GAAP vs. Pro-Forma: Four Income Insights - TheStreet

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) - Get Report

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) - Get Report

. 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.

2. Impairments

An impairment is the "writing-off" of an asset - either an investment or goodwill - because the value of the asset is permanently weakened.

As an example,

Google

(GOOG) - Get Report

reported on August 8, 2008 that the company could take as much as a $1 billion write-off for its investment in

Time Warner's

(TWX)

AOL unit. Simply put, Google is looking at its stake in AOL for its impairment status. I often thought that Google's investment in AOL was an insurance policy of sorts, since AOL was once considered a rival. As it's turning out, it might be a very costly insurance policy.

Whether the entire $1 billion is written off immediately is hard to say. Google disclosed this potential impairment after it reported its second-quarter results.

In a case like this, we need to be cognizant of this possible impairment in the future. So if in the future, Google announces a headline

EPS

disappointment, then we will not be quick to react negatively and as always, we will dig a bit deeper than the headline earnings information. (Don't miss: "

Get in Shape for Earnings Season

") Also, as analysts issue estimates on a pro-forma basis, we will be better prepared to conduct a proper comparison and analysis.

With Google, my guess is that the company takes these charges in more than one piece. By my estimates (simply dividing $1 billion by Google's outstanding shares), if Google writes off the entire $1 billion, it would amount to about $3.18 per share on a pre-tax basis by my estimates. Google's effective tax rate (tax expense divided by income before taxes) is running around 25%, so on an after-tax basis, the hit could be around $2.40 (give or take a penny). By Wall Street analysts' estimates, Google is currently expected to earn $4.86 in the third quarter and $5.36 in the fourth quarter. Word to the wise: Be prepared for the impairment, as it appears to imminent.

To continue this train of thought, Time Warner owns a majority of AOL. As my colleague Steve Birenberg, wrote on

RealMoney:

"It has been widely accepted for a long time, including when Google bought the 5% stake, that AOL is worth less than $20 billion. Yesterday

August 7, 2008 the

Wall Street Journal

suggested a $10 billion valuation.

In my bullish analysis of Time Warner posted

August 7, 2008, I used $6-9 billion

for AOL. Back when Google valued it at $20 billion based on a $1 billion investment it was discussed that at least part of the investment was in reality a marketing expense, so that it could control AOL search traffic. As for a Time Warner write-off, I am pretty sure that a huge, $10 billion or so write-off was already taken. More write-offs of AOL may be coming for TWX, but assuming they are associated with divestiture of the unit, that will be a happy day for TWX shareholders."

Typically, the impairment would be accounted for as a reduction to the asset, with a corresponding expense on the income statement such as a "capital loss."

3. Merger Costs

When two companies merge or one company acquires another there are a slew of merger-related costs that will be incurred over a period of time. Many mergers are borne out of a perceived cost savings but unfortunately there are upfront costs associated with these transactions. To name a few, these costs could be legal, physical (like changing the real estate signage), administrative (including staff reductions, office consolidation or moving) and the closing of stores or branches.

Let's take

Macy's

(M) - Get Report

as an example. This week, Macy's reported second-quarter 2008 EPS of 17 cents, on net sales of $5.72 billion. Excluding two non-recurring items Macy's earned 29 cents on a continuing basis (or pro-forma basis) during the quarter. These two items were for the consolidation of Macy's brand names such as Marshall Fields (a mistake in my opinion as it has caused consumer backlash in some locales) and impairment charges for private label brands acquired in a recent merger. As it turned out, Macy's gave us a one-two punch, as it had both merger costs and impairments during the quarter.

Focusing on the business consolidation costs, Macy's stated in its press release that this "unusual item relates to the consolidation of three Macy's divisions announced in February 2008, which is expected to save approximately $100 million per year beginning in 2009 (approximately $60 million in savings for the partial year in 2008). In the second quarter of 2008, the company booked consolidation costs of $26 million ($17 million after tax or 4 cents per diluted share)."

Clearly, in looking at the company's business of selling retail products to consumers we have to factor-out the "special charges" and focus on the pro-forma results of 29 cents per share of earnings.

Typically, merger costs will be accounted for on the income statement's SG&A line, but this may vary by company.

4. Discontinued Operations

From time-to-time companies will sell or shutdown business divisions or units. In doing so, those businesses will be reclassified as "discontinued operations." When this happens, we can take separate looks at the aspects of the business that will be part of the ongoing operations of the company for future earning valuation and comparative analysis.

As an example, in April 2007 McDonald's

(MCD) - Get Report

announced that it planned to re-franchise 1,600 restaurants in Latin America. In this transaction, which closed in August 2007, McDonald's would sell company-owned units to a franchisee under a development license. The franchisee would continue to operate the units in the future. Under this agreement, McDonald's will collect an annual royalty. As a result, revenue will decline by about $1.5 billion, while operating margins were expected to increase without any net significant impact to operating income.

In essence, what McDonald's did was swap restaurant sales for franchise royalty income. McDonald's no longer has to incur the expenses of operating these 1,600 restaurants. Thus, when the company reported its second-quarter 2008 results, it highlighted and spun-off the impact of the 2007 Latin American transaction, so that we could compare 2008's operational results to 2007's results on an "apples-to-apples" basis. However, you would not find this out unless you carefully read the entire

earnings press release

.

Here's an excerpt from the release:

"The results for the quarter and six months ended June 30, 2007 included impairment and other charges of $1,611.9 million associated with the Latam transaction, partly offset by a benefit of $17.5 million due to eliminating depreciation on the assets in Latam in mid-April 2007 in accordance with accounting rules. The resulting tax benefit of $12.8 million was minimal in the second quarter 2007 due to the Company's inability to utilize most of the capital losses generated by this transaction."

In a case like this, a company will usually segregate these businesses results on a net basis (total revenues less total expenses) on a single line item titled discontinued operations.

Your Homework

Special charges, non-recurring items and discontinued operations all contribute to GAAP results for a public company. However, we need to segregate the resulting impact from GAAP results to arrive at pro-forma results which offer a clearer picture of a company's operational performance.

Here is some homework based on this lesson:

For each company that you own or follow, identify each of the four types of items that can subtracted from GAAP results - litigation, impairment, merger and discontinued operations.As starting points, use the guidelines and pointers I covered above.

Understand how these items or charges affect your analysis of each company's most recent quarterly results and anticipate any issues that might arise in the future.

At the time of publication, Rothbort was long MA, GOOG and MCD, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at

www.lakeviewasset.com

. Scott appreciates your feedback;

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to send him an email.