What are Non-GAAP Earnings?

Non-GAAP earnings (GAAP stands for Generally Accepted Accounting Principles) are measures of profit that don't follow a standard calculation for companies and are not necessarily required in their disclosure.

To properly understand non-GAAP earnings, you first need to know what GAAP earnings are and why they are important.

For starters, the Securities and Exchange Commission (SEC) requires all companies that issue securities to the public to use GAAP accounting methods when preparing their financial statements. It also requires that those financial statements be audited to ensure that they comply with GAAP rules. The goal of GAAP is to ensure that all companies apply consistent accounting practices when preparing their financials. This helps analysts and investors by ensuring consistency across all publicly-traded company financial statements. When comparing Company A to Company B, an investor needs to know that the two companies have prepared their earnings using similar accounting rules in order to get an apples-to-apples comparison.

In addition to providing GAAP financial statements, most publicly-traded companies also present non-GAAP earnings as part of their regular quarterly financial reporting. In doing so, their goal is typically to emphasize their company's cash flow, or to provide investors with a better understanding of their results. For example, some companies will showcase non-GAAP earnings to demonstrate what their results would have been excluding the impact of large non-recurring events like the purchase or sale of a major asset.

How Do Non-GAAP Earnings Work?

A common example of Non-GAAP earnings is EBITDA -- earnings before interest, tax, depreciation and amortization. EBITDA provides a way to evaluate a company's operating performance independent of its financing decisions, accounting decisions or tax environments. The formula for EBITDA is:

EBITDA = EBIT + Depreciation + Amortization

EBITDA is a non-GAAP earnings measure calculated by adding back the non-cash expenses of depreciation and amortization to a firm's operating income. It allows analysts to focus on the outcome of operating decisions while excluding the impacts of non-operating decisions like interest expenses (a financing decision), tax rates (a governmental decision), or large non-cash items like depreciation and amortization (an accounting decision).

The Securities and Exchange Commission requires companies to reconcile their non-GAAP measures to the most comparable GAAP financial measure. So a company that decided to report EBITDA in its financial disclosures would also be required to provide a reconciliation to show its net earnings according to GAAP.

EBITDA is just one example of Non-GAAP Earnings. Other examples include cash earnings, operating earnings, adjusted operating income, and adjusted EPS.

In addition, some non-GAAP earnings measures have become ubiquitous in specific industries. For example, nearly all real estate companies prepare a non-GAAP earnings figure called Funds from Operations (FFO). FFO is a measure of cash generated by a real estate investment trust (REIT) that strips out the impacts of non-cash measures such as depreciation and amortization, as well as one-time events like gains from the sale of real estate.

Why Do Non-GAAP Earnings Matter?

In a recent quarter, nearly 90% of companies in the S&P 500 reported at least one measure of non-GAAP earnings along with their financial results. Companies often present non-GAAP earnings in addition to GAAP earnings because they feel the non-GAAP earnings more accurately showcase their performance. They do so by stripping out the impact of one or more of the following, which rank as some of the most common items removed from GAAP earnings to arrive at non-GAAP numbers:

-- acquisitions and divestitures
-- restructuring costs
-- litigation and settlements
-- depreciation and amortization
-- impairment of goodwill and property, plant and equipment (PPE)

In many instances, these expenses will be non-recurring. By excluding them from their earnings numbers, companies often attempt to showcase numbers that more accurately reflect what their business results might look like going forward.

However, non-GAAP earnings can also be deceptive when applied incorrectly. The measures are especially unsuitable for firms saddled with high debt loads or those that must frequently upgrade costly equipment. Furthermore, non-GAAP earnings can be trumpeted by companies with low net incomes in an effort to 'window-dress' their profitability. EBITDA, for example, will almost always be higher than reported net income. Therefore, when analyzing a firm's EBITDA, it is best to do so in conjunction with other factors such as capital expenditures and debt payments.

Because non-GAAP earnings are by definition not subject to GAAP, companies have discretion over what they do, and do not, include in their earnings calculations. There's also the possibility that a company may include different items in its earnings calculations from one reporting period to the next, making it more difficult for analysts and investors to track the company's results over time.

The bottom line is that investors should always review a company's GAAP financial results, as the standardized methodology provides a reliable means of comparing financial results from company to company, from industry to industry, and from year to year.