Underlying Earnings is a concept that stems from a need to eliminate some of the noise created by accounting policies. It is required to be provided in supplemental disclosures under US GAAP.
In this post we will discuss what underlying earnings is, how to interpret and utilize it, and its advantages and disadvantages.
What Is Underlying Earnings?
Underlying Earnings, commonly referred to as underlying profit, is a calculation that eliminates exceptional and non-recurring expenses or income from the income statement. This deviates from accounting profit that is presented in the financial statements and as a result, requires disclosure in the management discussion and analysis section of a company’s quarterly or annual report.
Underlying earnings is used to help understand the profit of a business throughout a normal accounting cycle. In theory, this presents a more accurate reflection of financial performance that reduces potential noise from extraordinary events. It is a good representation of the recurring earning potential of a business and is often relied upon for financial modeling.
How To Interpret and Utilize Underlying Earnings
Understanding how to use and interpret underlying profit will help you sharpen your financial analytics. Because reporting underlying earnings is also a requirement under US GAAP it benefits aspiring accountants to learn how to calculate and interpret as well.
Learning how to calculate underlying profit is simple and the methodology is often disclosed in the footnotes to the financial statements. Its objective is to eliminate exceptional and non-recurring costs because they aren’t considered to be within the scope of the normal operations of a business.
This usually results in the elimination of all expenses that are not related to the below:
● Rent, mortgage, or other ongoing expenses related to real property
● Payroll expenses
● Other employment-related expenses, like dues and subscriptions or training
● Cost of software and SaaS expenses
Because there is room for interpretation, sometimes taxes are included and sometimes they are excluded. One thing to bear in mind as you determine what to include and eliminate from recurring costs is that you should always have sufficient evidence to support your decision.
Underlying Profit is often used in financial models as the basis for future projections of income. This is because it is considered to be the normal recurring profit that a business is expected to make.
When used for valuation purposes, underlying profit enables objective evaluations of a business as it compares to its peer group and gives analysts some context to justify multiples. All distortions from the profitability line item must be removed for analysts to make educated judgments on the quality of business profits.
There are often material impacts to the financial statements that are the pure result of changes in accounting policies. For example, the adoption of certain IFRS policies requires a change in accounting policies that could adversely impact how expenses are reported.
The change could be material but also fabricated purely by the shift in policies. Bad Debt for example often leads to significant impairments to income depending on the reporting jurisdiction of the business.
Conversely, changes in policies might have a materially positive impact on financial statements which is equally misleading. Both scenarios benefit from the use of a standardized view of profitability.
Advantages And Disadvantages of Underlying Profit
Like all financial metrics, there is some give and take when it comes to the use of underlying profit.
Advantages of Underlying Profit
Conceptually, the use of underlying profit is helpful for investors to identify how a business operates over time. This is because it smooths out the extraordinary events that occur randomly to produce a more reliable measure of profitability over an extended period.
Because of this, corporate finance professionals rely on it for planning purposes. Financial planners need to remove extraordinary non-recurring events from revenue, COGS, and operating costs to more accurately predict what will occur in the coming period.
In almost all financial models, underlying earnings is used as the basis to begin forecasting.
Disadvantages of Underlying Profit
Because it is left to interpretation as to what constitutes normal and recurring income and expenses, every company has its own way of presenting the figure. There is no governance provided by US GAAP or IFRS to assist in calculating underlying profit.
One if the primary critiques of underlying earnings is that investors need to be keenly aware of how the calculation is being made.
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