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Earnings Season 101, Part 3: Mind the GAAP

18 August 2015 in Investing Insights

As you continue to pay attention to earnings season announcements, you might start to notice a subtle variation in how different companies format their numbers.

One format is called Generally Accepted Accounting Standards (GAAP) and the other is called non-GAAP. Understanding the difference between the two can give you insights into companies’ earnings announcements.

First, familiarize yourself with the earnings fundamentals we introduced in the first two articles in this series, Earnings Season 101 and Earnings Season 101, Part 2. Now, let’s examine how GAAP and non-GAAP accounting methodologies differ.

Mind the GAAP

The Securities and Exchange Commission (SEC) has utilized nongovernmental entities to establish accounting and reporting standards for publicly traded companies since 1939.[1] One such entity, the U.S. Financial Accounting Standards Board (FASB), has overseen GAAP since 1973.[2]

In other words, GAAP creates apples-to-apples comparisons so investors can better evaluate a company to its competitors.

Setting a baseline of consistency in how financial statements are prepared is essential to GAAP. It benefits shareholders, employees and customers by helping prevent fraud.[3]

Another advantage of GAAP is it helps ensure accuracy of earnings data. Companies are also required to prepare their quarterly statements using the same GAAP methods as their annual financials.

GAAP is not without its flaws, however. It does allow companies to use their discretion in determining the value of assets and the methods used to recognize costs and revenue.

In addition, there are still variances between U.S. GAAP and the international financial reporting standards (IFRS) set by the International Accounting Standards Board (IASB).

IFRS is already in use by many foreign countries including the European Union. Although IASB and FASB have been working together since 2002 to converge, it is a slow and complex process.[4]

Look, No GAAP

Although the SEC requires public U.S. companies to adhere to GAAP, in 2010 U.S. securities regulators began allowing companies to use certain metrics that are non-GAAP, also known as adjusted or pro forma earnings.[5]

Companies sometimes use non-GAAP methods in order to better reflect ongoing performance and operational metrics.[6]

Additionally, firms tend to use non-GAAP metrics to report results during periods with large one-off events, such as corporate restructurings and write-downs of large assets.[7]

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), cash earnings, and pro-forma income are a few popular non-GAAP earnings figures you may come across.[8]

Investors should be aware that non-GAAP earnings can yield very different results than GAAP. Some believe GAAP has a tendency to understate earnings while non-GAAP methods can overstate earnings.[9]

Once you know the difference between GAAP and non-GAAP earnings, trade better at Motif Investing.

Source: Business Insider[9]

Technology companies have tended to issue non-GAAP earnings more frequently than firms in other industries. A study by accounting expert Jack Ciesielski found 56 out of 69 tech companies reported non-GAAP earnings in 2011 through 2012, with 23 percent higher income than GAAP measures on average.[10]

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Source: Forbes[10]

The good news is the SEC prohibits public companies from reporting fabricated and erroneous earnings designed to mislead investors. In addition, companies that issue non-GAAP earnings must include the closest GAAP comparable.[11]

Below is an example of what a company’s reconciliation between GAAP and non-GAAP figures can look like.

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Source: Seeking Alpha[12]

Read The Fine Print

Spending the extra time researching the explanations for differences between non-GAAP and GAAP figures may help you discover opportunities and risks that other investors might have missed.[13]That may call for reading the fine print—footnotes, disclosures and the summary of significant accounting policies (SSAP)—to understand the methodologies used to prepare financial statements.

Footnotes also provide further information about companies’ operations, financial status, long-term debt, employee stock ownership, and other items excluded from the financial statements. These disclosures also include references to errors made in prior reporting periods.[14]

You might want to supplement your research with a look at the company’ annual report or full-year financial statements, which may have more detailed disclosures.[15] Analyzing how a company changes its disclosures over time can also reveal how management’s assumptions evolves.

If at first you don’t understand any of the jargon used in footnotes, proceed with caution instead of glossing over them.[16]

Now that you have learned about GAAP and non-GAAP formats, your increased financial literacy may help you make more informed investment decisions.

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[1] Wolk, Harry I., Dodd, James L., Rozycki, John J., “Accounting Theory: Conceptual Issues In A Political And Economic Environment,” SAGE, October 17, 2007.

[2] FASB, “Facts About FASB,” FASB.org, 2015.

[3] Ibid.

[4] IFRS, “Convergence between IFRSs and U.S. GAAP,” IFRS.org, accessed August 4, 2015.

[5] Ro, Sam, “Chart of the Day: Here’s How You Should Think About ‘Adjusted’ Earnings,” Business Insider, December 23, 2013.

[6] Siegel, Marc, “For the Investor: The Use of Non-GAAP Metrics,” FASB.org, 2014.

[7] Chasan, Emily, “Four Reasons Non-GAAP Metrics Are Exploding,” The Wall Street Journal,”

[8] Investopedia, “Non-GAAP Earnings,” Investopedia.com, accessed August 4, 2015.

[9] Ro, Sam, “Chart Of The Day: Here’s How You Should Think About ‘Adjusted’ Earnings,” Business Insider, December 26, 2013.

[10] Bercovici, Jeff, “These 20 Tech Firms Report The Most Fictionalized Earnings,” Forbes, November 11, 2013.

[11] SEC, “Final Rule: Conditions for Use of Non-GAAP Financial Measures,” SEC.gov, January 24, 2002.

 

[12] Bryant, Celan, “NetScout: The Perfect Preamble For A Tech Growth Story,” Seeking Alpha, January 29, 2015.

[13] Keulen, Pim, “Be Aware of the Myth That Is Called Non-GAAP Earnings,” Seeking Alpha,” June 4, 2015.

[14] Investopedia, “Financial Footnotes: Start Reading The Fine Print,” Investopedia.com, accessed August 4, 2015.

[15] Banks, Theodore L. and Banks, Frederick Z., Corporate Legal Compliance Handbook, Wolters Kluwer, 2010.

[16] Buffett, Mary and Clark, David, Warren Buffett and the Interpretation of Financial Statements, Simon and Schuster, October 2008.

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