Normalized earnings definition
/What are Normalized Earnings?
Normalized earnings are an organization’s reported profits, adjusted to remove the impact of seasonality, as well as unusual revenues and expenses. Adjustments to eliminate the effects of seasonality involve the use of a moving average for revenue and operating expenses; doing so dampens the seasonality effect without entirely eliminating it. Normalization can be useful when there are unusual one-time events that are materially skewing reported results.
Examples of Earnings Normalization Adjustments
Here are several examples of the earnings normalization adjustments that might be applied to an organization’s financial statements:
Lawsuit adjustment. Strip out the one-time gain caused by winning a lawsuit, since it does not reflect the operational capabilities of the organization.
Gain/loss from an asset sale. Strip out large gains or losses from the sale of fixed assets, since these events are not related to operational activities.
Weather-related losses. Strip out losses from adverse weather events, such as the impact of flooding damage on a production facility.
Gain/loss from security sales. Strip out large gains or losses from the sale of securities.
Asset impairment losses. Strip out large losses from recognized asset impairments.
Subsequent events. Strip out the impact of business units that have been sold since the financial statements were produced.
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The Interpretation of Financial Statements
How to Use Normalized Earnings
By normalizing earnings, you can gain a better understanding of the performance of a company’s core operations. While the normalization process typically only impacts a company’s income statement, a better approach is to release the entire set of financial statements with these corrections made throughout, so that readers can see the impact on a firm’s financial position and cash flows.
Normalized earnings information is useful for comparisons on a trend line, to see how a company is performing in comparison to its previous normalized results. This information can also be used to compare a firm’s results to the normalized earnings reported by competitors.
Fraudulent Use of Normalized Earnings
The inconsistent application of normalization adjustments to a company’s earnings can be employed to give investors and analysts an excessively rosy view of a company’s results. An example of such fraudulent reporting comes from Enron. Enron fraudulently used normalized earnings to mislead investors and regulators about its true financial health. To present a stable and growing profit trend, Enron’s executives adjusted earnings by excluding significant losses and non-recurring expenses, claiming they were one-time events. For instance, they shifted losses from failed ventures and operational costs into off-balance-sheet entities, making them appear as if they were not part of Enron’s core operations.
Additionally, Enron used aggressive accounting practices, like mark-to-market accounting, to book projected future profits as current revenue, even if those profits were uncertain or never materialized. By doing so, Enron’s financial statements showed a steady and normalized earnings growth, attracting investors and inflating stock prices. This manipulation concealed the company’s mounting debts and operational losses, eventually leading to one of the largest bankruptcies in U.S. history when the fraud was exposed.
This example illustrates how manipulating normalized earnings can create a false image of financial stability, deceiving investors and causing massive financial losses when the truth emerges.