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There is a Huge GAP Between Reported and GAAP Earnings


  • Real earnings are currently 25% lower than pro forma reported ones.
  • The other consolidated income statement can also hide surprises.

Introduction

How would life look if things were as you saw them or exactly like someone presented them? Surreal for sure as it would require a non-human mind to objectively process information and accept a situation as it is. People usually fall in love with the wrong person or feel depressed over nothing important. The same is applicable in business, but it’s strongly biased toward falling in love with one’s business and refusing to see the flaws of it. Such a behavior results in a large gap between pro forma reported earnings and official Generally Accepted Accounting Principles (GAAP) results.

Investors have to be mindful about that when analyzing earnings, and must precisely determine what the real situation is compared to managements’ rosier view. Even Buffett touched on the subject in his last letter to shareholders warning that “it has become common for managers to tell their owners to ignore certain expense items that are all too real” and analysts are part of the culprit as they propagate misleading numbers that can deceive investors.

Gap Between GAAP and Pro Forma Earnings is Widening

Pro forma figures exclude certain items that are considered by management as non-recurring. Some of those expense items include the costs of laying off workers, legal costs, acquisition expenses, cost of stock-based compensation, expenses related to asset volatility, asset write-downs, effects of foreign-currency moves, omitting results from newly opened and recently closed stores and depreciations not related to current operations. By eliminating noise, management’s intention is to present earnings related to the core business as what is happening around it is of no importance. The best way to explain what is going on is to let you read yourself. Apache Corporation (NYSE: APA) reported the following in its annual report:

For the year ending 2015, Apache reported a net loss of $23.1 billion, or $61.20 per diluted common share. On an adjusted basis, Apache’s 2015 loss totaled $130 million, or $0.34 per share. Net cash provided by continuing operating activities was approximately $2.8 billion, and adjusted EBITDA was $3.9 billion in 2015. Total capital expenditures were $4.7 billion for the full year, or $3.6 billion when excluding leasehold acquisitions, capitalized interest, Egypt noncontrolling interest, and spending on divested LNG and associated assets. This was at the low end of the company’s full-year 2015 guidance range of $3.6 to $3.8 billion.

APA’s management managed to turn a loss of $23 billion into an adjusted loss of $130 million and even finish with positive adjusted EBITDA of $3.9 billion. It is practically impossible for an investor not specialized in accounting to understand what is real and what not in such an annual report. Unfortunately, APA is not an exemption in the corporate world but more of a new mainstream.

1 figure gaap and pro forma

Figure 1: Gap between pro-forma and GAAP earnings widening. Source: The Wall Street Journal.

The official GAAP S&P 500 earnings in 2015 were $787 billion versus pro forma estimates of $1.04 billion which means that 25% of expenses are not treated by management as expenses but as mere non-recurring items. It is the widest difference since 2008 and a closer look shows that S&P 500 real GAAP earnings have not increased by 0.4% like pro forma earnings show, but instead declined by 12.7%. The issue is not only related to smaller companies like the above mentioned APA, but also to blue chips. 18 of the 30 Dow Jones Industrial Average (DJIA) members have reported higher pro forma than GAAP earnings.

2 DJIA

Figure 2: DJIA average year-over-year change in EPS. Source: FACTSET.

Even blue chips report higher earnings than real earnings, and companies have had a history of treating the ordinary as extraordinary when business conditions worsen. In 2014, the difference between GAAP and pro forma earnings was 11.8% while in 2015 it jumped to 30.7% for the DJIA companies that report pro forma earnings.

3 difference 2014 2015

Figure 3: Difference between (%) pro forma and GAAP earnings for DJIA stocks. Source: FACTSET.

The most notable example from the DJIA is Merck (NYSE: MRK), who reported 2015 GAAP EPS of $1.56 and pro forma EPS of $3.59. The difference, according to management, comes from acquisition and divestiture related costs, restructuring costs and legal fees. The funny part is that in 2014 they excluded the same costs to form pro forma earnings and also forecast 2016 GAAP EPS to be between $1.96 and $2.23 while pro forma reported earnings are expected to be between $3.6 and $3.75. It seems illogical to name costs that occur year after year non-recurring.

Other Comprehensive Income

Another accounting issue that is not so much discussed about in the media is other comprehensive income (OCI). OCI includes revenues, expenses, gains, and losses under both GAAP and International Financial Reporting Standards (IFRS) that are excluded from net income on the income statement and are therefore listed after the income statement. Those items are mostly items that have not yet been realized and might change in the future. For example, an investment in a foreign country and currency is affected by currency fluctuations when the value is translated into the home currency. One year it can have a positive effect while the other a negative effect, therefore those differences are kept in the other comprehensive income statement until realized.

Items included in OCI and excluded from the income statement usually are:

  • Unrealized holding gains or losses on investments that are classified as available for sale.
  • Foreign currency translation gains or losses.
  • Pension plan gains or losses.

Before investing, it is good to take a look at accumulated OCI in order to see if the company has some huge unrealized future risks or benefits. Unfortunately the risks and unrealized losses are always wider than unrealized gains.

Conclusion

A good note for the average investor is that the SEC is looking at the issue and probably is going to regulate the way companies report earnings in order to limit the deceiving of investors. But, in the meantime, each investor should meticulously study the pro forma, GAAP and OCI earnings in order to estimate his investment. To conclude, Buffett applauds companies that report OCI income in the regular income statement and only real GAAP earnings.

 

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