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GAAP vs. Non-GAAP: An Overview
The generally accepted accounting principles (GAAP) are the standardized set of principles that public companies in the U.S. must follow. Thorough investment research requires an assessment of both GAAP and adjusted results (non-GAAP), but investors should carefully consider the validity of non-GAAP exclusions on a case-by-case basis. The reason is to avoid misleading figures, especially as reporting standards diverge. Internationally, the accounting standard is the International Financial Reporting Standards (IFRS).
Key Takeaways
- GAAP standardizes financial reporting and provides a uniform set of rules and formats to facilitate analysis by investors and creditors.
- There are instances in which GAAP reporting fails to accurately portray the operations of a business.
- Investors should observe and interpret non-GAAP figures, but they must also recognize instances in which GAAP figures are more appropriate.
- While public U.S. firms must follow GAAP, other countries adhere to International Financial Reporting Standards (IFRS).
- Non-GAAP measures adjust earnings to exclude non-operational costs, such as those associated with acquisitions.
GAAP
GAAP was developed by the Financial Accounting Standards Board (FASB) to standardize financial reporting and provide a uniform set of rules and formats to facilitate analysis by investors and creditors. The GAAP created guidelines for item recognition, measurement, presentation, and disclosure.
Bringing uniformity and objectivity to accounting improves the credibility and stability of corporate financial reporting, factors that are deemed necessary for capital markets to function optimally.
Following standardized rules allows for companies to be compared against one another, results to be verified by reputable auditors, and investors to be assured that the reports are reflective of a company’s true standing. These principles were established and adapted largely to protect investors from misleading or dubious reporting.
Non-GAAP
There are instances in which GAAP reporting fails to accurately portray the operations of a business. Companies are allowed to display their own accounting figures, as long as they are disclosed as non-GAAP and provide a reconciliation between the adjusted and regular results.
Non-GAAP figures usually exclude irregular or non-cash expenses, such as those related to acquisitions, restructuring, or one-time balance sheet adjustments. This smooths out high earnings volatility that can result from temporary conditions, providing a clearer picture of the ongoing business.
The Securities Exchange Commission (SEC) prohibits the use of misleading non-GAAP measures, such as inconsistently reporting earnings between periods.
Forward-looking statements are important because valuations are largely based on anticipated cash flows. However, non-GAAP figures are developed by the company employing them; so, they may be subject to situations in which the incentives of shareholders and corporate management are not aligned.
Prevalence of Non-GAAP Use
Investors should observe and interpret non-GAAP figures, but they must also recognize instances in which GAAP figures are more appropriate. Successful identification of misleading or incomplete non-GAAP results becomes more important as those numbers diverge from GAAP.
Studies have shown that adjusted figures are more likely to back out losses than gains, suggesting that management teams are willing to abandon consistency to foster investor optimism.
In the fourth quarter of 2020, 77% of the companies in the Dow Jones Industrial Average (DJIA) reported non-GAAP earnings per share (EPS). Seventeen out of these 23 companies (74%) reported non-GAAP EPS that was higher than GAAP EPS.
According to research conducted by Harvard accounting professors and MIT’s School of Management, non-GAAP adjustments to net income increased by 33% from 1998 to 2017. Of the companies in the S&P 500, 97% used non-GAAP adjustments in 2017, a 38% increase from 1996. They concluded that as this trend continues, analysts and investors may find it more difficult to adequately forecast future performance.
Technology companies have been large users of non-GAAP adjustments as these companies typically don’t report high net income from the use of GAAP, due to the nature of their businesses. Some companies, such as UBER (UBER), remove recurring costs that are needed to grow in markets that are competitive. This practice makes it difficult to value public companies with one another.
What Is the Main Difference Between GAAP and Non-GAAP?
GAAP is the U.S. financial reporting standard for public companies, whereas non-GAAP is not. Unlike GAAP, non-GAAP figures do not include non-recurring or non-cash expenses. Also, because there are no standards under non-GAAP, companies may use different methods for financial reporting. As a result, it is difficult to compare financial results between companies in an industry and between industries.
What Are GAAP-Based Earnings vs. Non-GAAP Based Earnings?
Non-GAAP reporting adjusts earnings to show the operational performance of a firm. This accounting measure does not include irregular or non-recurring costs, such as those associated with acquisitions. Alternatively, GAAP earnings include irregular or non-recurring costs and are reported using specific standards. The difference between what’s reported for each can be substantial.
How Do Companies Decide Between GAAP and Non-GAAP Adjustments?
Public companies in the United States are required to use GAAP for financial reporting. However, these firms may also opt to use non-GAAP measures to show more accurate performance results. This is especially important to investors and analysts who want a clear picture of the health of an organization and its operations.
The Bottom Line
GAAP and non-GAAP results are both important in many cases, and studies by academic and professional sources support this stance. Investors forced to choose a side as the two diverge should consider the specific exclusions in adjusted figures.
Companies that consistently purchase smaller firms and intend to sustain this acquisitive strategy often exclude certain acquisition-related costs that remain a material ongoing expense to the business, but should not be overlooked.
Studies have suggested that the exclusion of stock-based compensation from earnings results reduces the predictive power of analyst forecasts, so non-GAAP figures that merely adjust for equity compensation are less likely to provide actionable data.
However, non-GAAP results from responsible firms grant investors unparalleled insight into the methodology employed by management teams as they analyze their own companies and plan future operations.