The Generally Accepted Accounting Principles (GAAP) earnings for the Standard & Poor's 500 significantly trailed the pro-forma adjusted figures reported in 2015, with GAAP earnings per share of approximately $85 falling well below the non-GAAP $118. This marked the largest discrepancy in years, with write-downs in the energy sector being the primary driver, though rising stock-based compensation and restructuring expenses in the technology sector also played a role. Thorough investment research requires assessment of both GAAP and adjusted results, but investors should carefully consider the validity of non-GAAP exclusions on a case-by-case basis to avoid misleading and excessively bullish figures, especially as reporting standards diverge.

GAAP

GAAP was developed by the Financial Accounting and Standards Board (FASB) to standardize financial reporting, providing a uniform set of rules and formats to facilitate analysis by investors and creditors. The GAAP created guidelines for item recognition, measurement, presentation and disclosure. Bringing uniformity and objectivity to accounting improves the credibility and stability of corporate financial reporting, factors that are deemed necessary for optimally functioning capital markets. Companies can be compared against one another; results can be verified by reputable auditors, and investors can be assured that the reports are reflective of fundamental well-being. These principles were established and adapted largely to protect investors from misleading or dubious reporting.

Non-GAAP

There are instances in which GAAP reporting fails to accurately portray the operations of a business. Companies are allowed to display their own accounting figures, as long as they are disclosed as non-GAAP and provide reconciliation between the adjusted and regular results. Non-GAAP figures usually exclude irregular or noncash expenses, such as those related to acquisitions, restructuring or one-time balance sheet adjustments. This smooths out high earnings volatility that can result from temporary conditions, providing a clearer picture of the ongoing business. Forward-looking statements are important because valuations are largely based on anticipated cash flows. However, non-GAAP figures are developed by the reporting company, so they may be subject to situations in which the incentives of shareholders and corporate management are not aligned.

Divergence

Investors are required to observe and interpret non-GAAP figures, but they must also recognize instances in which GAAP figures are more appropriate. Successful identification of misleading or incomplete non-GAAP results becomes more important as those numbers diverge from GAAP. Studies have shown that adjusted figures are more likely to back out losses than gains, suggesting that management teams are willing to abandon consistency to foster investor optimism. The discrepancy between GAAP net income and non-GAAP profits among Dow Jones Industrial Average (DJIA) firms grew from 11.8% in 2014 to 30.7% in 2015. Much of this can be attributed to turmoil in commodity and currency markets, which heavily distorted GAAP earnings in several industries. Concerns over reporting practices reached beyond the impacts of slumping energy prices as Equifax Inc. (NYSE: EFX) and T-Mobile US Inc. (NASDAQ: TMUS) both received warning letters in 2015 from the Securities and Exchange Commission (SEC) regarding improper reporting.

Where Should Investors Focus?

GAAP and non-GAAP results are both important in many cases, and studies by academic and professional sources support this stance. Investors forced to choose a side as the two diverge should consider the specific exclusions in adjusted figures, and personal economic outlook is also important. The 2015 divergence of non-GAAP figures is due largely to commodity and energy price turmoil, so investors with bullish outlooks on the rebound are more likely to find value in non-GAAP figures than those who expect commodities to remain depressed. Companies that consistently purchase smaller firms and intend to sustain this acquisitive strategy often exclude certain acquisition-related costs that remain a material ongoing expense to the business but should not be overlooked.

Studies have suggested that the exclusion of stock-based compensation from earnings results materially reduces the predictive power of analyst forecasts, so non-GAAP figures that merely adjust for equity compensation are less likely to provide actionable data. However, non-GAAP results from responsible firms grant investors unparalleled insight into the methodology employed by management teams as they analyze their own companies and plan future operations.

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