Non-GAAP Earnings: Definition and How They Work in Analysis

What Are Non-GAAP Earnings?

Non-GAAP earnings are an alternative accounting method used to measure the earnings of a company. Many companies report non-GAAP earnings in addition to their earnings based on Generally Accepted Accounting Principles (GAAP). These pro forma figures, which exclude "one-time" transactions, can sometimes provide a more accurate measure of a company’s financial performance from direct business operations.

However, investors need to be wary of a company's potential for misleading reporting which excludes items that have a negative effect on GAAP earnings, quarter after quarter.

Understanding Non-GAAP Earnings

To understand non-GAAP earnings, it's important to understand GAAP earnings. GAAP earnings are a common set of standards accepted and used by companies and their accounting departments. GAAP earnings are used to standardize the financial reporting of publicly traded companies.

The justification for reporting non-GAAP earnings is that large one-off costs, such as asset write-downs or organizational restructuring, should not be considered normal operational costs because they distort the true financial performance of a company. Therefore, some companies provide an adjusted earnings number that excludes these nonrecurring items. Commonly used non-GAAP financial measures include earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), adjusted revenues, free cash flows, core earnings, and funds from operations.

When used appropriately, these non-GAAP financial measures can help companies provide a more meaningful picture of the company's performance and value. Presenting only the financial results of the core business activities can be useful. However, there are no regulations around non-GAAP earnings per share (EPS). Investors have no way of knowing whether Non-GAAP EPS figures are genuine or manipulated in an attempt to deceive the automated news-watching trading algorithms into taking action as the results are published in headlines.

Criticism of Non-GAAP Earnings

A company's quality of earnings is important, so investors need to consider the validity of non-GAAP exclusions on a case-by-case basis to avoid being misled. Studies have shown that adjusted figures are more likely to exclude losses than gains. GAAP earnings now significantly trail non-GAAP earnings, as companies become addicted to “one-time” adjustments, which become meaningless when they happen every quarter. Merck, for example, turned a loss of -$0.02 per share under GAAP into an “adjusted” profit of $1.11 a share in the fourth quarter of 2017—a 5,650% difference.

So investors should be careful not to lose sight of GAAP earnings. Standardized accounting rules are in place for consistency and comparability. Consistent revenue recognition makes reported earnings more reliable for historical comparison, and it allows investors to compare the financial results of one company to that of its industry peers and competitors. That is why the Securities and Exchange Commission (SEC) requires publicly traded companies to use GAAP accounting in the first place.

The SEC has begun taking enforcement actions against improper practices where companies provide greater prominence to non-GAAP figures than GAAP figures. Technology companies are among the most frequent abusers of non-GAAP EPS because they use a significant amount of stock compensation and have large asset impairments and R&D costs.