By George Wilson
On January 30, 2020 the SEC issued formal guidance in a Financial Release about the use of key performance indicators and metrics. This new Release, number 33-10751 or FR 87, was issued at the same time as a proposed rule to amend the MD&A requirements and eliminate S-K Item 301 Selected Financial Data and the quarterly information required by S-K Item 302.
While the MD&A changes and elimination of S-K Items 301 and 302 are all proposed, the new guidance about the use of metrics is not a proposed rule and its requirements will be effective when it is published in the Federal Register.
(We will put up a post when the Release is published in the Federal Register.)
Its imminent effectiveness makes becoming familiar with the Release important when preparing earnings releases as it may well apply to key performance indicators and metrics in year-end earnings releases and will almost certainly apply to such measures used in first quarter earnings releases.
As a brief review the SEC addressed Key Performance Indicators in its 2003 MD&A release, (33-8350 – FR 72):
1. Focus on Key Indicators of Financial Condition and Operating Performance
As discussed, one of the principal objectives of MD&A is to give readers a view of the company through the eyes of management by providing both a short and long-term analysis of the business. To do this, companies should "identify and address those key variables and other qualitative and quantitative factors which are peculiar to and necessary for an understanding and evaluation of the individual company."
Financial measures generally are the starting point in ascertaining these key variables and other factors. However, financial measures often tell only part of how a company manages its business. Therefore, when preparing MD&A, companies should consider whether disclosure of all key variables and other factors that management uses to manage the business would be material to investors, and therefore required. These key variables and other factors may be non-financial, and companies should consider whether that non-financial information should be disclosed.
Over the years the staff has asked companies to provide additional information about their use of metrics in the comment process. You can find some examples in this post which provides deeper background about metrics, this post with example SEC comments on the use of metrics and this post about an enforcement case focused on metrics.
In this new Release the SEC builds on and formalizes what it did in FR 72 and its comments about metrics in filing reviews. The major points the SEC focuses on in the new Release include:
1. Metrics should be used with care to assure they are not misleading.
The release states:
“When including metrics in their disclosure, companies should consider existing MD&A requirements and the need to include such further material information, if any, as may be necessary in order to make the presentation of the metric, in light of the circumstances under which it is presented, not misleading.”
This language harkens back to Exchange Act Rule 12b-20:
12b-20 Additional information.
In addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading.
A perhaps extreme example of this situation would be presenting a metric that shows a business as improving and getting stronger when on a GAAP basis it is experiencing widening losses and potential liquidity issues.
2. When presenting a metric companies should consider whether an existing set of requirements such as GAAP, IFRS or the SEC’s non-GAAP measure guidance in Regulation G or Regulation S-K Item 10(e) applies.
3. When presenting a metric, companies should consider what additional information should be presented to “provide adequate context” for investors to understand the metric and the information it conveys. The Release indicates that the SEC would “generally expect” these disclosures:
“A clear definition of the metric and how it is calculated;
A statement indicating the reasons why the metric provides useful information to
A statement indicating how management uses the metric in managing or monitoring the
performance of the business.”
The release also notes that if there are “estimates or assumptions underlying the metric or its calculation careful consideration should be given to disclosure of such items to assure the metric is not materially misleading”.
4. The release emphasizes consistency in the preparation and presentation of metrics, an issue that the SEC has dealt with in the comment process. For example, when a company changes how a metric is computed it likely should explain why the change was made and what the impact of the change was. Additionally, if a new metric is presented or a previously presented metric is discontinued, this should likely be discussed and the metric for previous periods may need to be recomputed.
The Release states:
“If a company changes the method by which it calculates or presents the metric from one period to another or otherwise, the company should consider the need to disclose, to the extent material:
(1) the differences in the way the metric is calculated or presented compared to prior periods,
(2) the reasons for such changes,
(3) the effects of any such change on the amounts or
(4) such other differences in methodology and results that would reasonably be expected to be relevant to an understanding of the company’s performance or prospects.
Depending on the significance of the change(s) in methodology and results, the company should consider whether it is necessary to recast prior metrics to conform to the current presentation and place the current disclosure in an appropriate context.”
5. FR 87 also emphasizes that metrics should be considered in a company’s disclosure controls and procedures. Disclosure controls and procedures (DCP) are defined in Exchange Act Rule 13(a)-15:
(e) For purposes of this section, the term disclosure controls and procedures means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Act (15 U.S.C. 78a et seq.) is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Act is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
Since DCP are applicable in reports “filed or submitted” and earnings releases are furnished to the SEC in an Item 2.02 Form 8-K it is important that metrics that provide material information be considered in the DCP process. A likely starting point in this consideration is: are metrics included in your disclosure committee’s discussions?
Clearly the SEC will begin to focus on how companies use metrics and the adequacy of disclosures around metrics. As an example of issues to consider, you could review this section at the beginning of Facebook’s most recent Form 10-K titled “Limitations of Key Metrics and Other Data” or the section about metrics at the beginning of Twitter’s 2018 Form 10-K.
In our next post we will review an example of the disclosures a company made when they decided to change their presentation of a metric like non-GAAP measure.
As always, your thoughts and comments are welcome.