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Assessing the gap in GAAP: which numbers represent true earnings?

Investors studying the financial statements of existing publicly held companies such as Quintiles and newly public ones such as Patheon are undoubtedly confused over the different numbers many firms report to reflect their true profitability. As they compile their financial statements, U.S.-based publicly held firms must follow the set of principles, standards, and procedures known as GAAP, or Generally Accepted Accounting Principles. Non-U.S.-based companies generally follow closely related set of principles known as IFRS, or International Financial Reporting Standards. This column is about differences not between GAAP and IFRS, but between the numbers reported using GAAP and a separate sect of figures compiled after making some non-GAAP adjustments.

In any accounting period, a company's net income as determined while applying GAAP might include certain one-time expenses that management believes might actually distort that period's earnings picture. That company is permitted to report a non-GAAP adjusted net income figure that eliminates those one-time expenses and presents what management believes to be a more relevant picture of the period's earnings. Some typical expense items that managements might properly choose to eliminate when computing a period's non-GAAP adjusted net income include those related to completing a merger, settling a lawsuit, or closing a non-core operating facility. The Securities and Exchange Commission (SEC) requires the company to reconcile the differences between the two earnings figures, and to note that the non-GAAP results are presented as a supplement to, not a replacement for GAAP.

The SEC has a set of rules describing the types of non-GAAP adjustments to revenue or expenses that it believes are fair, relevant, and useful to acknowledge in financial statements. Over time, creative management teams have adopted an increasingly wide variety of non-GAAP adjustments they believe provide financial statement users with incremental insight into their business. In so doing, however, they have stretched the historic meaning of "appropriate adjustments" and widened the gap between the GAAP numbers reported for net income and the non-GAAP numbers reported as adjusted net income.

More than 80% of the companies in the Standard & Poor's 500 regularly use up to 30 measures to differentiate their non-GAAP earnings from those computed using GAAP. The numbers show that the 2015 non-GAAP earnings figure for the companies that make up that index was about 54% higher than the number calculated according to GAAP. In the recent past, that gap had ranged from 11% in 2011 to 20% in 2012 and 2014.

Separately, the financial information and analytics company FactSet Research Systems noted that the average difference between GAAP earnings per share and non-GAAP earnings per share was 28% for the 19 of the 30 companies in the Dow Jones Industrial Average (DJIA) that reported non-GAAP adjustments to their net income in the first quarter of 2016.

Using non-GAAP adjustments to report higher adjusted net income figures has several consequences, the most obvious of which supports the expectation of higher stock prices. For example, applying a 20.Ox price earnings multiple to an adjusted EPS number of $3.00 per share would support a stock price expectation of $60.00; applying that same multiple to a GAAP EPS figure of $2.50 would support a stock price expectation of $50.00.

The SEC has recently expressed its concerns about corporate America's growing use of non-GAAP adjustments to define earnings. Chairman Mary Jo White has cautioned corporate executives and auditing firm managements alike to limit their use of non-GAAP adjustments only to those that have clear justifications, and are clearly labeled. Other agency officials have asked managements to be particularly careful about applying the term "one-time" to some common adjustment items that seem to recur regularly over time.

We'll be watching closely during the next few quarters to see if this guidance is taken to heart. And we urge the readers of ContractPharma to do the same.

Michael A. Martorelli is a Director at the Investment banking firm Fairmount Partners. For additional commentary on the topics covered in this article, contact him at Michael.martorelli@ or at Tel: (610) 260-6232; Fax (610) 260-6285.
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Title Annotation:BACK PAGE
Author:Martorelli, Michael A.
Publication:Contract Pharma
Date:Sep 1, 2016
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