• SEC Proposes Rules Governing Non-GAAP Financial Information
  • August 5, 2003
  • Law Firm: Perkins Coie LLP - Seattle Office
  • On November 5, 2002, the Securities and Exchange Commission (SEC) proposed new "Regulation G," as well as amendments to certain existing rules, that would require public companies to provide specific disclosure when releasing proforma or non-GAAP financial information, including reconciling that information to GAAP.

    The Commission also proposes to require a Form 8-K filing for earnings releases and similar financial announcements containing material nonpublic information concerning period-end financial results.

    The SEC intends these proposed rules, which implement Section 401(b) of the Sarbanes-Oxley Act, to improve transparency and quality of financial disclosure and enhance the current reporting of earnings information. The SEC is required to release final rules by January 26, 2003.

    Context of the Proposed Rules

    Since 1973, the SEC has voiced concern that companies' use of pro forma financial information has the potential to confuse investors. As recently as December 2001, the SEC issued "cautionary" advice warning that pro forma financial information "can mislead investors if it obscures GAAP results." And in January 2002, in In the Matter of Trump Hotels & Casino Resorts, Inc., the SEC took its first enforcement action involving misleading non-GAAP financial reporting. Trump Hotels focused on the inappropriate use of pro forma presentation to disguise a negative trend in operating results.

    By passing Section 401(b) of the Sarbanes-Oxley Act, Congress provided the SEC with a legislative mandate to address the disclosure of non-GAAP financial information, and set into motion the regulation of pro forma financial information foreshadowed nearly 30 years ago.

    SEC's Three-Pronged Approach to Non-GAAP Financial Disclosure

    The SEC has proposed a three-pronged approach to upgrade disclosure of proforma and non-GAAP data.

    Regulation G requires reconciliation to GAAP in all public communications -- filed with the SEC or not. Whenever companies disclose non-GAAP financial information, proposed Regulation G would:

    • require companies to reconcile the non-GAAP historic measures to comparable GAAP financial information; and

    • prohibit any public communication that either omits or misstates material facts necessary to make a financial measure not misleading.

    Regulation S-K will incorporate Regulation G concepts. Amended Item 10 of Regulation S-K will require an enhanced version of the Regulation G reconciliation to GAAP of non-GAAP financial measures in all SEC filings.

    "Rapid and Current" Disclosure on Form 8-K: First SEC Response to Sarbanes-Oxley Act Section 409. Section 409 of the Sarbanes-Oxley Act requires reporting companies to publicly disclose, on a "rapid and current basis," material changes to financial condition or operations, as the SEC may require. This Form 8-K amendment would require public companies to file earnings releases or similar announcements about completed annual or quarterly fiscal periods, whether or not the earnings release contains non-GAAP financial measures.

    Proposed Regulation G: Regulating Non-GAAP Disclosure

    Proposed Regulation G would apply whenever a reporting company publicly discloses or releases any material information that includes a non-GAAP financial measure, whether that disclosure is communicated in writing, orally, telephonically, in a Webcast or broadcast or by similar means.

    What is a "Non-GAAP Financial Measure"?

    In the proposed rules, the SEC uses "non-GAAP financial measure" instead of "pro forma financial information" in order to avoid confusion with other SEC rules.

    A "non-GAAP financial measure" is a numerical measure of a company's historical or future financial performance, position or cash flows that:

    • excludes amounts (or is subject to adjustments that have the effect of excluding amounts) that would otherwise be included if calculated according to GAAP; or

    • includes amounts (or is subject to adjustments that have the effect of including amounts) that are excluded from the comparable GAAP measure.

    Regulation G Does Not Sweep In All Financial Information

    Regulation G casts a wide net, but it does not encompass all financial information that may be derived from non-GAAP methodologies. For example, Regulation G does not apply to:

    • data such as unit sales, stores opened or numbers of subscribers; and

    • ratios that are calculated using only financial measures calculated in accordance with GAAP.

    Amended Regulation S-K Item 10: Enhanced Disclosure for Filed Documents

    The SEC proposes to amend Item 10 of Regulation S-K to address the disclosure of non-GAAP financial measures in material filed with the SEC. These amendments would apply to the same categories of non-GAAP financial measures as are covered by proposed Regulation G, but would contain more detailed requirements. In particular, Item 10 would require that the description of a comparable GAAP financial measure must be at least as prominent as the non-GAAP financial measure.

    Requirements of Proposed Item 10

    Proposed Item 10 would require companies that use non-GAAP financial measures in SEC filings to provide the following three items:

    • GAAP Prominence: Prominent presentation of comparable GAAP financial measures;

    • Reconciliation: Quantitative reconciliation of the difference between the disclosed non-GAAP financial measure with the comparable GAAP measure; and

    • Management Explanation: Why management uses the particular non-GAAP financial measure and believes the non-GAAP financial measure provides useful information.

    In addition to the affirmative disclosure described above, the proposed amendments will prohibit disclosure that (a) gives greater prominence to non-GAAP financial measures or presents such measures on the face of GAAP financial statements, (b) excludes charges or liabilities that required cash settlement from non-GAAP liquidity measures or (c) adjusts non-GAAP performance measures to eliminate nonrecurring items when the charge or gain will likely recur.

    Earnings Releases in Form 8-K: Mandatory Filing under Item 1.04

    The proposed amendment to Form 8-K would add new Item 1.04. This Item, "Disclosure of Results of Operations and Financial Condition," would require companies to file earnings releases (or other public announcement that discloses material nonpublic information regarding results of operations or financial condition) on Form 8-K within two days.

    Under current rules, earnings releases are subject to Regulation FD, which prohibits selective disclosure of material nonpublic information and requires companies to broadly disseminate the information via a press release, Form 8-K or other method. Filing a release under Regulation FD on Item 6.01 of Form 8-K "furnishes" rather than "files" the information. Historical information provided under proposed Item 1.04 of Form 8-K would be considered "filed" and would be incorporated by reference into certain proxy and registration statements.

    Method of Disclosure; Proposed 48-Hour "Freshness" Rule

    Proposed Item 1.04 will require an earnings release to be filed as an exhibit to the Form 8-K. If the earnings release contained any non-GAAP financial measures, the 8-K must reconcile GAAP and non-GAAP as new Item 10 of Regulation S-K requires.

    In what is likely to be a highly controversial proposal, if the nonpublic information is disclosed orally (e.g., by conference call or Webcast), the issuer will need to file a Form 8-K unless:

    • the disclosure occurs within 48 hours of a written release filed on Form 8-K pursuant to Item 1.04; and

    • the information is made widely accessible to the public, including availability on the company's Web site.

    Form 8-K Item 1.04 Applies Only to Historical Information

    Proposed Item 1.04 applies only to earnings releases concerning a fiscal period that has ended; it does not apply to earnings estimates for future or ongoing fiscal periods, unless those estimates accompany information about past fiscal periods as well. If an earnings release contains both past and future earnings information, the forward-looking information could be "furnished" under proposed Item 6.01 of Form 8-K (pursuant to Regulation FD) rather than "filed" under proposed Item 1.04. It appears that if such forward-looking statements are specifically identified, they will be considered furnished rather than filed and would not be incorporated by reference into proxy and registration statements or periodic reports.

    Repetition of previously disclosed information (or the release of the same information in a different form, such as in an annual report to shareholders) does not trigger Item 1.04. In addition, the requirement to file under Item 1.04 of Form 8-K would not apply to companies that make their financial disclosures only in their periodic reports on Forms 10-Q and 10-K.

    How Are Foreign Private Issuers Affected?

    Regulation G will apply to financial disclosure made by foreign private issuers, unless (i) the issuer's securities are listed on an exchange outside the United States, (ii) the non-GAAP and comparable GAAP measures are not presented in accordance with U.S. GAAP and (iii) the disclosure is made or released outside the United States.

    The SEC proposes to amend Form 20-F to incorporate Item 10 of Regulation S-K. A financial measure that Item 10 might prohibit, though, could be included in a 20-F if expressly permitted under the GAAP standard of the issuer's primary financial statements and if included in the annual report or financial statements used in the issuer's home jurisdiction.

    Text of the Proposed Rules

    This Update is intended only as a summary of the SEC's proposed rules. You are encouraged to review the full text of the proposed rules at http://www.sec.gov/rules/proposed/33-8145.htm. Comments to the SEC are due by December 13, 2002.