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GAAP vs. Non-GAAP: An Overview
Generally accepted accounting principles, usually called GAAP, are the rules that accountants for public companies in the U.S. must follow to make sure that the numbers they report to the company’s investors are clear and accurate.
GAAP rules are intended to prevent company management from using accounting tricks to overestimate their revenues, earnings, and margins or to underestimate their expenses. Since everyone is using the same standards, it also allows apples-to-apples comparisons of the results of peer companies.
Non-GAAP numbers are revised versions of GAAP numbers that are released when the company wants to add context to its results. Usually, the GAAP number looks bad but can be explained as an unusual occurrence. These are labeled non-GAAP.
In-depth stock research requires consideration of both GAAP and adjusted, or non-GAAP, results.
Key Takeaways
- GAAP standardizes financial reporting and provides a uniform set of rules and formats to make it easier for investors and creditors to evaluate a company.
- In some instances, GAAP reporting falls short of portraying the big picture accurately. That’s when non-GAAP adjustments are released.
- Non-GAAP measures adjust earnings to exclude non-operational costs, such as costs associated with acquisitions.
GAAP
GAAP was established and adapted largely to protect investors from misleading or dubious reporting.
The standards were developed by the Financial Accounting Standards Board (FASB), an independent association for accountants. It provides a uniform set of rules and formats to make it easier for investors and creditors to analyze a company’s finances.
Bringing uniformity and objectivity to accounting improves the credibility and stability of corporate financial reporting. Those factors are deemed necessary for capital markets to function optimally.
Following standardized rules allows for companies to be compared against one another. The results can be verified by reputable outside auditors. And, investors know that the reports are accurate.
Non-GAAP
Sometimes, company management feels that the numbers produced using GAAP fail to accurately portray the state of their business. Companies are allowed to display adjusted 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 can provide a clearer picture of the state of the ongoing business.
Fast Fact
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 internally. It’s wise to keep in mind that the incentives of shareholders and corporate management may not be perfectly 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.
Important
Studies have shown that adjusted figures are more likely to back out losses than gains, suggesting that management teams are more willing to share optimistic views.
In the fourth quarter of 2023, 80% of the companies in the Dow Jones Industrial Average (DJIA) reported non-GAAP earnings per share (EPS). Twenty out of these 24 companies (83%) reported non-GAAP EPS that was higher than GAAP EPS.
Technology companies are frequent users of non-GAAP adjustments as they typically don’t show 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 the most competitive markets.
What Is the Main Difference Between GAAP and Non-GAAP?
GAAP is the financial reporting standard for public companies. All public companies must report their GAAP numbers, but they may also report non-GAAP numbers as long as they are clearly labeled as such.
Non-GAAP numbers are used to add context to GAAP numbers. Usually, they remove unusual or one-time expenses to place the results in a more favorable context.
What Are GAAP-Based Earnings Vs. Non-GAAP-Based Earnings??
Non-GAAP earnings numbers do not include irregular or non-recurring costs, such as those associated with acquisitions. GAAP earnings include those costs. The difference can be substantial.
How Do Companies Decide Between GAAP and Non-GAAP Adjustments?
Public companies in the U.S. are required to use GAAP for financial reporting. However, they may also opt to use non-GAAP measures to show more accurate performance results. This is important to investors and analysts who want a clear picture of the health of the company.
The Bottom Line
GAAP and non-GAAP results are both important. Investors forced to choose between two numbers should consider the specific exclusions in the adjusted figures.
Companies that consistently purchase smaller firms and intend to sustain this acquisitive strategy often exclude certain acquisition-related costs in their non-GAAP numbers, but those costs could remain a material ongoing expense.
However, non-GAAP results from responsible firms grant investors insight into the strategies used by management teams as they plan for the future.
