GAAP vs. Pro-Forma: Four Income Insights

In our continuing look at financial statements and earnings, let's return to the income statement. This time around, I want to zero-in on a few confusing, misunderstood and all too often overlooked aspects of the income statement.

But first, as a quick refresher, whenever a company reports its quarterly results it has to do so in conjunction with generally accepted accounting principles (also referred to as GAAP). GAAP is guided by a whole set of rules established by the Financial Accounting Standard Board (Website: fasb.org).

While companies must conform to GAAP, GAAP reporting does not necessarily provide investors with a true picture of the continuing operations of the company. Thus, many public companies will also report results on a "modified" GAAP basis, which is also commonly referred to as a "pro-forma" basis. Pro-forma is a term borrowed from Latin that roughly means "for the form." In accounting, pro-forma statements are those that are modified from GAAP to satisfy specific presentation purposes.

The differences between GAAP and pro-forma reported items are plentiful. Here are some of most typical items that you should be on the look-out for.

1. Litigation Settlements

MasterCard (MA Quote) reported a large quarterly loss of $5.74 per share. However, included in that loss was a $1.0 billion after-tax charge for an antitrust litigation settlement with American Express (AXP Quote). Excluding that charge, MasterCard earned $2.11 per share. Under the agreement with American Express, MasterCard will pay $150 million per quarter for 12 quarters (not to exceed $1.8 billion in total). Since this is a real expense for MasterCard, GAAP requires that MasterCard record this as an expense. Meanwhile, American Express will have to record it as a revenue item.

However, we need to understand two important implications of this agreement.

First, the cash flows will take place over the course of a 12-quarter period of time. Thus, the litigation settlement is now considered a "non-cash item" that will impact MasterCard and American Express cash flows for the next three years. Non-cash items are accruals that are accounting entries which do not have a corresponding cash flow in the same accounting period.

Second, with MasterCard, this particular charge relates to a litigation settlement and was not a function of the execution of the companies' businesses during the accounting period. Thus, we don't want to confuse it with the recurring credit card business that both MasterCard and American Express are involved in. (Don't miss: "Understanding the Financial Sector: Credit Card Companies") In other words, when researching the earnings of a company that's been involved in a situation like this, emphasis should be placed on the non-GAAP results because the litigation charge is non-recurring and non-operational in nature.

Typically, litigation charges will appear under "SG&A (Selling, General and Administrative)" expenses on a company's income statement. Also, any unpaid amounts will be accrued as a liability on the company's balance sheet.