3.2 Reconciliation Requirement

In addition, some registrants do not present a gross margin subtotal on the face of the income statement; however, they may present outside the financial statements a non-GAAP margin for which the most comparable GAAP measure could be considered gross margin. This practice has been observed in the public utility and oil and gas industries (e.g., refining margin), but it is not limited to those sectors. The measure may also be labeled “non-GAAP contribution margin” or “adjusted gross margin.” The SEC staff expects such registrants to (1) disclose that these measures are non-GAAP financial measures and (2) consider the disclosure requirements in Item 10(e). Further, the SEC staff has reminded registrants that non-GAAP measures should be presented in a balanced manner and reconciled to the most comparable GAAP measure. If a registrant does not present a gross margin subtotal on the face of the income statement but concludes that gross margin is the most comparable measure, the registrant should consider calculating and presenting a “fully loaded” GAAP measure of gross margin as the starting point in the non-GAAP reconciliation. For additional information about non-GAAP measures of gross margin, see Section 4.9.

In other circumstances, registrants should use judgment in determining the most directly comparable GAAP measure. See the next section.

For example, a performance measure should generally be reconciled to a line item from the statement of operations such as net income or income from continuing operations or, if a per-share performance measure is presented, to GAAP earnings per share. A liquidity measure should be reconciled to an amount from the statement of cash flows, such as cash provided by operating activities. The SEC’s general view is that the presentation of non-GAAP liquidity measures “should be balanced with disclosure of amounts from the statement of cash flows (cash flows from operating, investing and financing activities)” (see Section 3.2.3); and the presentation of non-GAAP performance measures “should be balanced with net income, or income from continuing operations, taken from the [income] statement.”8

Historically, the SEC staff has generally accepted management’s determination of whether a measure is a performance measure or a liquidity measure. However, as indicated in C&DI Question 102.05 (see Section 4.4), the SEC staff may challenge a measure designated as a performance measure that appears to be more like a liquidity measure.

Registrants should consider whether the classification of a non-GAAP measure as a performance measure is appropriate if the non-GAAP measure is, in substance, a liquidity measure. The context of the non-GAAP disclosure may be an important consideration. Depending in part on the size and nature of the adjustments to the corresponding GAAP measure, a registrant may need to use judgment in assessing whether a non-GAAP performance measure can be used as a liquidity measure. The SEC staff may comment if, for example:

• A non-GAAP measure is located in the registrant’s discussion of financial condition and liquidity even though the registrant considers the measure to be a performance measure and reconciles it to net income.
• Several adjustments (many of which are noncash amounts) must be made to reconcile a non-GAAP measure, that a registrant purports to be a performance measure, to the most comparable GAAP income measure, and only one or two adjustments would be needed to reconcile it to a GAAP measure from the statement of cash flows, such as operating cash flow.
• The total dollar amount of the non-GAAP adjustments consists of a large percentage of noncash charges.

If the measure could be used as a liquidity measure and is ultimately determined to be a liquidity measure, a registrant would be prohibited from disclosing a per-share amount (e.g., free cash flow is a liquidity measure, and per-share presentation is expressly prohibited9). Given the prohibition against per-share liquidity measures, registrants that disclose a per-share measure should ensure that (1) they have appropriately characterized the measure and (2) if they consider it a performance measure, they are able to articulate specifically why.

As noted in C&DI Question 102.05 (see Section 4.4 and also the discussion above), a registrant is prohibited from disclosing a non-GAAP per-share amount as a liquidity measure such as cash flow per-share data and other per-share measures of liquidity (since they are prohibited under GAAP [ASC 230] and SEC rules [ASR 142]); however, a non-GAAP per-share measure may be disclosed if it is a performance measure (subject to the other requirements of the guidance). The C&DI indicates that, if presented, a non-GAAP per-share performance measure should be reconciled to GAAP earnings per share.

When disclosing a non-GAAP per-share performance measure, a registrant is required to reconcile both the numerator and the denominator used to calculate the non-GAAP per-share measure to the most directly comparable GAAP measure.10 However, if the denominator represents diluted shares calculated in accordance with the guidance on earnings per share in ASC 260, a reconciliation of the denominator is not necessary. As noted in footnote 49 of the Release, a registrant should carefully consider (1) whether it is appropriate to use any denominator other than diluted shares calculated in accordance with ASC 260 and (2) whether the resulting measure could potentially be misleading.