4.3 What Is a Potentially Misleading Non-GAAP Measure?

Restructuring, transformation, realignment, and acquisition costs — If a registrant has recurring restructuring charges or frequent business acquisitions, the SEC staff may ask about the facts and circumstances supporting an adjustment for what may appear to be a normal cash operating cost. A registrant should therefore carefully consider which costs are being attributed to a restructuring or transformation activity. Depending on its specific circumstances, the registrant may be able to support its conclusion that such an adjustment is appropriate. However, the registrant may wish to consider whether enhancements to its disclosures about the nature and purpose of the adjustment or resulting non-GAAP measure would help clarify the intent of the measure or its use by management and investors. Similar considerations would apply to costs characterized as transformation or realignment costs.

Earnings before interest, taxes, depreciation, amortization, and rent (EBITDAR) and adjusted EBITDAR — The SEC has also asked certain registrants about their presentation of EBITDAR and adjusted EBITDAR because the adjustment for rent could be viewed as eliminating a normal, recurring cash operating expense from a non-GAAP performance measure. Such non-GAAP measures are often presented as (1) a component of the ROIC metric or (2) individually, in certain industries (e.g., managed care facilities, airline, and gaming). In recent SEC comment correspondence, the staff has indicated that EBITDAR and adjusted EBITDAR should not be characterized as performance measures. However, in some circumstances, the staff may not object to disclosure of the measures if they are characterized as financial valuation measures. If EBITDAR and adjusted EBITDAR are disclosed as financial valuation measures, the purpose and use disclosures that accompany them should also indicate that the measures are used for valuation purposes (see Section 1.2.2), and they should still be reconciled to net income. Further, if EBITDAR is presented as a financial valuation measure, the SEC may object to such presentation for all comparative periods because it may indicate that the measure is also a performance measure. Accordingly, the SEC may request that the measure be presented only for the most recent period.

Preopening and start-up costs — Preopening costs are routinely incurred in certain industries, such as the restaurant and retail industries. Such costs are related to the opening of new company-operated store locations and may include legal fees, rent, training expenses, and travel and lodging costs for the preopening team before a store’s opening date. The SEC staff generally considers preopening costs for new stores to be a standard part of a stated growth strategy or of ongoing operations since such costs are generally viewed as normal, recurring cash operating expenses. Accordingly, the staff may challenge registrants that eliminate material preopening costs to arrive at a non-GAAP performance measure. Similarly, a registrant may incur start-up costs as part of a strategic initiative to expand an existing business line or offering. The staff generally evaluates such costs in the context of the registrant’s entire operation rather than one specific offering or location and views these costs as part of the registrant’s normal operations and its broader strategy to generate additional revenue.

At the 2022 and 2023 AICPA Conferences, the SEC staff discussed an example from the retail industry in which retailers often open, close, and relocate stores in the normal course of business. The staff indicated that a retailer would not be able to reasonably argue that the expenses associated with opening a new store are unique because this would be considered part of (1) revenue generation and (2) the business strategy for the retailer’s growth. While new stores may not be opening at a high frequency (e.g., daily or monthly), such openings would still be considered part of normal operations and would most likely be occurring occasionally at irregular intervals. Therefore, the associated preopening expenses should not be excluded from the calculation of a non-GAAP measure. While the example given at the conference focused on the retail industry, the SEC staff has issued comments to registrants in other industries (e.g., restaurants, hospitality) that excluded preopening costs from non-GAAP measures.

Up-front and subsequent-development milestone expenses — In certain industries (e.g., life sciences), the parties to contractual arrangements often incur up-front and ongoing costs. For example, collaborative or licensing arrangements often involve an expense for the payment of an up-front licensing fee (in the form of cash, an equity investment, or both) and future expenses for subsequent payments based on the achievement of development milestones. Also, research and development arrangements accounted for as an asset acquisition may often involve an up-front expense for acquired in-process research and development (IPR&D) as of the acquisition date if such IPR&D has no alternative future use. Notwithstanding the fact that these two types of arrangements are different, registrants in the life sciences industry often include adjustments to eliminate the up-front and subsequent-development milestone expenses from their non-GAAP performance measures. In recent correspondence, the SEC staff has commented on the nature, purpose, and presentation of these adjustments. The staff indicated that when such arrangements are recurring or are a normal part of business activities or strategies, registrants should not include adjustments to eliminate these expenses.

Inventory losses — At the 2023 AICPA Conference, the SEC staff discussed inventory losses encountered by many registrants over the past few years as a result of (1) inventory backlog or obsolescence due to supply-chain disruptions caused by the COVID-19 pandemic and (2) significant amounts of inventory shrink due to theft. The staff also reiterated remarks made at the 2022 AICPA Conference that in the context of normal, recurring cash operating expenses, (1) the term “normal” should be evaluated in light of the registrant’s operations, revenue-generating activities, business strategy, industry, and regulatory environment and (2) an operating expense is considered “recurring” if it occurs repeatedly or occasionally, including at irregular intervals. The staff gave some examples of adjustments that may be considered normal or recurring, such as losses on inventory. Further, the staff noted that to determine whether a specific inventory loss is normal or recurring, a registrant must use significant judgment and consider its individual facts and circumstances. Depending on those facts and circumstances, the staff may view the nature of losses associated with market shocks or other short-term declines in demand as normal and recurring, in which case registrants should not make adjustments to eliminate them.

Adjusted revenue — One example in the C&DI refers to a prohibited non-GAAP performance measure that reflects revenue recognized ratably over time under GAAP on an accelerated basis as if the registrant earned revenue when it billed its customers. The measure is prohibited because it is an individually tailored accounting principle and does not reflect the registrant’s required GAAP measurement method. However, as outlined at the 2020 AICPA Conference, the SEC may not object in certain circumstances when a registrant presents the amount of revenue billed to a customer — that is, “billings” or “bookings” (with appropriate characterization) as an operational metric — because such measures are not considered non-GAAP measures. At the 2020 AICPA Conference, the SEC staff also cautioned registrants about the presentation of a non-GAAP measure labeled “net revenue” in which certain costs of sales are subtracted from GAAP revenue. The staff indicated that the labeling of such measures could be misleading if the measures refer to revenue or sales and emphasized that it is likely to ask questions if a registrant identifies something as revenue that is not, in fact, revenue. The staff further explained that it may be acceptable to refer to such measures as “Adjusted Gross Profit” or “Contribution Margin” but reminded registrants that the GAAP measure that is most comparable to an adjusted gross profit or contribution margin is generally a “fully loaded” GAAP gross margin.

Another example in the C&DI refers to a prohibited non-GAAP measure of revenue in which transaction costs are deducted to arrive at a net revenue amount when the registrant is the principal in the transaction, as required by GAAP. This measure is prohibited because the accounting method is tailored to present revenue as if the registrant were an agent in the transaction. The example also states that the inverse of this situation would also be prohibited — that is, if the registrant is an agent in the transaction and the non-GAAP measure of revenue is presented on a gross basis when net presentation is required by GAAP.

Sales incentives — Registrants should not exclude from their presentation the effects of any sales incentives, discounts, or rebates that are recorded as a reduction to revenue as adjustments to revenue or earnings measures because such a presentation may be an individually tailored method of revenue recognition and measurement. Similarly, depending on the terms in a warrant and other related agreements, a registrant may be required under U.S. GAAP to offset the expense associated with warrants issued as sales incentives as a reduction of revenue over the related performance period. The SEC staff has noted that registrants should also generally not exclude from their presentation the effects of the fair value of warrants issued as sales incentives as adjustments to revenue or earnings measures because this presentation may be an individually tailored method of revenue recognition and measurement.

Adjustments affecting capital structure — In certain circumstances, a registrant may wish to adjust a non-GAAP measure in a manner that provides an alternative presentation of the entity’s capital structure. For example, a registrant may want to present an adjustment in which two separate classes of stock with different rights and economics are combined into one class of stock for the presentation of an adjusted earnings-per-share measure even though the registrant is required under GAAP to use the two-class method to present earnings per share. The SEC staff has commented that such an adjustment may constitute an individually tailored accounting method.

Inventory adjustments — In certain situations, it may not be misleading for a registrant to present a measure that substitutes one acceptable measure under GAAP for another such measure. For example, if a registrant reports its inventory by using the LIFO method of accounting, it may make an adjustment to show the impact of reporting inventory on a FIFO basis if the adjustment is otherwise in compliance with the Rules. This may not be considered individually tailored accounting and therefore may be permitted because both presentations are acceptable under GAAP. However, if the presentation of a non-GAAP performance measure changes the accounting for inventory to an internal basis used by management (i.e., a basis not in accordance with GAAP), such presentation could be misleading.

Presentation of EBITDA measures after the adoption of IFRS 16 — Because of differences between the guidance in ASC 842 and IFRS 16, EBITDA measures presented by a domestic registrant that applies ASC 842 may not be comparable to similar measures presented by an IFRS filer. For example, ASC 842 requires the reduction of the right-of-use asset for an operating lease to be recorded as rent expense in the income statement. Under IFRS 16, however, such a reduction must be presented in a manner similar to that of a financing lease, which would result in depreciation expense for the right-of-use asset. At the March 20, 2019, CAQ SEC Regulations Committee joint meeting with the SEC staff, the SEC staff explained that it would view “a measure presented by an IFRS registrant that adjusts EBITDA to deduct interest and depreciation solely related to leases as an individually tailored accounting principle.” For more information about the differences between ASC 842 and IFRS 16, see Deloitte’s Roadmap Leases.

Segment measures — Under ASC 280, a registrant may present a segment measure of profit or loss on a basis that is consistent with the manner in which the registrant is managed but different from the GAAP basis of presentation in its consolidated financial statements (e.g., a material charge for restructuring or impairment that is related to a specific segment may not be included in management’s measure of the segment’s operating profit or loss). Such segment measures are not non-GAAP financial measures under the Rules as long as they are presented on a separate segment basis, although the SEC staff would consider their presentation or discussion on a consolidated basis, if disclosed outside of the footnotes to the financial statements, to be a non-GAAP financial measure. See additional discussion in Section 2.5.

In addition, the SEC staff has objected to entity-wide disclosures in which revenue information is presented in a manner that is inconsistent with GAAP. For example, a company may have presented revenue exclusive of discounts, returns, allowances, and other concessions that it must, under GAAP, recognize as a deduction from revenue. Since ASC 280 requires companies to align entity-wide disclosures with the corresponding amounts in the GAAP financial statements, excluding certain adjustments from revenue may be considered an individually tailored accounting principle and may not be appropriate.

Similarly, when reviewing a registrant’s determination of the segment measure of profit or loss within the financial statements, the SEC staff has objected to the application of a recognition or measurement principle to income or expense line items for a company’s segments that differs from the accounting principle it used for recognition and measurement in its GAAP financial statements (see additional discussion of tailored accounting principles in Section 2.5).

Adjusted allowance for loan loss disclosures — Banking industry registrants use certain non-GAAP financial measures that may adjust the allowance for loan losses. The SEC has objected to measures that remove the impact of purchase accounting (“fair value”) adjustments for acquired loans from the GAAP measure and therefore may be considered individually tailored accounting measures, which are prohibited under Rule 100(b) of Regulation G and C&DI Question 100.04. Such measures would include those that:

• Present an “adjusted allowance for loan losses to total loans” which adds the remaining discount on purchased loans to both the numerator and denominator.
• Reduce interest income by the amount of accretion income on purchased loans to compute the related loan yield or net interest margin.

Valuation allowances for deferred tax assets — Some registrants may consider removing the effects of significant or infrequent changes to a valuation allowance from the GAAP tax provision or a measure of net earnings. Registrants should carefully assess the facts and circumstances underlying a change in the valuation allowances when evaluating whether a non-GAAP adjustment is appropriate. For example, in certain scenarios, a registrant may recognize a valuation allowance for deferred tax assets in the GAAP financial statements on the basis of cumulative GAAP results even though it may not be required to recognize a valuation allowance based on the cumulative non-GAAP results. In such scenarios, when presenting the measure in accordance with the guidance described in C&DI Question 102.11 (see Section 4.10), it may be appropriate for a registrant to include a separate non-GAAP adjustment to remove the impact of recording the valuation allowance on a GAAP basis. However, in certain other scenarios in which, for example, an adjustment to remove the effect of a change in the valuation allowance appears inconsistent with the calculation of the non-GAAP tax impacts, the SEC staff has objected to such adjustments on the basis that they may result in an individually tailored non-GAAP income tax recognition method. Consultation with tax and accounting advisers is encouraged if a registrant is considering including adjustments for changes in a valuation allowance in its presentation of a non-GAAP measure.

Pro rata consolidation — The calculation and presentation of non-GAAP measures that use the pro rata consolidation method, which is common in the real estate, health care, and energy industries, may be inconsistent with the interpretive guidance related to individually tailored accounting principles10 as well as with C&DI 102.10 regarding prominence (see also Section 3.3). In this type of presentation, a registrant may want to combine some or all of the information in its GAAP statement of operations line item with information related to its pro rata share of unconsolidated investees or affiliates to arrive at a non-GAAP pro rata statement of operations.

Use GAAP titles such as “gross margin” or “operating income” for amounts presented that exclude costs that the registrant would generally include in these totals under GAAP or Regulation S-X, Article 5. If the registrant does exclude such costs, the label associated with them should clearly indicate that the amounts are adjusted. For example, a registrant may exclude restructuring charges from its non-GAAP “operating earnings” measure in MD&A. If so, the registrant could label the measure as “adjusted operating earnings” or “non-GAAP operating earnings” to avoid confusion with the GAAP measure as reflected in the income statement.

Label a measure “pro forma” if the measure was not calculated in a manner consistent with the concepts in Regulation S-X, Article 11, or in ASC 805.

Refer to a non-GAAP measure as “operating income” or “operating earnings,” which is a common practice in the insurance industry (although it may occur in other industries as well). If such measures are not calculated as they would be under GAAP, registrants should instead label them as “adjusted” or “non-GAAP” operating earnings or income. See Section 4.9 for a discussion of measures that exclude depreciation and amortization.