Roughly two-thirds of companies keep two sets of books—one for auditors and one for investors.

All companies are obligated to report net income, and some report EBITDA on their audited financial statements as well. However, the vast majority of companies also report adjusted earnings or adjusted EBITDA.

Why? For decades, companies had been providing an adjusted figure to smooth out one-time realized gains and losses (e.g., selling assets or closing manufacturing plants). But with accounting changes over the years, including changes that try to fairly value the balance sheet from quarter to quarter, companies have been required to report many more non-realized, or mark-to-market, gains and losses. These include estimated changes in the value of items including financial instruments, currency hedges, resource assets and inventory.

The result is often a mess, producing some volatile swings from quarter to quarter in the audited financial statements. So, companies will try to present a smoothed-out, longer-term picture of their performance via adjusted earnings.

Further, adjusted numbers fall outside of the purview of financial statement auditors, so auditors offer no opinion on the veracity of the adjusted figures. The securities commissions regulate the presentation of adjusted figures, but not the calculation.

This gives management significant leeway—they can essentially provide whatever alternative adjusted figures they choose. Investors must realize that companies fall into two camps: those that report reasonable adjustments and those that push the envelope by presenting an adjusted earnings measure that makes them look consistently better.

Here are some red flags investors should be wary of.

Smoothed expenses vs. deleted expenses

Once companies realize they can publish whatever adjusted earnings measure they want and get the market to focus on those figures, some executives decide to stretch the boundaries of the original concept. A major red flag is when management decides to delete expenses from their adjusted earnings measure instead of trying to smooth them out. That’s a big jump in substance, but it sometimes flies under the radar of investors because it seems like just another run-of-the-mill accounting adjustment.

Valeant, for instance, had a $100-billion valuation as of September 2015 that was largely premised on sell-side analyst estimates of cash EPS (an adjusted earnings measure provided by management). As part of its calculation of cash EPS, Valeant habitually deletes expenses such as executive compensation, costs related to R&D and intellectual property, and outlays for integration. These costs are not reallocated to other periods; they simply vanish altogether.

Large differences between normal and adjusted earnings

In the first nine months of 2015, Valeant reported cash EPS of $7.68 per share. Actual EPS, according to accounting rules, was $0.20 per share. Similar massive gaps exist for prior periods as well; for the previous four years combined, Valeant reported cash EPS of $22.02 per share, versus actual earnings of just $0.08. When companies delete expenses instead of deferring them to another period, the adjusted figure is always greater than the actual figure. That’s done intentionally to make management look better. If a company is smoothing out expenses, the adjusted and unadjusted figures should be much closer to equal over the longer term.

Investors need to watch out for large and persistent gaps between the adjusted figures and normal earnings figures.

Management bonuses based on adjusted earnings

The dreaded triple play occurs when a company uses its adjusted earnings as a major factor in determining executive compensation. According to Valeant’s most recent disclosures, 60% of the CEO’s annual cash bonus is based on meeting a target for cash EPS—a number wide open to the subjective opinion of management.

This provides the motive, in addition to the aforementioned opportunity, for executives to become especially creative when deciding what amounts are excluded from adjusted earnings measures.

Looking at the wrong numbers

Many large companies in various sectors provide adjusted figures that ignore regular operating costs, including Northland Power and Concordia Healthcare Corp. So, Valeant is by no means an isolated case, but it’s a recent example of what can occur when investors get caught focusing on the wrong set of books. The company’s stock price collapsed in the last half of 2015. It’s unlikely that as many people would’ve invested in Valeant had they been told up front that analysts were excluding many of the everyday cash costs of running the business in their earnings estimates.

The biggest risk is that investors don’t realize how expensive a stock is because too much focus has been placed on an earnings measure that’s been inflated by fundamentally flawed adjustments. Steering clear of the red flags of adjusted earnings is a good way to remove unnecessary risk from client portfolios, and make room for investing in better alternatives that don’t rely on accounting gimmicks to justify share price.

More on adjusted ebitda

Adjustments to EBITDA can be determined at the discretion of a company, finds an October 2014 PwC U.S. report. And those adjustments can vary significantly from organization to organization, impacting comparability between companies and industries.

PwC’s research, laid out in a report called “How non-GAAP Measures Can Impact Your IPO,” shows that adjusted EBITDA non-GAAP measures (NGM) appeared in 46% of reviewed filings. Of those, more than 70% included an adjustment for stock, share or other equity-based compensation. Other common EBITDA adjustments were related to impairment (33%), acquisition (20%) and restructuring & reorganization impacts (15%). PwC also identifies a wide diversity of EBITDA adjustments made by companies. It finds 80% of the filings included at least one unique adjustment, which ranged from management fees to income or losses from discontinued operations.

The research also shows some industries have developed other common NGMs in addition to, or as a replacement for, adjusted EBITDA, including the asset management, banking & capital markets, as well as the entertainment, media and communications sectors. After adjusted EBITDA, other common NGMs in the financial statements analyzed included EBITDA (19% of filings), adjusted net income (9%), free cash flow (4%) and adjusted gross profits (4%).

“Companies should be ready to enter the IPO markets while the window is open, and having their financial reporting in order from the start is a key factor in the process,” says Mike Gould, PwC’s U.S. public offerings leader.

“While NGMs are a key tool for companies planning to enter the public market, it is a complex process that must be thought through objectively to avoid potential missteps, unanticipated costs and delays in their offerings.”