Not all companies dress up their earnings just to make themselves look better. Image source: iStock/Thinkstock.
Continue Reading Below
I wrote an article two weeks ago arguing that investors should give more weight to Bank of America's (NYSE: BAC) non-GAAP adjusted earnings as opposed to its GAAP earnings. Then this week, The Wall Street Journal published a story that called the use of adjusted earnings into question. As a general rule, the Journal is right. But there are exceptions to this rule, and Bank of America is one.
A nefarious use of adjusted earnings
It's easy to understand where the Journal is coming from. Twitter's (NYSE: TWTR) use of adjusted earnings offers a perfect example.
Every quarter, the social network reports what it earned according to standard accounting rules, and what it earned on an adjusted basis. The gap between the two is wide. In the second quarter, Twitter reported a $107-million GAAP net loss. But after adjustments, the company claimed to have earned a non-GAAP profit of $93 million.
Data source: Twitter's 2Q16 earnings report, page 4.
What were these adjustments? There were four of them, though a single one was responsible for 84% of the difference. This was stock-based compensation, paid to employees in lieu of a salary.
By Twitter's logic, investors should ignore the fact that it pays its employees with stock as opposed to cash. The implication is that it's either a one-time expense that isn't representative of its standard operating procedure, or that compensation has no meaningful impact on the value of an investor's stake in the company.
Neither of these implications is factually accurate. In the first case, paying employees with stock is the rule at Twitter, not the exception. Its stock-based compensation last year was $682 million, equating to 26% of its total costs. The year before that, it was $632 million, or 33% of its total costs.
In the second case, while it's true that stock-based compensation doesn't require Twitter to spend cash, it would be a mistake to think that it doesn't impact shareholders. Indeed, each share Twitter issues to one of its employees dilutes the ownership interest of every other then-existing shareholder.
This is why I agree with the sentiment expressed in The Wall Street Journal piece about the overemphasis of certain companies of customized earnings metrics. To this end, a study by Audit Analytics cited in the piece found that companies that do so "are more likely to encounter some kinds of accounting problems than those that stick to standard measures."
An understandable use of adjusted earnings
Yet in Bank of America's case, even though it's heavily emphasized its non-GAAP earnings over the last few quarters, it's not doing so for nefarious purposes.Take Bank of America's latest quarter as an example -- click here for an in-depth analysis of its results.
In the three months ended June 30, the nation's second-biggest bank by assets reported GAAP revenue and earnings of $20.6 billion and $4.2 billion, respectively, which were down 7% and 18%, respectively, from the second quarter of 2015. But after adjusting its earnings, both figures grew on a year-over-year basis.
This looks suspicious, but it makes sense when you dig into the reasons for the adjustments.
Almost all of the difference stems from the fact that Bank of America uses a different rule than other big banks to account for the impact of interest-rate fluctuations on the income from its mortgage-backed securities portfolio. Most other banks account for the changes gradually over time, while Bank of America takes the benefit or detriment all at once. It made the accounting election in the 1980s, when interest rates were much-less volatile than they are today, a source at Bank of America previously explained to me.
As a result, if you want to compare Bank of America to its peers on an apples-to-apples basis, then you have little choice but to use its adjusted earnings. This isn't because it's trying to pull the wool over investors' eyes, but rather because the bank seems to be genuinely interested in accurately communicating its performance.
A secret billion-dollar stock opportunity The world's biggest tech company forgot to show you something, but a few Wall Street analysts and the Fool didn't miss a beat: There's a small company that's powering their brand-new gadgets and the coming revolution in technology. And we think its stock price has nearly unlimited room to run for early in-the-know investors! To be one of them, just click here.
John Maxfield owns shares of Bank of America. The Motley Fool owns shares of and recommends Twitter. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.