Author Archives: eliezer.nunez

“Investors, It Pays to Mind the GAAP Gaps”, is a great article that shines a light on the increasing gap between non gaap operating earnings and gaap conforming operating earnings among companies within the Standard & Poor’s 500.  Before expanding on the significance of this gap, first, let me briefly explain the reasoning behind announcing non gaap operating earnings along with gaap earnings.  Management teams inside of corporations as well as some analysts believe that non gaap operating earnings can be a better indicator of the performance of a corporation.  This alternative method of reporting operating earnings removes any one-time charges or any one-time gains as opposed to gaap conforming operating earnings which account for the impact of one-time items.  Executives and analyst will argue that the impact of these special items skews or blurs a company’s true financial picture. 

The Microsoft case is a great example of this occurrence.  Microsoft in the quarter ended June 30^th 2007, reported gaap operating earnings of $4 billion while also providing investors with non gaap operating earnings of $5 billion.  The difference in the two figures is related to a $1.06 billion Xbox warranty enhancement charge.  According to management and probably most of the analyst community, this charge is a one-time occurrence and is not expected to reappear.  Looking at this example it is understandable why some investors would prefer non gaap earnings as they believe it is a better depiction of Microsoft’s operating performance for the quarter. 

The article’s author, Mark Gongloff, raises a number of legitimate concerns.  When looking at the past 14 years, the gap between gaap and non gaap operating earnings numbers has risen by $2.41.  When the averaging the gaps between these earnings over the past 10 years to eliminate any spikes or dips, non gaap operating earnings were almost 24% higher than gaap earnings.  After reading the article, I thought to myself, “What does this signify?”  Why has the gap between gaap and non gaap earnings grown so much over the last decade or so?  Is it simply that executives are managing today’s corporations more differently than before or could there be an underlining cynical reason that’s causing one-time charges to increase when compared to one-time gains.

A critical look inside the Microsoft case might provide some answers to these questions.  As mentioned, Microsoft took an Xbox related charge of $1.06 billion.  Part of the charge was related to warranty claim payments to customers who bought the Xbox, experienced problems with the device, then turned to Microsoft for a fix.  Microsoft, in an attempt to ensure customers who were interested in the Xbox that it stood behind its product, enhanced the existing warranty policy.  Thirty five percent of the charge was also “attributable to inventory valuation adjustment” or, in other words, Microsoft looked at its Xbox and realized that some of its chips did not work properly and had to replace them. 

It is very possible that when Microsoft’s management team was setting the budget for its latest innovative product that the team was more interested in supporting Xbox’s profit margin, therefore, cutting cost and corners.  This cost cutting strategy might be the reason that Xbox did not perform as expected by customers thus forcing Microsoft to pay high warranty claims.  It would not be the craziest idea to think that executives would push today’s cost to tomorrow in the form of one time charges to help please Wall Street and most importantly to help pay for the new home in Hawaii.  This strategy and others that compromise product quality across America’s industries might be just one reason for the increasing gap between gaap earnings numbers and non gaap earnings numbers.