What Are Non-GAAP Earnings?
Non-GAAP earnings are an alternative accounting 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). These pro forma figures, which exclude "one-time" transactions, can sometimes provide a more accurate measure of a company’s financial performance from direct business operations.
However, investors need to be wary of a company's potential for misleading reporting that exclude items that have a negative effect on GAAP earnings, quarter after quarter.
Understanding Non-GAAP Earnings
To understand non-GAAP earning, it is important to first understand GAAP earning. GAAP earnings are a common set of standards accepted and used by companies and their accounting departments. GAAP earnings are used to standardize financial reporting of publicly traded companies.
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. Therefore, 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 the company's performance and value. Presenting only the financial results of the core business activities can be useful. However, there are no regulations around non-GAAP earnings per share (EPS). Many of these adjusted-EPS figures are merely designed to appear in headlines and deceive trading algorithms, as well as investors.
Criticism of Non-GAAP Earnings
A company's quality of earnings is important, so 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 companies become addicted to “one-time” adjustments which become meaningless 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 careful to not lose sight of GAAP earnings. Standardized accounting rules are in place for consistency and comparability. Consistent revenue recognition makes reported earnings more reliable for historical comparison, and it allows investors to compare the financial results of one company to that of its industry peers and competitors. That is why the Securities and Exchange Commission (SEC) requires that publicly traded companies use GAAP accounting in the first place.
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.
The SEC has begun taking enforcement actions against improper practices where companies provide greater prominence to non-GAAP figures than GAAP figures. Technology companies are among the most frequent abusers of non-GAAP EPS, because they use a significant amount of stock compensation and have large asset impairments and R&D costs.