarter 2016 Results

GAAP measure increased 0.5%; Adjusted measure up 2.3%

John Doe, XYZ Corp Chief Executive Officer, commented, “While the GAAP measure showed a modest increase of 0.5% over the same period in 2015, wWe are pleased that the Adjusted Measure went up by a solid 4.2%. This exceptional This growth can be attributed to the continued expansion of our business in new markets.”

Beware non-GAAP measures in headlines and executive quotes – GAAP measure must be included and must come first.  Also beware descriptive words for non-GAAP, but not GAAP measures:

The Company also expects that its full year 2016 diluted earnings per share after adjustments will be $2 – $3 per share.*

* With respect to the Company’s full year guidance, the Company is not able to provide a reconciliation of the non-GAAP financial measures to GAAP because certain items that are included have not yet occurred or are out of the Company’s control and/or cannot be reasonably predicted.  The reconciling information that is unavailable would include a forward-looking balance sheet prepared in accordance with GAAP. The probable significance of having a forward-looking GAAP balance sheet is estimated to be a variance of plus or minus 10 percent of the forward-looking earnings per share measures provided in this presentation.

What to Do Now

Reassess. Step back and reassess the company’s current use of non-GAAP financial measures for consistency with the updated CDIs, both within and outside the four corners of SEC-filed reports. The Disclosure Committee, or a subset consisting of legal, finance and investor relations personnel, may be the appropriate forum for this. If so, we suggest adding a separate workstream needs to be added to the Committee’s agenda this quarter and commencing it early in light of the nature of the required review and the need to factor in IR considerations.

Determine Whether Change Is Needed. Based on the reassessment process, determine whether any changes should be made to the company’s non-GAAP disclosure practices. Change could include the elimination of particular adjustments to GAAP-prescribed recognition and measurement methodologies previously used to calculate non-GAAP measures (as to which the Staff has raised a red flag), reformatting of the presentation of the reconciliations of non-GAAP to GAAP results, and/or providing clearer descriptions of the adjustments and explanations of why and how they are used by the company. Even if management ultimately determines that no changes are needed on the basis of its review, we recommend briefing the Audit Committee on management’s reassessment and conclusions.

Act Promptly. Any changes to the company’s use of non-GAAP measures resulting from the reassessment and review should be reflected in the company’s next earnings release, investor presentation and periodic report.

Focus on the Company’s Use of Non-GAAP Measures. Companies should continue to focus on compliance with the rules regarding non-GAAP measures, as interpreted by the SEC or its Staff and as self-correcting practices develop among companies this quarter. In addition, companies should pay particular attention to non-GAAP measures that could trigger heightened scrutiny from the Staff, shareholder activists or proxy advisory firms, such as a measure that results in significantly higher executive compensation or that transforms a GAAP loss into a non-GAAP gain.

ENDNOTE

[1] See Appendix B available here.

The preceding post is based on a 25 page memorandum produced by Weil, Gotshal & Manges LLP on June 24, 2016, which is available here.