GAAP to Non - GAAP
Analysts on Wall Street sometimes differ with the treatment of certain items under GAAP and make adjustments for these when conducting their own analysis. Companies too present key financials on a non – GAAP basis. The idea behind this is to eliminate “noise” and present a better picture of “run rate” or “sustainable” or “recurring” operations. Normalisation as it commonly known across the world, is the process of removing one time, exceptional and non recurring expenses or incomes from financials so that a truer and more accurate picture of underlying performance emerges. Even during a M&A process, potential buyers evaluate target companies based on Non-GAAP financials. In order to normalize earnings and calculate Non GAAP metrics, adjustments are made for:
- Stock Based Compensation
- Other Non Recurring, Exceptional or One Time items
So how do analysts make adjustments for some of these non cash, exceptional and non recurring items and normalize financials? At the operating profit level i.e EBIT, expenses are simply added back and incomes are subtracted. So this is fairly straight forward
To adjust at the earnings or net income level, these expenses are added back as well, but post taxes. Earlier when a particular item was treated as a regular expense, the company had lower operating profits, lower profit before tax or PBT and a lower resulting tax bill. Therefore these expenses provided the company with a tax shield. Now that some of these expense items are being reversed, the associated tax shield should be reversed as well when making GAAP to non GAAP adjustments at the net income level. Income adjustments are made at the net income level along similar lines, and they are subtracted post taxes.