Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Specific Provisions Of Regulation G Of The Sarbanes-Oxley Act (SOX) Explained

|Includes: Tesla, Inc. (TSLA)

Based upon a couple of responses to a couple of posts of mine on Tesla articles recently, apparently, there are some who don't understand Regulation G of the Securities and Exchange Commission, specifically item (3) and the reason for which it was created and became effective on March 28, 2003.

As stated by the SEC, per its Final Rule on conditions for use of Non-GAAP Financial Measures:

"As directed by the Sarbanes-Oxley Act of 2002, we are adopting new rules and amendments to address public companies' disclosure or release of certain financial information that is calculated and presented on the basis of methodologies other than in accordance with generally accepted accounting principles (GAAP). We are adopting a new disclosure regulation, Regulation G, which will require public 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. "

The SEC further states:

"I. Background

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act).7 As directed by Section 401(b) of the Sarbanes-Oxley Act, we published for comment a number of new rules and amendments to address the use of 'non-GAAP financial measures' on November 4, 2002.8 As discussed in that proposing release, the Commission has expressed concerns regarding the improper use of non-GAAP financial measures during the past 30 years.9 The rules we adopt today reflect the letter and spirit of the Sarbanes-Oxley Act, our history in regulating non-GAAP financial measures, and the comments we received on the proposals."

For some background on "why" Regulation G was created, Enron had filed for bankruptcy on December 2, 2001, and MCI Worldcom filed for bankruptcy on July 21, 2002. Other accounting scandals had occurred at Cendant, Rite-Aid, Xerox, and Tyco International. As a result the Sarbanes Oxley Act (SOX) was instituted to reform the financial reporting process.

Regulation G was created, as a result of Sarbanes-Oxley, to stop the improper use of non-GAAP financial measures. It has a general requirement and a specific requirement. According to Ernst and Young:

"The Act directed the SEC to implement and enforce rules requiring that, when non-GAAP financial measures are disclosed, they must be presented in a manner that (1) does not contain an untrue statement of a material fact or omit a material fact necessary to make the 'pro forma financial information,' in light of the circumstances under which it is presented, not misleading, and (2) reconciles the 'pro forma financial information' presented with the financial condition and results of operations of the company under US GAAP."

www.ey.com/Publication/vwLUAssets/Techni...

The "general" requirement of Reg G is that the non-GAAP information not contain an untrue statement of a material fact or does not omit a material fact necessary to make the non-GAAP information not misleading. A company is prohibited from presenting misleading non-GAAP information, in other words.

Then the "specific" requirement of the regulation is that the non-GAAP information must be reconciled with GAAP.

Both requirements must be met, not just the specific requirement of reconciliation.

"3. Requirements of Regulation G

Regulation G contains a general disclosure requirement and a specific requirement of a reconciliation of the non-GAAP financial measure to the most directly comparable GAAP financial measure.

a. General disclosure requirement

Regulation G includes the general disclosure requirement that a registrant, or a person acting on its behalf, shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.

b. Reconciliation Requirement

Whenever a company that is subject to Regulation G, or a person acting on its behalf, publicly discloses any material information that includes a non-GAAP financial measure, Regulation G requires the registrant to provide the following information as part of the disclosure or release of the non-GAAP financial measure:

  • a presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP; and
  • a reconciliation (by schedule or other clearly understandable method), which shall be quantitative for historic measures and quantitative, to the extent available without unreasonable efforts, for prospective measures, of the differences between the non-GAAP financial measure presented and the most directly comparable financial measure or measures calculated and presented in accordance with GAAP."

www.sec.gov/rules/final/33-8176.htm

In the September, 2016, in correspondence between Tesla and the SEC, the SEC instructs Tesla to stop reporting the deferred lease revenues and the Resale Value Guarantee (RVG) Liabilities, associated with the RVG transactions, as non-GAAP revenue, and to also stop the reporting of the associated costs of those items. But, Tesla "hems" and "haws" and doesn't state they will comply.

www.sec.gov/Archives/edgar/data/1318605/...

In the same letter, the SEC tells Tesla to relabel the "Cash Flow from Core Operations" so that it is not confused with a measure of operating cash flow. However, Tesla, in fact, meant that measure to be a measure of operating cash flow. They still add the collateralized lease borrowings to the GAAP operating cash flow in their shareholder newsletters and present the sum of the two, together. Their intent is that the sum represent a measure of operating cash flow.

In a September 23, 2016, letter, the SEC asks Tesla what changes they are going to make to the non-GAAP revenue in regards to the RVG transactions, as discussed previously. It is at this point that Tesla states they will change the non-GAAP reporting and no longer report the deferred leasing revenue and RVG liabilities as revenue, along with the associated costs.

The SEC regarded these items as "potentially misleading" and in violation of Regulation G. This was material to Tesla's non-GAAP revenues and many Tesla investors regard the non-GAAP revenue with these items as more relevant and credible than GAAP. It is because of this fact that this is important, because investors are relying on the non-GAAP data, rather than the GAAP data. Some of the RVG transactions are not actually sales, but just leases. Yet, Tesla was reporting these transactions as sales in its non-GAAP revenues and costs.

No company may present non-GAAP information considered to be materially misleading in public disclosures, per Regulation G.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.