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:
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 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.
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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