What Happened To Regulation G?

What happened to Regulation G, the SEC rule intended to stop companies touting EBABS, or "Earnings Before All The Bad Stuff?"

The regulation, adopted in January 2003, applies whenever a company publicly discloses a non-GAAP financial measure. All such disclosures must include a quantitative reconciliation of the differences “between the non-GAAP financial measure presented and the comparable financial measure or measures calculated and presented in accordance with GAAP.“ In addition to a GAAP reconciliation schedule, the disclosure must be clear; it cannot include a misstatement or omission that might be misleading.

However, recent earnings announcements—like the ones below—would likely dismay anyone who expected companies to abandon non-GAAP financial measures as a result of the rule:

"Chiron Reports 2004 First-Quarter Pro-Forma Results of 22 Cents Per Share

24 Percent Increase in Pro-Forma Revenues Over First Quarter 2003"

"Intuit Posts Record Revenue of $713 Million in Third Quarter

Third-Quarter Revenue Up 12%; Pro Forma EPS Up 14%"

But the death of pro forma reporting was never the SEC's intent.

Curtis

The agency recognizes that non-GAAP numbers management uses to measure financial performance may help analysts and investors. "The SEC is saying, 'We understand the desire to present the most appropriate picture of the financial statements, but we've got to have some rules,' " says Christopher Curtis, a former investor relations executive at $4.8 billion R.R. Donnelly who now serves as vice president at communications consultants Ashton Partners. "Two years ago, some earnings releases did not include GAAP numbers at all."

Silver

Michael Silver, a partner at Hogan & Hartson, is not surprised companies continue to use non-GAAP numbers, and sees nothing wrong with them as long as they're balanced. Non-GAAP financial measures are appropriate when companies take a special charge or record a one-time gain, circumstances most will encounter. "The SEC is saying, 'Look, if you’re going to do this, you need to be clear with people that you’re doing it and reconcile it to GAAP,' " he says, noting that the Commission allows companies to show cash flow measures like EBIT and EBITDA even though they are non-GAAP numbers.

Distinctions And Confusions

Reg. G, which applies to information "furnished" to the SEC, was part of a package that included amendments to Item 10 of Regulation S-K and Item 10 of Regulation S-B, which apply to documents "filed" with the SEC.

The distinction is important because companies face greater liability for misstatements in documents that are filed rather than furnished, but it has also created confusion.

Reg. G requires "companies that disclose or release such non-GAAP financial measures to include, in that disclosure or release, a presentation of the most directly comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure."

In the examples above, Chiron and Intuit both complied; they cited GAAP numbers shortly after the non-GAAP ones, and included a reconciliation table at the end of the releases, which were furnished to the SEC on Form 8-K.

However, experts note that the headlines would not pass muster if the companies "filed" the releases as an exhibit to their 10-Q.

Item 10 of Regulation S-K and Item 10 of Regulation S-B require companies to "provide a presentation, with equal or greater prominence, of the most directly comparable financial measure calculated and presented in accordance with GAAP."

Olson

Yet many advisers suggest companies adhere to the "equal prominence" standard even in press releases. "I wouldn’t advise using non-GAAP numbers in a headline or caption in MD&A," says John Olson, a partner at Gibson, Dunn & Crutcher.

Thompson

Louis Thompson, president and CEO of the National Investor Relations Institute, goes further. "Our guidelines say put the GAAP numbers first and follow with the non-GAAP numbers," he says, "Both sets of numbers should be in the lead, you don't want to bury the GAAP numbers at the back." Ashton's Curtis also cautions clients against putting non-GAAP numbers in the headline, though he adds, "If you do do it, at least identify it as non-GAAP."

Diverging Opinions And Exceptions

But Curtis disagrees with what he calls an "emerging best practice" that states companies should always lead with GAAP.

"Suppose a company has a big special credit," he says, "If you lead with the GAAP number, it's absurd and misleading. You need to highlight that there's a big hunk of earnings that are non-recurring."

Curtis generally sees companies divided into two camps. The first, which includes those afraid of violating Reg. G., don’t give non-GAAP numbers, but append to the GAAP number a list of what's included. That list might include asset impairments, restructuring charges or one-time gains. "They say, 'Here's the list, you figure it out,' " he says. "The other camp says, 'Reg. G is not that hard, here's GAAP, here's what's in it, and here's a non-GAAP number you should probably be looking at.' "

RELATED SURVEYS

Pro-Forma Use Survey From August 2003

NIRI Survey From June 2003 On Pro-Forma Usage

A NIRI survey of first quarter earnings releases (at right) showed a 10 percent drop in the number of companies using pro forma figures. Thompson says the reason most often cited for stopping was the reconciliation process, but others find that excuse hard to swallow. "You have the GAAP financial information anyway," says Silver, "If you choose to present non-GAAP financial information, you have to show how you get from one to the other and why it’s important to show non-GAAP measures. It’s not that difficult."

But the "equal prominence" debate does not end the confusion over Reg. G.

The rule, for example, does not cover all numbers—only non-GAAP financial measures that could be mistaken for GAAP measures. Margin calculations, which are not GAAP numbers, do not count as non-GAAP financial measures as long as both the numerator and the denominator are GAAP numbers.

Non-GAAP non-financial measures are exempt, too. "Auto sales and same store sales are non-GAAP measures, but they’re not covered by Reg. G," says Olson. "When I talk to non-lawyers, I have to go through this very carefully."

A third category includes numbers like local currency sales, which are not GAAP but do not qualify as non-GAAP financial measures subject to Reg. G.

Curtis singles out three companies he uses as models for Reg. G compliance. [Editor’s note: All companies are current or former clients of Curtis’ firm, Ashton Partners] "R.R. Donnelly and Hospira have done a phenomenal job in reconciliation, and a really good job reconciling guidance," he says, "American Axle Manufacturing has done an awesome job from day one."

The presentation of pro forma numbers troubled the SEC long before Reg. G, which derives from the Sarbanes-Oxley Act of 2002. Three years ago the agency charged Trump Hotels & Casino Resorts under basic anti-fraud principles with issuing a misleading 1999 earnings release.

As a result, experts note that companies who ignore Reg. G are tempting fate; the question is when, not whether, the SEC will take enforcement action. "The SEC has given some guidance to individual issuers," says Silver, "But until the SEC publishes an update to its FAQ, companies will approach Reg. G in different ways."

Silver thinks the SEC may follow the same procedure it applied to Regulation FD and look for a poster-child. Back in June, the Commission filed a complaint alleging violations of Reg. FD against Siebel Systems, its second such action against the company. "I’ve heard they are looking at a handful of issuers for violations of Reg. G. That’s all hearsay, though, nothing definite," he says.