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In an unusual action that may portend closer scrutiny of routine earnings announcements, the Securities and Exchange Commission on Tuesday issued “cautionary advice” on the widespread practice of using non-GAAP pro forma financial information in earnings releases. Rel. No. 33-8039 (Dec. 4, 2001). While the SEC’s warning should not require existing practices at most registrants to change, it is a useful reminder of the SEC’s view that GAAP (generally accepted accounting principles) remains the touchstone for fair and accurate financial reporting, inside or outside of formal periodic securities filings. In its statement, the SEC warned that pro forma financial information, while it can be “useful” and “appropriate,” can mislead investors if it obscures GAAP results. Noting that pro forma information by its nature departs from accounting conventions intended to assure that financial data is presented uniformly across issuers and periods to facilitate comparison, the SEC warned that improper use of pro forma financial information renders these comparisons difficult. The SEC reminded public companies — and their advisors — that: � pro forma information by its nature is derived by “selective editing” of GAAP financial information; registrants must be particularly wary of the potential to mislead investors thereby violating the antifraud provisions of the securities laws; � when non-GAAP financial measures are presented, there is risk that they may be misleading unless accompanied by an accurate description of the controlling principles and methodologies behind the pro forma presentation; � information omitted in a pro forma presentation may be material, and therefore pro forma information may be misleading unless accompanied by a clear, comprehensible explanation of the nature and size of the omissions (the SEC gave a specific example of the use of a pro forma presentation to recast a loss as a profit); and � a financial presentation addressed to a limited feature of financial results, or that sets forth calculations of financial results on a non-GAAP basis, generally will not be deemed misleading due to that deviation from GAAP if the company, in the same public statement, discloses in plain English how it has deviated from GAAP and the amounts of those deviations. In urging registrants to reconcile pro forma financial results to GAAP results in earnings releases, the SEC cited the Earnings Press Release Guidelines jointly developed by the Financial Executives International and the National Investor Relations Institute (which can be found at www.niri.org/publications/ alerts/ea042601.cfm). These guidelines provide that, while pro forma presentations can clarify a period’s performance as well as future prospects and may even be “more analytically useful” in some situations, GAAP results provide a critical framework for pro forma results, which should always be accompanied by a clearly described reconciliation to GAAP results, often provided in tabular form. The SEC’s cautionary advice largely reflects what many companies are already doing in their earnings releases — providing clear explanation of nonrecurring items, extraordinary charges and other special items that are omitted from GAAP results to derive pro forma financial results. Significantly, the SEC’s statement notes that the use of pro forma financials to focus investors’ attention on critical components of results to facilitate meaningful comparisons to prior periods, or to emphasize core trends, is to a large extent the intended function of the Management’s Discussion and Analysis disclosure that appears in formal periodic securities filings. In this regard, the SEC’s advice is consistent with its other recent disclosure initiatives — including Regulation FD and plain English — and part of a trend toward integration and convergence of the formats for informal communications such as earnings releases and formal periodic securities filings on Forms 10-K and 10-Q (see our memorandum of October 20, 2000). The more frequent and comprehensive periodic communications that may result from these initiatives can effectively be used by issuers to improve the flow of information to investors and reduce the potential for surprises and volatility. The SEC’s statement can be found at www.sec.gov/rules/ other/33-8039.htm. The SEC has also issued an investor alert on “pro forma” financial statements which is available at http://www.sec.gov/investor/ pubs/proforma12-4.htm. David A. Katz is a partner at the law firm Wachtell, Lipton, Rosen & Katz. Lawrence S. Makow is an associate at the firm.

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