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posted on 28 March 2016

The Truth About Non-GAAP Earnings You're Being Deceived

by Diane Alter

Money Morning Article of the Week

A growing number of Wall Street experts have become increasingly critical of companies highlighting adjusted earnings. Also known as non-GAAP, these adjusted earnings are repeatedly being used to deceive investors...

Here's how non-GAAP earnings differ so dramatically from GAAP earnings...

GAAP is short for Generally Accepted Accounting Principles. GAAP accounting standards provide uniformity in how companies report their financial performance.

But income statements based on GAAP don't always accurately reflect the ongoing performance of a company's underlying operations.

For example, a company may write-down an asset or restructure its organization. Those actions are usually accompanied by significant one-time costs that distort company profits. In such cases, a company will also provide "adjusted" earnings, or non-GAAP numbers. These non-GAAP numbers exclude one-time items.

That's why when looking at S&P 500 earnings, we only care about GAAP numbers. Non-GAAP numbers don't provide a clear (if any) indication of the true financial state of the company.

Many argue non-GAAP is really nothing more than a tool used by management to raise capital, the company's stock price, or stock-linked executive compensation.

Money Morning Capital Wave Strategist Shah Gilani says make no mistake, non-GAAP earning methods are simple manipulation.

Gilani asks:

"I'm not an accountant, so I have to ask myself, and you have to ask yourself, if GAAP is based on accepted accounting principles, why would companies use non-GAAP accounting methods, which are by definition not generally accepted as being principled?"

His answer:

"Because it makes their earnings look better..."

There are times when non-GAAP, or adjusted earnings, are warranted. Maybe when earnings are substantially impacted by merger or acquisition costs, restructuring charges, goodwill write-downs, asset impairment charges, or other supposed one-time charges.

But according to Gilani, there's a major problem because some companies seem to keep incurring these "one-time" charges. And even though they are repeated, they frequently end up in non-GAAP accounting.

It's become a major problem because the difference between non-GAAP and GAAP earnings is stark...

For all of 2015, S&P 500 non-GAAP 12-month trailing earnings came in at $118. GAAP earnings, meanwhile, were $87 for 2015.

Gilani said:

"Looking at non-GAAP earnings, investors would say earnings have been growing nicely. The truth is that GAAP earnings in 2015, after a seven-year bull market, are only about $5 higher than what they were in 2006 before the meltdown."

The fourth quarter of 2015 saw non-GAAP earnings of $29.49, while GAAP earnings were $19.92.

Gilani added:

"If that's not manipulation, I don't know what is."

According to FactSet, Dow Jones Industrial Average components that reported non-GAAP earnings per share last year posted earnings that were on average 30% above earnings per share under GAAP.

The massive distortion makes the uneven U.S. economic recovery more pronounced. But there is a way for investors to protect themselves from this repeated Wall Street deception...

Protect Yourself from Non-GAAP Market Manipulation Now

With more and more companies relying on non-GAAP results, regulatory scrutiny has heightened.

Last week, the U.S. Securities and Exchange Commission said it's mulling whether to curb some of the freedom firms enjoy to provide adjusted earnings figures.

SEC Chairman Mary Jo White said at a conference of finance and business lobbyists in Washington:

"It's something that we are really looking at - whether we need to rein that in a bit even by regulation. We have a lot of concern in that space."

Yet it's unclear when the SEC will actually implement new measures restricting non-GAAP results.

Gilani said:

"The best thing investors can do right now is to contact your broker (or hop online if you manage your own investments) and put down stop orders to get out of your winners if a reality check knocks the market back down to earth. And since the manipulation isn't going to stop any time soon, and the market can be manipulated even higher, enjoy the ride as long as it lasts."

In the meantime, Gilani advises investors to keep raising their stops so they can book profits when the markets head back down.

Stay informed on what's going on in the markets by following us on Twitter @moneymorning or liking us on Facebook.

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