U.S. public companies must prepare their financial statements according to generally accepted accounting principles (GAAP) and much of the investor attention is concentrated on the Income Statement to asses a company’s operating performance. Any income or earnings to be GAAP compliant must be a separate line item reported on the Income Statement.
Over the last few decades, companies have been increasingly deviating from US GAAP earnings/income by underscoring some form of an adjusted income/earnings, also known as pro-forma earnings (e.g., EBITDA, or adjusted net income). What investors may not realize is that any pro-form number is not GAAP compliant and therefore the adjusted number may convey a biased assessment of the company, which may be the hidden purpose.
The adjustments allow companies to exclude expenses such as asset write-downs, impairments, restructuring charges, losses from foreign-currency translations that management believes is not relevant to the company’s most fundamental operations. It should not come as a surprise that most adjusted measures tend to portray a much healthier image of corporate earnings. Companies are willing to go to any lengths or use any definition of earnings to avoid reporting losses.
According to Deutsche Bank research, about one in 10 major companies use the term adjusted EBITDA, up from one in 40 a decade ago. The difference between standard and adjusted earnings is also growing. Deutsche Bank expects the gap to widen to 40% in the fourth quarter of 2015, from 20% or 30% in recent periods. According to Wall Street Journal analysis, about a quarter of earnings disclosed in earnings announcements don’t comply with GAAP.
United Technologies Corp. CEO Greg Hayes reported “…by adhering to accounting rules, we’re actually confusing people more than we were helping people understand what’s going on in the business. This is a simplification and really allows the investors to more easily understand what the businesses are doing.”
The implication is that we don’t need to adhere to accounting standards, we don’t need to worry about complying with the SEC reporting requirements, and we don’t need auditors or their attestation. Let us disregard the mechanisms in place to generate financial information that is representationally faithful, reliable and transparent; instead, let us trust the numbers generated by management according to what they believe is the best definition of earnings. A compelling story.
According to Mary Jo White, Chair of the Securities and Exchange Commission, “Non-GAAP measures are used extensively and in some instances may be a source of confusion.. This area deserves close attention.”
Regulators occasionally take companies to task for de-emphasizing US GAAP accounting numbers. The SEC has queried companies at least 100 times since 2006 about non-GAAP measures. For example, the SEC told T-Mobile US Inc. to include figures that comply with accounting rules in its quarterly earnings release. The company had only used adjusted Ebitda, and omitted net income.
Trust the company’s bottom line number, which is net income, and beware of pro-form or adjusted numbers generated by management!