Adjusted income statement

What Is an Adjusted Income Statement?

An adjusted income statement is a financial report that modifies a company's reported financial results, typically derived from its standard income statement, to exclude or include certain items that management considers non-recurring, non-operational, or distorting to the underlying business performance. These adjustments are made outside of the traditional framework of Generally Accepted Accounting Principles (GAAP) in the United States or International Financial Reporting Standards (IFRS) elsewhere. As such, an adjusted income statement falls under the broader category of financial reporting and is designed to offer an alternative perspective on a company's profitability and ongoing operational results. Companies often present these adjusted figures, such as adjusted net income or adjusted earnings per share (EPS), in earnings press releases or investor presentations to supplement their GAAP-compliant statements.

History and Origin

The practice of presenting adjusted financial figures, often termed "non-GAAP measures," gained prominence, particularly following the dot-com boom of the late 1990s and early 2000s. During this period, many companies, especially in nascent technology sectors, faced unique circumstances like significant stock-based compensation expenses or large acquisition-related costs. Managers argued that traditional GAAP measures did not adequately reflect their core business performance, leading to a rise in the use of alternative metrics to tell their "story." This proliferation of non-GAAP disclosures prompted regulatory bodies, notably the U.S. Securities and Exchange Commission (SEC), to issue guidance to ensure these measures were not misleading. The SEC has since updated its SEC guidance multiple times, reinforcing disclosure requirements and highlighting concerns about potentially misleading adjustments.

Key Takeaways

• An adjusted income statement presents financial results that differ from those prepared under GAAP by excluding or including specific items.
• The goal of an adjusted income statement is typically to highlight a company's core, recurring operational performance.
• Common adjustments include one-time events, non-cash expenses like depreciation and amortization, or merger-related costs.
• While providing additional insight, adjusted income statements are not standardized and may not be directly comparable between different companies or even for the same company across periods without careful analysis.
• Regulatory bodies like the SEC provide guidance for public companies on how to present these non-GAAP measures to prevent investor confusion.

Formula and Calculation

The calculation of an adjusted income statement begins with a company's GAAP-reported net income. From this baseline, specific items are either added back or subtracted, depending on whether they are expenses deemed non-recurring or revenues considered non-operational. There is no single universal formula for an adjusted income statement, as the adjustments vary by company and purpose. However, the general approach can be represented as:

Where:

• Adjusted Net Income is the company's profitability after management-selected modifications.
• GAAP Net Income is the profit calculated according to Generally Accepted Accounting Principles.
• Non-Recurring Adjustments refer to the specific revenue or expenses that management chooses to add back or subtract (e.g., restructuring charges, impairment losses, gains/losses on asset sales).

For example, a common adjustment is the exclusion of operating income items that are considered non-cash or non-recurring by management.

Interpreting the Adjusted Income Statement

Interpreting an adjusted income statement requires a critical eye, as these statements provide a "management's view" of financial performance. The primary purpose of an adjusted income statement is often to show investors what management believes to be the company's sustainable earnings from its core operations. Analysts and investors may use these figures to gain a clearer picture of ongoing performance by excluding items that might obscure the underlying business trend, such as large, infrequent legal settlements or asset write-downs. However, it is crucial to compare these adjusted figures to the reported GAAP figures and understand the rationale behind each adjustment. While an adjusted income statement can highlight operational efficiency, consistently excluding recurring but significant expenses may present an overly optimistic view of a company's financial health.

Hypothetical Example

Consider "Tech Innovations Inc.," a software company. In the latest fiscal year, Tech Innovations Inc. reported a GAAP net income of $50 million. However, during the year, the company incurred $10 million in restructuring charges related to a reorganization of its sales department, and it also recognized a one-time gain of $5 million from the sale of an old office building.

To present an adjusted income statement reflecting its core software operations, management decides to exclude these two items.

1. Start with GAAP Net Income: $50 million
2. Add back Restructuring Charges: Since these are considered a one-time, non-recurring operational expense, they are added back to show what core earnings would have been without them.
   • $50 million + $10 million = $60 million
3. Subtract One-Time Gain on Asset Sale: This gain is non-operational and not expected to recur, so it is subtracted to focus on core business revenue.
   • $60 million - $5 million = $55 million

Thus, Tech Innovations Inc.'s adjusted net income would be $55 million. This adjusted figure aims to show the performance of the ongoing software business, excluding the unusual events.

Practical Applications

Adjusted income statements are widely used across various aspects of finance and business analysis. In corporate finance, management often uses these figures internally for budgeting, performance evaluation, and setting executive compensation targets, as they aim to filter out noise from unusual events. For external stakeholders, analysts frequently use adjusted figures in their valuation models to project future cash flow and earnings, believing they offer a more predictive measure of a company's sustainable performance than pure GAAP numbers.

Companies include adjusted income statements in their quarterly earnings releases and investor presentations, alongside their GAAP financial statements. The Reuters financial news service, for instance, often highlights these adjusted earnings figures in its reporting on company performance, recognizing their role in market communication. Investors closely watch these metrics to understand management's perspective on core business trends, especially when assessing a company's ability to generate consistent profitability without the influence of one-off events or significant capital expenditures.

Limitations and Criticisms

While an adjusted income statement can offer valuable insights, it faces significant limitations and criticisms. A primary concern is the lack of standardization; companies have considerable discretion in determining which items to exclude or include, making comparisons across different companies or even different periods for the same company challenging. Critics argue that management may opportunistically use these adjustments to present a more favorable picture of financial performance, often by consistently excluding recurring expenses that should be considered part of normal operations. For example, some firms might routinely exclude restructuring charges or stock-based compensation, despite these being ongoing costs of doing business.

This discretionary nature can sometimes mislead investors, potentially contributing to an overvaluation of a company's stock if excluded items are, in fact, integral to its operations. Academic research has explored how the use of non-GAAP earnings might correlate with stock price volatility or even "crash risk," especially when these metrics present an overly optimistic view. Regulatory bodies, like the SEC, continuously issue guidance, and resources such as Deloitte's Roadmap help companies navigate the complex requirements for disclosing non-GAAP measures to mitigate these risks and ensure transparency.

Adjusted Income Statement vs. Non-GAAP Earnings

The terms "adjusted income statement" and "Non-GAAP earnings" are often used interchangeably, and indeed, an adjusted income statement is a primary way companies present non-GAAP earnings. The fundamental difference lies in scope: "Non-GAAP earnings" is the broader category encompassing any financial metric that deviates from Generally Accepted Accounting Principles (GAAP) or IFRS. This can include adjusted net income, adjusted earnings per share (EPS), EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), or free cash flow. An adjusted income statement specifically refers to the income statement itself being modified to reflect these non-GAAP adjustments, leading to an "adjusted net income" figure. The confusion often arises because the purpose of both is to present a company's performance "through the eyes of management," typically by removing items deemed non-recurring or non-operational.

FAQs

What is the main purpose of an adjusted income statement?

The main purpose of an adjusted income statement is to provide a clearer view of a company's core operational performance by excluding items that management considers unusual, non-recurring, or non-representative of ongoing business activities. It supplements the GAAP-compliant income statement.

Are adjusted income statements audited?

No, adjusted income statements and other non-GAAP measures are typically not audited in the same way that a company's formal GAAP financial statements are. While public companies must reconcile their non-GAAP figures to the most directly comparable GAAP measure, the specific adjustments themselves are largely at management's discretion. This is a key reason why investors should exercise caution and always compare adjusted figures to the audited Generally Accepted Accounting Principles (GAAP) results.

How do adjusted income statements differ from a standard income statement?

A standard income statement presents a company's financial performance strictly according to GAAP or IFRS, including all revenue and expenses as they occurred. An adjusted income statement starts with these GAAP figures but then modifies them by adding back or subtracting certain items (e.g., one-time charges, non-cash expenses) that management believes distort the view of ongoing operations. The goal of the adjusted statement is to provide an alternative perspective on the company's underlying profitability.