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Adjusted earnings

What Is Adjusted Earnings?

Adjusted earnings, also known as non-GAAP earnings or "pro forma" earnings, represent a company's financial performance as reported by management, excluding certain items that are considered non-recurring, non-cash, or otherwise not reflective of the core operational profitability of the business. This financial reporting metric falls under the broader category of financial reporting. While companies traditionally report their financial results according to Generally Accepted Accounting Principles (GAAP earnings), adjusted earnings provide an alternative view, often aiming to give shareholders and investors a clearer picture of ongoing operations.

Adjusted earnings are commonly used by management in their public statements and investor presentations to highlight what they perceive as the sustainable earning power of the company, often stripping out items like one-time legal settlements, restructuring charges, impairments, or stock-based compensation. The intent behind presenting adjusted earnings is to remove the noise from a company's standard financial statements, allowing for better comparative financial analysis between periods or with competitors.

History and Origin

The concept of presenting financial results with adjustments beyond strict GAAP reporting gained significant traction over time, particularly as businesses became more complex and engaged in various non-routine activities. The proliferation of such "pro forma" or "adjusted" figures became widespread by the late 1990s and early 2000s, often as companies sought to highlight their operational performance without the impact of extraordinary items.

However, the increased use of adjusted earnings also led to concerns about potential manipulation and the obscuring of a company's true financial health. High-profile accounting scandals, such as Enron in 2001, where complex accounting loopholes and special purpose entities were used to hide billions in debt, underscored the need for greater transparency and oversight in financial reporting. In response to such corporate governance failures, the U.S. Congress passed the Sarbanes-Oxley Act of 2002. This landmark legislation aimed to improve corporate accountability and transparency, including stricter rules around the presentation of non-GAAP financial measures13. The Securities and Exchange Commission (SEC) subsequently issued regulations like Regulation G, requiring companies to reconcile non-GAAP measures to their most directly comparable GAAP measures and to explain why these non-GAAP measures are useful to investors. The SEC has continued to update its guidance on non-GAAP financial measures, emphasizing that such presentations should not be misleading and that GAAP financial measures should be presented with equal or greater prominence12.

Key Takeaways

  • Adjusted earnings aim to reflect a company's core operational profitability by excluding certain items from GAAP net income.
  • Common adjustments include non-recurring charges, non-cash expenses, or other items management deems atypical.
  • Companies use adjusted earnings to provide what they believe is a more representative view of their ongoing performance.
  • The Securities and Exchange Commission (SEC) regulates the disclosure of non-GAAP measures, requiring reconciliation to GAAP and an explanation of their utility.
  • While useful for specific analytical purposes, adjusted earnings can be subject to managerial discretion and may not always provide a complete picture of financial health.

Formula and Calculation

Adjusted earnings are not derived from a standardized formula like GAAP net income. Instead, they are calculated by taking GAAP earnings and adding back or subtracting specific items that management believes distort the underlying operational performance.

The general approach can be represented as:

Adjusted Earnings=GAAP Net Income±Specific Adjustments\text{Adjusted Earnings} = \text{GAAP Net Income} \pm \text{Specific Adjustments}

Here:

  • (\text{GAAP Net Income}) is the company's profit as reported on its income statement, calculated in accordance with Generally Accepted Accounting Principles.
  • (\text{Specific Adjustments}) are the items added back or subtracted. These often include:
    • Restructuring costs
    • Impairment charges
    • Amortization of intangible assets
    • Stock-based compensation
    • One-time gains or losses (e.g., from asset sales, legal settlements)
    • Merger and acquisition-related expenses

For example, a company might add back stock-based compensation, which is a non-cash expense, to arrive at its adjusted earnings per share.

Interpreting the Adjusted Earnings

Interpreting adjusted earnings requires careful consideration of the specific adjustments made and the rationale behind them. Companies present adjusted earnings to offer what they consider a clearer view of their underlying profitability, free from the impact of unusual or non-recurring events. For investors, these non-GAAP measures can provide insights into a company's recurring operational strength and aid in valuation by helping to distinguish between core business performance and transitory earnings.

For example, if a company incurs a significant one-time charge due to a major lawsuit, its GAAP net income for that period would be substantially reduced. Management might argue that this event is not indicative of the company's regular operational capabilities and present adjusted earnings that exclude this charge. Understanding these adjustments is crucial for financial analysis, as it allows users to compare a company's performance over time or against competitors without the distortion of non-routine items. However, it is essential to scrutinize the nature of these adjustments, as some expenses categorized as "one-time" might recur in different forms, or might be normal and necessary operating expenses that are being excluded11.

Hypothetical Example

Consider "Tech Innovations Inc.," a publicly traded company. In its latest quarterly report, Tech Innovations Inc. reports the following:

  • GAAP Net Income: $100 million
  • Restructuring Charge (one-time): $20 million
  • Stock-Based Compensation Expense: $10 million
  • Gain on Sale of Non-Core Asset (one-time): $5 million

To calculate its adjusted earnings, Tech Innovations Inc. would typically add back the expenses it considers non-recurring or non-cash, and subtract one-time gains that aren't part of core operations.

Here's the step-by-step calculation:

  1. Start with GAAP Net Income: $100 million
  2. Add back the Restructuring Charge: This is a one-time expense not considered part of regular operations.
    $100 million + $20 million = $120 million
  3. Add back Stock-Based Compensation Expense: This is a significant non-cash expense.
    $120 million + $10 million = $130 million
  4. Subtract the Gain on Sale of Non-Core Asset: This is a one-time gain not related to primary business activities.
    $130 million - $5 million = $125 million

Therefore, Tech Innovations Inc.'s adjusted earnings for the quarter would be $125 million. This adjusted figure aims to show investors what the company's earnings would have been from its ongoing business operations, excluding the specific unusual or non-cash items.

Practical Applications

Adjusted earnings are widely used in several areas of finance and investing, particularly in financial analysis and investor relations.

  • Investor Communications: Companies frequently highlight adjusted earnings in their press releases, earnings calls, and investor presentations to guide the narrative around their financial performance. For instance, a technology company like Apple might focus on adjusted profitability metrics alongside GAAP figures when discussing iPhone demand and overall revenue10.
  • Analyst Models: Financial analysts often build their valuation models and earnings forecasts based on adjusted earnings, as they attempt to predict future core profitability. They believe these figures provide a more stable and predictable base for projecting future cash flow and earnings.
  • Performance Evaluation: Boards of directors and compensation committees may use adjusted earnings as a metric for evaluating management performance and determining executive compensation, arguing that it better reflects the operational success under management's control9.
  • Debt Covenants: In some cases, loan agreements and debt covenants may refer to earnings figures that are adjusted for specific items, reflecting a negotiated understanding of a company's ability to service its debt based on its core operations.

However, the use of non-GAAP measures is subject to regulatory scrutiny. The SEC frequently issues comments on companies' compliance with rules regarding the presentation and prominence of non-GAAP financial measures8.

Limitations and Criticisms

Despite their widespread use, adjusted earnings face several limitations and criticisms:

  • Lack of Standardization: Unlike GAAP earnings, there is no single, universally accepted standard for calculating adjusted earnings. Each company can define its own adjustments, leading to inconsistencies and making direct comparisons between companies challenging. This lack of standardization can make it difficult for investors to fully understand and trust the reported figures7.
  • Potential for Manipulation: Critics argue that companies can use adjusted earnings to present a more favorable picture of their financial health by selectively excluding inconvenient expenses or losses. While the intent might be to remove "noise," this discretion can be misused to mask underlying problems or to hit earnings targets6. Research suggests that while non-GAAP earnings can improve investment efficiency by adjusting for transitory earnings, they can also introduce opportunistic bias5.
  • Excluding "Normal" Expenses: Sometimes, items excluded from adjusted earnings, such as recurring restructuring charges or certain legal expenses, might be normal and necessary costs of doing business. The SEC's guidance specifically highlights that excluding "normal, recurring, cash operating expenses" can render a non-GAAP measure misleading4.
  • Investor Confusion: The proliferation of different adjusted metrics can confuse investors, who may struggle to reconcile these figures with statutory GAAP numbers and understand their true implications for a company's long-term viability. Studies indicate that while investors increasingly use non-GAAP measures, their ability to price the implications of non-GAAP exclusions can vary with their experience with such disclosures3.

Ultimately, while adjusted earnings can offer valuable insights into a company's core operations, they should always be evaluated in conjunction with, and reconciled to, the company's official GAAP financial statements.

Adjusted Earnings vs. GAAP Earnings

The primary distinction between adjusted earnings and GAAP earnings lies in their basis and purpose. GAAP earnings are computed strictly according to Generally Accepted Accounting Principles, a comprehensive set of rules and standards established by authoritative bodies like the Financial Accounting Standards Board (FASB). These rules ensure consistency and comparability across companies and industries, aiming to provide a standardized, objective view of financial performance.

Conversely, adjusted earnings (or non-GAAP measures) are discretionary figures presented by company management. They involve taking the GAAP net income and then adding back or subtracting specific items that management believes do not reflect the company's ongoing core operations or are non-recurring. The intent is often to present what management perceives as the company's "true" operating profitability. While GAAP earnings provide a legally mandated and auditable baseline, adjusted earnings offer a management-defined perspective, which can be useful for analytical purposes but also carries the risk of bias due to its subjective nature. Investors often scrutinize the reconciliation provided by companies to bridge the gap between their GAAP and adjusted figures.

FAQs

Why do companies report adjusted earnings?

Companies report adjusted earnings to provide what they consider a clearer view of their core operational performance, free from the impact of non-recurring, unusual, or non-cash items. This can help investors focus on the sustainable profitability of the business.

Are adjusted earnings regulated?

Yes, in the United States, the Securities and Exchange Commission (SEC) regulates the disclosure of non-GAAP financial measures, including adjusted earnings. Companies are required to reconcile these measures to the most directly comparable GAAP financial measure and explain why the non-GAAP measure is useful to investors. The SEC continually updates its Compliance & Disclosure Interpretations (CDIs) to ensure transparency and prevent misleading presentations2,1.

Should investors rely solely on adjusted earnings?

No, investors should not rely solely on adjusted earnings. While they can provide useful insights, it is crucial to analyze them in conjunction with the company's official GAAP financial statements. GAAP earnings offer a standardized and audited view of financial performance, and a full understanding requires examining all aspects of a company's financial statements and accompanying disclosures.

What types of adjustments are commonly made to GAAP earnings?

Common adjustments include adding back non-cash expenses like stock-based compensation and amortization of intangible assets, or one-time charges such as restructuring costs, impairment charges, legal settlements, and merger and acquisition-related expenses. Conversely, one-time gains from asset sales might be subtracted to reflect core operating profit.

How do adjusted earnings affect financial analysis and valuation?

Adjusted earnings can simplify financial analysis by removing "noise" from a company's results, potentially making it easier to compare performance year-over-year or against peers. For valuation purposes, analysts may use adjusted earnings as a basis for forecasting future earnings or cash flow, believing it provides a better indicator of ongoing operational performance than GAAP earnings alone.