Adjusted earnings indicator

What Is Adjusted Earnings Indicator?

The Adjusted Earnings Indicator is a financial metric used by companies to present their profitability by excluding certain items that are considered non-recurring, non-cash, or otherwise outside of normal business operations. It falls under the broader category of financial reporting, specifically as a type of non-GAAP financial measures. This indicator aims to provide a clearer view of a company's core operating performance by stripping away elements that might distort the perception of ongoing financial health. Companies often present adjusted earnings alongside their figures calculated according to Generally Accepted Accounting Principles (GAAP) to offer an alternative perspective to investors and analysts.

History and Origin

The practice of companies presenting adjusted earnings or other non-GAAP financial measures gained prominence as businesses sought to highlight underlying operational performance, often arguing that GAAP numbers could be obscured by unusual or infrequent events. While companies have long made informal adjustments in internal reporting, the public disclosure of these adjusted figures increased significantly, particularly in the early 2000s and post-Sarbanes-Oxley Act period. The increased use of non-GAAP measures prompted the Securities and Exchange Commission (SEC) to issue Regulation G and update Item 10(e) of Regulation S-K in 2003. These regulations aim to ensure that such disclosures are not misleading and are reconciled to the most directly comparable GAAP measures. The SEC staff has continued to update its Compliance & Disclosure Interpretations (CDIs) regarding non-GAAP financial measures, with significant updates occurring in May 2016 and December 2022, to provide further guidance on what constitutes a misleading non-GAAP measure and to emphasize the prominence of GAAP reporting.⁵, ⁶

Key Takeaways

• The Adjusted Earnings Indicator aims to present a company's core operational performance by excluding specific items.
• These adjustments often remove non-recurring or non-cash expenses and revenues.
• Adjusted earnings are a form of non-GAAP financial measures and must be reconciled to GAAP.
• Regulators, such as the SEC, scrutinize the use and prominence of adjusted earnings to ensure they are not misleading.
• Investors use adjusted earnings as a supplementary tool for financial analysis and to assess underlying business trends.

Formula and Calculation

The calculation of the Adjusted Earnings Indicator typically begins with a company's net income as reported under GAAP, and then adds back or subtracts specific items. While there is no single standardized formula for adjusted earnings, the general approach can be represented as:

Where:

• Net Income (GAAP): The company's profit as calculated according to Generally Accepted Accounting Principles.
• Add-back Adjustments: Expenses or losses that management deems non-recurring, non-cash, or not indicative of core operations. Common examples include restructuring charges, impairment losses, amortization of acquired intangibles, stock-based compensation, and certain litigation expenses.
• Deducting Adjustments: Revenues or gains that management deems non-recurring or not indicative of core operations, such as one-time gains from asset sales or legal settlements.

The specific items added back or deducted can vary widely by company and industry, depending on what management believes provides a more insightful view of ongoing performance. For example, some companies might adjust for non-cash operating expenses like depreciation and amortization to arrive at metrics such as EBITDA or EBIT, which are related concepts.

Interpreting the Adjusted Earnings Indicator

Interpreting the Adjusted Earnings Indicator requires careful consideration of the specific adjustments made. Companies use this metric to emphasize what they consider to be their "core" revenue generating capability, free from the noise of unusual events. For example, if a company incurs a large, one-time restructuring charge, excluding this cost from adjusted earnings might highlight the underlying strength of its ongoing business operations. Investors often compare adjusted earnings over several periods to identify trends in a company's fundamental performance without the volatility introduced by infrequent events. When evaluating a company, it is important to examine the reconciliation of adjusted earnings to GAAP net income, which publicly traded companies are required to provide in their financial statements and investor communications. This allows for a deeper understanding of management's view on its own performance and helps in conducting thorough due diligence.

Hypothetical Example

Consider "Tech Innovate Inc.," a publicly traded software company. For the fiscal year, Tech Innovate Inc. reports GAAP net income of $50 million. However, during the year, the company incurred several notable items:

1. Restructuring Charge: A $10 million one-time expense related to closing an outdated division and reorganizing its workforce. This is a non-recurring item.
2. Gain on Sale of Non-Core Asset: A $5 million gain from selling a small, non-strategic patent portfolio. This is also a non-recurring item not related to its primary software business.
3. Stock-Based Compensation: $3 million in non-cash expense for employee stock options. While recurring, some companies may adjust for this to focus on cash operating performance.

To calculate its Adjusted Earnings Indicator, Tech Innovate Inc. would apply these adjustments to its GAAP net income:

In this hypothetical example, Tech Innovate Inc.'s Adjusted Earnings Indicator of $58 million presents a higher figure than its GAAP net income of $50 million. The company would present this adjusted figure along with a clear reconciliation to its GAAP net income, providing transparency on the specific items it chose to exclude or include to arrive at this adjusted metric. This adjusted figure might be used by the company in its investor relations materials to highlight what it considers its ongoing operational strength.

Practical Applications

The Adjusted Earnings Indicator is widely used in various facets of finance and investing. Companies frequently highlight adjusted earnings in their earnings releases and presentations, often arguing that it provides a more accurate reflection of their ongoing business performance than raw GAAP figures. For investors and analysts, adjusted earnings can be a useful tool for:

• Valuation Models: Analysts often incorporate adjusted earnings into their valuation models to project future cash flow and arrive at a more "normalized" view of a company's earning power.
• Performance Benchmarking: Comparing adjusted earnings across different periods or against competitors can help assess a company's operational trends, especially when all companies in an industry apply similar types of adjustments.
• Management Compensation: Executive compensation plans may sometimes be tied to adjusted earnings targets, aiming to incentivize performance based on core operations rather than one-off events.
• Credit Analysis: Lenders and credit rating agencies may look at adjusted earnings to gauge a borrower's ability to generate consistent income for debt repayment, often focusing on adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

The utility of adjusted earnings is frequently discussed in financial circles. A study by the CFA Institute indicates that many investors find non-GAAP financial measures, including adjusted earnings, useful for predicting future cash flows and valuing companies.⁴

Limitations and Criticisms

Despite their widespread use, Adjusted Earnings Indicators face significant limitations and criticisms. The primary concern revolves around the lack of standardization and the potential for companies to manipulate these figures. Unlike GAAP, which has strict rules for calculating metrics like earnings per share or income statement line items, there are no universally accepted rules for adjusted earnings. This discretion allows management to cherry-pick which items to exclude, potentially presenting an overly optimistic view of financial performance.

Critics argue that companies may consistently exclude "non-recurring" charges that, in practice, recur regularly (e.g., restructuring charges or impairment losses), thus inflating the perceived sustained profitability. The SEC has repeatedly cautioned companies against using non-GAAP measures in a way that is misleading, particularly when such measures exclude "normal, recurring, cash operating expenses" or are given undue prominence over comparable GAAP measures.², ³ The Brattle Group highlights that the SEC focuses on whether comparable GAAP measures are presented with equal prominence and if the purpose of the non-GAAP disclosure is clear, noting concerns about adjusted earnings/net income as frequent targets for scrutiny.¹ Investors should therefore exercise caution and always reconcile the adjusted earnings back to the GAAP numbers on the company's balance sheet and income statement to understand the full financial picture.

Adjusted Earnings Indicator vs. GAAP Earnings

The core difference between the Adjusted Earnings Indicator and GAAP Earnings lies in their adherence to standardized accounting principles.

While the Adjusted Earnings Indicator aims to offer a refined view of a company's underlying operating profitability, it is essential to remember that it is a supplementary metric. GAAP Earnings remains the official and legally recognized measure of a company's financial performance. Investors often find confusion arises when companies emphasize adjusted metrics that consistently paint a more favorable picture than their GAAP counterparts.

FAQs

What types of adjustments are commonly made in the Adjusted Earnings Indicator?

Common adjustments include adding back non-cash expenses like stock-based compensation and amortization of intangible assets, or excluding one-time charges such as restructuring costs, litigation settlements, or gains/losses from asset sales. The goal is to present a view of ongoing operations.

Why do companies report adjusted earnings if GAAP earnings already exist?

Companies report adjusted earnings to provide what they consider a more representative view of their core business performance. They often argue that GAAP earnings can be distorted by non-recurring events or non-cash charges that do not reflect the true operational health of the company. It serves as a supplementary metric to their official financial statements.

Are Adjusted Earnings Indicator figures regulated?

Yes, in the United States, the Securities and Exchange Commission (SEC) regulates the public disclosure of non-GAAP financial measures, including adjusted earnings, through Regulation G and Item 10(e) of Regulation S-K. These rules require companies to reconcile adjusted earnings to the most directly comparable GAAP measure and prohibit presentations that are misleading or give undue prominence to non-GAAP figures.

Can the Adjusted Earnings Indicator be misleading?

Yes, the Adjusted Earnings Indicator can be misleading if companies make inappropriate or inconsistent adjustments, especially if they regularly exclude "non-recurring" expenses that are, in fact, regular operating costs. Investors should always review the reconciliation to GAAP earnings and understand the nature of all adjustments before relying solely on adjusted figures.

How should investors use the Adjusted Earnings Indicator?

Investors should use the Adjusted Earnings Indicator as a supplementary tool for financial analysis, not as a replacement for GAAP earnings. It can offer insights into a company's underlying operational trends. However, it is crucial to understand the specific adjustments made, compare them across periods and against competitors, and always cross-reference with the official GAAP figures presented in a company's financial reports.