Question

Discuss the following regarding non-GAAP financial measures used in publicly held companies’ reports filed with the SEC. Don’t just give a short answer but have a discussion on each question:

1. Discuss how non-GAAP financial reporting has impacted GE.

Answer 1

Since 2003, when the SEC first adopted rules regarding the use of non-GAAP financial measures, there has been a constant tension between the utility of these measures and their potential to mislead investors. In recent years, the use of non-GAAP measures in public company filings has significantly increased, as has the discrepancy between these measures and their GAAP equivalents. The SEC has taken note of these trends and, since 2016, has correspondingly escalated its scrutiny of non-GAAP disclosures. In 2018, the SEC indicated that it may further intensify its enforcement in this area for the protection of investors.

Increased Use and Variance of Non-GAAP Measures

Nearly all large public companies now report non-GAAP metrics in their financial statements. In 1996, around 60 percent of S&P 500 companies reported at least one non-GAAP earnings-per-share figure. Today, according to Audit Analytics, over 97 percent of S&P 500 companies use at least one non-GAAP metric in their financial statements. Item 10(e)(1)(i)(A) of Regulation S-K states that an issuer including non-GAAP financial measures in SEC filings must present, with equal or greater prominence, the most directly comparable financial measures calculated and presented in accordance with GAAP.

Along with the use of non-GAAP metrics, the discrepancy between GAAP and non-GAAP measures has been growing, and non-GAAP measures are invariably more favorable. In 2015, pro forma earnings-per-share were 30 percent higher on average than GAAP EPS for companies in the S&P 500. Notably, in an August 2018 comment letter, the SEC instructed an issuer not to title non-GAAP measures “pro forma” but instead, “as adjusted” if the measures do not comply with Article 11 of Regulation S-X—another indication that the SEC is keen to ensure that investors are not misled by the presentation of non-GAAP financial statements.

Increased SEC Scrutiny and Enforcement

In 2016, then-SEC Chair Mary Jo White indicated that the prevalence of non-GAAP financial measures could be confusing to investors. The SEC highlighted the issue in a number of its 2016 and 2017 comment letters, with over 35 percent of comment letters addressing the use of a non-GAAP metric in those years. Though this percentage decreased to 25 percent in the first half of 2018, the overall trend is one of heightening scrutiny: From January 2010 to June 2018, the number of comment letters issued by the SEC has dramatically decreased, but the percentage of letters addressing non-GAAP measures has grown.

It is clear that the SEC Staff under Chairman Jay Clayton is continuing to focus on this issue, and this scrutiny has led to an enforcement action in at least one case. In the first half of 2018, 22 percent of non-GAAP related comments addressed the presentation of non-GAAP measures with undue prominence, by far the most common issue addressed. At the end of 2018, the SEC instituted an enforcement action against an issuer for failing to afford “equal or greater prominence to comparable GAAP financial measures” in filings containing non-GAAP financial measures. The company settled the action in December by paying a $100,000 civil money penalty and agreeing to cease and desist from such practices. It is notable that the enforcement action stemmed only from the issue of prominence in presentation, as the settlement suggested neither that the issuer formulated the non-GAAP measure in a misleading way, nor that the issuer used it inconsistently. Though the SEC has addressed this issue in hundreds of comment letters and has updated Compliance & Disclosure Interpretations on the topic, this is the first enforcement action regarding the failure to present comparable GAAP measures with equal or greater prominence.

In comments at the AICPA Conference on SEC and PCAOB Developments in December 2018, Chairman Clayton emphasized the importance of consistency in the reporting of non-GAAP numbers and key performance indicators. As Chairman Clayton observed, non-GAAP reporting should reflect how management actually operates and views the business. As non-GAAP measures are reported precisely in order to show higher EPS and a more favorable price-to-earnings ratio than their GAAP equivalents, it is important for issuers to be rigorous in their application of the disclosure requirements so as not to paint a misleadingly rosy picture.

Board Oversight of Non-GAAP Disclosures

In his prepared statement at the AICPA conference, SEC Chief Accountant Wesley Bricker discussed the role of independent audit committees, which are tasked by the board of directors with oversight of financial reporting. He emphasized the need for each audit committee to stay current with respect to financial reporting requirements, as only an audit committee that is both financially literate and up-to-date will be able to effectively oversee and, where necessary, challenge management decisions on complex financial issues. Directors on Audit Committees may wish to review their issuer’s practices with respect to using non-GAAP financial measures in order to confirm that appropriate processes are in place to ensure compliance with the SEC requirements regarding the presentation of non-GAAP financial information. Appropriate disclosure controls depend upon the rigor with which processes are followed and the consistent use of good judgment. Both Mr. Bricker and Chairman Clayton spoke at the AICPA conference about the essential human element in financial reporting and the importance of good professional judgment and analysis.

Non-GAAP financial measures can be useful disclosure metrics intended to provide insight into company performance and prospects. In certain cases they more accurately describe the financial picture than the comparable GAAP measures. However, non-GAAP measures can be misleading or confusing, and may be presented in ways that violate SEC regulations or guidance. The equal-or-greater prominence requirement is not a difficult regulation with which to comply. Particularly in light of continued SEC scrutiny and possibly increasing enforcement activity, companies should ensure that they follow the relevant reporting requirements. In order for non-GAAP financial statements to provide high-quality information that is useful to investors, they should be accurate, complete, consistent, and in compliance with applicable regulations.

The use of non-GAAP financial measures by public companies continues to draw regulatory scrutiny and media attention. The Securities and Exchange Commission (SEC) has the threefold mandate to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. The SEC has been focused recently on the prevalence and increased prominence of non-GAAP financial measures in company disclosures, amid concerns of their potential to distort actual company performance numbers and mislead the investing public. In May 2016, the staff (Staff) of the SEC’s Division of Corporation Finance (Corp Fin) released its updated Compliance and Disclosure Interpretations (C&DIs) on the use of non-GAAP financial measures (Updated C&DIs) in an effort to clarify and amplify the SEC’s existing rules and regulations in this area and to rein in problematic practices by companies involving the use of these measures. Since the release of the Updated C&DIs to date, the Staff has issued more than 700 comment letters involving over 600 public companies related to non-GAAP financial measures. In the same time frame, the topic of non-GAAP financial measures has become one of the most frequently-cited issues in Staff comment letters. The heightened SEC attention has also piqued the media’s interest. Throughout the past year, the media has reported on the SEC’s crackdown on ‘fuzzy math’, ‘novel earnings measures’ and ‘made-up accounting metrics’, as well as the Staff’s specific interactions with a number of high-profile companies in relation to the review of their non-GAAP financial reporting disclosures.1 In September 2016, the SEC’s Division of Enforcement brought civil charges against the former chief accounting officer and former chief financial officer of a publicly traded real estate investment trust (REIT) for purposely inflating a key non-GAAP financial measure used by analysts and investors to assess the REIT’s performance. A parallel criminal action brought by the US Attorney’s Office for the Southern District of New York culminated in a securities fraud conviction on June 30 2017. In this publication, we describe the nature of non-GAAP financial measures and the disclosure rules governing them, including the Updated C&DIs. We focus on recent SEC comment letters addressing non-GAAP financial measures and examine common themes or areas of concern identified by the Staff. We also highlight pronouncements by senior members of the Staff on the important ‘critical gatekeeper’ role audit committee members play in ensuring credible and reliable financial reporting. In addition, we discuss industry initiatives aimed at improving the dialogue among management, audit committee members, external auditors and other stakeholders with respect to the use and disclosure of non-GAAP financial measures. Finally, we also offer some practical advice for public companies on complying with the updated SEC guidance. HISTORY The concern with non-GAAP financial measures is not new. In December 2001, the SEC issued a warning to public companies that present to the public their earnings and results of operations on the basis of methodologies otherthan generally accepted accounting principles (GAAP). Such presentation was commonly referred to then as pro forma financial information. While there is no prohibition on companies publishing interpretations of their results or summaries of their GAAP financial statements, the SEC cautioned that such pro forma financial information can mislead investors if it obscures GAAP results. The SEC stated that, because this pro forma financial information by its very nature departs from traditional accounting conventions, its use can make it hard for investors to compare an issuer’s financial information with other reporting periods and with other companies. Since pro forma financial information is derived by selective editing of financial information compiled in accordance with GAAP, the SEC noted that companies should be particularly mindful of their obligation not to mislead investors when using such information. In the beginning of 2002, the SEC instituted an enforcement action against a well-known public company, alleging it knowingly and recklessly issued false and materially misleading statements in the form of pro forma financial information in its earnings press release, in violation of the anti-fraud provisions of the federal securities laws. In that case, the subject registrant presented non-GAAP net income figures that excluded a one-time charge, without disclosing that such figures had included a similar and material onetime gain, thereby showing an increase in its earnings from the prior year’s comparable quarter and beating analysts’ expectations. The company then touted in its earnings release that operational improvements at the company drove the increase in quarterly earnings, when in fact this was not the case. In other words, the increase in earnings resulted from an improper accounting gain, which, had it been properly excluded (similar to the company’ exclusion of the one-time charge), would have shown that the company’s earnings actually declined for the quarter and had fallen short of analyst expectations. The company settled the case with the SEC and agreed to cease and desist from committing such violations then and in the future. On May 19 2002, the technical committee of the International Organisation of Securities Commissions (IOSCO Committee) released its Cautionary Statement Regarding Non-GAAP Results Measures. The IOSCO Committee observed that it had become common practice for many issuers to publish company-specific measurements of earnings other than those prescribed by GAAP. This would often occur in the form of company press releases, and in periodic reports to shareholders and other documents filed with securities regulators and stock exchanges. The IOSCO Committee remarked that non-GAAP earnings measures, when properly used and presented, could assist investors in gaining a better understanding of a company’s financial performance. However, the IOSCO Committee noted that problems arose if non-GAAP earnings measures were used inconsistently or were inadequately defined, or if such measures were used in such a way as to obscure the financial results determined according to GAAP or provide an incomplete description of true financial results. Issuers, investors and other users of financial information were reminded to use care when presenting and interpreting nonGAAP results measures. On July 30 2002, the Sarbanes-Oxley Act of 2002 (SOX) was signed into law. The law, enacted in response to theaccounting scandals at Enron and Worldcom in the early 2000s, sought to enhance financial disclosures of public companies to investors, among other statutory objectives. Section 401(b) of SOX mandated that the SEC issue ‘final rules providing that pro forma financial information included in any periodic or other report filed with the SEC pursuant to the federal securities laws, or in any public disclosure or press or other release, be presented in a manner that: (1) does not contain an untrue statement of a material fact or omit to state a material fact necessary in order to make the pro forma financial information, in light of the circumstances under which it is presented, not misleading; and, (2) reconciles it with the financial condition and results of operations of the issuer under GAAP. In line with its mandate under SOX, on November 4 2002, the SEC issued SEC Release 33-8145 (Proposing Release). Among other things, the Proposing Release proposed the adoption of a new disclosure regulation under the Securities Act of 1933, as amended (Securities Act), which is now known as Regulation G under the Securities Act (Regulation G), along with amendments to item 10(e) of Regulation S-K under the Securities Act (Regulation S-K) and conforming amendments to Form 20-F. The Proposing Release also sought to require registrants to file their earning releases or similar announcements on Form 8-K under the Securities Exchange Act of 1934, as amended (Securities Exchange Act), and subject those filings to the requirements under amended item 10(e) of Regulation S-K. According to the Proposing Release, Regulation G and the proposed amendments were intended to implement the requirements of SOX and to provide investors with balanced financial disclosure when non-GAAP financial measures are presented. Since the term ‘pro forma financial information’, as used in section 401(b) of SOX, was actually being used by the SEC in its rules and regulations in different contexts (in particular, with respect to certain pro forma financial information requirements of Regulation S-X under the Securities Act (Regulation S-X)), the SEC decided to adopt the term ‘non-GAAP financial measures’ instead. After receiving substantial public comment on the Proposing Release, the SEC issued SEC 33-8176 (the Final Rule Release and, together with the Proposing Release, the SEC Releases) on January 15 2003, adopting the new regulation and proposed amendments effective March 28 2003.

WHAT ARE NON-GAAP FINANCIAL MEASURES?

Regulation G and item 10(e) of Regulation S-K define a non-GAAP financial measure as a numerical measure of 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 issuer’s statement of income, 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 measure so calculated and presented. The SEC Releases further provide that the definition of a non-GAAP financial measure is intended to capture 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. Therefore, if a company takes a defined GAAP measure (such as GAAP net income), and thereafter adjusts for (that is, excludes or includes) one or more expense or revenue items that are components of that GAAP measure (for instance, excluding a restructuring expense identified as non-recurring), then the resulting measure (called ‘adjusted net income’, for example) is a non-GAAP financial measure. In the same vein, EBITDA (earnings before interest, taxes, depreciation and amortisation) is another common and widely used nonGAAP financial measure. It is a non-GAAP financial measure because the company takes GAAP earnings (that is, net income as presented in the statement of operations under GAAP) and then adjusts for interest, taxes, depreciation and amortisation components (which are elements derived from GAAP financial presentations) to arrive at a measure (EBITDA) that is not presented in accordance with GAAP. Other common examples of non-GAAP financial measures include variants of EBITDA, such as: EBIT (earnings before interest and taxes), EBITA (earnings before interest, taxes and amortisation), EBITD (earnings before interest, taxes and depreciation) (which is also sometimes called PBDIT, or profit before depreciation, interest and taxes), EBITDAR (earnings before interest, taxes, depreciation, amortisation, and restructuring or rent costs), adjusted EBITDA, core earnings, adjusted earnings, adjusted earnings per share, adjusted revenues, free cash flow, funds from operations (FFO), and adjusted FFO (AFFO). The definition of a non-GAAP financial measure, however, excludes: • operating and other statistical measures (such as unit sales, number of employees, number of subscribers, or number of advertisers); • ratios or statistical measures that are calculated using exclusively one or both: • financial measures calculated in accordance with GAAP (such as operating margin, where GAAP revenue is divided by GAAP operating income); and, • operating measures or other measures that are not nonGAAP financial measures (such as sales per square foot or same store sales, assuming that the sales figures were calculated in accordance with GAAP); and, • financial measures required to be disclosed by GAAP, SEC rules, or a system of regulation of a government or governmental authority or self-regulatory organisation that is applicable to the registrant (such as measures of capital or reserves calculated for regulatory purposes).

WHY DO COMPANIES USE NON-GAAP FINANCIAL MEASURES?

A company often uses non-GAAP financial measures in the Management’s Discussion and Analysis of Results of Operation (MD&A) section of its periodic reports, as well as in its earnings releases, investor presentations and other communications. It does so to supplement its GAAP financial presentations and to provide investors with a better understanding of the company’s performance, liquidity and financial position. Often, non-GAAP operating measures are used by research analysts, rating agencies, and other financial professionals in evaluating or comparing the performance of comparable companies. For instance, EBITDA is commonly used in debt covenants and widely used by analysts in valuing businesses (for example theenterprise value of a company is often calculated as a multiple of its EBITDA) and making financial projections. It is also frequently used as a proxy or estimate for a company’s operating cash flow or cash available to service its debt. NonGAAP financial measures are allowed by the SEC in order for a registrant to convey information to investors that the registrant believes is relevant and useful in understanding its performance or liquidity. Non-GAAP financial measures also enable management to convey a picture of how it sees the company’s financial condition or results of operations in a manner that GAAP results alone may not be able to convey.

SEC GUIDANCE ON NON-GAAP FINANCIAL MEASURES

Subsequent to the adoption of Regulation G, the amendments to item 10 of Regulation S-K and the other related amendments under the SEC Releases in March 2003, the SEC has continued to provide guidance on the topic of non-GAAP financial measures. The SEC has engaged registrants, the investing public and other stakeholders through both formal and informal channels. Formal guidance has taken the form of: (1) FAQs and C&DIs related to non-GAAP financial measures, which the Staff update from time to time; (2) written comments provided to and communications with registrants as a result of the SEC comment letter process during which the Staff review registration statements and periodic filings submitted by registrants; and (3) updates to the SEC financial reporting manual provisions relating to non-GAAP financial measures, among other things. Informally, senior members of the Staff and the SEC have regularly commented on the use of non-GAAP financial measures, delivering speeches, participating in webcasts, panel discussions and Q&A sessions with accounting and legal practitioners, industry groups and other stakeholders, and addressing the public in general about the topic. 2003 FAQs, 2010 C&DIs and 2011 C&DIs On June 13 2003, the Staff issued 33 FAQs regarding the use of non-GAAP financial measures (2003 FAQs) that focused on the implementation and interpretation of the rules adopted in the SEC Releases a few months earlier. The 2003 FAQs dealt with a number of topics that included, among others, questions and answers dealing with transition issues, proposed business combination transactions, segment information, EBIT and EBITDA, and the applicability of the rules to foreign private issuers. The 2003 FAQs contained a number of provisions that restricted the use and inclusion of certain non-GAAP financial measures in SEC filings. One such restriction was the Staff’s guidance with respect to the permissibility of non-GAAP financial measures that adjusted for recurring items. To illustrate, item 10(e) of Regulation S-K prohibits adjustments that eliminate or smooth items identified as nonrecurring, 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 preceding two years. Questions subsequently arose from companies and practitioners whether a registrant was prohibited altogether from using a non-GAAP financial measure that eliminated recurring items, or whether it was permissible to use a non-GAAP financial measure that eliminated recurring items if those items were not labelled as non-recurring. The Staff, in question 8 of the 2003 FAQs, stated that: ‘…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 nonGAAP financial measure is used to evaluate performance.’ Further, question 9 of the 2003 FAQs stated that the Staff’s practice had been to object to the use of nonGAAP financial measures that eliminated the effect of recurring items by describing them as non-recurring. The Staff advised that management should consider the substantive nature of the item when determining whether to classify it as recurring or non-recurring, because merely labelling an item as non-recurring does not make it so. As a result of these stringent requirements under item 10(e) of Regulation S-K as interpreted by the 2003 FAQs, companies avoided using non-GAAP financial measures that adjusted for recurring items in their SEC filings. However, they continued to present such non-GAAP financial measures in their press releases, earnings calls and other public disclosures other than SEC filings, as those were not subject to item 10(e) of Regulation S-K.In 2009, the Staff began to review its interpretative guidance on non-GAAP financial measures. At the December 2009 American Institute of Certified Public Accountants (AICPA) Conference, senior members of the Staff acknowledged that registrants may be omitting non-GAAP measures in their SEC filings while still using these measures in their press releases and public disclosures, because of concerns with receiving future Staff comments on SEC filings. Senior members of the Staff confirmed at the AICPA conference that they were reviewing the 2003 FAQs to ensure that the they were not being read ‘in a fashion that causes companies to keep key information out of their filings, which they are otherwise using to tell investors their story [through communications such as earnings calls and press releases] and which they believe is the most meaningful indicator of how they are doing.’4 On January 11 2010, the Staff issued C&DIs related to nonGAAP financial measures (2010 C&DIs), which superseded the 2003 FAQs. The 2010 C&DIs relaxed a number of the prohibitions and restrictions in the 2003 FAQs (including those contained in questions 8 and 9 therein) and offered registrants more flexibility to use and disclose their nonGAAP financial measures. In particular, new question 102.03 of the 2010 C&DIs (which remains the same in the Updated C&DIs) states that the prohibition in item 10(e) of Regulation S-K that prohibits adjusting a non-GAAP financial measure that eliminates or smooths items identified as nonrecurring, infrequent or unusual, is based on the description of the charge or gain, and not on the nature of the charge or gain. The Staff also stated that ‘the fact that a registrant cannot describe a charge or gain as nonrecurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of item 10(e) of Regulation S-K.’ In a March 2010 speech delivered at the Westchester/Fairfield County chapter of the Association of Corporate Counsel conference, then SEC Commissioner Elisse B Walter stated that the guidance contained in the new 2010 C&DIs ‘seeks to encourage you to at least think about including non-GAAP measures in commission filings if your company uses those measures in earnings releases and other communications with the investor and analyst community.’5 The 2010 C&DIs were updated on July 8 2011 (2011 C&DIs) to add a new question 108.01. The latter clarified that Regulation G and item 10(e) of Regulation S-K applied to non-GAAP financial measures disclosures, other than targetlevel disclosures, that were included in a registrant’s proxy statement. With respect to pay-related disclosures, the Staff said it would not object if a registrant included the required GAAP reconciliations in a prominently cross-referenced annex to the proxy statement. Alternatively, if the non-GAAP financial measures were the same as those included in the Form 10-K that was incorporating by reference the proxy statement, a prominent cross-reference to the pages in the Form 10-K containing the required GAAP reconciliation could be provided.

CONCLUSION

The use of non-GAAP financial measures can be an important tool for registrants to tell their own stories. It allows them to convey information to investors that registrants believe to be relevant, meaningful and useful in understanding their financial performance, financial position or liquidity. The prevalence and wide acceptance of non-GAAP financial measures, the importance and attention accorded by research analysts, rating agencies, financial professionals and the business community in general to these measures, and the adoption and development of these measures by various industry groups, all point to and demonstrate that there are legitimate, meaningful and relevant purposes in using non-GAAP financial measures. However, as the SEC has highlighted, the presentation of non-GAAP financial measures is also prone to misuse and abuse. As shown in a number of cases, non-GAAP financial measures can become tools to distort the truth, conceal, fabricate or inflate the actual performance and financial condition of a given company, confuse investors, and even perpetuate outright fraud. The marked increase in the prevalence and wide use of these measures over the few past years has prompted the Staff to revisit the existing rules and regulations governing the use and disclosure of these measures and to issue updated guidance in the form the Updated C&DIs. The Staff has reminded registrants that non-GAAP financial measures should merely supplement, and not substitute, GAAP financial measures, and that management should understand and articulate the reasons for using non-GAAP financial measures in SEC disclosures and take steps to ensure that such measures are neither misleading nor prohibited by SEC rules. Consistent, transparent, credible and truthful disclosures by registrants are paramount to the effective functioning of the capital markets. Therefore, it is important for registrants to carefully revisit and examine their use and presentation of non-GAAP financial measures in their disclosures and to take concrete steps to comply with the updated SEC guidance and ensure that the presentation of their non-GAAP financial measures is consistent, transparent, credible and truthful.