Regulation G and Item 10(e) of regulation S-K: Conditions for Use of Non-GAAP Financial Measures


On January 22, 2003 the Securities and Exchange Commission published Release No. 34-47226 promulgating final rules that require most public companies to:

provide, under new Regulation G, additional disclosure concerning any non-GAAP financial measure contained in any public disclosure, written or oral, including disclosure of the most directly comparable GAAP financial measure and a quantitative reconciliation of the two measures; and

amend Item 10 of Regulation S-K (as well as comparable items of Regulation S-B, which applies to small business issuers, and Form 20-F, which applies to many foreign private issuers) to impose additional disclosure requirements and restrictions when a non-GAAP financial measure is included in an SEC filing.

On June 12, 2003 the Staff of the SEC's Division of Corporation Finance published Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures (the "FAQ"), which clarified the application of Regulation G and Item 10(e) of Regulation S-K in the areas of transition issues, business combination transactions, EBIT/EBITDA and other frequently used measures, and segment information, among others.

Effectiveness and Transition Rules

Regulation G applies to all disclosures as of March 28, 2003, and the Item 10(e) disclosure requirements for non-GAAP financial measures in SEC filings apply to all annual and quarterly reports filed for fiscal periods ending after March 28, 2003. The FAQ clarified the SEC's view that when annual or quarterly reports filed before March 28, 2003 are incorporated by reference into a Securities Act of 1933 registration statement filed after that date (other than one on Form S-8), the registration statement must:

comply with regulation G, with such compliance being effected through any of the following means: an amendment to the previously filed report; added reconciliation and other disclosures in the registration statement itself; or a current report on Form 8-K that identifies the non-GAAP financial measures contained in the incorporated reports and provides the required reconciliation; and

comply with Item 10(e) only with respect to non-GAAP financial measures calculated for a fiscal period ended after March 28, 2003.

Limited Exemption for Business Combination Transactions

Neither Regulation G nor Item 10(e) of regulation S-K apply to a non-GAAP financial measure included in a communication, such as a merger press release, regarding a proposed business combination, the entity resulting from the business combination transaction, or an entity that is a party to a proposed business combination transaction, if the communication is subject to the SEC's current rules on communications of such transactions (Rules 425, 14a-12, 14d-2(b)(2) or 14d-9(a)(2)). However, the FAQ states that the exemption does not extend beyond communications that are subject to those rules. Accordingly, if the same non-GAAP financial measure that was included in a communication filed under one of those rules is also disclosed in a Securities Act registration statement or an Exchange Act proxy statement or tender offer statement, the exemption does not apply.

Similarly, neither Regulation G nor Item 10(e) of regulation S-K apply to non-GAAP financial measures included in the reports or opinions of financial advisors, wherever they appear. Contrary to the exemption for merger-related press releases and similar communications, however, this exemption applies to the use of non-GAAP financial measures in any disclosure that is subject to Item 1015 of regulation M-A (Reports, Opinions, Appraisals and Negotiations); it is not limited to pre-commencement communications and will also cover Item 1015 disclosures contained in registration statements, proxy statements and tender offer statements.

Further, the FAQ states that where reconciliation of a non-GAAP financial measure is required and the most directly comparable measure is a "pro forma" measure prepared and presented in accordance with Article 11 of regulation S-X, companies may use that measure for reconciliation purposes in lieu of an "actual" GAAP financial measure.

Regulation G - All Public Disclosures of Non-GAAP Financial Measures

The SEC's approach to regulating the public disclosure of material financial information that includes a non-GAAP financial measure reflects a two-part approach, depending on where and how the non-GAAP information is disclosed. The first part, Regulation G, applies to any public disclosure, whether made in writing or orally, and whether or not the disclosure appears in a document filed with or furnished to the SEC. The second part, Item 10(e) of Regulation S-K, applies additional and more stringent requirements to periodic reports and other documents filed with the SEC that include non-GAAP financial measures.

Whenever a company publicly discloses or releases material information that includes a non-GAAP financial measure, as defined below, Regulation G requires the company to:

present the most directly comparable financial measure, calculated and presented in accordance with GAAP; and

provide a quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-GAAP financial measure presented and the most directly comparable financial measure calculated and presented in accordance with GAAP.

While the SEC did not mandate or define what "the most directly comparable" GAAP financial measure is, it cautioned that: (1) any non-GAAP liquidity measure should be balanced with disclosure of GAAP cash flows from operating, investing and financing activities; and (2) any non-GAAP performance measure should be balanced with GAAP net income or income from continuing operations. In addition, ratios where a non-GAAP financial measure is in the numerator and/or denominator of the formula must be accompanied by both: (1) a reconciliation of each separate non-GAAP measure used in the calculation; and (2) a ratio calculated using the most directly comparable GAAP financial measure(s).

Regulation G also imposes its own targeted anti-fraud provision by prohibiting presentation of any non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains a material misstatement or a material omission necessary to make the presentation of the non-GAAP financial measure not misleading, in light of the circumstances in which the information is presented. By way of illustration, when a company changes the method of calculating or presenting a non-GAAP financial measure from one period to another without a complete description of the change in that methodology, this targeted anti-fraud provision may very well be violated even if the use of the non-GAAP measure in and of itself otherwise complies with Regulation G.

"Non-GAAP Financial Measure" Defined. Regulation G defines a "non-GAAP financial measure" as a numerical measure of a company's historical or future financial performance, financial position or cash flow that:

excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with GAAP in the company's income statement, balance sheet or statement of cash flows (or equivalent statements); or

includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable GAAP measure.

This definition is intended to capture all financial metrics that depict either: (1) a measure of performance different from those presented on the face of the financial statements as calculated in accordance with GAAP; or (2) a measure of liquidity that is different from cash flows computed in accordance with GAAP. Examples include:

EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation and amortization) which, though calculated using elements derived from GAAP financial statements, are not presented in accordance with GAAP;

FFO (funds from operations), commonly disclosed by real estate investment trusts;

operating income presentations that exclude "non-recurring" expense or revenue items contrary to SEC guidance on the proper components of operating income (loss);

performance or liquidity measures that are different from GAAP measures; and

ratios that include components not calculated in accordance with GAAP.

The definition of a non-GAAP financial measure does not include financial information that does not have the effect of providing numerical measures that are different from comparable GAAP measures. Examples include:

amounts of expected indebtedness or debt repayments;

estimated revenues or expenses of a new product line, if the amounts are estimated in the same manner as the actual results would be computed under GAAP; and

measures of revenue, profit or loss and total assets for business segments that are required to be disclosed in accordance with GAAP.

Non-GAAP financial measures also do not include:

operating and other statistical measures such as: (1) unit sales; (2) numbers of employees; (3) numbers of subscribers; or (4) numbers of advertisers; or

ratios or statistical measures calculated using only one or both of GAAP financial measures and operating measures or other measures that are not non-GAAP financial measures, such as: (1) same-store sales or sales per square foot, if and only if sales figures for the store are calculated in accordance with GAAP; or (2) gross or operating margin percentages, if and only if the ratio is calculated by dividing revenues into operating income, where both revenue and operating income are calculated in accordance with GAAP.

In response to concerns raised about the application of Regulation G to financial measures used for regulatory purposes, the SEC excluded from the definition of non-GAAP financial measure any financial measure required to be disclosed by GAAP, SEC rules, or a system of regulation of a government or governmental authority or self-regulatory organization.

Forward-Looking Information. Regulation G requires companies to provide a quantitative reconciliation of forward-looking non-GAAP financial measures to the most directly comparable GAAP measure if they can do so without unreasonable effort. In the adopting release, the SEC indicated that if the most directly comparable GAAP measure is not accessible on a forward-looking basis, the company must disclose that fact, provide any reconciling information that is available without unreasonable effort, and identify any unavailable information and disclose the probable significance of that information. The SEC noted the comment that at the time companies present forward-looking non-GAAP financial measures in earnings releases, they may not have the most directly comparable GAAP measure available because they are unable to quantify certain amounts that would be required to be included in the GAAP measure, but not in the non-GAAP measure (such as realized gains on disposition of assets or the impact of accounting changes). In that case the SEC stated that a company could provide the projected non-GAAP measure, omit the quantitative reconciliation, and explain qualitatively the types of gains, losses, revenues or expenses that would need to be added to or subtracted from the non-GAAP measure to arrive at the most directly comparable GAAP measure, without attempting to quantify all those items.

Limited Exception for Oral, Telephonic or Webcast Announcements. If a company announces a non-GAAP financial measure orally, by telephone, or by Webcast or other similar means, the company can satisfy the requirements of Regulation G by posting the required disclosure and reconciliation on its Web site, provided that the required disclosure and reconciliation is available on the company's Web site at the time the non-GAAP financial measure is made public and the location of the Web site is made public in the same presentation.

Companies Subject to Regulation G. Regulation G applies to all domestic and foreign public companies, with a limited exception for foreign private issuers if:

the foreign private issuer's securities are listed or quoted on a securities exchange or inter-dealer quotation system outside the United States;

the non-GAAP financial measure is not derived from or based on a measure calculated and presented in accordance with generally accepted accounting principles in the United States; and

the disclosure is made by or on behalf of the foreign private issuer outside the United States, or is included in a written communication that is released by or on behalf of the issuer only outside the United States.


Finally, Regulation G does not apply to registered investment companies.

SEC Filings - Additional Disclosure and Restrictions on Non-GAAP Financial Measures under Item 10(e) of Regulation S-K

The SEC amended Item 10 of Regulation S-K to require additional disclosures when companies include non-GAAP financial measures in SEC filings. These conditions are in addition to the requirements of Regulation G, which also apply to SEC filings. However, unlike Regulation G, Item 10(e) applies only to SEC filings. Thus, Item 10(e) does not apply to press releases or other public announcements containing material non-public information regarding a company's results of operations or financial condition for a completed fiscal period that must be furnished to the SEC within five business days under Item 12 of Form 8-K. Item 10(e) applies to the same non-GAAP financial measures as Regulation G, but contains additional disclosure requirements and prohibitions.

Required Disclosure Concerning Non-GAAP Financial Measures. Item 10(e) requires companies that include non-GAAP financial measures in SEC filings to include the following disclosure, in addition to the disclosure required by Regulation G:

a presentation, with equal or greater prominence, of the most directly comparable GAAP financial measure;

a statement of the reasons why management believes the non-GAAP financial measure provides useful information to investors about the company's financial condition or results of operations; and

if material, a statement disclosing the additional purposes for which management uses the non-GAAP financial measure that are not otherwise disclosed.

The fact that a non-GAAP measure is used by or useful to analysts alone is not sufficient to satisfy the requirement to explain why it provides useful information to investors; the justification for presenting the measure must be substantive. The statements regarding why management believes the non-GAAP financial measure provides useful information and additional purposes for which management uses the measure may be provided in the company's most recent annual report filed with the SEC (or more recent filing), provided they are updated as necessary as of the time of the filing of a document including the non-GAAP financial measure. Accordingly, there will be no need to repeat this information each time a non-GAAP financial measure is used, so long as the previously disclosed information does not require updating to apply to that non-GAAP financial measure.

Prohibited Non-GAAP Financial Disclosure. In addition to these new disclosures, the Item 10 amendments prohibit the following specific uses and presentations of non-GAAP financial measures:

adjusting non-GAAP performance measures to eliminate or smooth items described as non-recurring, infrequent or unusual if 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;

excluding charges or liabilities that required, or will require, cash settlement from non-GAAP liquidity measures, other than EBIT and EBITDA;

presenting non-GAAP financial measures on the face of the company's GAAP financial statements or in the accompanying notes;

presenting non-GAAP financial measures on the face of any pro forma financial information required by Article 11 of Regulation S-X (for example, for material acquisitions and dispositions of assets and businesses); and

using titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, GAAP titles or descriptions.

"Smoothing" and Similar Adjustments. Under Item 10(e), companies will no longer be able to adjust non-GAAP financial measures to exclude "unusual" or "infrequent" items in SEC filings. The new rules create a four-year window on prohibited "smoothing" adjustments: the two-year period following disclosure of the non-GAAP measure with this type of adjustment, and a two-year look-back on similar adjustments. It is important to note that the two-year look-back is a bright-line test that results in an absolute block on "similar" adjustments in SEC filings during the subsequent two-year period: there is no exception for charge or gain items that were believed to be not reasonably likely to recur when made, but did in fact recur. Item 10(e) does not prohibit adjustments for charges or gain that technically qualify as "extraordinary items" for GAAP purposes.

The FAQ notes that the Item 10(e) "anti-smoothing" prohibition refers to "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" and provides guidance on the issue whether it is appropriate to eliminate or smooth an item that is identified as "recurring" as follows:

as has been clear under pre-Item 10(e) SEC Staff guidance and practice, companies should never use a non-GAAP financial measure in an attempt to smooth earnings;

while there is no per se prohibition against removing a recurring item, companies must meet the burden of demonstrating the usefulness of any measure that excludes recurring items, especially if the non-GAAP financial measure is used to evaluate performance;

it is permissible and may well be necessary to identify, discuss, and analyze material restructuring charges and other items, whether they are recurring or non-recurring, in Management's Discussion and Analysis of Financial Condition and Results of Operations. Depending on the nature and materiality of the charge or other item, it will likely be necessary to discuss the nature of such charges or other items, their recurring or non-recurring nature, their significance to an investor in evaluating the company's financial condition and/or results of operations, and whether they relate to material known trends, events or uncertainties that must be disclosed. However, whether an item may, or indeed must, be discussed in MD&A is a different question from whether it may be eliminated or adjusted in connection with a non-GAAP financial measure. Whether a non-GAAP financial measure that eliminates a recurring item or items from the most directly comparable GAAP financial measure is acceptable depends on all of the facts and circumstances. Such measures more likely would be permissible if management reasonably believes it is probable that the financial impact of the item will disappear or become immaterial within a near-term finite period. In addition, inclusion of such a measure may be misleading absent the following disclosure:
  • the manner in which management uses the non-GAAP measure to conduct or evaluate its business;
  • the economic substance behind management's decision to use such a measure;
  • the material limitations associated with use of the non-GAAP financial measure as compared to the use of the most directly comparable GAAP financial measure;
  • the manner in which management compensates for these limitations when using the non-GAAP financial measure; and
  • the substantive reasons why management believes the non-GAAP financial measure provides useful information to investors;
although for many years SEC Staff practice has been to object to the use of non-GAAP financial measures that eliminate the effect of recurring items by describing them as non-recurring, it may be permissible under Item 10(e) to use non-GAAP financial measures that eliminate recurring restructuring charges or other recurring items if those charges or items are not labeled as non-recurring. Management should consider the substantive nature of the item when determining whether to classify it as recurring or non-recurring, because merely labeling an item as non-recurring does not make it so. Whether a company can present a non-GAAP financial measure that eliminates recurring restructuring charges will depend on all the facts and circumstances. However, if:
  • there is a past pattern of restructuring charges;
  • no articulated demonstration that such charges will not continue; and
  • no other unusual reason that a company can substantiate to identify the special nature of the restructuring charges;
then it would be difficult for a company to meet the burden of disclosing why such a non-GAAP financial measure is useful to investors, and thus its use would not comply with Item 10(e) of Regulation S-K.

Non-GAAP Liquidity Measures. The provision of Item 10(e) of Regulation S-K that prohibits excluding charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures is likely to be the source of many technical and practical issues because of its breadth. In the FAQ the SEC gives guidance on a few selected topics. First, the FAQ clarifies that the requirements in Item 10(e)(1)(i) of Regulation S-K for the prominent presentation of, and reconciliation to, the most directly comparable GAAP financial measure or measures do not change the SEC Staff's historical practice of requiring the prominent presentation of amounts for the three major categories of the statement of cash flows when a non-GAAP liquidity measure is presented. Second, the FAQ states that the presentation of a measure of "free cash flow" (typically calculated as cash flows from operating activities as presented in the statement of cash flows under GAAP less capital expenditures) would not ordinarily violate the prohibitions in Item 10(e)(1)(ii). However, companies should be cautious when using such a measure because it does not have a uniform definition and its title does not describe how it is calculated. Accordingly, a clear description of its calculation, as well as the necessary reconciliation, should accompany the measure where it is used. Companies should also be careful to avoid inappropriate or potentially misleading inferences about its usefulness. All material limitations of the measure should be disclosed. For example, "free cash flow" should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures, since many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure.

In the adopting release the SEC stated that, in response to concerns that the widespread use of EBITDA (earnings before interest, taxes, depreciation and amortization) would be prohibited under the new rules, both EBITDA and EBIT (earnings before interest and taxes) would be exempted from this provision "because of their wide and recognized existing use." As a condition to this exemption, the SEC required that companies:

reconcile EBIT and EBITDA to their most directly comparable GAAP financial measures; and

in the discussion of why the measure is useful to investors, provide a discussion of why investors would find the measure valuable in the context in which it is presented, given the excluded items.

The FAQ gives guidance on how far the SEC is prepared to extend the "special status" of EBITDA and EDIT under Item 10(e):

the term "earnings" for purposes of the definition of EBIT as "earnings before interest and taxes" and EBITDA as "earnings before interest, taxes, depreciation and amortization" is intended to mean net income as presented in the statement of operations under GAAP;

measures that are calculated differently than those described as EBIT and EBITDA in the adopting release should not be characterized as "EBIT" or "EBIDTA." Instead, the titles of these measures should clearly identify the earnings measure being used and all adjustments;

these "different" measures are not exempt from the prohibition in Item 10(e)(1)(ii)(A) of Regulation S-K;

Separately the FAQ warns companies that attempt to comply with Item 10(e) by presenting EBIT, EBITDA or other similar metrics as a performance measure, rather than as a liquidity measure, that:

because EBIT and EBITDA exclude recurring charges, the discussion of recurring versus non-recurring items for purposes of the anti-smoothing prohibition must be considered carefully;

if a company is able to justify such use, EBIT or EBITDA should be reconciled to net income as presented in the statement of operations under GAAP; and

operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income.

The FAQ also addresses a key practical application of EBITDA and its Item 10(e) implications. Debt covenants often require companies to calculate EBITDA is ways that deviate from the "recognized" definition and the FAQ notes that if a company's borrowing agreement(s) contain a material covenant regarding the non-GAAP financial measure "Adjusted EBITDA" and the company wants to present "Adjusted EBITDA" in an SEC filing, the EBITDA exemption would not technically be available, and the use of "Adjusted EBITDA" would violate the Item 10(e) prohibition, if it excludes charges that are required to be settled in cash. Nonetheless, the FAQ states that insofar as MD&A requires disclosure of material items affecting liquidity, a discussion of "Adjusted EBITDA" as a parameter for compliance with debt covenants would be appropriate despite the prohibition in Item 10(e), if management believes that the borrowing agreement(s) are material, that the covenant is a material term of the agreement(s), and that information about the covenant is material to an investor's understanding of the company's financial condition and/or liquidity. If so, the company may be required to disclose "Adjusted EBITDA" as calculated by the debt covenant as part of its MD&A, and may do so for this, but no other purpose without violating Item 10(e), so long as it also discusses:

the materiality of the borrowing agreement(s) and the covenant;

the amount or limit required for compliance with the covenant; and

the actual or reasonably likely effects of compliance or non-compliance with the covenant on the company's financial condition and liquidity.

Non-GAAP Measures on a Per Share Basis. Contrary to the Item 10 amendments as originally proposed by the SEC, the final rules do not include a prohibition on the use of non-GAAP per share financial measures in SEC filings (and thus by definition in press releases or other disclosures). The adopting release attributes the change to a belief that the prohibition would have deprived investors of useful information and that the requirements of Regulation G and Item 10(e) will provide adequate protection anyway. Nonetheless, it is clear that the SEC continues to view per share non-GAAP measures with concern because of their perceived potential to mislead investors. Therefore the SEC prohibited some uses of per share non-GAAP information and issued serious cautions about other uses. Of special interest are: (1) the prohibition on per share disclosure of cash flow measures; and (2) the caution against disclosing per share information except on a diluted basis.

In a footnote (footnote 49) to the adopting release the SEC warned companies planning to disclose non-GAAP metrics on a per share basis in SEC filings which are not calculated on a diluted basis in accordance with GAAP (the SEC cites FASB Statement No. 128, Earnings Per Share) that such disclosure may violate the anti-fraud prohibitions of Regulation G and Rule 10b-5. While not an express prohibition against presenting non-GAAP measures on an undiluted basis, this is a potentially serious warning that company executives, accountants and attorneys should bear in mind.

In another footnote (footnote 11), the SEC stated that per share measures that are prohibited specifically under GAAP or SEC rules continue to be prohibited in materials filed with or furnished to the SEC. The SEC pointed specifically to the prohibition on disclosing cash flow per share set forth in paragraph 33 of FASB Statement No. 95, Statement of Cash Flows. In the FAQ the SEC refers to its Accounting Series Release No. 142 (ASR 142), Reporting Cash Flow and Other Related Data, which states "per share data other than that relating to net income, net assets and dividends should be avoided in reporting financial results." ASR 142 was issued in 1973 primarily to address the confusion over the use of cash flow per share and the basis of presentation of other non-GAAP data, and in the FAQ the SEC attempts to resolve the apparent conflict between ASR 142 and Item 10(e). In ASR 142, the Commission noted that: (1) significant questions arise as to the relevance of per share data presented on any basis other than earnings; (2) certain figures cannot logically be related to the common shareholder without adjustment; and (3) certain aggregate financial data, while of importance to analysts and management, are not items that accrue directly to the benefit of an investor in common equity. The FAQ states that while those same concerns continue to be present, the current SEC view, as reflected in Item 10(e) is that:

certain non-GAAP per share measures may be meaningful from an operating viewpoint;

however, the disclosure that explains how these measures are used by management and in what way they provide meaningful information to investors (as the per share measure would not depict the amount that accrues directly to shareholders' benefit) is critical to addressing these concerns;

also critical is a reconciliation of the measure to the GAAP financial measure of earnings per share;

the GAAP prohibition on presenting cash flow per share is maintained and per share measures of liquidity are prohibited not only in SEC filings, but also in materials furnished to the SEC under Item 12 of Form 8-K; and

that use of non-GAAP per share measures is always subject to the anti-fraud prohibitions of Regulation G and Rule 10b-5.

In yet another footnote (note 50) to the adopting release, the SEC focused on a non-GAAP financial measure that is of particular importance to the real estate industry: FFO or "funds from operations." The SEC stated specifically that FFO can be used in earnings releases as well as SEC filings on a per share basis. FFO per share is a common metric for valuing REIT stocks because it is perceived to be a better performance measure in the real estate sector than GAAP net income; REIT stocks are often valued as a multiple of FFO. The FAQ further clarifies the use of FFO by stating that:

the measure contemplated by the SEC in footnote 50 is only the measure "funds from operations" defined and clarified, as of January 1, 2000, by the National Association of Real Estate Investment Trusts ("NAREIT"); and

footnote 50 does not contemplate measures that contain modifications from the measure "funds from operations" as so defined and clarified. Accordingly, the use of such a modified measure, or a per share amount based on such a modified measure, in materials filed with the SEC would be subject to all of the provisions of Item 10(e) of Regulation S-K.

The FAQ refers to NAREIT's January 2000 definition of FFO, but makes no mention of the fact that the definition was subsequently updated in July 2000 and April 2002; neither does it contemplate that NAREIT could interpret its definition and give guidance to REITs on its application, which NAREIT routinely does. Following issuance of the FAQ, representatives of NAREIT engaged in discussions with the SEC's Staff and confirmed that the SEC did not intend for the definition of FFO to be "static." The FAQ, as so clarified, stands for the propositions that:

the measure of FFO as currently defined and clarified by NAREIT meets the requirements of Item 10(e);

the SEC is willing to consider extending this "favorable status" to future modifications and clarifications made by NAREIT to its FFO standard from time to time to address relevant changes in accounting standards, SEC rules and regulations and periodic best practices reviews; and

the use of measures that contain modifications to NAREIT's definition of FFO is not prohibited per se, but would separately be subject to all of the provisions of Item 10(e) of Regulation S-K.

FFO disclosure is likely to continue to be the source of interpretive issues under Regulation G and Item 10(e). For example, on October 1, 2003 NAREIT alerted its members that the SEC had taken the position that impairment write-downs required by GAAP should not be excluded from FFO (i.e., they should not be added back to GAAP net income in calculating FFO). That position contradicted NAREIT's own guidance, which indicated that impairment write-downs of depreciable real estate should be excluded from FFO (i.e. added back). NAREIT's position was predicated on the following reasoning:

a key objective of FFO as a metric is to exclude gains and losses on sale of real estate;

impairment write-downs are often early recognition of losses on prospective sales of property; and

therefore it would be appropriate for FFO to be calculated consistently whether a loss on depreciable real estate is recorded upon sale or in advance of an actual sale, if required by GAAP.

The SEC remained unconvinced and indicated it would issue a comment if REITs excluded impairment write-downs from FFO.

Disclosure of FFO per share is a perfect case study of the complexity of Regulation G and Item 10(e) as applied in daily practice. While it has not been common for REITs to disclose per share cash flow data as such, FFO lends itself to adjustments that arguably convert it from an accrual basis metric for earnings and operating profitability (thus a performance measure), to a measure of stabilized cash flows generated by operations or dividend-paying capacity (thus a liquidity measure). Leaving aside the issue whether some of the adjustments are prohibited as "smoothing," somewhere along this continuum, disclosure on FFO on per share basis violates the Item 10(e) prohibition against presentation of cash flows per share. The most common adjustments to FFO that require careful consideration include:

translating rents from a straight-line, GAAP accrual basis to a cash basis (i.e., reversing the so-called "straightlining of rents");

adding back non-cash amortization or write-offs of deferred financing costs to GAAP net income;

adding back deferred income taxes to GAAP net income;

adding back the non-cash portion of compensation expense to GAAP net income;

adjusting GAAP basis contingent rental income to reflect billing of contingent rents;

adjusting GAAP rental income/expense for amortization of premium/discount attributable to above/below market rents in accordance with SFAS 141, Business Combinations; and

adding back non-cash write-offs of investments in new ventures to GAAP net income.

While these types of adjustments are peculiar to FFO and the real estate industry, many other industries face similar issues when they choose to report on a per share basis non-GAAP measures that are inherently "hybrids" of performance and liquidity measures. While disclosure of these adjusted measures on an aggregate basis is not per se prohibited (subject to the anti-smoothing, cash-settlement and other prohibitions) by the new SEC rules, disclosure of cash flow metrics on a per share basis in earnings releases and other documents filed with or furnished to the SEC is per se prohibited. To be clear, companies must in all cases comply with the various definitional and presentation requirements of Regulation G and Item 10(e) summarized above, as well as applicable anti-fraud provisions.

Segment Information. Another practical issue under Item 10(e) is whether disclosing de-consolidated or dis-aggregated financial metrics on a segmented basis when the company technically does not report business segments in accordance with GAAP constitutes the use of non-GAAP financial measures. FASB Statement 131, Disclosures about Segments of an Enterprise and Related Information, requires that: (1) companies report a measure of profit or loss and total assets for each "reportable segment"; and (2) companies disclose revenues from external customers for each product and service, based on the revenue amounts reported in the financial statements. Tabular presentation is required in a note to the audited financial statements, with a reconciliation to GAAP measures and a list of each separate reconciling item. MD&A discussion of segment information is also required if necessary to an understanding of the business. The FAQ gives detailed guidance on this topic as follows:

segment information presented in conformity with FASB Statement 131 is never a non-GAAP financial measure under Regulation G and Item 10(e), because non-GAAP financial measures do not include financial measures that are required to be disclosed by GAAP. In the adopting release the SEC mentioned "measures of profit or loss and total assets for each segment required to be disclosed in accordance with GAAP" as an example of such a measure because in defining "reportable segments" those are the measures reported to the chief operating decision maker for purposes of making decisions about allocating resources to the segment and assessing its performance. However, this example was not intended to be all-inclusive. As an additional example, because FASB Statement 131 requires or expressly permits the footnotes to the company's financial statements to include specific additional financial information for each segment, that information also would be excluded from the definition of non-GAAP financial measures;

a table illustrating a breakdown of revenues by product will not be considered a non-GAAP financial measure under Regulation G and Item 10(e), if the aggregate revenues presented for each product sum to the revenue amount presented on the GAAP financial statements. The presentation, however, would be considered a non-GAAP financial measure if the revenue is adjusted in any manner;

a company may include in its MD&A a table illustrating a breakdown of revenues by geographic location and in the table: (1) adjust its GAAP revenue measure for its international operations to exclude the effects of changes in foreign exchange rates associated with the current fiscal period; and (2) present the related foreign currency effect for the period, so as to show changes in revenue derived from increases in sales volumes, prices, and exchange rates from period to period. The table will not be considered a non-GAAP financial measure under Regulation G and Item 10(e) if the aggregate revenues presented for each geographic location sum to the revenue amount presented on the GAAP financial statements. However, if the company presents the foreign exchange adjusted measure by itself, it has presented a non-GAAP financial measure;

Item 10(e) does not prohibit the discussion in MD&A of segment information determined in conformity with FASB Statement 131. On the contrary, a company may be required to do so, if such a discussion is necessary to an understanding of the business and the discussion generally would include the measures reported in the footnotes to the company's financial statements. FASB Statement 131 requires footnote disclosure of segment profit or loss, segment total assets, and other specified segment measures. If the first discussion of segment data in a company's disclosure document precedes the financial statements – for example, in the MD&A – the company should either: (1) present the FASB Statement 131-required information in the MD&A; or (2) include a cross reference in the MD&A to the FASB Statement 131-required information in the footnote to the financial statements. Under FASB Statement 131, a company may determine segment profitability on a basis that differs from consolidated operating profit as defined by GAAP or excludes the effects of items attributable to that segment. In this situation, FASB Statement 131 requires that a footnote to the company's consolidated financial statements provide a reconciliation. Where a company includes in its MD&A a discussion of segment profitability determined in such a manner, the company also should include in the segment discussion in the MD&A a complete discussion of the reconciling items that apply to the particular segment being discussed (see Financial Reporting Codification Section 501.01.a, footnote 28, as added by Commission Release 33-7620, Segment Reporting);

measures of segment profit/loss or liquidity that are not in conformity with FASB Statement 131 are non-GAAP financial measures under Regulation G and Item 10(e) of Regulation S-K if they are adjusted to include amounts excluded from, or to exclude amounts included in, the measure reported to the chief operating decision maker for purposes of making decisions about allocating resources to a reportable segment and assessing its performance. Further, the SEC's Staff believes it would be difficult to demonstrate that segment measures that are not reported to or used by the chief operating decision maker, or otherwise are not in conformity with FASB Statement 131, are useful for investors; and

the presentation of a "consolidated" segment profit or loss measure consisting of the total of the profit or loss for all individual segments in any context other than the reconciliation required by FASB Statement 131 in a footnote to the financial statements would be the presentation of a non-GAAP financial measure, because it has "no authoritative meaning outside of the FASB Statement 131-required reconciliation in the footnotes to the company's consolidated financial statements."

Key Differences Between Regulation G and Rules for SEC Filings. There are several differences between the requirements of Regulation G generally and the Item 10(e) requirements for the use of non-GAAP financial measures in SEC filings. The principal differences are:

Regulation G does not require companies to present the GAAP financial measure with equal or greater prominence than the comparable non-GAAP financial measure;

Regulation G does not require companies to disclose the purposes for which management uses the non-GAAP financial measure, nor why management believes the non-GAAP financial measure provides useful information to investors;

Item 10(e) prohibits "smoothing" adjustments to non-GAAP performance measures only in documents filed with the SEC, not in press releases, even if they are "furnished" to the SEC under Item 9 or Item 12 of Form 8-K (as now required for earnings releases); and

Item 10(e) prohibits excluding charges or liabilities that required, or will require, cash settlement from non-GAAP liquidity measures, other than EBIT and EBITDA, only in documents filed with the SEC, not in press releases, even if they are "furnished" to the SEC under Item 9 or Item 12 of Form 8-K (as now required for earnings releases).

It is possible that this bifurcated regime will lead some companies to adopt a two-track approach to non-GAAP financial disclosures depending on whether or not a particular non-GAAP measure is used in materials filed with the SEC. However, if for example a company makes adjustments that do not comply with Item 10(e) to a non-GAAP financial measure in a press release, it must then be careful not to: (1) file the press release under Item 5 of Form 8-K; (2) include the adjustments in a Form 10-K or 10-Q or other report filed under the Exchange Act; or (3) repeat the adjusted non-GAAP measure in a registration statement filed under the Securities Act. It is worth noting that public companies do sometimes elect to file earnings press releases under Item 5 of Form 8-K (for example, to update material information incorporated by reference with respect to take-down offerings under a shelf registration statement in advance of filing the Form 10-Q report for a completed quarter) or include their substance as "recent developments" or marketing detail in prospectuses. Doing so when a prohibited adjustment has been made in the press release would result in an automatic violation of Item 10(e). It may also be worth considering the risk of confusion to investors from disclosing a particular non-GAAP measure "as adjusted" in a press release that cannot also be disclosed in the company's periodic SEC reports.

Companies Subject to the New Disclosure Requirements. The new disclosure requirements and restrictions on non-GAAP financial measures in SEC filings apply to all domestic and many foreign companies. The exception for foreign private issuers is different from the exception provided in Regulation G, and more limited. The disclosure requirements will apply to non-GAAP financial measures in filings by foreign private issuers on Form 20-F unless the non-GAAP financial measure is:

required or expressly permitted by the generally accepted accounting principles used in the company's primary financial statements; and

contained in the company's annual report for its home jurisdiction or market.

The amendments to Item 10 and Form 20-F will not apply to Canadian filers that file Form 40-F, nor will they apply to registered investment companies. The FAQ addresses the applicability of the new rules to "voluntary filers" (companies whose reporting obligation under Section 15(d) of the Exchange Act is suspended automatically under the statute, but choose not to file the notice required by Rule 15d-6 and continue to file Exchange Act reports) as follows:

compliance with Item 10(e) is required because voluntary filings are nonetheless filings with the SEC; and

compliance with regulation G with respect to other public communications that are not filed with the SEC technically is not required. However, the SEC's Staff cautions that insofar as voluntary filers create the "appearance" in the markets of being a public company, failure to comply with all requirements (including Regulation G) applicable to reporting companies can raise significant issues under the general anti-fraud provisions of the federal securities laws.