Question

1. Discuss GAAP versus non-GAAP numbers and their impact on financial statements. Which method best reflects the economic reality?

Answer 1

GAAP-GENERALLY ACCEPTED ACCOUNTING PRINCIPLES,it offers uniformity in how companies report there financial statements,However, income statements reported based on GAAP don't always reflect the ongoing performance of a companies underlying operations. For example, a company may write-down an asset or restructure its organization. These actions usually come with large one-time costs that distort company profits. As such, a company will also provide an "adjusted" earnings number that excludes these nonrecurring items.for example We believe that the best EPS measure for valuation purposes sits somewhere between pro forma and GAAP EPS, where in between varies by company, industry and sector,however pro forma EPS can overstate true EPS, GAAP EPS can understate true EPS.

S&P 500 GAAP EPS has both a cyclical and secular tendency to understate EPS appropriate for valuation. During recessions GAAP EPS can collapse owing to large asset write-downs, which crushes reported EPS relative to continuing EPS. A similar effect can occur when a company incurrs large restructuring or litigation costs.Thus, most equity analysts reverse such charges from their pro forma EPS metrics as maintained in their models and posted to the major data services to prevent distortions in the underlying operating profit trend and to help better forecast future EPS.However, just because a cost is infrequent does not mean it is non-recurring. Thus, it is often argued by some strategists and many quants that GAAP EPS for the overall S&P 500 over a full economic cycle will represent EPS appropriate for valuation purposes. We would agree if it weren't for that about half of the difference between GAAP and pro forma EPS measures over full economic cycles is from asset write-downs.Write-downs reflect a directional bias in GAAP accounting. Because they are carried at cost or NRV whichever is lower,write-downs occur whenever bad investments are made but write-ups never occur when good investments are made. This distortion has been magnified by large goodwill impairments in recent recessions. Goodwill created in an acquisition must be periodically tested for impairment. Sharp market downturns usually bring goodwill impairments.