News & Insights


October 31, 2019

REIT Advisor - October 2019

A Cautionary Tale on Non-GAAP Metrics

Robert Grue

Increasingly used by REITs, non-GAAP metrics can provide insights into a company’s operating results that official GAAP metrics cannot. Such measures can demonstrate a company’s ability to deliver sustainable growth in earnings. Non-GAAP metrics can help investors better understand their investments. Consequently, nearly all large public companies (over 97% according to one report) include non-GAAP metrics in their financial statements. At the same time, given the lack of uniformity in calculations, these metrics can also potentially paint an inaccurate picture of a company’s performance and are susceptible to abuse. Specifically, the use of non-GAAP metrics by former executives of the New York-based REIT, Brixmor Property Group Inc. (the “Company”), provides an example.

On December 23, 2015, one of the Company’s employees submitted an anonymous complaint to the Audit Committee, accusing certain executives of directing the accounting team to manage the Company’s earnings through an internal ledger account, where extra income was improperly held for future use. After an internal investigation, the Company’s board concluded that certain accounting and financial reporting personnel had “smoothed” income items, both gains and losses, to show consistent quarterly same property net operating income (“SP-NOI”) growth. The calculation of SP-NOI reportedly stripped out revenues and costs that former executives deemed less relevant to the Company’s performance, such as lease termination payments. However, the investigation revealed that such “excluded” income was included in the calculation at times to conceal volatility in the Company’s earnings performance. Internally, former executives of the Company tried to cover up the deception. According to a subsequently filed indictment, when one investor relations employee inquired about the removal of certain properties from a same-property pool to reduce income from a prior comparative period, the Company’s former CFO reportedly asked “How did she find out? She must not be given access to how we make the sausage.”

Following the investigation, the Company self-reported its findings to the SEC and filed a Form 8-K on February 8, 2016, disclosing the results. According to the SEC, the Company’s SP-NOI growth rate in one quarter in 2014 was overstated by 50%, a fluctuation that even diligent investors and analysts were unaware of. By underreporting income in “up times” and overreporting income in “down times,” former executives of the Company were able to show consistent growth that attracted investors wary of market fluctuations after 2008. The first trading day following the disclosure, the Company lost around $1.6 billion in market valuation. Subsequently, the Company paid $7 million in a civil settlement with the SEC. The Company has since (i) replaced its management group, including its former CEO and CFO who have since been charged by a grand jury indictment with criminal securities fraud, conspiracy to commit fraud, and making false statements in federal securities filings, and (ii) hired an outside consultant to review its policies to ensure the accuracy of its financial reporting.

This story provides some important takeaways that are relevant to all publicly-traded REITs:

  • The SEC is more closely scrutinizing non-GAAP metrics in financial statements. While extreme, the story above is just one example. Just last year, the SEC warned that it may further intensify enforcement efforts to better protect investors.
  • Though garnering less publicity than a sensational coverup story, even ethical, well-intentioned executives can run into trouble with non-GAAP measures. In the first half of 2018, 22% of SEC comments on non-GAAP measures related to the “undue prominence” rule (i.e., an SEC requirement that an issuer that includes non-GAAP measures in SEC filings must present, with equal or greater prominence, the most directly comparable financial measures calculated in accordance with GAAP). At the end of last year, one issuer reached a $100,000 civil settlement after running afoul of the undue prominence rule – despite the fact that the issuer otherwise was not found guilty of misleading investors or inconsistently applying the metric.
  • REIT audit committees should stay current on financial reporting requirements, which are continually evolving. As the New York SEC regional director Marc Berger stated, “A company that chooses to publicly present non-GAAP financial measures must do so truthfully.” That starts with a knowledgeable and attentive audit committee, ready to question management decisions when necessary.
  • Consistency in presentation period-over-period remains a key substantive point in presenting non-GAAP information.

SEC Proposes Amendments to Financial Disclosures for Acquisitions and Dispositions

Claire Alexander

On May 3, 2019, the Securities and Exchange Commission (“SEC”) proposed amendments to the financial disclosure requirements in Rules 3-05, 3-14 and Article 11 of Regulation S-X governing acquisitions and dispositions of businesses. According to the official Press Release issued by the SEC, the purpose of the proposed amendments is trifold: improve the financial information available to investors about significant acquisitions and dispositions, facilitate more timely access to capital sources and reduce the costs and burdens of compliance. Overall, the new rules seek to scale back the financial reporting required in M&A transactions and provide clarification on their applicability to certain types of registrants.

Changes to Significance Tests

Rule 3-05 requires registrants to provide separate audited annual and unaudited interim financial statements of a target business if the acquisition of that business is “significant” to the registrant. Significance is determined by three SEC-prescribed tests identified in Rule 1-02(w) of Regulation S-X: the investment test, the asset test and the income test. The level of significance determines the scope of information required. While generally less applicable to REITs, understanding the Rule 3-05 framework is important to the more broadly applied “real estate operation” test under Rule 3-14 for REITs.

Under the current rules, the investment test compares the registrant’s investment in the target company, based on the fair value of the purchase consideration, to the registrant’s total assets as reported on its latest audited balance sheet. The asset test compares the total assets of the target against the total assets of the acquirer. The income test compares the pre-tax income from continuing operations of the target and registrant. However, the current tests have been criticized for creating “false positives” requiring enhanced disclosures for transactions that, in reality, are relatively insignificant to the registrant.

The SEC’s proposed amendments would revise the investment and income tests to improve the accuracy of the significance determination, in an effort to reduce such false positives. The new rules would permit the use of the registrant’s market capitalization (“aggregate worldwide market value of the registrant’s voting and nonvoting common equity”), determined as of the last business day of the registrant’s most recent fiscal year immediately prior to the acquisition, in place of total assets in the investment test. In addition, the revised income test would utilize after-tax income from continuing operations and revenue as the metrics of comparison between the registrant and acquired business. Under the revised test, the registrant would use the lower of the income and revenue components for its significance determination. The result would allow registrants to take advantage of line-item disclosures from their financial statements, significantly simplifying the disclosure process. The revised tests are also expected to produce lower significance from revenue and after-tax income calculations.

The proposed amendments would also expand the situations in which a registrant can use pro forma (rather than historical) financial information to measure significance. The current rules permit the use of pro forma financial information in the significance determination only if the registrant has made a significant acquisition subsequent to the prior fiscal year and filed the target’s historical and pro forma financial statements on Form 8-K. Under the new rules, such use would be permitted if the registrant has made a significant acquisition or disposition subsequent to the last fiscal year, as long as pro forma information has been filed for such transaction. The proposed amendment would also allow the use of pro forma financial information to test significance in the context of initial public offerings.

The proposed changes would also raise the significance threshold for business acquisitions from 10% to 20%. In addition, the new rules revise the financial statement obligations for individually insignificant acquisitions that are significant in the aggregate to require historical financial statements only for acquisitions whose individual significance exceeds 20% be included in registration statements. Pro forma information about the aggregate effects of all acquisitions would still be required.

Changes to Financial Statements of Acquired Businesses

The level of significance also determines the number of periods for which registrants must provide target financial statements. Under the current rules, up to three years of audited financial statements, and unaudited financials for the most recent interim period and prior year interim period, are required for business acquisitions with a significance rating of 50% or more.

The proposed new rules would eliminate the three-year requirement and instead impose a maximum of two years of audited financial statements, in addition to unaudited financial statements for the most recent interim period and prior year interim period, for acquisitions whose individual significance exceeds 40%. For acquisitions that individually exceed 20% significance, only one year of audited financials, and unaudited financial statements for the most recent interim period, would be required. Notably, the revisions eliminate the requirement to provide unaudited interim financial statements of the target for the prior year (as is required under the current rules) when only one year of audited financials is required.

The SEC’s amendments would also modify the filing requirements for pre-acquisition financial statements. The rules, as currently drafted, require the registrant to include target financial statements in registration and proxy statements when they have not been previously filed or when they have been filed but the acquisition is of “major significance”. The proposed changes to the rules would dispense with such requirement once the target has been reflected in filed, post-acquisition financial statements of the registrant for at least one fiscal year, regardless of the transaction’s significance.

The proposed revisions also expand the use of IFRS-compliant financial statements by foreign businesses. Under the current rules, an acquired business must separately qualify as a “foreign business” under the U.S. securities laws before it can prepare financial statements under IFRS without reconciliation to U.S. GAAP. The new rules would allow registrants to provide financial statements prepared in accordance with IFRS if the target would qualify as a “foreign private issuer” on its own, which is less restrictive.

Pro Forma Financial Information

Article 11 requires registrants to file unaudited pro forma financial information relating to acquired or disposed businesses. Historically, this disclosure has taken the form of a pro forma balance sheet and pro forma income statements based on the historical financial statements of the registrant and the target business. Under the current rules, adjustments to pro formas are permitted to show how business acquisitions might have affected the financial statements to the extent “directly attributable” to the transaction and “factually supportable.” With respect to pro forma income statements, there is an additional requirement that only such adjustments with a “continuing impact” on the registrant are permitted.

The proposed amendments to Article 11 would replace the current adjustment criteria with two simple categories: transaction accounting adjustments and management’s adjustments. Transaction accounting adjustments would reflect the required accounting for the transaction in accordance with U.S. GAAP or IFRS. Management’s adjustments would present the “reasonably estimable synergies” and other transaction effects identified by management as having occurred or reasonably expected to occur, in a separate column in the pro forma financial statements. The SEC’s proposal would also require a description of the synergy or effect including material uncertainties, disclosure of the underlying assumptions, methods of calculation and estimated time frame, and qualitative information necessary to give a fair presentation of the information for each such management adjustment.

Replacement of the current adjustment bases with more flexible criteria would allow registrants to present information that is more indicative of the financial effect of the transaction. However, the exercise of judgment necessarily entailed in the proposed management’s adjustments may lead to longer preparation time and potentially create liability with respect to the adjustment for companies and, in securities offerings, underwriters.

Real Estate Operations

Rule 3-14 requires registrants that have acquired significant real estate operations to file separate pre-acquisition financial statements with respect to such operation. Under the current rules, the disclosure requirements in Rule 3-14 for acquired properties differ from those for acquired businesses under Rule 3-05. Under the current rules, the obligation to provide separate financial statements is triggered when a real estate acquisition has individual significance of 10% or greater. In addition to unaudited interim financial statements and pro forma information, the current rules require registrants to provide one year of audited financial statements for most acquired properties and three years for real estate operations acquired from related parties.

The new rules would codify the definition of “real estate operations” as business that generate substantially all of its revenues through the leasing of real property, consistent with prior SEC staff interpretations on the subject. In an attempt to align Rule 3-14 with Rule 3-05, the proposed amendments increase the significance threshold applicable to real estate operations to 20% and eliminate the three-year requirement and distinction between properties acquired from related parties and those from third parties. New Rule 3-14 would require on year of audited financials and information for the most recent interim period for acquisitions with individual significance of 20%. In addition, the revised rule would no longer require separate financials once the operating results of the acquired property have been reflected in the registrant’s audited financials for one year.

The proposed rules would also explicitly require significance of a real estate operation to be measured using the investment test in Rule 1-02(w), albeit with slight modifications. Although this change is consistent with current practice, the current rules do not specify how real estate companies should determine significance. According to the SEC’s proposal, the registrant’s investment in the acquired real estate would be compared against its market capitalization or, if market value is not available, against its total consolidated assets as of the end of the most recent fiscal year.

In addition, the proposed amendments to Rule 3-14 would prescribe a modified significance test for blind pool offerings by REITs. For REITs in the process of building a portfolio based on proceeds from continuous offerings, the total assets metric in the current investment test would cause almost all acquisitions to be deemed “significant.” To address the incongruity, the SEC’s proposal would codify its practice of advising registrants to measure significance of real estate operations acquired during an initial distribution period using the sum of pro forma total assets as of the date of the acquisition and proceeds that the registrant expects in good faith to raise in the offering in the following twelve months.

New Rule 3-14 would also change the requirements applicable to real estate subject to triple net leases. Under current staff practice, registrants are required to file audited financial statements of the lessee or guarantor of the lease in acquisitions of properties triple net leased to a single tenant, instead of financial statements of the acquired operation, in certain circumstances. The proposed changes would eliminate this requirement and treat triple net leased properties the same as other acquired real estate operations under amended Rule 3-14. This change could significantly ease the burden of disclosure for registrants who acquire triple net leased properties with a single tenant.

Impact of Changes

If adopted, the proposed changes would have a direct impact on REITs and their financial reporting in M&A transactions. The new rules would substantially change the rules that currently require REITs to file separate financial statements for acquired real estate companies and funds. Moreover, the codification of the significance test to be used for blind pool REITs conducting continuous offerings over extended periods of time and the triple net lease changes would ease the burdens of compliance and lead to more meaningful disclosures for such companies.


The new rules were subject to a sixty day public comment period, which expired on July 29, 2019. During such time, the big four accounting firms expressed their support for the new rules and the much-needed clarity, although they have written to the SEC recommending a handful of tweaks and clarifications to the new metrics and terminology. In contrast, critics of the new rules have doubted the amendments’ intelligibility. In a letter addressed to the SEC, the Council of Institutional Investors shared concerns that the supporting analysis behind the proposed changes is incomplete and fails to give due consideration to the potential costs of “value-destructive mergers and acquisitions” to long-term investors. The SEC has not yet announced when it plans to hold a vote to adopt the changes.