Don't Stop at Reported Earnings: Forensic Accounting Tips for Converting GAAP Data

David Trainer
  2014-04-11 14:07:05

 


It's important to protect your portfolio from blowups. And for that, there's no substitute for our unrivaled diligence.

Reported earnings don't tell the whole story of a company's profits. They're based on accounting rules originally designed for debt investors, not equity investors, and are manipulated by companies to manage earnings. 

Below I detail all the red flags and hidden items buried deeply in SEC disclosures that can be used to provide a more accurate measure of cash flow and valuation.

Finance 101

Only economic earnings that incorporate due diligence in the financial footnotes provide a complete and unadulterated measure of profitability, and converting generally accepted accounting principles (GAAP) data into economic earnings should be part of every investor's diligence process.

Here's a look at the adjustments our firm makes in evaluating the companies we cover.

A) Adjustments for NOPAT (converting reported GAAP income to net operating profit after tax):
  1. Remove asset write-downs hidden in operating expenses
  2. Remove nonoperating expenses hidden in operating earnings; this includes foreign currency exchange losses hidden in operating earnings
  3. Remove nonoperating income hidden in operating earnings
  4. Add back change in reserves
  5. Remove income and loss from discontinued operations (except for REITs)
  6. Add back implied interest for the present value of operating leases
  7. Adjust for nonoperating tax expenses
  8. Historical adjustments: Add back goodwill amortization prior to 2002 and include employee stock option expenses prior to 2006
  9. Remove reported nonoperating items
B) Adjustments for invested capital (converting reported assets to invested capital):
  1. Add back off-balance sheet reserves
  2. Add back off-balance sheet debt due to operating leases
  3. Remove discontinued operations
  4. Remove accumulated "Other Comprehensive Income"
  5. Add back asset write-downs
  6. Remove deferred compensation assets and liabilities
  7. Remove deferred tax assets and liabilities
  8. Remove overfunded pensions
  9. Remove excess cash
  10. Prior to 2002: Add back unrecorded and accumulated goodwill
  11. Adjust for midyear acquisitions
  12. Remove nonoperating unconsolidated subsidiaries
C) Adjustments for our discounted cash-flow model, economic book value, and enterprise value calculations:
  1. Employee stock option liabilities
  2. Preferred stock
  3. Minority interests
  4. Adjusted total debt (including off-balance sheet debt)
  5. Pension net-funded status
  6. Net-deferred tax assets or liabilities
  7. Net-deferred compensation assets or liabilities
  8. Discontinued operations
  9. Excess cash
  10. Unconsolidated subsidiaries
For more, see detailed information on these checklist items here

Mr. Trainer is a Wall Street veteran and corporate finance expert. He specializes in reversing accounting distortions on the underlying economics of business performance and stock valuation. He is author of Modern Tools for Valuation (Wiley Finance 2010).