Profits aren't actually growing -- companies are just fudging the numbers more than usual

Some slick accounting maneuvers may be making S&P 500 companies appear more profitable than they really are.

Accounting is one of the most excruciating subjects that investment analysts and strategists have to deal with because there are just so many ways a company can account for something.

With big publicly-traded companies, there are two categories of accounting methods: GAAP and non-GAAP.

GAAP is short for generally accepted accounting principles. GAAP accounting standards offer uniformity in how companies report their financial performance. However, income statements reported based on GAAP don’t always reflect the ongoing performance of a companies underlying operations. For example, a company may write-down an asset, restructure its organisation, or put contribute to its underperforming hedge fund. These actions usually come with large one-time costs that distort company profits and misrepresent long-term profitability. As such, a company will also provide an “adjusted” earnings number that excludes these nonrecurring items.

For the most part, the numbers generated by GAAP and non-GAAP will move in the same direction.

However, there’s something peculiar and worrisome going on right now. Deutsche Bank’s David Bianco examines it in a troubling note titled “Stretching To Hit Numbers?: GAAP vs. Non-GAAP S&P EPS Spread Widens.”

The GAAP/non-GAAP S&P EPS ratio deteriorated from 94% during 1Q13-3Q14 to 78% the past 3 quarters,” Bianco writes. “Loss on asset sales, asset/ goodwill impairments and restructuring costs lowered the ratio significantly at Energy, Industrials & Materials. Higher M&A costs and excluded stock compensation dragged the ratio lower at Tech, Staples & Healthcare. Pension losses lowered the 4Q ratio too.”

The twisted part of all this is that earnings per share on a GAAP basis are down.

“The S&P avoided down EPS in 1H15, up ~2% y/y on non-GAAP EPS, but the GAAP EPS declined by 13% y/y,” Bianco added. “We have always argued that the best EPS measure lies somewhere between GAAP and non-GAAP EPS.”

It’s worth noting that sales at S&P 500 companies actually fell during the quarter. So, any EPS growth is due to fatter profit margins and shrinking share counts.

Bianco is not bullish on the US stock market. He expects the S&P’s next 5%+ move to be down and his year-end target is 2,058. The S&P ws trading near 2,090 on Monday.

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