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Non gaap earnings

What Is Non-GAAP Earnings?

Non-GAAP earnings represent a company's financial performance as calculated by management, excluding certain items that are typically included in earnings reported under generally accepted accounting principles (GAAP). This falls under the broader category of financial reporting. Companies often present non-GAAP earnings to provide what they believe is a clearer picture of their core operational profitability, free from the impact of unusual, non-recurring, or non-cash items. While GAAP provides a standardized framework for financial statements, non-GAAP earnings offer a supplementary view that management deems relevant for investors. Companies are required to reconcile non-GAAP earnings to their most directly comparable GAAP measure.16

History and Origin

The practice of companies reporting financial metrics outside of GAAP, including non-GAAP earnings, gained prominence in the mid-1990s.15 This rise was partly driven by the increasing complexity of business operations and a desire by management to highlight performance metrics they believed were more indicative of ongoing business trends. However, the proliferation and sometimes inconsistent application of these measures quickly drew the attention of financial journalists, industry bodies, and regulators.14

Concerns about the potential for misleading disclosures led the U.S. Securities and Exchange Commission (SEC) to issue guidance. In response to directives from the Sarbanes-Oxley Act, the SEC adopted Regulation G and Item 10(e) of Regulation S-K in 2003. These regulations aimed to enhance transparency and comparability by requiring companies to provide a reconciliation of non-GAAP measures to the most directly comparable GAAP measure and to explain why management believes the non-GAAP measure is useful to investors.13 The SEC has continued to update its guidance over the years, with significant revisions in 2016 and December 2022, to address issues like the prominence of non-GAAP measures and the exclusion of normal, recurring operating expenses.12,11

Key Takeaways

  • Non-GAAP earnings are financial metrics presented by companies that deviate from GAAP.
  • They often exclude items management considers non-recurring, non-cash, or not indicative of core operations.
  • The SEC mandates that companies reconcile non-GAAP earnings to comparable GAAP measures and justify their use.
  • While they can offer additional insights, non-GAAP measures may lack comparability across companies and periods.
  • Investors and analysts should scrutinize adjustments and understand the rationale behind non-GAAP presentations.

Formula and Calculation

Non-GAAP earnings do not have a single, universally defined formula, as they are tailored by individual companies based on what they consider relevant exclusions from their GAAP earnings. However, the general approach involves starting with a GAAP earnings figure, such as net income, and then adjusting for specific items.

A simplified conceptual formula for non-GAAP earnings might look like this:

Non-GAAP Earnings=GAAP Net Income±Adjustments\text{Non-GAAP Earnings} = \text{GAAP Net Income} \pm \text{Adjustments}

Where:

  • GAAP Net Income: The company's profit as reported on its income statement according to GAAP. This is the starting point for most non-GAAP adjustments.
  • Adjustments: These can include adding back certain expenses (e.g., stock-based compensation, amortization of acquired intangibles, restructuring charges, one-time legal settlements) or subtracting certain gains (e.g., proceeds from asset sales). The nature of these adjustments is at the discretion of management, but they must be disclosed and justified.

For example, a company might exclude the impact of a large, one-time legal settlement from its GAAP net income to arrive at its non-GAAP earnings, arguing that this settlement is not part of its regular business operations. Similarly, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a common non-GAAP measure that adds back certain non-cash expenses and financing costs to net income.

Interpreting Non-GAAP Earnings

Interpreting non-GAAP earnings requires careful consideration, as they are management's customized view of performance and may not be directly comparable between different companies or even for the same company across different reporting periods. Analysts and investors often use non-GAAP earnings to gauge a company's underlying operational profitability and its ability to generate cash flow from its core activities. By stripping out certain volatile or non-recurring items, non-GAAP figures can, in some cases, offer a more stable measure of ongoing business performance, which can be useful for forecasting future results.

However, a critical aspect of interpretation is understanding the specific adjustments made. Investors should always review the company's reconciliation of non-GAAP earnings to the most comparable GAAP measure, typically net income or operating income. This reconciliation provides transparency regarding the items that management has chosen to exclude or include. Without this context, relying solely on non-GAAP figures can lead to a distorted view of financial health, especially if recurring expenses are presented as non-recurring.

Hypothetical Example

Consider "Tech Innovations Inc.," a publicly traded software company. For the fiscal year, Tech Innovations reports the following GAAP results:

  • GAAP Net Income: $100 million
  • One-time Restructuring Charge: $20 million (due to a significant reorganization)
  • Amortization of Acquired Intangibles: $10 million (related to a recent acquisition)
  • Stock-Based Compensation Expense: $15 million

Tech Innovations Inc.'s management believes that the restructuring charge and the amortization of acquired intangibles are non-recurring and non-cash items, respectively, and do not reflect the company's ongoing operational performance. They also consider stock-based compensation a non-cash expense that can obscure core profitability.

To calculate its non-GAAP earnings, Tech Innovations Inc. makes the following adjustments:

  • Start with GAAP Net Income: $100 million
  • Add back One-time Restructuring Charge: + $20 million
  • Add back Amortization of Acquired Intangibles: + $10 million
  • Add back Stock-Based Compensation Expense: + $15 million

So, the non-GAAP earnings for Tech Innovations Inc. would be:

$100 million + $20 million + $10 million + $15 million = $145 million

In their earnings release, Tech Innovations Inc. would report a GAAP net income of $100 million and a non-GAAP earnings figure of $145 million, providing a clear reconciliation between the two. This allows investors to see both the standardized GAAP view and management's adjusted view of profitability.

Practical Applications

Non-GAAP earnings are frequently used in equity analysis and by company management to convey a specific narrative about financial performance. In investor presentations and earnings calls, companies often highlight non-GAAP figures to emphasize what they consider their core, ongoing profitability, distinct from one-time events or non-cash expenses.10 This can be particularly relevant in industries with frequent mergers and acquisitions or significant research and development expenditures, where GAAP earnings might be significantly impacted by non-recurring items.

For example, a technology company might consistently present non-GAAP earnings that exclude stock compensation and amortization of acquired intangible assets, arguing that these items do not reflect the underlying performance of its software subscriptions. Financial analysts frequently calculate and rely on non-GAAP measures in their valuation models and financial models to compare companies within an industry, believing these adjusted figures provide a more consistent basis for comparison. The SEC mandates that non-GAAP measures not be misleading and that they are reconciled to their GAAP counterparts, often leading to comment letters for non-compliance.9,8

Limitations and Criticisms

Despite their widespread use, non-GAAP earnings face significant criticism and come with inherent limitations. A primary concern is the potential for companies to use these measures opportunistically to present a more favorable financial picture than GAAP earnings suggest, especially when GAAP results fall short of expectations.7,6 This can involve selectively excluding recurring operating expenses by labeling them as "non-recurring" or "unusual," even if they occur frequently. The SEC has explicitly warned against excluding normal, recurring cash operating expenses in non-GAAP performance measures.5,4

Another major criticism revolves around the lack of standardization, which makes comparability challenging. Each company can define its non-GAAP measures differently, leading to inconsistencies across industries and even within the same industry.3 This can make it difficult for investors to accurately compare the performance of different companies or to track a single company's performance consistently over time. The CFA Institute has highlighted concerns regarding the lack of comparability across reporting periods and companies due to inconsistent definitions, as well as the greater prominence sometimes given to non-GAAP figures over GAAP.2 Concerns also extend to executive compensation often being linked to non-GAAP earnings, potentially incentivizing management to manipulate these figures.1 This discretionary nature of non-GAAP reporting can lead to a less transparent financial presentation, raising questions about earnings quality and potentially contributing to information asymmetry.

Non-GAAP Earnings vs. GAAP Earnings

Non-GAAP earnings and GAAP earnings represent two distinct approaches to measuring a company's financial profitability, and understanding their differences is crucial for investors.

FeatureNon-GAAP EarningsGAAP Earnings
DefinitionCompany-defined measures of profitability, adjusted by management to exclude certain items they deem non-operational, non-recurring, or non-cash.Standardized measures of profitability calculated according to Generally Accepted Accounting Principles (GAAP) in the U.S. or International Financial Reporting Standards (IFRS) globally.
StandardizationNot standardized; definitions and adjustments vary by company and reporting period.Highly standardized and prescriptive, governed by established accounting rules and principles (e.g., accrual accounting, revenue recognition).
PurposeTo provide an alternative view of core operational performance, often aimed at highlighting underlying trends or excluding specific events.To provide a consistent, comparable, and transparent financial picture for all stakeholders.
ComparabilityLimited comparability across different companies due to varied adjustments; can also be inconsistent for the same company over time.High comparability across companies within the same jurisdiction and over time due to uniform rules.
RegulationSubject to SEC Regulation G and Item 10(e) of Regulation S-K, requiring reconciliation to GAAP and justification for use, but management has discretion over specific exclusions.Mandated for all public companies in the U.S. by the SEC; audited by independent accountants.
TransparencyRequires clear reconciliation to GAAP and explanation of adjustments to maintain transparency.Inherently transparent due to strict adherence to rules and auditing requirements.

The key difference lies in the flexibility and discretion afforded to management. While GAAP earnings provide a uniform, audited snapshot of a company's financial performance, non-GAAP earnings offer a customized perspective. Investors commonly confuse the two because non-GAAP figures are often presented prominently in earnings releases and investor communications. It's essential to remember that non-GAAP earnings are supplementary and should always be evaluated in conjunction with their GAAP counterparts to gain a comprehensive understanding of a company's financial health.

FAQs

Why do companies report non-GAAP earnings if GAAP already exists?

Companies report non-GAAP earnings to provide what they consider a more accurate representation of their ongoing business operations. They may exclude certain items, such as one-time charges, non-cash expenses like depreciation, or acquisition-related costs, which they believe obscure the true underlying profitability of their core business. This aims to offer investors additional insights into the company's performance trends.

Are non-GAAP earnings regulated?

Yes, non-GAAP earnings are regulated by the U.S. Securities and Exchange Commission (SEC) through rules like Regulation G and Item 10(e) of Regulation S-K. These regulations require companies to reconcile non-GAAP measures to their most directly comparable GAAP figures and to explain why management believes these non-GAAP measures are useful. The SEC also prohibits the use of misleading non-GAAP measures, especially those that exclude normal, recurring operating expenses.

Can non-GAAP earnings be misleading?

Yes, non-GAAP earnings can be misleading if not properly scrutinized. Because companies have discretion over what to include or exclude, there's a risk that management might "cherry-pick" adjustments to present a more favorable financial picture. For instance, repeatedly excluding certain operating expenses as "one-time" could distort the true profitability of the business. Investors should always review the accompanying GAAP figures and the reconciliation provided.

How do analysts use non-GAAP earnings?

Many financial analysts use non-GAAP earnings as part of their financial analysis to gain a clearer understanding of a company's core operating performance. They often adjust GAAP figures themselves to create comparable non-GAAP metrics across companies and industries, particularly when comparing firms with different accounting policies or significant non-recurring events. This can help them in their investment analysis and forecasting efforts.

What is the difference between pro forma earnings and non-GAAP earnings?

The terms "pro forma earnings" and "non-GAAP earnings" are often used interchangeably, and they both refer to financial metrics that are not calculated strictly according to GAAP. Historically, "pro forma" might have specifically referred to earnings adjusted for the impact of proposed or completed acquisitions and divestitures, presenting what the financial results "would have been" under different circumstances. However, in modern financial reporting, "non-GAAP earnings" is the broader term encompassing any earnings measure that deviates from GAAP.