GAAP vs Non-GAAP: Key Differences and Their Effect on Financial Reporting

Do company financial statements really show how well they’re doing? They use non-GAAP measures to clear things up by not counting certain costs. But does this hurt financial transparency and investor relations?

In the financial reporting world, the GAAP vs. Non-GAAP debate is always on. GAAP is a set of rules the SEC (Securities and Exchange Commission) created for company financial reports. It makes sure everyone uses the same methods.

On the other hand, non-GAAP lets companies report their financials their own way. They can adjust for certain costs. This might give a different view of the company’s financial health.

But, the SEC says non-GAAP can’t trick people. Companies have to explain how their non-GAAP numbers match up with GAAP ones. They must follow the rules, staying honest and clear. This way, they can still share important financial insights without misleading anyone.

Key Takeaways

• GAAP is the standard set of accounting policies for U.S. public companies.
• Non-GAAP measures change earnings to not include some costs, like from buying other companies.
• The SEC looks after non-GAAP numbers to stop them from being misleading.
• Companies use non-GAAP to give a better picture of their true business performance.
• Making sure non-GAAP and GAAP numbers match is crucial for understanding earnings per share and revenue.

GAAP vs Non-GAAP

GAAP (Generally Accepted Accounting Principles) and non-GAAP are two different accounting methods used by companies to report their financial performance. These ways of presenting financial statements can affect publicly traded companies and those who invest in them.

Here is a comparison table for GAAP vs Non-GAAP:

The key takeaways are:

• GAAP is standardized, required, includes non-recurring expenses, auditable, and more conservative, while non-GAAP is non-standardized, optional, excludes non-recurring expenses, not auditable, and less conservative.

• GAAP is better for comparability and transparency, while non-GAAP can be misleading if not used carefully.

• Companies often report both GAAP and non-GAAP results, with non-GAAP results typically excluding certain expenses to present a more favorable view of their financial performance.

Introduction to GAAP and Non-GAAP

There are two key ways to present finances: Generally Accepted Accounting Principles (GAAP) and non-GAAP. GAAP sticks to standard accounting principles set by bodies like the FASB and the SEC. But non-GAAP is different. It changes some costs to show a different view.

What is GAAP?

Non-GAAP: An Alternative Approach

Non-GAAP, or non-Generally Accepted Accounting Principles, refers to an alternative accounting method used by companies to measure their earnings. Unlike GAAP, which is a standardized set of accounting principles, non-GAAP figures are adjusted results that exclude certain items like one-time transactions or non-cash expenses.

Even though GAAP is the usual way to report, more firms are using non-GAAP methods. These methods show a company’s real work, cutting out some costs. This helps highlight their main activities. But, the SEC keeps an eye on non-GAAP use to make sure it’s not misleading.

Research shows that companies are making more non-GAAP changes each year:

• In the last quarter of 2020, 77% of top Dow Jones firms shared non-GAAP earnings. And 74% of those had higher non-GAAP earnings.
• Between 1998 and 2017, changes to net income because of non-GAAP reasons grew by 33%. In 2017, almost all of S&P 500 firms used non-GAAP changes.

Non-GAAP lets companies show their performance in different ways. But, leaders and those looking at a company must be smart when using non-GAAP. They need to make sure the changes are fair and follow the rules.

Common Non-GAAP Metrics

Many companies now use non-GAAP reporting to show earnings in a different light. They want to give a clearer view of how well their business is really doing. This differs from GAAP standards, which are more rigid. Non-GAAP allows them to remove certain costs that might not reflect their true business performance.

Adjusted EBITDA

Adjusted EBITDA is a key non-GAAP measure. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Companies leave out certain costs to show how well their actual business is performing.

Adjusted Earnings per Share

Adjusted earnings per share is also a common non-GAAP measure. It wipes out one-time events from the GAAP net income. This lets companies illustrate their regular profit, without these unusual events.

Free Cash Flow

Free cash flow is a telling non-GAAP metric. It’s the cash a company makes after covering its expenses and investing. This figure highlights how much money they can use for growth or to reward investors.

Although these non-GAAP metrics offer deep insights, they should be viewed with caution. It’s important to understand what has been left out to avoid misinterpretation. The SEC keeps an eye on how companies use these metrics, making sure they’re not trying to deceive anyone.

Advantages and Disadvantages of Non-GAAP Measures

Using non-GAAP measures helps show a clearer look at how a company is doing. These numbers take out one-time events and non-cash costs. This gives a better picture of everyday business activities. But, because not every company calculates these the same, it’s hard to compare them directly.

Advantages: Clearer Operational Performance

With non-GAAP reporting, companies can share results without some unusual or one-time costs. This lets investors see the business’s main performance more clearly. It can also make the company’s profits seem more smooth and reliable by taking out these one-off costs.

For example, costs from buying other companies, or from changes to the business, don’t usually count in non-GAAP numbers. So, a company can show a more precise look at its earnings and cash they make without these unique situations.

Disadvantages: Limited Comparability

The problem with non-GAAP measures is that not everyone does them the same way. With GAAP, rules are strict and everyone follows them. But with non-GAAP, companies get to choose what they don’t count, which isn’t always clear or the same across the board.

This can make it hard to compare companies. What one company thinks is a one-time cost, another might say is just part of regular business. So, figuring out how one company stacks up against another can be challenging. This is especially true for investors and analysts who rely heavily on these numbers.

Also, companies seem to often take out bad news in their non-GAAP numbers more than the good news. This could mean they’re trying – maybe a bit too hard – to show things in a better light. It’s another reason why it’s key to check how these numbers are used and that they follow the right rules.

When using non-GAAP measures, companies need to be clear but also follow the law. Reflecting their performance accurately while staying transparent and consistent is crucial.

Regulatory Oversight and Guidelines

The Securities and Exchange Commission (SEC) oversees the use of non-GAAP earnings by public companies. It aims to ensure these companies are clear and truthful in their financial reporting.

SEC’s Role in Non-GAAP Reporting

Companies must show how their non-GAAP earnings relate to standard net income. This helps make things clear for investors. The SEC’s guidance and updates in this area help prevent confusion.

Guidance such as the Compliance and Disclosure Interpretations (C&DIs) is there to make rules clearer. The SEC updates these regularly, like in 2022, to cover current issues and prevent misinterpretation in company reports.

Prohibited Practices in Non-GAAP Disclosure

The SEC disallows misleading practices in non-GAAP reporting. For instance, companies can’t leave important recurring cash expenses out of their non-GAAP earnings reports. Additionally, how they name and explain non-GAAP measures matters a lot.

Comment letters from 2023 showed that many discussions focused on non-GAAP adjustments. This shows a lot of attention and some challenges in interpreting these financial figures.

The SEC first set down rules for non-GAAP financial measures in 2003. These rules seek to balance the need for transparency with flexibility for companies in how they report earnings. The SEC has updated them since, in 2010 and 2016.

Reconciling GAAP and Non-GAAP Figures

Understanding non-GAAP figures means finding the differences from standard GAAP numbers. These differences often include things like non-cash expenses, costs to restructure, or stock-based compensation. People look at these to see if they truly won’t happen again. This is based on how a company expects to operate in the future, following financial accounting standards set by the Securities and Exchange Commission (SEC).

Adjusted figures usually remove losses and keep positive gains. This could show management teams want to make investors feel positive. But, the ongoing differences between these figures need careful checking by investors. This is to avoid getting the wrong financial picture.

Finding the true meaning in non-GAAP figures is important. They can shed light on how a company is really doing. But, it’s just as vital to question if the ‘one-time’ costs aren’t really going to happen again. This analysis follows accounting rules and tries to predict the effects on future performance.

The table shows the gap between GAAP and non-GAAP EPS for big tech companies. To understand these numbers better, investors need to focus on what’s being excluded. This helps them see if the non-GAAP data gives a clearer view of the company’s net income and main performance.

Industry Trends and Practices

More and more companies in the U.S. are using non-GAAP reporting. They do this to offer a clearer view of their financial state to investors and stakeholders. This method helps to show how well the company is really doing by not counting certain one-time or not directly related costs.

Prevalence of Non-GAAP Use

Around the U.S., many different types of companies are jumping on the non-GAAP bandwagon. Especially, a lot of big companies are using it. By the end of 2017, 97% of S&P 500 firms were tweaking their financial statements with non-GAAP adjustments. This number was up 38% from 1996.

In late 2020, a whopping 77% of Dow Jones Industrial Average companies showed non-GAAP earnings per share. Even more impressive, 74% of those companies had higher non-GAAP EPS than their regular EPS.

Sector-specific Considerations

While many industries use non-GAAP reports, some are more into it than others. Tech companies, especially, turn to non-GAAP a lot. This is because GAAP net incomes don’t often show their true financial success. Without non-GAAP, it’s harder to compare companies in these sectors.

Start-ups in life sciences tend to use these reports too. Many of these companies don’t make profits for a while because they’re focusing on research and development. Non-GAAP helps to remove these huge costs and show investors a clearer future picture. Without it, these companies’ potentials could be overlooked.

Non-GAAP reports can offer important insights. But, companies must follow the rules laid out by the SEC and other regulators. This ensures that the information is clear and fair, not misleading. Sticking to these guidelines is important in non-GAAP use.

Conclusion

Our look into GAAP vs. non-GAAP methods shows us they both play important roles in gauging a company’s financial well-being. GAAP uses standard accounting rules from the Financial Accounting Standards Board. This makes financial statements and reports uniform and easy to compare. On the other hand, non-GAAP numbers let us see a company’s true operational health. They take out one-time costs and special items like merger deductions and stock options.

When using non-GAAP figures, it’s important for investors to be cautious. They should thoroughly check the fairness of these adjustments. For example, they should closely look at numbers like EBITDA and stock-based compensation. It’s key to match these adjusted figures with the official GAAP numbers to get a full picture of the business’s financial status.

Both GAAP and non-GAAP ways of measurement are useful for experts and investors. GAAP gives us a common starting point. Non-GAAP gives us extra views on a company’s free cash flow and effectiveness. By looking at both, and making sure it’s done correctly according to the legal rules, people can better understand a company’s future prospects and its ability to make long-term value.

Source Links

• https://www.investopedia.com/articles/financial-analysis/062716/gaap-vs-nongaap-which-should-you-consider-evaluation.asp
• https://staxpayments.com/blog/gaap-vs-non-gaap-need-to-know/
• https://www.fool.com/investing/how-to-invest/stocks/gaap-vs-non-gaap/
• https://www2.deloitte.com/us/en/pages/audit/articles/benefits-sec-non-gaap-measures.html
• https://www.pwc.com/us/en/ghosts/non-gaap-measures.html
• https://www.cpajournal.com/2020/03/18/the-gap-between-gaap-and-non-gaap/
• https://www.gsquaredcfo.com/blog/gaap-vs-non-gaap

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