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Mind the GAAP: Buffett warns of deceptive earnings

Warren Buffett had a few words in his most recent shareholder letter for managers who mislead their shareholders with massaged earning numbers.

Buffett suggested that shareholders should ignore certain expenses, but noted that "it has become common for managers to tell their owners to ignore certain expense items that are all too real." That is, in some cases the difference between the figures reached using generally accepted accounting principles and the adjusted non-GAAP numbers may be less about improving the numbers and more about artificially boosting earnings.

Over the past five years, the two S&P 500 sectors with the highest average difference between GAAP and non-GAPP measures were energy minerals, with an average difference of nearly $12 a share, and health technology, with a difference of $7.40 a share.

Here's all the data laid out in a scatter plot — companies on the blue line reported nearly identical GAAP and non-GAAP earnings on average over those five years, while companies above the line have adjusted their earnings to a higher level than under GAAP alone. Most companies with negative GAAP earnings have positive non-GAAP earnings (and are off the line), suggesting that companies with low earnings are more likely to adjust upward.

Companies often have perfectly good reasons for recommending that investors ignore certain GAAP numbers. Buffett, for example, said that about 20 percent of the $1.1 billion amortization charges reported for Berkshire Hathaway were "non-real" — simply an accounting side-effect of recent acquisitions.

Botox-maker Allergan, which had the second-highest discrepancy between GAAP and non-GAAP ($13 per share more in non-GAAP reporting), also has had recent acquisitions. Allergan was bought by Actavis (now known as Allergan) in March and also bought Kythera, a company that makes a cure for double chins, in October.

"GAAP results were impacted by amortization and acquisition-related expenses, including license agreements, impairments, acquisition accounting valuation related expenses and severance associated with acquired businesses," the company wrote in a report last week.

Here are the 10 companies with the biggest difference between their average five-year annual GAAP earnings per share and non-GAAP earnings per share.

company
Average non-GAAP minus GAAP
Sector
Apache Corporation $17.64 Energy Minerals
Allergan plc $13.06 Health Technology
Devon Energy Corporation $8.40 Energy Minerals
Endo International Plc $7.18 Health Technology
Transocean Ltd. $7.16 Industrial Services
Ensco plc $7.06 Industrial Services
Newfield Exploration Company $5.84 Energy Minerals
Anadarko Petroleum Corporation $5.76 Energy Minerals
Chesapeake Energy Corporation $5.04 Energy Minerals
Cimarex Energy Co. $4.86 Energy Minerals

The biggest differential between the two measures in the S&P 500 was reported by energy company Apache, which adjusted an average GAAP loss of $11 per share to an average non-GAAP profit per share of about $7. While reporting its fourth quarter results last week, the company said that the figure was adjusted for "non-cash after-tax ceiling test write downs and impairments of $5.9 billion driven by current low commodity price levels," and "additional items that impact the comparability of results."

To be sure, the difference between GAAP and non-GAAP results can be challenging for the average investor to interpret. They can't count on analysts to clear it up, Buffett said. By parroting numbers provided by company executives, some analysts are "guilty of propagating misleading numbers that can deceive investors," he wrote.

Regardless of whether any individual company can be called out for misleading non-GAAP figures, the market as a whole is feeling the impact of the disparity. This year's reported earnings were 25 percent lower than pro forma figures, the biggest difference since 2008, according to the Wall Street Journal. A CNBC.com analysis found a similar creep in the width of that gap.

Those numbers, misleading or not, mean that many investors may not be clear on what they're buying.

If an investor owned just one stock in every company in the S&P 500, the difference between the two measures would be worth more than $400 in earnings. That means that the average price-to-earnings ratio is higher than it seems, and perhaps that expectations for the future are sunnier than they should be.