Funds from Operations (FFO) has been a key metric for real estate investment trusts (REITs) since the National Association of Real Estate Investment Trusts (NAREIT) first adopted a definition of FFO in 1991. The SEC's recently-adopted rules governing disclosure of non-GAAP financial measures provides welcome clarification of the use of FFO and other non-GAAP financial measures. However, the SEC has also prohibited some uses of non-GAAP financial information, and it has provided cautions about others. REITs in particular should be aware of the impact of the new rules on FFO, which in some cases may require changes in how individual REITs define, calculate and publish FFO and other non-GAAP financial measures.
This article summarizes selected issues involving use of FFO by REITs in SEC filings, but does not describe all of these issues or the impact of the rules on earnings releases and other non-filed disclosures. For more information on SEC rules governing non-GAAP financial measures, the new Form 8-K requirement for earnings releases and other related information, see our advisories posted on our website at www.goodwinprocter.com under Knowledge Center > Goodwin Publications > Corporate.
The SEC rules create a two-part structure for disclosure of FFO and other non-GAAP financial measures:
- Regulation G, which applies to all public disclosures, including press releases and SEC filings, requires presentation of the most directly comparable GAAP financial measure and a quantitative reconciliation to that GAAP measure, and also prohibits material misstatements and omissions.
- Item 10 of Regulation S-K, which applies only to SEC filings, requires at least equally prominent presentation of the most directly comparable GAAP financial measure and a quantitative reconciliation, as well as an explanation of why management believes the non-GAAP financial measure provides useful information and, if material, a statement disclosing any other purposes for which management uses the non-GAAP financial measure. Note that Item 12 of Form 8-K, which requires companies to "furnish" their earnings releases for completed fiscal periods, requires these disclosures in earnings releases even though they are not "filed" with the SEC.
The new rules provide exceptions for some oral disclosures of non-GAAP financial information and for some disclosures by foreign private issuers, if the company satisfies specified conditions.
In addition to the disclosure requirements summarized above, Item 10 imposes a variety of restrictions and prohibitions on the use of non-GAAP financial measures in SEC filings. Item 10 presents issues in two areas that are of special interest to REITs: "smoothing" adjustments to FFO, and use of FFO per share.
"Smoothing" and Similar Adjustments. Under NAREIT's current definition of FFO, only unusual or non-recurring items treated as "extraordinary" under GAAP should be excluded from FFO, although not all REITs observe this practice. Under the new SEC rules, REITs will no longer be able to adjust or "smooth" FFO to eliminate "unusual" or "infrequent" items in SEC filings. The prohibition on "smoothing" adjustments includes not only the two-year period following disclosure of FFO with this type of adjustment, but also a two-year look-back on similar adjustments. The two-year look-back creates a 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. Note, however, that this and other prohibitions in Item 10 do not apply to earnings releases, even if they are "furnished" to the SEC under the new Form 8-K requirement, although REITs may wish to consider their press release and other disclosures in light of the prohibitions that apply to SEC filings.
Per Share FFO Use and Limitations. A key aspect of the new SEC rules is that they expressly permit use of per share non-GAAP measures – specifically including FFO per share – both in press releases and in SEC filings. We believe this modifies in significant ways the SEC's earlier guidance in ASR 142, Cash Flow and Other Related Data. However, the SEC also clearly stated that some uses of per share non-GAAP information are prohibited, and it issued cautions about other uses.
Although the new rules specifically allow per share FFO disclosure, the SEC stated that both GAAP and existing SEC rules prohibit per share cash flow information in materials filed with – or furnished to – the SEC. Because Form 8-K now requires companies to furnish earnings releases, companies cannot include per share cash flow information in earnings releases or other documents filed with or furnished to the SEC. This presents potential issues for REITs. FFO as defined by NAREIT is an accrual-basis measure of earnings and operating profitability. However, if a REIT makes adjustments to FFO that have the effect of turning FFO into a measure of stabilized cash flows generated by operations, dividend-paying capacity or liquidity, SEC rules could be interpreted as prohibiting per share presentation of FFO as so adjusted in earnings releases, SEC reports, and other documents filed with or furnished to the SEC.
The SEC also cautioned companies to consider whether the use of per share measures that are not calculated on a diluted basis complies with (a) the Regulation G requirement that disclosure of non-GAAP financial measure contains no material misstatements or omissions and (b) GAAP requirements (see, e.g., FASB Statement No. 128, Earnings Per Share). While not an express prohibition, this is a potentially serious caution that REITs should consider.
The new SEC rules on use of non-GAAP financial measures provide welcome clarification on use of FFO and other non-GAAP metrics by REITs. At the same time, however, these rules present significant, and sometimes subtle, compliance issues in an atmosphere of enhanced scrutiny. Interested REIT industry executives, as well as attorneys and accountants that work with REITs, will want to follow developments in this area closely.