To understand the stock market, investors should know how to read an earnings report. Doing this can help an investor decide whether to buy more stock or sell existing stock. However, even this can be difficult with how companies employ manipulative tactics to mislead investors.
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What are General Accepted Accounting Principles (GAAP) earnings?
Developed by the Financial Accounting Standards Board (FASB), the GAAP is a collection of standardized rules and procedures for accounting. The Securities Exchange Commission (SEC) requires all publicly traded companies in the U.S to follow GAAP methods of accounting in the reports.
GAAP measures enable analysts, investors, and creditors to have an easier time analyzing a company’s financial performance. It also allows them to compare the performance of two different companies within an industry.
The International Financial Reporting Standards (IFRS) are the accounting rules used in other countries. Because it is still new, most analysts consider it more comprehensive. However, work is being done to align the two accounting frameworks, thus make them more interchangeable.
Non-GAAP earnings
In some cases, a company may feel that the GAAP measures do not fully reflect its performance. In this case, the SEC allows it to use non-GAAP measures. However, the SEC requires that non-GAAP criteria should not be used by themselves but with GAAP measures. These measures show the performance of a company from the management’s perspective.
In general, non-GAAP measures exclude one-time transactions such as acquisitions and restructuring costs. Companies exclude such transactions because they don’t think that these one-time costs should be considered part of standard operational costs since they can make it harder to see a business’s actual performance.
While investors should look at GAAP and non-GAAP measures, they should be aware that companies can use GAAP measures to mislead them. For example, many businesses tend to exclude purchases that hurt GAAP earnings. Moreover, very few companies will exclude gains in the non-GAAP reports.
Investors should note that non-GAAP EPS have no regulations. For this reason, it is impossible to know if a report is accurate; hence investors have to consider the validity of a non-GAAP.
Some of the most commonly used non-GAAP measures are adjusted revenues, Earnings Before Interest and Taxes (EBIT), core earnings, Earnings Before Interest, Taxes, Interest and Amortization (EBIDTA), and free cash flows.
GAAP and non-GAAP measures, when used together, provide a more in-depth analysis of a company which is essential for an investor. However, investors should be even more careful when looking at non-GAAP measures as they are not regulated and could be used to mislead.
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