Not GAAP Is Not Always Non-GAAP

When is quantitative disclosure that’s not GAAP considered a non-GAAP financial measure and when is it not? To answer that question requires a brief history lesson on non-GAAP financial measures.

Almost 20 years ago, the SEC adopted Regulation G and amendments to Item 10(e) of Regulation S-K.  This relatively mundane regulatory act defined in one stroke a new regulatory discipline for financial, accounting, and legal professionals who work with public companies: non-GAAP financial measures, which soon became known as “NGFMs”.  Non-GAAP financial disclosure had been a quiet area: the most recent written SEC staff pronouncement was Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data, published in 1973.  Remarkably, the SEC Division of Enforcement brought the first enforcement action involving non-GAAP financial disclosure in a company earnings release in 2002, relying on general anti-fraud prohibitions.

As Julius Caesar had done with Gaul nearly two thousand years earlier, the SEC divided the world of NGFMs into three parts.  These included (1) all public communications, however made; (2) documents legally considered “filed” with the SEC; and, between them, (3) public communications containing material non-public financial information released by or on behalf of a company about its results of operations or financial condition for a completed quarterly or annual fiscal period, which are required to be furnished under Item 2.02 of Form 8-K.  The most common example of this third type is quarterly “earnings releases” issued by public companies, although other communications can fall into this category.  Fortunately for all concerned, the geographical boundaries between these three – the “where” of NGFM disclosure – are generally clear.

What is sometimes more subtle is what is a NGFM, which determines whether specific disclosure statements are subject to Regulation G and Item 10(e) in the first place.  It is usually easy to determine whether the disclosure is a GAAP financial measure by referring to the company’s financial statements, but the use of quantitative financial and operating measures that are not defined as NGFM under SEC rules continues to expand.

The distinction makes a big difference.  For example, companies must always provide a reconciliation to the most directly comparable GAAP equivalent, regardless of how the company discloses a NGFM.  Further, NGFMs in materials filed or furnished under SEC rules must satisfy the “equal or greater prominence” requirement of Item 10(e), which in practice means that the comparable GAAP financial measure must appear first in the body of the document or communication, in charts and tables and in press release headlines.

So we return to the question: when is quantitative disclosure that’s not GAAP considered a NGFM and when is it not?  In very general terms, a NGFM is a numerical financial measure that reflects adjustments not permitted or required by GAAP.  Because the application of this definition may not always be clear, Regulation G specifically excludes operating and other financial measures and ratios and statistical measures calculated using financial measures calculated in accordance with GAAP and/or the somewhat circular and often less than helpful category of “operating measures or other measures that are not non-GAAP financial measures.” The Financial Reporting Manual, prepared by the Division of Corporation Finance, provides a series of examples, including among others the following:

  • operating and statistical measures (such as unit sales, number of employees, number of subscribers), and
  • ratios or statistical measures that are calculated using exclusively operating measures or other measures that are not non-GAAP measures (such as dollar revenues per square foot for hotels, same store sales, and revenues per slot machine for casinos, assuming that sales/revenues for each measure is based on GAAP numbers).

Because metrics such as those listed above are not NGFM, they are not subject to the requirements that apply to NGFMs.  Further, even if “adjusted,” since they were not derived from GAAP financial measures, “adjustments” that would be problematic if applied to a GAAP financial measure are not per se problematic in these cases.  Of course, general anti-fraud provisions of the federal securities laws and SEC rules always apply.  In addition, since many of these metrics are likely to be “key performance indicators,” or KPIs, companies should consider the factors cited in the interpretive guidance issued by the SEC in 2020:

  • Is the metric subject to an existing regulatory framework, such as GAAP or SEC rules on NGFM (both of which we have assumed away for purposes of this discussion)?
  • Is the metric clearly defined and the company’s calculation method clearly disclosed?
  • Has the company explained why the metric is useful to investors and how management uses the metric to manage or monitor the company’s business?
  • Is the metric presented in a manner that is consistent with prior disclosure? If not, has the company disclosed how the current presentation differs, the reasons for the change(s) and the impact of any changes on the disclosure?  Is it necessary to recast prior disclosure to facilitate comparison between periods?

Of course, companies should understand that use of these metrics requires understanding why the metric is material.  Equally important, it is worth noting the analysis that leads to the determination that the metric was not a NGFM, because disclosing these metrics increases the chances of receiving a comment letter from the SEC staff asking about the presentation and use of the metric, but reading the comment letters available in the SEC’s EDGAR system shows that many of these comment letters are ultimately resolved with modest or no changes in the company’s future disclosures.

So returning to our question, we can feel more comfortable that the geography of quantitative disclosure is bigger than GAAP financial measures and non-GAAP financial measures.  Thoughtful companies – and lawyers – can navigate the alternative ecosystem of operating and statistical metrics that are neither GAAP nor non-GAAP but merely not GAAP.