Do Not Be Fooled by Earnings Adjustments – Focus on Cash Flow

Wait, what are they talking about it? And, why does it matter?

Simply put, this is a discussion about accounting differences.

The first is related to the difference between accrual and cash accounting. The second difference is between GAAP (Generally Accepted Accounting Principles) reporting and non-GAAP reporting. Non-GAAP reporting is commonplace and can help improve income statement comparability across time periods and between different companies. However, it is not standardized and can lead to incorrect conclusions if assumptions are not fully understood.

The key to successfully navigating such accounting treatments is to focus on cash flow instead of earnings.

Let us start with the difference between accrual and cash accounting. Accrual accounting recognizes and records revenue and expenses when they occur, whereas cash accounting dictates these items are not accounted for until cash changes hands. GAAP standards require accrual accounting because it presents a more accurate picture of a company’s financial condition.

A good example of this difference is the accounting treatment of incentive compensation. Incentive compensation is often paid in a lump sum near the end of an accounting period. Cash accounting necessitates this expense simply be recorded when it is paid. However, incentive compensation is often earned over the entirety of one or more accounting periods. Therefore, accrual accounting treats incentive compensation as an obligation that must be estimated up front and expensed proportionately over time.

Non-GAAP reporting is often provided to investors to improve the comparability of current and historical corporate results, and to create a more accurate starting point for financial projections. Therefore, it is common for non-GAAP results to exclude one-time expenses such as restructuring costs, goodwill write-downs, and legal expenses. However, non-GAAP reporting can vary widely from company to company as there is no standard framework. The Securities and Exchange Commission simply requires that “when an issuer presents a non-GAAP measure, the most directly comparable GAAP measure must be reported with equal or greater prominence.”²

Consequently, investors are largely on their own to determine the veracity and impact of non-GAAP financial adjustments. And, the magnitude of income statement differences between GAAP and non-GAAP figures can be substantial.

For example, consider the 2021 financial results from Stryker Corporation (SYK) shown in Table 1.

In this table, non-GAAP earnings are nearly 75% greater than GAAP earnings. How can we explain this difference? Descriptions for the non-GAAP adjustments shed some light:

• Acquisition and integration-related charges: one-time costs associated with integration efforts on recently acquired companies, the mark-to-market impact on acquired inventories, and amortization on acquired intangible assets.
• Restructuring-related and other charges: costs associated with the termination of sales relationships in certain countries, workforce reductions, elimination of product lines, and intangible asset write-downs.
• Medical device regulations: costs related to updating manufacturing quality systems, product labeling, asset write-offs, and product remanufacturing to comply with new medical device regulations in the European Union and China.
• Recall related matters: estimate of the probable loss to resolve certain recall-related matters.
• Regulatory and legal matters: estimate of the loss to resolve certain regulatory or other legal matters and the amount of favorable awards from settlements.
• Tax matters: tax adjustments, including those related to the Tax Cuts and Jobs Act of 2017, and the transfer of certain intellectual properties between tax jurisdictions.

Despite the large difference between GAAP and non-GAAP figures shown in Table 1, these all appear to be reasonable adjustments to determine non-GAAP net income. Stryker has identified what it believes are mostly non-recurring expenses related to acquisitions, restructuring, regulatory changes, product recalls, legal proceedings, and taxes.

Non-GAAP figures can help us better compare 2021 performance versus historical results and establish a more representative baseline for projecting future performance. However, these adjustments have no impact on the cash flow used in valuation models as illustrated in Table 2.

As shown in Table 2, cash flow is not impacted by non-GAAP earnings adjustments. Understanding this reconciliation is critical for security valuation because we do not value net income – GAAP or non-GAAP. Rather, our method of security valuation is derived from the present value of future cash flows that are available to shareholders.

We can use our framework to determine the cash impact, if any, to Pfizer’s change in non-GAAP reporting methodology, as quoted at the beginning of this piece.

“Previously, we only excluded amortization related to large mergers and acquisitions…”

This statement relates to the difference between GAAP and non-GAAP reporting. Until now, Pfizer only excluded amortization expenses from its non-GAAP earnings that it deemed “one-time” in nature. In this case, the company was referring to expenses that arose specifically from large acquisitions.

“… [but we will now] exclude all intangible asset amortization expense.”

The methodology change stated here is related to the difference between accrual and cash accounting. Going forward, Pfizer will now exclude all amortization expense from non-GAAP earnings because it is a non-cash expense, which the company believes is not indicative of its future earnings power.

Does this impact cash flow? No. As amortization is a non-cash expense, it is always excluded from the free cash flow calculation that drives our valuation models. By focusing on cash flow, we can use non-GAAP reporting as an analytical tool while ensuring it does not become a distraction for security valuation.

In conclusion, we at Jensen prioritize our analysis of the current and projected cash flows generated by our portfolio companies and potential investments. Cash is tangible and less susceptible to earnings adjustments that may color our judgment of the real shareholder value being generated by a business. In our judgment, correctly analyzing cash generation is an important component of “know what you own.”

¹ Frank D’Amelio, “Q4 2021 Pfizer Inc Earnings Call,” transcript of conference call on February 8, 2022, Refinitiv.

² Ken Tysiac, “Tips for avoiding trouble with non-GAAP reporting,” Journal of Accounting, December 7, 2021.
   https://www.journalofaccountancy.com/news/2021/dec/avoiding-trouble-non-gaap-reporting.html

³ Working capital items reconcile the difference between cash and accrual accounting for operating expenses.