This article enlightened me—a novice in the investment world—to a few things:
1) In regards to earnings, companies release either/both of two figures to the public: 1. “as reported earnings” which conform to GAAP, and 2. “operating earnings” which exclude one-time items (and allow management a bit more flexibility in what is reported).
2) Historically, the gap between “reported” and “operating” earnings has been wide, illustrating a fundamental and philosophical divide between how FASB and businesses define earnings. Why can’t the two camps figure out one standard for reporting earnings? Subjective judgments from company to company make them non-comparable over time.
3) Regardless of which camp you’re in, two earnings figures translates to investor confusion. So, don’t make an investment based on “earnings,” unless you’ve first read the financial statements and determined exactly what those “earnings” report.
On the businesses side of things, “operating earnings” are calculated to the exclusion of one-time events, presumably reflecting a more accurate account of “business-as-usual” earnings. The article points out that since 1995, “operating earnings” have topped GAAP earnings by an average of $2.47 per share—showing that the “business-as-usual” outlook has historically been brighter than what has actually occurred in any given year (how optimistic!). But recently (June 2009), the gap between those earnings figures narrowed to $0.31.
The author interprets this narrowing as a sign of market stability. I speculate that a major cause for this narrowing is investor skepticism (a mark of instability). On the heels of the Madoff scandal, and in response to public outrage, I think Wall St. reported earnings more conservatively, and closer to their GAAP earnings, in the name of transparency and in attempts to restore investor confidence. Honestly, I think that we’ll need to deem one consistent, less prone-to-manipulation method for reporting earnings (among doing many other things), to restore my confidence. But in the meantime investors, it pays to mind the GAAP gaps.
The gap merging of both earnings does show a sign of stability. Even the Wall Street Journal mentioned the percentage of companies defaulting dropped from above 14% to under 7%. Analysts project this percentage to continue to drop down to a little over 3% by next year.
Should investors mind the GAAP and take this as a sign of stability, or take this as a sign that companies are finding new ways to manipulate numbers? Whatever the case, the markets need investors to come back by the norm.