The financial reporting regulators in most countries have strict disclosure rules for how adjusted earnings are reported, and these rules typically require companies to reconcile the adjusted earnings with the nearest GAAP equivalent profit measure reported on the face of the income statements. Companies must also identify and explain the main adjustments made when calculating adjusted earnings. This helps us to assess whether the adjustments made are appropriate.

Here is an example of a non-GAAP earnings reconciliation provided by a company, and it reconciles reported operating profit from the face of the income statements with the underlying EBIT figure calculated by management. For this reconciliation, we've been asked to identify what concerns we have about the adjustments been made by the company. So please now pause the recording and spend 30 seconds thinking about which adjustments shown here could provide evidence of management bias. And once you've done that, you can resume the recording before we even look at the individual adjustments. A couple of issues immediately stand out from this table. Firstly, the overall difference between reported operating profit and underlying EBIT is significant. In fact, underlying EBIT is more than double operating profit in 2018, and this in itself is a red flag as a large proportion of underlying EBIT is dependent on adjustments that are made by management.

Secondly, the year on year trend for reported operating profit is completely opposite to the trend for underlying EBIT. We have reported operating profits falling between 2017 and 2018 while underlying EBIT is increasing, which is another red flag. Now let's look at the specific adjustments. Firstly, restructuring costs. These are extremely common as an adjustment to non-GAAP earnings, but the issue here is that these costs appear to be recurring and relatively stable. So I think we really should question whether this adjustment is appropriate. And in reality, we probably want to take a look at the company's 2016 and 2015 non GAAP reconciliation as well to see if this adjustment appears in those years. The next adjustment is the add add-back of asset disposal costs. This appears to be a sensible adjustment by management as companies don't expect to dispose of assets each year. However, it's always concerning when companies identify costs associated with asset disposal, but there's no obvious adjustment for the gains or losses arising on disposal of that asset. So I think this adjustment should prompt further analysis to see if asset disposal gains and losses have been appropriately adjusted for.

The third adjustment we have is for pension service costs, which have been added back, and I think this really is a questionable adjustment. Companies sometimes do this because they argue that these costs are non-cash, but these pensions will need to be paid at some point in the future. So I do think this is a very low quality adjustment. The final adjustment is associate profits, and these have been added in to underlying EBIT. And again, I think this is a really questionable adjustment. Most analysts view associate profits as non-core, and therefore we would not usually want those in our underlying ebit. So hopefully you can see from this exercise that reviewing this reconciliation allows us to, at a glance, look at the overall difference between underlying profits and reported operating profits, but also to look through and challenge the adjustments that are being made by management.