What are Non-GAAP Earnings
Non-GAAP earnings are an alternative method used to measure the earnings of a company, and many companies report non-GAAP earnings in addition to their earnings based on Generally Accepted Accounting Principles (GAAP). While these pro forma figures, which exclude "one-time" items, can sometimes provide a more accurate measure of a company’s underlying financial performance, investors need to be wary of misleading reporting that exclude items that have a negative impact on GAAP earnings, quarter after quarter.
BREAKING DOWN Non-GAAP Earnings
The justification for reporting non-GAAP earnings is that large one-off costs, such as asset write-downs or organizational restructuring, should not be considered normal operational costs, because they distort the true financial performance of a company. So, some companies provide an adjusted earnings number that excludes these nonrecurring items. Commonly used non-GAAP financial measures include earnings before interest and taxes (EBIT); earnings before interest, taxes, depreciation, and amortization (EBITDA); adjusted revenues; free cash flows; core earnings; and funds from operations.
When used appropriately, these non-GAAP financial measures can help companies provide a more meaningful picture of their performance and value. Showing how the core portion of the business is doing can be useful. However, there is no industry-standard definition of non-GAAP EPS, and many of these adjusted-EPS figures are merely designed to appear in headlines — and deceive trading algorithms as well as investors.
Non-GAAP Figures Have Become a Bad Habit
Investors need to consider the validity of non-GAAP exclusions on a case-by-case basis to avoid being misled. Studies have shown that adjusted figures are more likely to exclude losses than gains. GAAP earnings now significantly trail non-GAAP earnings, as firms become addicted to “one-time” adjustments which become a nonsense when they happen every quarter. Merck, for example, turned a loss of -$0.02 per share under GAAP into an “adjusted” profit of $1.11 a share in the fourth quarter of 2017 — a 5,650% difference!
So, investors should be minded to not lose sight of GAAP figures. Standardized accounting rules and consistent revenue recognition make reported earnings more reliable, and allow investors to compare the financial results of different companies. That is why the Securities and Exchange Commission (SEC) requires publicly listed companies to use GAAP accounting in the first place.
SEC Crackdown on Non-GAAP Disclosures
U.S. companies are under increasing pressure from the SEC to disclose GAAP earnings upfront in their earnings reports, before pointing at non-GAAP earnings. In 2017, it began taking enforcement actions against improper practices that provide greater prominence to non-GAAP measure than GAAP measures. Technology companies are among the most frequent abusers of non-GAAP EPS, because they use a lot of stock compensation and have a lot of asset impairments and R&D costs.