An earnings measures that do not follow GAAP’s (Generally Accepted Accounting Principles) standard calculations
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Written byCFI Team
What are Non-GAAP Earnings?
Non-GAAP earnings are earnings measures that are not prepared using GAAP (Generally Accepted Accounting Principles) and are not required for external reporting or other public disclosures. However, non-GAAP earnings are sometimes reported in company filings with the Securities and Exchange Commission (SEC) when management feels it will be useful for stakeholders, and they are often used internally to make managerial decisions or to evaluate management.
GAAP Earnings vs. Non-GAAP Earnings
To understand non-GAAP earnings, it is important to understand GAAP earnings and how to calculate GAAP earnings. GAAP is a set of standard accounting rules that companies must use to prepare their financial statements. Auditors ensure GAAP is properly applied so that they can provide assurance on the financial statements, which public companies need to file under Securities and Exchange Commission rules.
GAAP aims to keep accounting practices consistent for all companies, and within different reporting periods of a company. It ensures market participants that they will be able to analyze the companies’ financial statements on a level playing field and that companies prepared their earnings use the same set of accounting rules.
Why are Non-GAAP Earnings Reported?
At the basic level, non-GAAP earnings are reported because management may find it to be a more suitable way to depict the company’s earnings. An example would be if a company incurred a large one-time expense; the company would need to report that expense under GAAP rules.
However, the company may report a pro-forma statement or adjusted earnings statement, which would mark the large expense as a one-time expense and would not include it when calculating non-GAAP income. Thus, the discrepancy between non-GAAP and GAAP earnings might be large.
Another reason that companies use non-GAAP earnings is to show investors management’s view of its core operations.
Significance of Non-GAAP Earnings
The use of non-GAAP earnings in SEC filings is at its highest. In 1996, 59% of S&P 500 companies used at least one non-GAAP earnings measure, whereas in 2018, 97% of S&P 500 companies used at least one non-GAAP earnings measure in company filings. The use of non-GAAP earnings, in part, increased because of the increase in large non-recurring items. For example, the number of mergers and acquisitions worldwide has generally increased over the past 20 years, and merger-integration and restructuring costs are typically deemed to be non-recurring.
In addition, investors pay close attention to non-GAAP earnings, as it provides insight into how management believes its core operations are performing. However, non-GAAP earnings may be misleading when incorrectly used. A company may include significant non-recurring costs in every filing, which can suggest the company is attempting to inflate its non-GAAP earnings.
Common Non-GAAP Earnings Measures
The following are non-GAAP earnings measures that are frequently used:
EBITDA
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is one of the most popular non-GAAP earnings measures. It is a proxy for a company’s operating profitability excluding large, non-cash expenses (depreciation and amortization).
For companies with significant PP&E, their EBITDA figure can be quite different from their GAAP net income because of the depreciation of PP&E. EBITDA also evaluates a company independent of its financing decisions and taxation.
The EBITDA metric is calculated by adding interest expense, taxes, depreciation and amortization to the company’s net earnings, as seen below:
EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortization
Free Cash Flow (FCF)
Free cash flow (FCF) is a commonly used non-GAAP earnings measure that shows cash flows a company receives that are available for distribution among all securities holders of the company. FCF measures profitability, excluding non-cash expenses from the income statement, but includes changes in net working capital and capital expenditures.
FCF can be calculated by using many methods, including the one below:
Free Cash Flow = Cash Flow from Operations + Interest – Interest Tax Shield – Capital Expenditures
Pro-Forma Earnings
Pro-forma earnings exclude expenses that the company does not believe to be recurring. i.e., one-time restructuring expenses. Also, pro-forma earnings are typically used to show investors what management thinks its true net income is.
Criticisms
Non-GAAP earnings often face criticism because they try to show the companies’ results in the best possible light. Critics believe that non-GAAP earnings sometimes exclude recurring costs by labeling them as non-recurring or one-time expenses.
In addition, non-GAAP earnings are not standardized, making it difficult to compare with the earnings of competing companies. Thus, investors should look at non-GAAP earnings with a critical eye.
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As a seasoned financial expert with a background in accounting and financial analysis, I've extensively delved into the intricate realm of earnings reporting and financial statement analysis. Over the years, my experience has encompassed navigating the nuances of Generally Accepted Accounting Principles (GAAP) and dissecting the dynamics of non-GAAP earnings, a subject that has become increasingly pivotal in the financial landscape.
The article you've provided sheds light on the significance and complexities surrounding non-GAAP earnings. It's crucial to understand that non-GAAP earnings are alternative measures that deviate from the standard GAAP calculations, offering companies a flexible framework for reporting their financial performance. This departure from GAAP allows management to present a more nuanced perspective to stakeholders and investors, steering away from the rigid constraints imposed by traditional accounting principles.
GAAP serves as the bedrock for financial reporting, ensuring consistency and comparability across diverse companies and reporting periods. Auditors play a vital role in upholding GAAP adherence, providing the necessary assurance for financial statements filed under Securities and Exchange Commission (SEC) regulations.
The article highlights the driving forces behind the reporting of non-GAAP earnings, emphasizing scenarios where companies find it more suitable to depart from GAAP standards. For instance, when faced with large one-time expenses, companies might opt for non-GAAP reporting, presenting a pro-forma or adjusted earnings statement that excludes these exceptional costs. This maneuver allows companies to articulate their core operational performance without the distortion caused by significant, non-recurring items.
The prominence of non-GAAP earnings in SEC filings has witnessed a steady rise, reaching 97% usage among S&P 500 companies in 2018. This surge can be attributed, in part, to the escalation of non-recurring items, such as costs associated with mergers and acquisitions. Investors, in turn, closely scrutinize non-GAAP earnings as they provide insights into management's perspective on core operations.
The article outlines common non-GAAP earnings measures, underscoring their significance in financial analysis:
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EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):
- A widely used non-GAAP metric, EBITDA serves as a proxy for a company's operating profitability, excluding non-cash expenses like depreciation and amortization.
- It evaluates a company independently of its financing decisions and taxation.
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Free Cash Flow (FCF):
- FCF, another prevalent non-GAAP measure, reflects the cash flows available for distribution among securities holders.
- Calculated by considering cash flow from operations, interest, interest tax shield, and capital expenditures.
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Pro-Forma Earnings:
- Pro-forma earnings exclude expenses deemed non-recurring, offering investors insight into management's perception of true net income.
The article also touches upon criticisms faced by non-GAAP earnings, citing concerns about attempts to present company results in an overly positive light. Critics argue that non-GAAP figures may sometimes exclude recurring costs by labeling them as one-time or non-recurring expenses. Moreover, the lack of standardization in non-GAAP reporting makes it challenging for investors to compare earnings across different companies.
In essence, the use of non-GAAP earnings introduces a layer of subjectivity to financial reporting, requiring investors to approach such metrics with a discerning eye. My expertise in financial analysis allows me to navigate this landscape, understanding both the practical applications and potential pitfalls associated with non-GAAP earnings.
