In the United States, companies that are publicly traded are obligated to adhere to certain accounting guidelines while preparing their financial statements. These regulations are referred to as Generally Accepted Accounting Principles or GAAP, and they cover various aspects of financial reporting such as revenue recognition and expense recording. Additionally, GAAP mandates that businesses must present a balance sheet, income statement, and cash flow statement while disclosing their earnings outcomes.
The key advantage of utilizing GAAP for financial reporting is that it presents investors with a uniform set of financial statements that can be used to evaluate various organizations. This simplifies the process of making knowledgeable investment choices for investors.
However, some companies choose to create a second set of adjusted reports, also known as non-GAAP financial reports. Non-GAAP financials are not standardized and can include a wide range of financial metrics, such as adjusted metrics, non-recurring expenses, and non-cash expenses. Non-GAAP metrics are designed to create a better financial picture than the GAAP metrics suggest.
Non-GAAP measures are frequently used by loss-making organizations to construct financial reports that remove expenses that they believe are unnecessary, non-recurring, or not representative of their underlying fundamentals. The most common non-GAAP metric is the adjusted income. The adjusted income typically excludes non-cash expenses such as stock-based compensation as well as one-time expenses like restructuring costs. By omitting these expenses, the company makes its financial performance look better.
Non-GAAP reporting can provide investors with additional information about a company's financial performance, but it can also be misleading. For example, some companies invent their own financial metrics to make their performance look stronger than it is. Excluding non-cash expenses like stock-based compensation may make a company look more profitable, but investors should never forget the implications of excessive share-based compensation.
Companies that use too much stock as a compensation tool decrease the value of each share, similar to how a central bank that issues too much money causes the currency to devalue. This is called dilution, and it quietly destroys shareholder value as most investors don't pay much attention to it.
To prevent public companies from misleading the public, the SEC requires them to reconcile non-GAAP financial metrics to GAAP financials so that investors know how the adjusted metrics are calculated.
Sometimes, GAAP financials do not show the whole picture. Analyzing both the GAAP and the non-GAAP financial metrics can help investors make better investment decisions by having a clearer picture of a company's fundamental performance. However, investors should be cautious when evaluating non-GAAP financials, as many companies invent their own metrics that make their underlying performance look stronger than it actually is.
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