While generally accepted accounting principles (GAAP) may define the lingua franca of financial reporting, investment analysts often modify GAAP-based results in order to improve the insights they can get from standard bottom-line summaries. Here is an overview of some issues and modifications.
Separating cash and noncash items
Cash may be "king" in routine commerce, but not necessarily in financial reporting. Cash accounting is essentially the process of charting revenue and expenses based on the actual movements of cash. But while this may be a convenient way to understand family finances or a small merchant business, GAAP accounting for complex businesses focuses on accruals rather than cash flows. As a result, segments of any given cash flow may be apportioned among multiple reporting periods and income statements, even when only one payment is involved.
In normal business circumstances, the cash flow and the accrual occur relatively near each other, so that an economically significant event can be associated more directly with both its benefit and its cost. But occasionally, there may be great distance and no clear relationships.
For example, certain kinds of asset write-downs may create the appearance of a significant recent cash flow when none had occurred. Some forms of stock and stock options issued for employee compensation may appear as expenses but have no associated cash outlays. And some changes in the value of financial assets may trigger their being marked to market, a process that can generate gains or losses on the income statement without any cash having changed hands.
Collectively, these are known as noncash items. They may be meaningful for purposes such as tax or regulatory accounting. But many analysts exclude them from measures intended to gauge a company's operating effectiveness and the quality of its business strategy.
The bottom line of any income statement includes the impact of all events that took place for accounting purposes during the period. But not all of these events occur as part of the normal course of business. There may be special costs incurred as the result of an accident or natural disaster. There may be one-time adjustments needed as the result of a business acquisition, a sale, or a restructuring. And there may be unusual gains or losses due to some unforeseen one-time-only happenstance.
These may all be accounted for as nonrecurring items. There are usually clear cash-flow consequences for nonrecurring items, and they generally have tax and regulatory consequences as well. But nonrecurring items may still offer little insight into the regular operations of the firm being studied, so many analysts recalculate income statements adding back or subtracting nonrecurring amounts to eliminate their impact on the bottom line.
Currency translation effects
Companies that conduct significant business activities across national boundaries generally have transactions and, in some cases, significant assets that carry original values in currencies other than U.S. dollars. These income- and balance-sheet items are generally shown in reports as if their foreign currency value was translated into dollars based on some specified formula during the reporting period. Changes in the values of these items from period to period are incorporated into financial reports as translation gains or losses.
Other potential causes for adjustment
- Off-balance-sheet items may include operating leases for equipment and buildings and the cash pools created to fund some kinds of secured debt, among other things. The actual values of off-balance-sheet items are usually disclosed somewhere in annual reports even if not as part of the asset-and-liability statements themselves. In some cases, an investor can create a pro forma balance sheet that includes these items to get a more complete overall image of a company's assets and liabilities.
- Consolidation practices are generally mandated by GAAP, but an analyst seeking a clearer picture of a particular line of business or market segment may seek to disaggregate the data of a company, or alternatively, to create a pro forma report that incorporates entities that might have been excluded from the consolidated reports.
- Pension accounting can introduce gains or losses that may be accounted for immediately but not be realized for years or even decades.
Many kinds of adjusted earnings and balance sheet statements are published by independent analysts, under terms such as core earnings or pro forma income statement. Publishers of such reports should clearly disclose what might be included or excluded, and why.