A Closer Look at GAAP and Non-GAAP Earnings

In US, listed companies are required to disclose their GAAP (Generally Accepted Accounting Principles) earnings. This standardised data provides investors with comparable information on earnings. However, companies can also provide non-GAAP earnings information, a trend arising recently.

What Are the Differences Between GAAP Earnings and Non-GAAP Earnings?

I am recently reading the 2014 10-K of DST Systems and notice it provides non-GAAP financial information. Let me derive the data as an example:

DST Non-GAAP
Data from p21, 2014 10-K Form of DST

From the table we can see what are the major types of adjustments in non-GAAP earnings: investment income/loss, restructuring charges, gain/loss on sales/purchase of assets and impairment charges. These are typically one-time or non-recurring income or expenses that will distort the operating income under GAAP. The non-GAAP number generally excludes the impact of temporary events, as they (are believed to) have limited impact on the continuous operations. However, since the non-GAAP classifications of these income or expenses are subject to the judgement of management, the non-GAAP figures can also be manipulated to deliver biased information about the companies.

Values of Non-GAAP Earnings

To learn more about the values of non-GAAP earnings, we can refer to the discussion of DST’s management:

Management believes the exclusion of these items provides a useful basis for evaluating underlying business unit performance, but should not be considered in isolation and is not in accordance with, or a substitute for, evaluating business unit performance utilizing GAAP financial information. Management uses non-GAAP measures in its budgeting and forecasting processes and to further analyze our financial trends and “operational run-rate,” as well as making financial comparisons to prior periods presented on a similar basis. We believe that providing such adjusted results allows investors and other users of our financial statements to better understand our comparative operating performance for the periods presented.

Reduce Bias: non-GAAP earning provides us a better look on how the business’s fundamental operations are going. Investors therefore won’t be biased by the one-time gains of losses that may not represent the core business’s performance.

Performance Measurement: For the company, using non-GAAP to measure the performance of the management can also free them from manipulating earnings through one-time restructuring or selling a business unit.

Problems of Non-GAAP Earnings

Recurring One-time Charges: Some may argue that non-GAAP earnings, which exclude those one-time gains or losses, may not necessarily reflect the real picture of the business. It is doubtful that whether some “one-time costs” really occur once or not. During recession, companies may incur impairment losses on their assets; some cyclical businesses may also incur regular restructuring costs. Deutsche Bank’s David Bianco talks about the fluctuation of GAAP earnings:

However, just because a cost is infrequent does not mean it is non-recurring. Thus, it is often argued by some strategists and many quants that GAAP EPS for the overall S&P 500 over a full economic cycle will represent EPS appropriate for valuation purposes. We would agree if it weren’t for that about half of the difference between GAAP and pro forma EPS measures over full economic cycles is from asset write-downs.

That is, in fact, GAAP earnings over a full economic cycle may better reveal the real performance of a company.

Long-term Effects: Besides, we also should not forget the long-lasting effects of some one-time charges. Some one-time gains of expenses can lead to future saving or expense increase. For example, restructuring of the organization can lead to future saving. This can have positive long-term impact on the earning. Also, for impairment charges, future expenses can be reduced, which also has impact on earnings. Under this consideration, using GAAP earning can make comparison more accurate and consistent.

Lessons

When calculating EPS (Earnings Per Share) of a company, we should be aware of which earnings are being used to reflect the true value of the company. While using non-GAAP earnings can reduce the impact of those one-time effects, we should consider whether these one-time events are truly non-recurring or not. Also, don’t forget to consider the long-term impact on earnings of these one-time charges.

I would recommend considering both GAAP and non-GAAP earnings when valuing companies. Due to the impacts mentioned above, non-GAAP earnings can sometimes overestimate the true earnings while GAAP earnings can be underestimated. By referring to both figures, you can have a better insight about the earning power of the company.

Also I would recommend looking at company’s earnings (GAAP, non-GAAP and their difference) over a full business cycle. Using an average GAAP earning data over a cycle to valuate or compare can be a wise choice. It reduces the effect of the special events but also considers the cyclical costs.

Of course simply using reported earnings can sometimes be misleading. In practice, some adjustments are needed in order to reflect the true earning power of the company. Nevertheless, it’s still useful to know the different between GAAP and non-GAAP earnings can gain useful information from the difference.

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