Steve's Gadget Blog

It took a phone call with the firm in question’s CFO before the matter was finally ironed out. The outcome? Our story was found to be accurate, with the CFO saying, “We read your blog and you are quite right, fair enough… our net income was as you showed it and I’m not going to go against that.” You can see that blog and more from our interview with that CFO here.

So why the controversy? How can a figure be down either 40% or 4%, depending on who you ask? The answer is in the way that companies report their financial results, and the way that regulators such as the Financial Services Authority (FSA) in the UK and the Securities and Exchange Commission (SEC) in the US insist that they provide them to shareholders, analysts and indeed the pesky media like ourselves.

GAAP versus non-GAAP

The trouble stems from the fact that, legally, companies must present in their financial results a net income figure, that complies with Generally Accepted Accounting Principles (GAAP). That figure includes all charges and costs that hit the company during the period in question, including one-off items like restructuring charges and so-called ‘non-cash charges’.

Non-cash charges stem from things like the amortisation of goodwill related to acquisitions – these are recorded as an expense though no cash was spent on them -- but their existence is not irrelevant, which is why the financial authorities insist they are all included in the net income figure. So far, so good. All publicly held companies must present their figures in accordance with GAAP, making them comparable.

But this is where it gets a little more, shall we say, murky. In press releases and other financial documents distributed to investors, analysts and the media, companies also offer a very different set of numbers, which they usually call ‘pro forma’. As far as they are concerned, these are the numbers that ‘count’.

Pro forma profit figures can ignore many of the costs and charges that would have to be included in the GAAP net income figure. Pro forma statements are not regulated in the same way as GAAP, which means companies can choose what to include in their pro forma results and what to leave out. That also means that pro forma or non-GAAP figures are rarely comparable from one company’s results to another’s.

The Danger of EBITDA

Acronyms like EBITDA [earnings before interest, taxes, depreciation and amortisation] define a certain kind of pro forma numbers. Again, EBITDA ignores many of the costs and charges that a company must legally include in its GAAP net income figures – namely ignoring interest, taxes, depreciation and amortisation.

The website legalzoom.com explains why you should look at GAAP figures and not just non-GAAP: “Without GAAP, companies would be free to decide for themselves what financial information to report and how to report it, making things quite difficult for investors and creditors who have a stake in that company.”

As investors’ site The Motley Fool wrote in an article warning against using anything other than GAAP to compare company earnings announcements, “Those who blindly accept pro forma earnings statements are simply aping what the companies want them to hear. This isn't to say companies are being dishonest with pro forma earnings: in general the numbers are not being manipulated, as pro forma statements don't constitute fraud. But when reading non-GAAP earnings, being serially sceptical may end up saving you big money.”

Why Merrill Lynch Got Tough on Non-GAAP

As long ago as 2002, Merrill Lynch began requiring all of its US equity research reports to include earnings based on generally accepted accounting principles (GAAP) in addition to any pro forma earnings that companies may have reported.

Furthermore, “when GAAP earnings differ significantly from pro forma earnings, those differences will be discussed and evaluated in the body of the research report,” the company announced. "We believe that by including both GAAP and pro forma data we are enhancing the value of Merrill Lynch research by providing more transparency for investors," said Deepak Raj, SVP and head of Merrill Lynch Global Equity Research. Sadly even today, some companies choose to play-down their GAAP-compliant results to make their earnings look a little rosier.