Earlier this year, the Securities and Exchange Commission updated its guidance on the use of non-Generally Accepted Accounting Principles financial measures. Based on the revised guidance, the SEC appears to have changed its tone on the use of non-GAAP financial measures, most notably in SEC filings. From the updated guidance, companies may be inclined to disclose more non-GAAP financial measures so long as they comply with the SEC disclosure requirements.

This is an interesting turn of events, especially since the first Regulation G non-GAAP SEC case came out just a few months earlier. This article will highlight the non-GAAP disclosure requirements according to Regulation G and Item 10(e) of Regulation S-K and the updated 2010 SEC guidance on the use of non-GAAP financial measures.

SEC REGULATIONS REGARDING NON-GAAP DISCLOSURE

A non-GAAP financial measure is a numerical measure of historical or future performance, financial position or cash flow that either excludes amounts included in the most comparable GAAP measure or includes amounts excluded from the most comparable GAAP measure. The SEC regulates the disclosure of non-GAAP financial measures under Regulation G and Item 10(e) to protect investors from being misled by such disclosure.

Regulation G applies whenever a company publicly discloses or releases material information that includes a non-GAAP financial measure. Regulation G broadly regulates all public disclosures, including those disclosures in both filed or furnished documents with the SEC, as well as press releases, analyst calls and disclosures on a company’s Web site. Regulation G prohibits using non-GAAP financial measures in a misleading manner. It requires a presentation of the most directly comparable GAAP measure and a reconciliation of the differences between the non-GAAP measure disclosed with the most directly comparable GAAP measure. Some common examples of non-GAAP financial measures include the following: (i) funds from operations, (ii) earnings before interest, taxes, depreciation and amortization (EBITDA) (iii) adjusted revenues and (iv) core earnings.

Item 10(e) only regulates non-GAAP financial measures included in SEC filings. While Item 10(e) regulates a much smaller realm of disclosure than Regulation G, Item 10(e) requires more extensive disclosure requirements that consist of the following: (i) a presentation, with equal or greater prominence, of the most directly comparable GAAP measure; (ii) a reconciliation of the differences between the non-GAAP measure and the most directly comparable GAAP measure; (iii) disclosure explaining management’s belief that the presentation of the non-GAAP financial measure provides useful information to investors regarding the registrant’s financial condition and results of operations; and (iv) a statement disclosing the additional purposes for which management uses the non-GAAP financial measure. In addition, Item 10(e) prohibits the following when disclosing non-GAAP financial measures: (i) excluding charges that require cash settlement from non-GAAP liquidity measures (other than earnings before interest and taxes (EBIT), and EBITDA); (ii) eliminating or smoothing items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is reasonably likely to recur within two years or there was a similar charge or gain within the two prior years; (iii) presenting non-GAAP financial measures on the face of the GAAP financial statements or in the footnotes to the financials; (iv) presenting non-GAAP financial measures on the face of any pro forma financial information required by Article 11 of Regulation S-X; and (v) using titles or descriptions of non-GAAP financial measures that are the same as or similar to GAAP measures.

RECENT SEC GUIDANCE

In January 2010, the SEC provided revised guidance on the use of non-GAAP financial measures. This guidance suggests that the SEC is providing flexibility for non-GAAP financial measure disclosures. The following is a summary of some of the key issues provided in the guidance:

• Measures not used by management. It is not mandatory for management to use a non-GAAP financial measure in managing its business in order to disclose such a non-GAAP financial measure. However, the company must still disclose the rationale for why management believes the non-GAAP financial measure will be useful to investors and the purposes for which management uses such a measure, even though it’s not used for managing the business.

• Recurring items. Even though a registrant cannot describe a recurring item as non-recurring, infrequent or unusual, this restriction does not mean that an adjustment may not be made for a recurring item. While it is clear that the recurring adjustment cannot be classified as non-recurring, the adjustment can still be permitted as long as the company satisfies the requirements of Item 10(e) and Regulation G. For example, in order to disclose the recurring adjustment, the registrant would have to disclose why management believes the presentation of the non-GAAP financial measure is useful to investors.

• EBIT and EBITDA. If adjustments are used to calculate EBIT and EBITDA, such financial measures may not be disclosed as EBIT and EBITDA. Instead, these financial measures must be distinguished from EBIT and EBITDA, for example, disclosing the financial measure as “Adjusted EBIT.”

• Non-GAAP per share measures. Non-GAAP earnings per share financial measures are permitted in SEC filings. However, it is important to note that such financial measures must also include a reconciliation to GAAP earnings per share and comply with the other Item 10(e) requirements noted above.

• Revenue by individual products. As long as revenue by specific product is calculated in accordance with GAAP, there is no requirement to total all the product revenue in the financial statements in order to comply with GAAP.

• Presenting non-GAAP income statements. It is not appropriate to present a full non-GAAP income statement for purposes of reconciling non-GAAP financial measures to the most directly comparable GAAP financial measures because such a presentation may attach unjustified importance to the non-GAAP information.

• Presenting “net of tax” adjustments. Registrants may disclose adjustments “net of tax” when reconciling non-GAAP performance measures to the most directly comparable GAAP measures as long as the tax effect of each reconciliation measure is provided in a footnote to the reconciliation, a parenthetical or in one line in the reconciliation. No matter how the “net of tax” adjustment is disclosed, it is important to note that registrants must state how the tax effect was calculated.

• Timeliness of Form 8-K and Form S-3 eligibility. Failure to furnish a Form 8-K required by Item 2.02 in a timely manner does not affect a company’s S-3 eligibility. It is important to note that failure to timely file a Form 8-K required by Item 2.02 would be a violation of Section 13(a) of the Exchange Act.

• Conditional exemption when disclosing earnings orally. Item 2.02 of Form 8-K contains a conditional exemption from its requirement to furnish a Form 8-K where earnings information is presented orally, telephonically, by webcast, by broadcast or by similar means. A company must provide on its Web site at the time the presentation is made any material financial and other statistical information not previously disclosed and contained in the information. If material information is disclosed unexpectedly, e.g., pursuant to a question and answer session that was part of an oral presentation, the material information must be posted on the company’s Web site promptly after it is disclosed.

It is important to note that there is no specific SEC Compliance & Disclosure Interpretation, or C&DI, that mandates companies to disclose their non-GAAP financial measures used in earnings releases in their upcoming SEC filings such as Forms 10-K and 10-Q. However, from these revised C&DIs, one may conclude that the SEC staff may start focusing on differences in disclosures between earnings releases and SEC filings.

If the SEC takes this possible approach in the future and concludes that particular differences are material to investors, then future SEC guidance, rule changes and enforcement actions may be forthcoming. It is possible that the SEC may look for more consistency regarding non-GAAP financial measures disclosed in SEC filings and earnings releases. If inconsistencies are found, the SEC may take enforcement action.

CONCLUSION

In November 2009, the SEC brought its first enforcement action that included allegations of Regulation G violations. Although the case was settled, companies should consider the SEC’s awareness and focus on the matter. In light of the recent SEC guidance and enforcement action, companies are advised to carefully ensure that their disclosures comply with Regulation G in particular and Item 10(e), to the extent the latter is applicable. •

Katayun I. Jaffari is a partner in Saul Ewing’s business department and chair of the corporate governance practice group and co-chair of the securities transactions and regulations practice group. Jaffari has extensive experience counseling public and private companies in the area of securities law and compliance, including reporting requirements under NYSE and NASDAQ regulations. Jaffari was selected as one of the Philadelphia Business Journal’s 2009″40 Under 40.” Ms. Jaffari can be reached at kjaffari@saul.com or 215-972-7161.

Jeffrey M. Lipschutz is an associate in Saul Ewing’s business department, where he concentrates his practice in securities regulation and securities transactions while also practicing in the areas of general corporate law, corporate healthcare law and mergers and acquisitions. He can be reached at jlipschutz@saul.com or 215-972-8579.