The Securities and Exchange Commission (the "SEC") adopted rules on January 15, 2002 (the "Final Rules") addressing the disclosure of financial information that is prepared other than in accordance with generally accepted accounting principles ("GAAP"). Release No. 33-8176, 34-47226 (January 22, 2003). The Final Rules cover the requirements of Section 401(b) of the Sarbanes-Oxley Act of 2002 (the "Act") and became effective on March 28, 2003.
Contents of the Final Rules
The Final Rules (1) create a new Regulation G, which will apply whenever a company publicly discloses or releases material non-public information that includes a non-GAAP financial measure; and (2) amend the prior set of rules governing the use of non-GAAP financial measures in SEC filings. While Section 401(b) of the Act refers to "pro forma financial information," in order to avoid confusion with other uses of that term in existing regulations, the Final Rules use the new term, "non-GAAP financial measure."
The SEC has also adopted, as part of the Final Rules, a new requirement that a company furnish, on Form 8-K, any earnings release or similar announcement of material non-public financial information for any completed fiscal period (regardless of whether such release or announcement includes any non-GAAP financial measures), beginning with releases issued on March 28, 2003. In the SEC's proposing release, the SEC cited, as a basis for such new requirement, Section 409 of the Act which obligates public companies to "disclose to the public on a rapid and current basis" such additional information concerning material changes in the financial condition or operations of the company as the SEC determines is necessary to protect investors. Release No. No. 33-8145, 34-46788 (November 5, 2002).
Effective Date
Regulation G will apply to all subject disclosures as of March 28, 2003. The new Form 8-K requirements will apply to Financial Releases made after March 28, 2003. The new disclosure requirements for SEC filings will apply to any annual or quarterly report filed with respect to a fiscal period ending after March 28, 2003.
Definition of Non-GAAP Financial Measures
Under the Final Rules, a "non-GAAP financial measure" is a numerical measure of the company's historical or future financial performance, financial position or cash flows 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 statement of income, balance sheet or statement of cash flows (or equivalent statements) of the company; 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 so calculated and presented.
The SEC has made clear in the adopting release that it intends that the definition of non-GAAP financial measure include all measures that have the effect of depicting either:
- a measure of performance that is different from that presented in the financial statements, such as income or loss before taxes or net income or loss, as calculated in accordance with GAAP; or
- a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP.
Examples of commonly used non-GAAP financial measures include EBITDA, FFO (funds from operations, a REIT concept) and a measure of operating results such as income that excludes "non-recurring" expense or revenue items. The definition of non-GAAP financial measures specifically excludes:
- operating and other statistical measures;
- ratios or measures calculated using only:
- financial measures calculated in accordance with GAAP; and/or
- operating measures or other measures that are not non-GAAP financial measures; and
- financial measures required to be disclosed by GAAP, SEC rules, or a system of regulation applicable to the company (this last exclusion was not in the rules originally proposed by the SEC (the "Proposed Rules")).
Examples of the types of measures that are not non-GAAP financial measures include:
- operating measures, such as unit sales, numbers of employees, numbers of subscribers and numbers of advertisers;
- sales per square foot or same store sales (assuming the sales figures were calculated in accordance with GAAP);
- unexpected indebtedness, including contracted and anticipated amounts;
- repayments that have been planned or decided upon but not yet made;
- estimated revenues or expenses of a new product line, so long as such amounts were estimated as GAAP figures;
- measures of profit or loss and total assets for each segment required to be disclosed in accordance with GAAP; and
- measures of capital or reserves calculated for a regulatory purpose.
Regulation G: Disclosure and Reconciliation of Non-GAAP Financial Measures in Earnings Releases
The SEC has adopted a new Regulation G, which will apply whenever a public company discloses or releases publicly any material non-public information that includes a non-GAAP financial measure. Regulation G, as adopted, applies to any entity that is required to file reports under Sections 13(a) or 15(d) of the Exchange Act, other than a registered investment company. Under Regulation G, the company will be required to include, in the same disclosure or release, (1) a presentation of the most directly comparable GAAP financial measure and (2) a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure. In the Final Rules, the SEC changed the requirement the GAAP presentation requirement from the proposed "comparable [GAAP] financial measure or measures" to "most directly comparable [GAAP] financial measure or measures" (emphasis added). Because there are many different conventions for defining common non-GAAP financial measures such as EBITDA, the Final Rules will require companies that use such non-GAAP financial measures to present them together with GAAP information in a way that will be clearly understandable by investors.
While the SEC indicated that registrants had the flexibility to determine what was the most directly comparable GAAP financial measure, it also indicated that it believes:
- non-GAAP financial measures that measure cash or "funds" generated from operations should be balanced with disclosure of amounts from the statement of cash flows; and
- non-GAAP financial measures that depict performance should be balanced with net income, or income from continuing operations, taken from the statement of operations.
The reconciliation (through a schedule or other detailed presentation) must be quantitative for historic measures and, to the extent available without unreasonable efforts, for prospective measures. If the prospective GAAP financial measure is not accessible, the company must identify the unavailable information and disclose its probable significance.
Regulation G also provides that a non-GAAP financial measure, taken together with the accompanying information, may not misstate a material fact or omit to state a material fact necessary to make the presentation of the non-GAAP financial measure not misleading, in light of the circumstances under which it is presented.
Regulation G does not prohibit the use of any non-GAAP financial measures.
The SEC declined to define "public disclosure" under Regulation G. In the adopting release, the SEC stated that Regulation FD, which defines "public disclosure," is inapposite in this respect, because under Regulation FD public disclosure is the requirement, not the triggering event as it is for Regulation G.
If a non-GAAP financial measure is released orally, telephonically, in a webcast or broadcast, or by similar means, Regulation G will permit a company to provide the required accompanying information by posting it on the company's website. The company must disclose the location and availability of the required accompanying information during its presentation. While Regulation G does not state how long a company must maintain this information on its website, in the adopting release the SEC encourages companies to provide website access to this information for at least 12 months.
Although this oral disclosure exception seems broad, the SEC has informally indicated that this exception was meant to apply principally to quarterly analysts calls, not to every conversation. Companies should be alert to the fact that Regulation FD will still apply to this type of disclosure. The SEC indicates that it expects Regulation FD and Regulation G to operate "in tandem." For example, a private communication of material, non-public information will trigger a requirement for public disclosure under Regulation FD and if that disclosure contains a non-GAAP financial measure, Regulation G will also apply.
The SEC also adopted two other exceptions to Regulation G. The first relates to foreign private issuers and is discussed below. The second relates to the disclosure of proposed business combination transactions. This exception was not in the Proposed Rules but was added by the SEC in response to comments. Disclosure with respect to non-GAAP financial measures relating to a proposed business combination transaction (or an entity resulting from, or party to the transaction) will not be subject to Regulation G if the disclosure is contained in a communication subject to existing SEC communications rules applicable to business combinations.
Disclosure and Reconciliation of Non-GAAP Financial Measures in SEC Filings
The SEC has also amended the rules concerning the use of non-GAAP financial measures in filings made with the SEC. Like Regulation G, these amendments do not apply to registered investment companies. The amended rules apply to the same categories of non-GAAP financial measures as Regulation G but these rules contain more detailed and stringent requirements regarding use of such non-GAAP financial measures, including a requirement that the company disclose why investors would find the information useful and, to the extent the information is material and not duplicative, why the company uses the measure. This last requirement may be satisfied by including these explanatory statements in the most recent annual report filed with the SEC and updating those statements as necessary. The SEC emphasized that these statements should not be boilerplate, but must be specific to the company and the nature of its business and industry.
The rules also require that the most directly comparable GAAP measure be presented with equal or greater prominence as the non-GAAP financial measure.
Like Regulation G, the amended disclosure rules provide an "unreasonable effort" exception for forward-looking information to the requirement for a quantitative reconciliation between the non-GAAP financial measure and the comparable GAAP financial measure.
Under the new rules, companies would be prohibited from:
- 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, other than the measures EBIT and EBITDA;
- adjusting a non-GAAP performance measure to eliminate non-recurring charges or gains if (1) such charges or gains are reasonably likely to recur within two years or (2) there were similar charges or gains within the prior two years;
- presenting non-GAAP financial measures on the face of (1) financial statements prepared in accordance with GAAP or in the accompanying notes or (2) pro forma financial information required to be disclosed under Regulation S-X; or
- using titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures.
In the Final Rules, the SEC dropped the proposed prohibition on the use of "non-GAAP per share measures." Per share measures that are specifically prohibited under GAAP or other SEC rules will continue to be prohibited, for example cash flow per share (FASB Statement No. 95 "Statement of Cash Flows"). In addition, the measures EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation, and amortization) have been specifically exempted from the prohibition on 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. Finally, the "anti-smoothing" provision (see the second bullet point in the list of prohibitions above) has been clarified by limiting the review to two-year time frames for both past and future charges or gains.
The SEC indicated that the requirements and prohibitions set forth in the Final Rules are generally consistent with the staff's historical practice when reviewing filings containing non-GAAP financial measures. However, these requirements may have an impact on current common practices of some companies. For example, the "anti-smoothing" prohibition will mean that where a company has a restructuring charge or acquisition expense that it is writing off over a period of 3-4 years, it will no longer be able to show financials carving out the charge or expense. Similarly, many companies, particularly those with debt outstanding, report EBITDA or net current assets as adjusted by the debt covenants since investors are interested how much leeway the company has on its covenants.
Like Regulation G, these disclosure requirements provide an exception (added in the Final Rules) for the disclosure of proposed business combination transactions. The other exceptions in Regulation G (for oral disclosures and for certain disclosures by foreign private issuers) do not apply to disclosures by foreign private issuers in SEC filings.
Furnishing Earnings and Other Financial Releases on Form 8-K
The Final Rules will require companies to furnish any earnings release or similar announcement that publicly discloses material non-public financial information for any completed fiscal period (each, a "Financial Release") under a new Item 12 of Form 8-K within five business days of making a Financial Release. This deadline is temporary, and may be shortened when the SEC addresses its proposal (Release No. 33-8106) to shorten the filing deadline for all reports on Form 8-K. The Final Rules do not require the issuance of Financial Releases, but the issuance of a Financial Release will trigger the requirements of Item 12. The requirement to furnish Financial Releases will not apply to companies that only disclose earnings (or other material non-public information) in quarterly and annual reports filed with the SEC. A company that provides a report to shareholders containing a Financial Release will also be permitted to specify in the Form 8-K which portion of the report contains the information being furnished under Item 12.
Although new Item 12 of Form 8-K was proposed by the SEC along with the new disclosure for non-GAAP financial measures, Item 12 will apply whether or not the Financial Release includes a non-GAAP financial measure. Financial Releases that contain non-GAAP financial measures will also be subject to new Regulation G. However, the SEC adopted an additional requirement as part of Item 12, not contained in Regulation G as adopted or in Item 12 as proposed, that applies to Financial Releases containing non-GAAP financial measures. Financial Releases containing non-GAAP financial measures must be accompanied by disclosure (either in the release or in the Form 8-K) indicating why investors would find the information useful and, to the extent the information is material and not duplicative, why the company uses the measure. This additional requirement is identical to one of the requirements imposed by the Final Rules on disclosure of non-GAAP financial measures in SEC filings.
Item 12 contains a limited exception for Financial Releases made orally, telephonically, by webcast, broadcast or similar means where:
- the related release or announcement has been furnished to the SEC on Form 8-K pursuant to Item 12 prior to the presentation;
- the presentation is accessible to the public by dial-in conference call, webcast or similar technology;
- the financial and statistical information contained in the presentation is provided on the company's website, together with any information required by the proposed Regulation G (in the case of non-GAAP financial measures); and
- the presentation was announced by a widely disseminated press release that included instructions as to when and how to access the presentation and the location where the information would be available on the website.
As proposed, Item 12 would have required a Financial Release to be "filed," rather than "furnished," under Form 8-K. The principal differences between filing and furnishing information to the SEC are that furnished information (1) is not subject to the liability provisions of Section 18 of the Exchange Act, and (2) is not automatically incorporated by reference into SEC filings. After consideration by the SEC of comments indicating that the need to "file" earnings releases would have a chilling effect on their use, Item 12 as adopted requires that Financial Releases be furnished on Form 8-K.
Financial Releases are already subject to Regulation FD. Regulation FD requires that whenever a public company, or any person acting on its behalf, discloses material nonpublic information to certain enumerated persons, the company must simultaneously, in the case of intentional disclosures, or promptly, in the case of unintentional disclosures, make public disclosure of that same information. The Regulation defines the outer boundary for "prompt disclosure" as the later of (i) 24 hours or (ii) the commencement of the next day's trading on the New York Stock Exchange (regardless of where a company's stock is traded), in each case after a senior company official learns of the disclosure. "Public disclosure" can be made under Regulation FD either by (1) a filing under Item 5 (which are deemed "filed") or Item 9 (which are deemed "furnished") of Form 8-K or (2) a method, or combination of methods, of public disclosure reasonably designed to provide a broad, non-exclusionary distribution of information to the public.
While Item 12 always requires the use of Form 8-K, Regulation FD can be satisfied either by use of Form 8-K or by other means. In addition, Item 9 of Form 8-K (the item used for information furnished on Form 8-K pursuant to Regulation FD) provides a shorter time period for furnishing information than Item 12. If a company wished to satisfy both Regulation FD and Item 12 with one SEC submission, it could do so by:
- furnishing the information within the timeframe required by Regulation FD,
- satisfying the requirements of both Item 9 and Item 12, and
- indicating that the Financial Release is being furnished under both Items 9 and 12.
However, if a company met the requirements of Regulation FD other than through the use of Form 8-K, the Financial Release would still be required to be furnished under Item 12.
Because Item 12 would only apply to information concerning a completed fiscal period, it would not apply to public disclosure of earnings estimates for future or ongoing fiscal periods, unless those estimates are included in a Financial Release regarding a completed fiscal period.
Interaction with Rule 10b-5
Regulation G expressly provides that nothing in Regulation G "shall affect any person's liability under Exchange Act Section 10(b) or Rule 10b-5 thereunder." A violation of Regulation G would not automatically result in a violation of Rule 10b-5. The facts and circumstances surrounding a violation of Regulation G, however, may give rise to a Rule 10b-5 violation if all the elements for a Rule 10b-5 violation are present. The SEC noted that, under certain circumstances, non-GAAP financial measures could mislead investors if they obscure the company's GAAP results, and thus could give rise to a Rule 10b-5 violation.
Impact on Foreign Private Issuers
"GAAP," in the context of the definition of "non-GAAP financial measures," refers to U.S. GAAP. However, for foreign private issuers whose primary financial statements are prepared in accordance with GAAP other than U.S. GAAP, references to "GAAP" refers to the principles under which those primary financial statements are prepared (this was clarified in the Final Rules). For foreign private issuers that include a non-GAAP financial measure derived from or based on a measure calculated in accordance with U.S. GAAP, "GAAP" refers to U.S. GAAP for purposes of the application of the Final Rules to the disclosure of that measure.
Regulation G. The Final Rules apply to foreign private issuers, subject to a limited exception for disclosures made primarily outside of the United States. In creating this exception, and in refining it in the Final Rules, the SEC focused on whether the disclosed financial measure relates to U.S. GAAP and whether the disclosure is targeted at United States investors. In the Final Rules, the safe harbor was revised to (1) make the subject matter of the exception non-GAAP financial measures not derived from U.S. GAAP measures and (2) permit communications in the United States contemporaneously with communications outside the United States, so long as the communications are not targeted at persons in the United States;
Regulation G will not apply to public disclosure of a non-GAAP financial measure by a foreign private issuer if:
- the securities of the issuer are listed or quoted outside the United States;
- the non-GAAP financial measure is not derived from a U.S. GAAP measure; and
- the disclosure is made outside the United States, or is included in a written communication released outside the United States.
The exception will continue to apply even if:
- the communication is released in the United States, as long as it is released contemporaneously with or after the release outside the United States and is not targeted at persons in the United States;
- journalists or other third parties have access to the information;
- the information is available on the issuer's website or websites, as long as the websites, taken together, are not targeted at, or made exclusively available to, United States persons; or
- the information is later submitted on a Form 6-K.
Disclosure of Non-GAAP Financial Measures in SEC Filings. Unlike Regulation G, there is no limited exception for foreign private issuers to the disclosure rules governing the use of non-GAAP financial measures in SEC filings. However, a non-GAAP financial measure that would otherwise be prohibited will be permitted in a Form 20-F filing if the non-GAAP financial measure was (1) required or expressly permitted under the GAAP used in the issuer's primary financial statements and (2) was included in the issuer's annual report or financial statements used in its home jurisdiction. In the adopting release, the SEC stated that this exception applies only where the use of the measure is expressly permitted, not where it is merely not prohibited.
The new rules regarding non-GAAP financial measures do not apply to Form 6-K because financial statements submitted under Form 6-K are not required to comply with United States disclosure requirements.
In addition, Canadian filers on Form 40-F under the Multi-Jurisdictional Disclosure System are not subject to the new disclosure rules because Canadian disclosure form requirements generally dictate the required disclosure in filings with the SEC.
Furnishing Earnings and Other Financial Releases on Form 8-K. Because foreign private issuers do not use Form 8-K, they will not be subject to the additional requirements governing furnishing of Financial Releases.