December 2003

SEC Regulations G, S-B, and S-K: Reporting Non-GAAP Financial Measures

By Robert Bloom and David Schirm, John Carroll University

In recent years, many companies have publicly emphasized earnings figures that do not conform to GAAP, excluding nonrecurring charges from those measures. Companies often report such charges, including restructuring costs and inventory writedowns, year after year. Some major companies have reported unusual charges in successive years and then excluded such charges from their pro forma earnings because they view such charges as irregular and nonrecurring. In an effort to enhance disclosure still further, the SEC, in implementing section 401(b) of the Sarbanes-Oxley Act, has addressed the issue of “pro forma” financial measures.

Discussion

The SEC has just adopted Regulation G, which deals with non-GAAP measures in financial reporting. This regulation mandates a reconciliation of non-GAAP to GAAP measures in all public announcements, including press releases and other forms of communication, which could effectively reduce the use of non-GAAP measures in business communications.

According to Regulation G, a non-GAAP measure is a numerical measure of a company’s financial position or performance that is not in accordance with GAAP, usually because the measure excludes or includes what the “most directly comparable” GAAP measure would contain. The more common term for non-GAAP measures is “pro forma”; however, that term is also used in connection with GAAP. For example, changes in accounting methods require “pro forma” earnings in comparative financial statements as if the new method had been used all along.

Non-GAAP measures do not include:

Regulation G does not apply to:

Examples of non-GAAP earnings measures include operating earnings per share; pro forma earnings per share; income excluding restructuring charges; and EBIT excluding nonrecurring charges. Excluded from non-GAAP measures would be such items as ratios computed on the basis of GAAP; financial regulatory measures; and statistical measures: for example, unit sales, amounts of expected indebtedness, amounts of planned debt repayments, or estimated revenues pertaining to a new product line (assuming they were estimated using GAAP).

Regulation G does not apply to disclosures of non-GAAP financial measures constituting the forecasted results of a proposed business combination nor to the entity stemming from the combination, nor to a party to the business combination. Regulation G pertains only to non-GAAP measures that have corresponding GAAP measures. While the regulation requires a reconciliation of the non-GAAP figures to the “most directly comparable GAAP” figures, there is no comparative presentation in the regulation providing such measures.

In companion regulations, the SEC has released an amendment to Item 10 of both Regulations S-K and S-B that deals with non-GAAP measures in SEC reporting. The same definitions in Regulation G apply here. However, the requirements for Regulations S-K and S-B call not only for reconciling the non-GAAP financial measure to its most directly comparable GAAP measure, but also for presenting it with at least as much prominence as its non-GAAP counterpart and for explaining why the non-GAAP financial measure provides useful information. In addition, Regulations S-K and S-B prohibit companies from the following actions:

The following disclosure activities are not prohibited under Regulations S-K and S-B:

Moreover, Regulations G, S-B, and S-K do not require a reconciliation of non-GAAP forward-looking measures to their GAAP counterparts if the forward-looking measures can be obtained only with unreasonable effort.

Analysis

The rationale for these new requirements to reconcile GAAP numbers to non-GAAP figures is to promote truthful financial disclosures to the public in plain English. In the recent past, too many high-profile companies have used non-GAAP measures to obscure their GAAP performance, especially in corporate press releases and other announcements.

One has to wonder why the SEC decided not to prohibit non-GAAP measures entirely. The SEC’s allowance of pro forma earnings evidently indicates that the Commission believes such measures have some validity, perhaps in assisting investors to determine regular, recurring income figures. It remains to be seen to what extent these regulations will curb the use of pro forma figures in corporate communications of all kinds.


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