If you've ever examined a company's financial statements, you'll undoubtedly have come across several measures of earnings. But what does it all mean and what can you trust? All public companies in the United States are required to report earnings according to general accepted accounting principles set forth by the Financial Accounting Standards Board. But here's the twist: companies can also report earnings based on whatever logic management finds suitable. The discrepancies between GAAP and non-GAAP earnings can be enormous and you should be mindful of them.
Standard financial reporting requirements are fairly prescriptive. Under GAAP, companies report earnings based on time-honored accounting principles like accrual accounting, revenue recognition and expense matching. For example, the matching principle requires that companies report expenses in the same period as related revenues. Thus, an automaker might report a quarterly depreciation expense associated with its factory. If the factory cost $100 million, the company might depreciate it evenly over 10 years and report a $2.5 million quarterly depreciation expense.
Companies may supplement GAAP earnings with non-GAAP measures. The rationale for allowing such departures is that management may have alternative ways of representing the company's "true" performance. In our earlier example, the company might choose to report earnings before depreciation. This is a popular adjustment because it offers investors a more accurate picture of the company's cash flow, since depreciation is a non-cash expense. Thus, the automaker might include a non-GAAP line item for earnings before interest, taxes, depreciation and amortization (EBITDA) that excludes the $2.5 million of quarterly depreciation.
The Securities and Exchange Commission requires that any company that reports non-GAAP earnings also present the most directly comparable GAAP financial measure. For example, a company reporting EBITDA would also have to provide a step-by-step reconciliation with net earnings (the most comparable GAAP measure). In our earlier example, the automaker would have to add back the $2.5 million of quarterly depreciation expense that it subtracted from net earnings.
Be wary of companies playing games with non-GAAP earnings. The SEC's Regulation G prohibits the dissemination of false or misleading GAAP or non-GAAP financial measures. The first time the SEC enforced this regulation was with a company called SafeNet in 2009. The management was charged with improperly reporting earnings in order to meet its earnings targets. Alleged violations included mischaracterizations of line items, reclassifying ordinary operating expenses as integration expenses and improperly reducing accruals.
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