Tracking Adjustment Trends
Tracking Adjustment Trends
Why Adjustment Trends Matter
The most revealing analysis of a company's earnings quality doesn't come from examining a single quarter or year—it comes from tracking how adjustments change over time. A company might make legitimate adjustments in year one. By year three, if the "one-time" adjustments have become routine, the story has changed. Adjustment trends reveal whether management is using GAAP flexibility to maintain transparency or to obscure deteriorating fundamentals.
The phenomenon of growing adjustments is so common it has a name: adjustment creep. As a company's GAAP earnings weaken, management increasingly relies on adjusted metrics to present an acceptable earnings picture to the market. The adjustments grow from 5% of net income to 15%, then to 30%, then to 50%. By the time adjustments exceed net income, investors usually have abandoned the stock. The window to sell before the reckoning is small—and it's defined by tracking adjustment trends.
The best investors develop an early warning system by monitoring adjustment trends. They watch the size of adjustments relative to earnings. They note when items repeat. They ask whether management's narrative (this is one-time) matches reality (this item has appeared in every earnings release for two years). This analysis is simple, requires no special skills or data, and catches deterioration that formal financial analysis often misses.
Quick definition: Adjustment trends are the changes in the magnitude and composition of adjustments over time. Growing adjustments relative to earnings, items becoming recurring when labeled non-recurring, and a widening gap between GAAP and adjusted metrics are red flags for deteriorating earnings quality.
Key Takeaways
- Adjustments growing as a percentage of net income signal deteriorating earnings quality
- Items labeled "one-time" but appearing repeatedly are a red flag for creative labeling
- The gap between GAAP and adjusted earnings should narrow over time as one-time items truly become one-time; widening gaps indicate adjustment creep
- Stock-based compensation should be analyzed separately from other adjustments, as it's economically different
- Comparing adjustment patterns to peers reveals which companies are more aggressive with accounting
- Early detection of negative adjustment trends allows investors to exit positions before major restatements or write-downs occur
Measuring Adjustment Magnitude
The first step in tracking adjustment trends is calculating adjustments as a percentage of net income. This normalizes for company size and growth, making trends visible.
For example:
| Year | GAAP NI | Adjustments | Adjustments as % of NI |
|---|---|---|---|
| 2018 | $500M | $50M | 10% |
| 2019 | $480M | $75M | 16% |
| 2020 | $420M | $120M | 29% |
| 2021 | $380M | $140M | 37% |
| 2022 | $300M | $180M | 60% |
| 2023 | $200M | $200M | 100% |
This company shows classic adjustment creep. GAAP earnings declined 60% over five years. Adjustments more than tripled in absolute terms and exploded as a percentage of reported earnings. By 2023, adjusted earnings equal GAAP earnings plus 100%—the adjusted metric is completely disconnected from GAAP results.
Red flags in this pattern:
- The widening gap between GAAP and adjusted metrics.
- Adjustments not declining as the supposed one-time items are resolved.
- Management's narrative likely became "adjusted earnings matter more than GAAP," a sign that management knows the GAAP story is weak.
To identify this pattern early, track this metric quarterly. If adjustments are growing faster than revenues (especially if revenues are declining), suspect management is managing earnings with adjustments rather than growing the business.
Classifying Adjustments as Recurring vs. Non-Recurring
The critical distinction is whether items appear repeatedly. Create a table tracking specific adjustments over time:
| Item | 2018 | 2019 | 2020 | 2021 | 2022 | Recurring? |
|---|---|---|---|---|---|---|
| Stock-based comp | $20M | $22M | $25M | $28M | $31M | Yes (exclude) |
| Restructuring | $5M | $0M | $8M | $0M | $0M | No (one-time) |
| Amortization* | $15M | $20M | $22M | $25M | $28M | Yes (exclude) |
| Asset sales gains | $10M | $15M | $30M | $40M | $50M | Yes (exclude) |
| Impairment charges | $0M | $18M | $35M | $47M | $71M | Yes (exclude) |
*Amortization of intangibles from acquisitions
In this table:
- Stock-based compensation is clearly recurring (increasing nearly every year) and should be treated as a regular expense despite being excluded from adjusted metrics.
- Restructuring appears intermittently (2020, possibly others) and is plausibly one-time.
- Amortization is clearly recurring and should be carefully considered when comparing to peers.
- Asset sales gains are increasing in absolute terms (2018: $10M, 2023: $50M), suggesting this is becoming a recurring business practice.
- Impairment charges are growing dramatically and appear to be recurring, despite being labeled as one-time or exceptional.
The company claiming "one-time restructuring charges" while also excluding recurring impairments suggests selective use of adjustments. Why does management exclude some items and not others? The answer often is: because it serves management's goal of presenting acceptable adjusted earnings.
The Adjustment Composition Chart
A visual representation of adjustment composition over time reveals patterns:
Case Study: Technology Company Adjustment Drift
A hypothetical tech company's adjustment evolution:
Year 1 (2018): "We adjust for stock-based compensation ($20M) to show underlying operational profitability."
- Adjusted earnings = GAAP earnings + $20M
- Adjustment is 4% of GAAP earnings
- Narrative is credible: stock-based compensation is real but non-cash and depends on stock price.
Year 2 (2019): "We adjust for stock-based compensation ($25M) and restructuring charges ($10M) related to sales integration."
- Adjusted earnings = GAAP earnings + $35M
- Adjustments are now 6% of GAAP earnings
- Restructuring is plausibly one-time.
Year 3 (2020): "We adjust for stock-based compensation ($30M), restructuring charges ($12M), and amortization of intangibles from acquisition ($18M)."
- Adjusted earnings = GAAP earnings + $60M
- Adjustments are 12% of GAAP earnings
- Amortization is recurring by definition (continues for years); management is redefining it as an adjustment.
Year 4 (2021): "We adjust for stock-based compensation ($35M), restructuring charges ($15M), amortization of intangibles ($22M), and certain acquisition-related costs ($10M)."
- Adjusted earnings = GAAP earnings + $82M
- Adjustments are 16% of GAAP earnings
- Restructuring is now recurring despite management's one-time claim.
Year 5 (2022): "We adjust for stock-based compensation ($40M), restructuring charges ($20M), amortization of intangibles ($26M), acquisition-related costs ($12M), and depreciation of acquired fixed assets ($8M)."
- Adjusted earnings = GAAP earnings + $106M
- Adjustments are 22% of GAAP earnings
- Depreciation of acquired fixed assets is by definition recurring; management is excluding it.
Investor's view in Year 5: The company that started with a defensible adjustment for stock-based comp is now excluding nearly every cost associated with growth and integration. The adjusted metric no longer represents sustainable earnings—it represents management's cherry-picked view of what should be counted as profit.
Detecting Adjustment Creep: Early Warning Signs
Sign 1: Adjustments Growing Faster Than Revenues If company revenues grow 10% but adjustments grow 25%, something is amiss. Adjustments should decline in absolute terms (as one-time items are resolved) or stay flat (if truly recurring). Growing faster than revenues is a red flag.
Sign 2: Management Redefining What's Excluded Track the reconciliation from quarter to quarter. If an item that was included in GAAP earnings last year is excluded this year, management has shifted its definition of adjusted earnings. This is common as deterioration accelerates. Companies add new exclusions to maintain flat adjusted earnings despite declining GAAP earnings.
Sign 3: One-Time Items Appearing Repeatedly If a company excludes "one-time restructuring charges" in 4 of the past 5 years, restructuring is not one-time. It's recurring, and management is mislabeling it to avoid moving those costs permanently into the adjusted metric. This is one of the most reliable signs of deteriorating earnings quality.
Sign 4: Adjustments Exceeding Net Income When adjustments exceed net income (adjusted earnings more than 2x GAAP earnings), the GAAP earnings metric is essentially meaningless, and the adjusted metric is unreliable. This pattern is associated with major restatements and stock price declines.
Sign 5: Auditor Qualification or Change If the auditor issues a "going concern" qualification, or if a company changes auditors after the previous auditor raised concerns, adjusted earnings should be viewed with extreme skepticism. The auditors have signaled problems; adjustments may be masking them.
Peer Comparison of Adjustment Trends
Adjustment creep is often visible in peer comparison. If all companies in an industry are growing adjustments, the problem may be industry-wide cyclical pressure. If one company is adjusting far more than peers, it's likely managing earnings more aggressively.
Compare three retailers over the same period:
| Company | Year 1 Adj. % | Year 3 Adj. % | Trend |
|---|---|---|---|
| Competitor A | 8% | 8% | Flat (healthy) |
| Competitor B | 7% | 12% | Increase (concerning) |
| Your company | 6% | 20% | Significant creep (red flag) |
In this scenario, your company is adjusting far more aggressively than competitors. Either:
- Its business model is genuinely different (possible but should be justified in MD&A).
- It's using adjustments to mask performance weakness (likely).
Peer comparison quickly identifies outliers.
Cash Flow Divergence: The Ultimate Adjustment Trend
The most important adjustment trend is the divergence between adjusted earnings and operating cash flow. As adjustments creep up, cash flow frequently doesn't keep pace. This reveals that adjustments are accounting artifacts, not real economics.
| Year | GAAP EPS | Adj. EPS | Op CF per Share | Gap (Adj – CF) |
|---|---|---|---|---|
| 2019 | $2.00 | $2.30 | $2.40 | -$0.10 |
| 2020 | $1.90 | $2.40 | $2.35 | +$0.05 |
| 2021 | $1.60 | $2.50 | $2.10 | +$0.40 |
| 2022 | $1.20 | $2.60 | $1.75 | +$0.85 |
| 2023 | $0.80 | $2.70 | $1.20 | +$1.50 |
In 2019, adjusted earnings roughly equal cash flow (credible). By 2023, adjusted earnings exceed cash flow by 125%—an enormous gap. This company's adjustments are completely disconnected from cash reality. Red flag.
The cash flow divergence is the most reliable indicator of deteriorating earnings quality because cash can't be managed with accounting. When a company's adjusted earnings growth diverges from cash flow growth, adjustments are inflating the picture.
Real-World Examples of Adjustment Trends
Apple (2008–2015). Apple's adjustments (primarily non-GAAP adjustments for stock-based compensation and certain tax items) remained relatively flat as a percentage of earnings because underlying business earnings were strong. Even as adjustments grew in absolute terms, they declined relative to earnings growth. No creep, credible presentation.
Cisco (2000–2005). During the post-bubble recovery, Cisco's adjustments were consistently around 10–15% of net income, primarily for acquisition-related amortization. As the company's organic growth slowed after 2005, adjustments should have declined; instead, management expanded the definition of adjustments to maintain growth appearance. Adjustments grew to 20–25% of earnings, and the adjusted/cash flow gap widened. This was an early warning sign of the company's slow growth that took years for the market to recognize.
WeWork (2016–2019). WeWork's adjustment creep was extreme. The company adjusted for stock-based compensation, depreciation, amortization, and then claimed negative GAAP earnings as positive "community-adjusted EBITDA" by excluding nearly all expenses. The adjustment grew to exceed net income by a factor of 10. This was obviously unsustainable and signaled to sophisticated investors that the business model was broken, not that the business was profitable on an adjusted basis.
Netflix (2012–2015). Netflix's adjustments (primarily stock-based compensation) were 5–10% of earnings and declined over time as the company's earnings grew faster than adjustments. This was healthy adjustment behavior: manageable size, declining relative to earnings, legitimate exclusion. The company's adjusted earnings proved sustainable and credible.
FAQ
Q: If a company's adjustments are growing, does that mean I should sell? A: Not automatically, but it's a red flag requiring investigation. Growing adjustments combined with declining GAAP earnings and widening cash flow divergence signal trouble. Growing adjustments with strong GAAP earnings and healthy cash flow are less concerning (the company may be growing through acquisition). Context matters, but the trend is the starting point for deeper analysis.
Q: How can I distinguish between legitimate adjustment growth and creep? A: Legitimate growth in adjustments occurs when a company makes acquisitions (generating amortization, integration costs) and then resolves them. Adjustments should then decline. Creep occurs when adjustments grow continuously and are never resolved. Legitimate adjustments are explained in MD&A with clear expiration dates; creep adjustments become permanent fixtures of the adjusted metric without explanation.
Q: Should I ignore GAAP earnings if adjustments are large? A: No—GAAP earnings matter even if they're small and adjusted earnings are large. GAAP earnings represent what the company actually earned under standardized accounting rules. Adjusted earnings show management's view of underlying performance. Both are useful: GAAP tells you the legal bottom line; adjusted tells you management's narrative. The more they diverge, the more skeptical you should be of management's narrative.
Q: Can I use adjustment trends to time when to sell a stock? A: Yes. Adjustment creep is often an early warning sign of deterioration, appearing 12–18 months before major restatements or significant stock price declines. Monitoring adjustment trends allows you to exit before the crisis. However, adjustment trends are a warning system, not a sell signal by themselves. Combine adjustment trend analysis with other metrics (cash flow, customer retention, competitive position) before deciding to exit.
Q: What if a company's reported adjustments are decreasing? A: That's generally positive. Decreasing adjustments relative to earnings suggest the company is resolving one-time issues or that its GAAP earnings are improving. This is the opposite of creep and signals improving earnings quality. Verify that adjustments are truly declining and not just being reclassified into other line items.
Q: Should I be concerned about stock-based compensation growing? A: Growth in stock-based compensation is common in technology and other industries with equity-heavy compensation. This isn't necessarily concerning if the company is growing faster than the dilution (i.e., EPS growth exceeds dilution from stock grants). However, if stock-based compensation is growing faster than revenue or margins, it's a sign that management is retaining talent at higher cost—often signaling that the company's competitive position is weakening and retention is becoming difficult.
Related Concepts
- Adjustment Creep: The tendency for companies' adjustments to grow over time, particularly as GAAP earnings weaken. Adjustment creep is a leading indicator of earnings quality deterioration and often precedes restatements or significant stock price declines.
- Quality of Earnings Deterioration: The decline in earnings quality as adjustments grow and GAAP earnings weaken. Deterioration is visible in adjustment trends before it becomes obvious from absolute performance metrics.
- Sustainable Earnings: The portion of reported earnings likely to persist into future periods. As adjustments grow, sustainable earnings decline because an increasing portion of reported earnings depends on one-time items or accounting choices rather than operations.
- Accrual Ratio: The proportion of earnings derived from accruals (accounting adjustments) versus cash. High accrual ratios (large adjustments, small cash flow) indicate low-quality earnings. Tracking the accrual ratio over time reveals earnings quality trends.
Summary
Adjustment trends reveal the story behind reported earnings growth or stability. A company with stable, small adjustments that resolve as promised is executing well. A company with growing adjustments, items recycled as one-time, and a widening gap between adjusted earnings and cash flow is deteriorating. By tracking adjustment magnitude, composition, and cash flow implications over time, investors identify deterioration early—often 12–18 months before the market recognizes the problem. This analysis is simple (tracking a few metrics over time) but extraordinarily valuable for avoiding value-destroying investments. Companies whose management is credible present consistent, moderate adjustments that decline over time. Companies whose management is stretching the rules show adjustment creep that accelerates as fundamentals weaken. The trends tell the story long before earnings crises arrive.