Minding the Gap Between GAAP, Pro Forma Earnings

As bull markets begin to age, companies start dropping some big items from earnings. Does that portend disaster?


When the going gets tough, companies embrace the use of pro forma earnings to cast their results in the best possible light. As a result, the gap between pro forma earnings and earnings from generally accepted accounting principles (GAAP) has reached its highest level since the financial crisis year of 2008.

“Earnings definitely aren’t as strong as they are being portrayed,” says Andrew Lapthorne, head of quantitative equity research for Société Générale in London. “This is symptomatic of the end of the business cycle. It’s an attempt to maintain an illusion by removing things from earnings to make them better.”

Companies are legally required to report GAAP earnings. But in their earnings releases, they will often first cite pro forma earnings that exclude items such as asset write-downs or legal expenses, justifying the omissions as one-time items or not indicative of the company’s underlying operations.

Not surprisingly, the gap between pro forma and GAAP earnings widens when companies face more problems. Last year GAAP profits for the Standard & Poor’s 500 index totaled only 74 percent of pro forma profits, the lowest ratio in seven years. “Companies have a natural bias to paint the best picture possible,” says Dan Suzuki, senior U.S. equities strategist for Bank of America Merrill Lynch in New York.

Companies with big gaps between pro forma and GAAP earnings tend to underperform the market, since the factors causing them to write down assets or incur large expenses frequently persist, he says. As for the stock market as a whole, a rising gap between pro forma and GAAP earnings tends to be a coincident or lagging indicator of weakness, analysts say. Items like write-downs generally reflect news that investors already know.

Among the industries reporting the biggest gaps are energy, where companies are excluding asset write-downs caused by plunging oil prices; health care, where companies are leaving out acquisition costs; financial services, where banks are excluding large legal fees; and technology, where companies are ignoring stock-based compensation.


For example, Oklahoma City–based Chesapeake Energy Corp. reported a loss of $14.9 billion last year under GAAP. But the company said it lost only $329 million after dropping items “typically excluded by securities analysts in their earnings estimates.” The primary items were losses in the value of Chesapeake’s oil and gas holdings.

Dublin-based pharmaceuticals company Allergan reported pro forma earnings per diluted share of $3.48 for the third quarter, compared with a GAAP loss from continuing operations per diluted share of $2.35. The discrepancy came from leaving out amortization and acquisition-related expenses,

Meanwhile, Twitter’s stock-based compensation totaled 247 percent of its pro forma earnings last year. And the San Francisco social media company is increasing that form of pay this year to avoid defections by employees. So that percentage figure will almost certainly rise. Warren Buffett has railed against companies for leaving stock-based compensation out of their pro forma earnings statements, and Bill Stone, chief investment strategist for PNC Wealth Management, agrees. “Compensation is compensation, whether you pay people in stock or cash,” he says. “It may be worth it, but it should be considered an expense.”

To be sure, given that companies report GAAP earnings alongside the pro forma earnings and offer an explanation of what adjustments have been made, investors and analysts generally have all the information they need to evaluate a company, experts say. “You can add adjustments back to the earnings if you think they are recurring,” Suzuki says. “As long as companies are giving transparency, that’s all you can ask. Most companies do a good job giving you visibility on what’s driving the adjustments.”

But the gap between GAAP and pro forma earnings is ringing an alarm bell among some equity investors, because the last time it grew this large coincided with the 2008–’09 financial crisis, Stone says. He’s not too concerned now, however. The energy industry is a mess and will probably endure further pain, but that’s unlikely to spill over into the rest of corporate America, he maintains. “Lower fuel prices will probably be a net help for the rest of the economy.”

So just because the GAAP and pro forma earnings gap is widening doesn’t necessarily mean a bear market is at the door.