How do I identify non-recurring items and calculate adjusted earnings for analysis?
Companies always report 'adjusted earnings' that exclude certain items. For CFA Level II, how do I determine which items are truly non-recurring vs which items management is conveniently excluding to inflate their adjusted numbers?
Adjusted earnings (or "non-GAAP earnings") strip out items management considers non-recurring. But analysts must critically evaluate whether these adjustments are appropriate.
Common Items Excluded from Adjusted Earnings:
| Item | Typically Excluded? | Analyst Assessment |
|---|---|---|
| Restructuring charges | Yes | If recurring every 2-3 years, include in core earnings |
| Impairment losses | Yes | May signal ongoing business deterioration |
| Litigation settlements | Yes | If frequent, may be a cost of doing business |
| Acquisition-related costs | Yes | Serial acquirers should include these |
| Stock-based compensation | Often excluded | Real economic cost -- should be included |
| Amortization of acquired intangibles | Often excluded | Debatable -- represents real asset consumption |
| One-time gains (asset sales) | Yes | Exclude unless asset sales are part of business model |
Framework for Evaluating Adjustments:
- Frequency test: Has this "non-recurring" item appeared in 3+ of the last 5 years? If so, it is probably recurring.
- Magnitude test: Does the adjustment represent > 10% of reported earnings? Large adjustments deserve extra scrutiny.
- Direction test: Do adjustments consistently increase reported earnings? One-sided adjustments suggest bias.
- Cash flow test: Does the adjusted earnings figure align with CFO trends? If not, the adjustments may be masking problems.
Example -- Clearfield Technologies (3-year history):
| Item | Year 1 | Year 2 | Year 3 |
|---|---|---|---|
| GAAP Net Income | $80M | $65M | $55M |
| + Restructuring | $15M | $20M | $25M |
| + SBC expense | $30M | $35M | $40M |
| + Acquisition costs | $10M | $12M | $8M |
| Adjusted Earnings | $135M | $132M | $128M |
Analysis:
- GAAP earnings are declining rapidly ($80M to $55M), but adjusted earnings look stable
- Restructuring charges are growing and appear every year -- not truly non-recurring
- SBC is a real economic cost (dilutes shareholders) and should not be excluded
- If we only add back acquisition costs (which vary by year), adjusted earnings = $65M, $77M, $63M -- a very different picture
Exam Tip: CFA Level II tests whether you can critically evaluate management's adjusted earnings and determine which adjustments are legitimate vs which obscure underlying business deterioration.
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