Leap Year: The First Non-GAAP Adjustment?

We’re a day after Leap Day, that awkward 366th day jammed into the calendar every four years. Most of us have heard the fuzzy explanation that the additional 24 hours are required because a solar year is a hair longer than our standard 365-day year. It is widely assumed that Leap Day is a mechanism to keep the seasons aligned with the months we’ve assigned to them on the calendar.

This is partly true. Leap Day is actually an adjustment introduced by the Roman Catholic church to keep the vernal equinox, the astrological event when day and night are equal length, as close as possible to Mar. 21st, the official first day of spring on our calendar.

I’ll spare you the biblical details, but this is important to the Roman Catholic Church because Easter is always the first Sunday after the first full moon after Mar. 21.

As humans we crave predictability. Just as we’ve adjusted the calendar so that March 21st is as close as possible to the vernal equinox, companies adjust earnings to highlight what a predictable stream would look like.

Public companies want their reported earnings to reflect their inherent earnings power and prefer to exclude non-recurring expenses. For example, when a company acquires another there are legal fees, inventory write-offs and advisory fees to pay consultants for valuation analysis that would not occur during a regular earnings period.

Think of it like this: the year that you purchased your home was saddled with one-time fees such as legal fees to draw up the purchase and sale, inspection charges, money paid to packers and movers, etc. You wouldn’t include these expenses into next year’s budget. Most importantly, the drop in your checking account due to paying these bills would not reflect deterioration in your personal earnings power but rather was a result of these one-time events.

If you think about your personal “income statement”, i.e. all of your income less every expense paid, non-GAAP adjustments make a lot of sense. Buying a new car, sending a child off to college or remodeling a kitchen are typically not annual events. When considering your personal budget each year, most people would consider these expenses, one-time or unusual.

Public companies, particularly those in high growth mode or those in restructuring mode, often carry significant one-time expenses. For those expanding, building out new manufacturing capacity, contract fees or perhaps sign-on bonuses for newly hired managers are all expenses that some companies consider non-recurring.

Companies restructuring their businesses are also chockfull of expense adjustments. Legal fees, severance expenses for laid off workers and transaction commissions for sold-off divisions all fall into this one-time bucket.

The problem of course, is when non-recurring expenses become recurring. Can that once-in-a-lifetime trip to the south of France be removed from your personal budget when you’re quietly planning another big trip for next year?

In the same vein, when buying new companies is part of a corporation’s growth strategy, should these expenses really be excluded from normalized earnings? Stock compensation, a perennial expense that allows companies to boost employee pay without cash walking out the door is often excluded from GAAP earnings, despite the fact that it is booked every quarter.

While it is impossible to ignore non-GAAP adjustments, it is important to look at the size of the adjustments. If the difference between non-GAAP and GAAP numbers is growing, another look is required to analyze the numbers. Perhaps the company’s earnings power is declining and the adjustments are an attempt to mask the deterioration.

Like it or not, non-GAAP (earnings that do not follow generally accepted accounting principles) earnings are more common than not for public companies. It is rare that I find an earnings announcement that does not include an adjustment from GAAP to non-GAAP.

Why the onslaught of non-GAAP numbers? Of course 99% of the time non-GAAP earnings are higher than those derived from GAAP methods. Non-GAAP earnings typically exclude one-time or unusual expenses.

Yet not all intentions are sinister. Many investors are eager to determine the ongoing profitability of a company and appreciate management splitting out these expenses. Sometimes the most important metric to look at is a company’s cash flow statement. If the amount of cash being generated by the business is growing despite non-GAAP adjustments, the model is usually healthy.

Salesforce.com for example regularly loses money on a GAAP basis. However after adjusting for a multitude of non-cash charges, it is profitable. Impressively the company generated $1.6 billion in cash flow last year, up 37%. I’m not recommending Salesforce.com as a stock but simply illustrating how important it is to analyze all the financial statements to gain a better perspective of its value.


The biggest reason to pay attention to non-GAAP earnings is that this is the set of numbers Wall Street uses to determine the fair value of a stock. While it is critical to analyze the path from GAAP to non-GAAP earnings, investors must use the same measuring stick as the rest of the market when assessing the potential of a stock.


So just as you must pay heed to Feb. 29th delaying the arrival of March, investors must be aware of non-GAAP earnings and their trends for the stocks they follow.


Stock Talk

Michael Sessions

Michael Sessions

Re your March 1 advisory, the problem is that companies now appear to have never-ending “one-time” adjustments. Telling what is or is not really a one-time adjustment requires that the company list and price every segment of their claim that and adjustment really is one time is never going to happen. See your comment re Salesforce for example…constant “multitude of non-cash charges”. I believe that any company which has one time items every time they report earnings is suspect and should be avoided.

Linda McDonough

Linda McDonough

I agree wholeheartedly that a stock with few non-GAAP adjustments is preferable to one with an addiction to them. However, there are many great stocks that still have these adjustments. I carefully comb through the adjustments, read the footnotes in the SEC filings and most importantly put a lot of weight into the cash flow statement, where it is more difficult for companies to hide their warts. I avoid companies with a widening difference between GAAP and non-GAAP numbers and have no appetite for stocks with deteriorating cash flow. Thank you for the comment and for being a subscriber.

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