Non-GAAP financial measures are financial metrics that are not based on standard accounting principles but are presented by a company to provide additional insight into its performance. These measures often exclude certain items or adjust the reported numbers to better reflect the company’s underlying business performance.

Common examples of non-GAAP financial measures include adjusted earnings, earnings before interest, taxes, depreciation and amortization (EBITDA), free cash flow and others. Companies use these measures to provide a clearer picture of their financial performance, especially when they believe that standard GAAP (generally accepted accounting principles) measures may not fully represent the economic reality of their business.

While non-GAAP measures can offer valuable insights, the US Securities and Exchange Commission (the SEC) has expressed concerns about the potential abuse and misleading use of such measures, including that companies often use non-GAAP measures to present a rosier financial picture. To address these concerns, the SEC has established regulations and guidelines for the use of non-GAAP financial measures. In particular, Regulation G and Item 10(e) of Regulation S-K were adopted in 2003 and designed to regulate the use of non-GAAP financial measures.

Applicability

Regulation G versus Item 10(e)

Reg G and Item 10(e) generally apply to all non-GAAP financial measures issued by domestic reporting companies and foreign private issuers (FPIs). While one must comply with both regulations in SEC filings, there are some key differences on the applicability of the two regulations:

  • Reg G applies to any public disclosure (SEC filings, press releases, earnings calls, website disclosure, social media, etc.), while Item 10(e) applies to only documents filed with (and earnings releases furnished to) the SEC.
  • Item 10(e) contains additional requirements for the use of non-GAAP financial measures in SEC filings, such as 10-Ks, 10-Qs, 8-Ks and registration statements.

Some Item 10(e) requirements apply to earnings releases and other material nonpublic information about a completed fiscal period pursuant to Item 2.02 of Form 8-K, even though these are “furnished” rather than “filed” with the SEC.

Item 10(e) contains all the key provisions of Reg G, but Reg G does not contain all provisions of Item 10(e), making Item 10(e) more stringent than Reg G. This makes sense intuitively of course – there is a higher burden on SEC filings as compared to other public disclosures.

Non-GAAP (versus not GAAP)

Both Reg G and Item 10(e) apply to non-GAAP financial measures.

  • Non-GAAP: “A number, calculation or ratio measuring a company’s historical or future financial position, financial performance or cash flows” that includes or excludes an amount that would otherwise be excluded or included, respectively, in the most directly comparable GAAP measure.
  • Not GAAP and not non-GAAP: Not all metrics that don’t fall squarely under GAAP are non-GAAP measures. Keep an eye out for the following, none of which are non-GAAP figures, and therefore do not fall under Reg G/Item 10(e):
    • Operating and other financial measures and ratios or statistical measures (measures), such as unit sales or number of subscribers.
    • Measures that are calculated exclusively using GAAP financial measures as inputs.
    • Measures that are calculated exclusively using not non-GAAP financial measures as inputs, such as same store sales or sales per square foot.
    • Measures that do not depend on GAAP, such as expected debt repayment schedules.
    • Measures that are not calculated differently from GAAP measures, such as estimated revenues or expenses (provided the estimates are made in the same manner as if computed under GAAP).
    • Measures required to be disclosed by the SEC (or another governmental regulatory authority or self-regulatory organization), such as measures of capital or reserves.
  • FPIs: In considering non-GAAP for FPIs, the relevant GAAP is not US GAAP but the accounting principles of the country under which the FPI’s financial statements are prepared.

Reg G disclosures

When disclosing non-GAAP measures, Reg G requires that an issuer include:

  • The most directly comparable GAAP financial measure.
    • Performance measures, such as EBITDA or operating income, must be accompanied by a presentation of net income or income from continuing operations, respectively. The SEC has specifically provided that issuers should use net income, not operating income, as the most comparable GAAP metric for EBIT or EBITDA (Question 103.02, Non-GAAP C&DIs).
    • Liquidity measures, like free cash flow, must be accompanied by a presentation of GAAP cash flow amounts (cash flows from operating, investing and financing activities).
  • A quantitative reconciliation between the non-GAAP measure and GAAP measure, showing the calculations necessary to bridge the two measures.

Considerations with respect to adjustments

Strict compliance with disclosure of GAAP information/reconciliation is not a cure-all. The SEC has made clear that certain adjustments could result in misleading non-GAAP measures that violate Reg G, even if detailed, extensive disclosure is provided (Question 100.06, Non-GAAP C&DIs). The SEC has provided guidance on how to navigate certain fine-line calls. Examples of inappropriate presentation include:

  • Excluding normal, recurring, cash operating expenses necessary to operate a business, even if the expense occurs occasionally or at irregular intervals. The SEC will consider the “nature and effect of the non-GAAP adjustment and how it relates to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment” (Question 100.01, Non-GAAP C&DIs). Specific examples of exclusions not expressly permitted by the SEC include:
    • Excluding cash compensation paid over a three-year vesting period to executives in connection with an acquisition.
    • Excluding employer payroll tax on employee stock transactions without additional information on the context/nature of the adjustment.
  • Not being consistent with adjustments over time, unless explained/disclosed. Sometimes significant changes require recasting historical presentation/disclosure (Question 100.02, Non-GAAP C&DIs).
  • Adjusting only for nonrecurring charges when there were nonrecurring gains occurring during the same period (Question 100.03, Non-GAAP C&DIs).
  • Adjustments that change recognition/measurement principles required under GAAP may cause the non-GAAP measure to be misleading. Specific examples include:
    • Changing revenue recognition (e.g., accelerating recognition, which under GAAP would be recognized ratably over time, excluding any components of revenue), for which the SEC frequently takes a “zero tolerance” policy, meaning any change in revenue recognition from GAAP would be considered misleading.
    • Presenting net instead of gross (or vice versa) when the inverse is required under GAAP.
    • Changing from accrual to cash accounting for revenue or expenses, when the inverse is required under GAAP (Question 100.04, Non-GAAP C&DIs).
  • Adjustments not labeled and clearly described as non-GAAP, including presenting non-GAAP measures with labels that do not reflect the nature of the non-GAAP measure, such as:
    • Labeling as “net revenue,” a contribution margin that is calculated as GAAP revenue less certain expenses.
    • Labeling as “gross profit” or “sales,” a non-GAAP measure calculated differently from the similarly labeled GAAP measure.
    • Labeling as “pro forma,” a measure that is not calculated consistently with the pro forma requirements in Article 11 of Regulation S-X (Question 100.05, Non-GAAP C&DIs).

Be mindful of what baseline GAAP measure the issuer is using to reconcile non-GAAP measures. While C&DI Question 103.02 specifically speaks to the reconciliation of EBIT/EBITDA to GAAP net income, the SEC’s general posture has been to reconcile non-GAAP financial measures upward from GAAP operating profit/loss as a more inclusive GAAP figure.

  • 10b-5 requirement: The same obligations arise under non-GAAP adjustments as they otherwise do, and must be kept in mind. Specifically, a non-GAAP financial measure must 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.

Item 10(e) disclosures

Remember that if you are required to comply with Item 10(e), you are, necessarily, required to comply with Reg G. [1] Therefore, the below should be considered in addition to those items discussed above with respect to Reg G compliance.

  1. Disclosure of a non-GAAP metric in SEC filings requires disclosure of – and reconciliation to – the most directly comparable GAAP measure with “equal or greater prominence” in the disclosure. This is a facts-and-circumstances test, but examples of inappropriate presentation the SEC has specified include:
  2. Presenting the non-GAAP measure first, before the GAAP measure, or omitting GAAP measures (including earnings release headlines/captions).[2]
  3. Showing a ratio using a non-GAAP input without presenting the ratio using the GAAP input (note that this includes percentage changes).
  4. A presentation style (bold, font, etc.) that emphasizes the non-GAAP measure.
  5. Qualitatively characterizing the non-GAAP measure (“record performance” or “exceptional”) without descriptions/characterization of the GAAP measure with equal or greater prominence.
  6. Presenting charts, tables or graphs of non-GAAP without corresponding GAAP disclosures.
  7. Providing disclosure and analysis of the non-GAAP measure without the corresponding GAAP measure (Question 102.10, Non-GAAP C&DIs).
  8. Disclosure as to why management believes that the non-GAAP disclosure is useful to investors, including substantive reasons based on the specific measure, company, industry and business (for periodic reports, this is only required annually in the 10-K/20-F, provided there is no change in the interim).
  9. If material, disclosure around additional purposes for which management uses the non-GAAP measures.

Other prohibitions/SEC guidance

The face of Item 10(e) includes certain delineated prohibitions, which have been further discussed and expanded upon through compliance and disclosure interpretations (C&DIs). Prohibitions include:

  • Cash settlement: Excluding charges or liabilities that required/will require cash settlement (or would have required cash settlement absent an ability to settle in another manner), from non-GAAP liquidity measures, such as free cash flow.
    • The SEC provides a limited exception for adjusted EBITDA and similar measures that exclude cash charges in the very specific circumstance of such metric being described as a material covenant to a credit agreement in the context of the MD&A’s liquidity and financial condition discussion, in which case it may only be disclosed in the MD&A (Question 102.09, Non-GAAP C&DIs).
  • Recurring measures: Adjusting non-GAAP performance metrics to eliminate/smooth out items identified as nonrecurring, infrequent or unusual, if it is reasonably likely that the charge/gain will recur within two years, or there was a similar charge/gain in the past two years.
    • As clarified through SEC guidance, Item 10(e) prohibits the description of a gain/charge as nonrecurring, infrequent or unusual unless it meets the above criteria, not the inclusion/exclusion of such gain/charge alone in the calculation of a non-GAAP metric (Question 102.03, Non-GAAP C&DIs). However, recall that normal, recurring, cash operating expenses necessary to operate a business should not be adjusted for, even if occurring occasionally or at irregular intervals, as such adjustments may violate the antifraud provisions of Reg G, as discussed above (Question 100.01, Non-GAAP C&DIs).
  • Confusing titles: Use of titles/descriptions of non-GAAP measures that are the same as (or confusingly similar to) GAAP financial measures.
  • Per-share items: Any measures that are otherwise specifically prohibited under GAAP or SEC rules, one example being per-share cash flow.
    • Note that non-GAAP per-share performancemeasures are permitted (reconciled to GAAP earnings per share), but the SEC specifically prohibits non-GAAP per-share liquidity metrics (Question 102.05, Non-GAAP C&DIs). EBIT/EBITDA cannot be presented on a per-share basis (Question 103.02, Non-GAAP C&DIs).

SEC commentary and action

Non-GAAP metrics and enforcement of Reg G and Item 10(e) have been an area of SEC focus, including comments to issuers and select enforcement action. Comments frequently encountered include:

  • Presentation with equal or greater prominence of the most directly comparable GAAP financial measure.
  • Reconciliation to the most comparable GAAP financial measure.
  • Appropriateness of adjustments to eliminate or smooth items identified as nonrecurring, infrequent or unusual.
  • Whether adjustment of certain ordinary or recurring cash charges would be misleading.
  • Use of individually tailored accounting principles.
  • Disclosure of why management believes the non-GAAP presentation provides useful information to investors regarding the financial condition or results of operations of the company.

Failure to comply with Reg G and/or Item 10(e) has also resulted in SEC enforcement action under various circumstances – including against issuers who inappropriately characterized recurring items as noncurrent and failed to meet the standard of giving equal or greater prominence to GAAP measures in earnings releases (identified non-GAAP in the headline without including similarly prominent GAAP disclosures).

Statements made by the SEC

Over the past decade, senior SEC staff have commented on non-GAAP questions, noting the importance that a company carefully review use of non-GAAP to consider the following:

  • Why the company is using the non-GAAP measure.
  • How the non-GAAP measure provides investors with useful information.
  • Whether the company is giving no greater prominence to the non-GAAP measure than the GAAP measure, as required under Reg G and Item 10(e).
  • Whether the company’s explanations of how it uses the non-GAAP measure and why the measure is useful for its investors are accurate and complete and drafted without a boilerplate.
  • Why – in contrast to the GAAP measure – the non-GAAP measure is an appropriate way to measure the company’s performance and is useful to investors.
  • Whether the measure is prepared in a manner that includes appropriate controls and oversight procedures.[3]

[1] There is an exception here with respect to voluntary filers. Item 10(e) applies to documents rather than persons, and therefore voluntary filers must comply even though they are exempt from Reg G.

[2] The SEC has not formally provided guidance regarding the limits of “greater prominence.” For example, in some cases, the SEC has not objected to placement of a non-GAAP measure in the management discussion and analysis (MD&A) of a Form 10-Q without the closest GAAP figure next to it, because the closest GAAP figure appears in the consolidated financial statements, which precede the MD&A section.

[3] See the 2023 DXC Technology Co. enforcement action for an example underscoring the importance of ensuring non-GAAP reconciliations are subject to adequate disclosure controls and procedures. The SEC charged DXC with making misleading disclosures on its non-GAAP financial performance over multiple reporting periods, noting the company materially increased its non-GAAP net income by negligently misclassifying tens of millions of dollars of expenses as non-GAAP adjustments for transaction, separation and integration (TSI) related costs (e.g., related to M&A and spin-off costs). DXC did not have a non-GAAP policy in place and lacked formal guidance for classifying TSI costs, which resulted in the inclusion of TSI costs in non-GAAP financial metrics that were inconsistent with the company’s description of TSI costs in other public filings. The SEC concluded that DXC’s material misstatements were the result of inadequate disclosure controls and procedures relating to the use of non-GAAP financial measures. In addition to remedial measures, the SEC ordered DXC to create and implement non-GAAP disclosure controls and procedures that would be periodically reviewed by the disclosure committee or another designated committee. DXC also agreed to pay an $8 million civil penalty in settlement.

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