GAAP Vs. Non GAAP Earnings
Set of accounting standards that encompass the legalities and specifics of financial reporting
What is GAAP vs. Non-GAAP Earnings?
The world of financial reporting is a labyrinth of numbers, disclosures, and interpretations. A complex interplay between key principles and adjustments can alter the narrative. In the landscape of accounting with millions of scenarios, rules, and standards, a set of principles prevents chaos.
This takes the form of the GAAP or the Generally Accepted Accounting Principles. These are a set of accounting standards that encompass the legalities and specifics of financial reporting.
Yet, now and then, you may come across the term Non-GAAP. It is an alternative form of reporting that companies can choose to employ.
They offer divergent lenses through which a company's financial health can be assessed, thereby giving rise to discussions, debates, and regulatory scrutiny.
Exploring the nuances of GAAP and non-GAAP earnings is key. It unveils their impact on financial statements but also sheds light on their role in shaping investment decisions.
As we embark on this journey, we aim to unravel the intricacies of these two approaches and gain insights into their implications for both companies and investors in the dynamic world of finance. So what do these two terms mean, and what are their key differences?
Key Takeaways
- GAAP, or Generally Accepted Accounting Principles, are accounting standards used by companies in financial reporting. However, in some cases, these standards may not apply. That is when Non-GAAP sets are utilized.
- GAAP encompasses a set of standardized accounting principles and procedures for publicly traded US companies to follow. Its goal is to provide stakeholders with reliable and consistent financial information.
- While GAAP is essential, it has limitations, such as its reliance on historical cost. The complexity of handling gains and losses and the subjectivity in judgment calls underscores the challenges of GAAP.
- Non-GAAP earnings emerge as an alternative when GAAP falls short. This approach provides companies with a clearer and tailored insight and can be used to align it with their business strategies.
What is GAAP?
GAAP refers to the set of standardized accounting principles and procedures that companies in the US follow. The goal of GAAP is to provide stakeholders with reliable and consistent information.
The standardization of this process allows for analysis across different entities. This trait has streamlined the process of information gathering and decision-making, proving to be a useful tool for investors and the public.
1. Early Development (1930s-1940s)
The origins of the GAAP can be traced back to 1934. This was when the Securities and Exchange Commission (SEC) in 1934. This was during the disastrous period of the Great Depression.
The SEC was tasked with regulating industries and restoring confidence in the markets. It required companies to adhere to a standardized accounting practice as part of its role.
2. Creation of the CAP and APB (1930s-1950s)
The SEC established the Committee on Accounting Procedure (CAP) in 1939. Their role was to develop accounting principles further. The CAP issued 51 Accounting Research Bulletins (ARBs) to address various accounting issues. However, as the complexity of business transactions increased, the CAP's influence waned.
This led to the establishment of the Accounting Principles Board (APB) in 1959. It aimed to improve the standard-setting process and streamline functions.
The APB issued 31 opinions to address accounting issues. However, criticism grew over the APB's incompetence, especially in their slow response to emerging issues and their composition.
3. FASB Era (1970s-Present)
Soon, the dissatisfaction had grown too large. This led to the founding of the Financial Accounting Foundation (FAF) in 1972. Unlike the previous institutions, they didn't set the accounting standard.
That role was instead lent to the Financial Accounting Standards Board (FASB), which the FAF would now oversee.
The FASB changed tactics and adopted a new approach. This called for a more emphasized and transparent process for standard-setting. It focused on issuing Statements of Financial Accounting Standards (SFAS).
4. Convergence with International Standards
As the years progressed, businesses became more global and interconnected than ever; thereby, the need for convergence between GAAP and international standards grew.
Attempts to align the GAAP to the International Financial Reporting Standards (IFRS) failed. While progress was made, full convergence was yet to be achieved, mainly due to differing philosophies underlying the two frameworks.
5. Transition to ASC and Beyond
In 2009, the FASB transitioned to the Accounting Standards Codification (ASC). They reorganized and codified existing standards into a single source, setting the current GAAP we use today. The ASC has since improved access to and application of GAAP principles.
Note
The ASC has continued to issue Accounting Standards Updates (ASUs) to address emerging issues.
The differences between GAAP and Non-GAAP require a basic idea of the founding principles to help identify the point of divergence between them and why. The core theory of GAAP lies in its assumptions and principles. Let's address them.
Assumptions of GAAP
For the GAAP to function, certain assumptions are made. This is necessary for it to be applied. Let us go over them below:
This assumes that a business will continue to operate indefinitely or at least for the foreseeable future. This allows liabilities and assets to be recorded without apprehension.
However, this assumption fails if the business shows signs of failing to meet its objectives. This can come in the form of liquidation or bankruptcy.
2. Consistency Assumption
This assumes that a company uses the same accounting methods across time periods. Any changes that are to be made must be disclosed beforehand.
3. Business Entity Assumption
This assumes that the business is a separate entity, regardless of its ownership or other businesses. Any corporate revenue or expenses should be separate from personal finance.
4. Monetary Unit Assumption
This requires a stable currency to be used consistently as the unit of measurement. In this case, this would be the US dollar.
Note
The currency is unadjusted for inflation.
5. Time-period Assumption
This implies that economic activities are divided into established and accepted time periods. These usually fall under quarterly or annually. This assumption enables meaningful comparisons between different time periods.
Principles Of GAAP
The following principles are the bread and butter of GAAP. These are the ideas that set the standard for all companies in the US. Understanding these will also highlight where non-GAAP standards may be more useful. So let us briefly go over each one:
1. Historical Cost Principle
This states that the info should be recorded on the balance sheet at its original cost, regardless of changes in market value over time. This principle promotes the reliability and verifiability of financial information.
It does this by discrediting subjective and biased market values. The disadvantage of this is that the values are no longer relevant to the market. As a result of this problem, more assets, such as securities, are reported at fair market value.
2. Full Disclosure Principle
This assumes that only significant or material information should be reported. The term 'material' refers to the importance of certain information pieces.
If its omission can greatly influence the decision of users, then it is 'material.' This is presented in the main body of financial statements or as supplementary information.
3. Accrual Basis / Revenue Recognition Principle
Under this assumption, transactions are recorded when exactly they occur and not when cash is received or paid. This defines the concept of accrual. Financial statements note when they are earned or incurred, regardless of the timing of cash flows.
Conversely, losses must be recorded when their occurrence becomes likely, regardless of whether or not it has occurred.
This conflicts with losses and liabilities as gains are recorded inconsistently with how losses are recorded. Losses are recorded when the product has contributed to the company's revenue.
4. Matching Principle
Costs have to be matched with gains as much as possible. This will allow a greater performance evaluation as it compares the cost of the product/service to its gain.
The only exception is when no connection between the two can be determined. In this case, they can be recorded in the current period. Some examples are Depreciation and Cost of Goods Sold.
5. Conservatism Principle
Also known as the "prudence principle." This idea suggests that when there are uncertainties, businesses should err on the side of caution. This helps to recognize potential losses and liabilities sooner rather than later.
What is Non-GAAP?
As useful as GAAP is, there exist situations when they fail to report data accurately. We see these when examining the shortfalls of the principles of GAAP. So let's go over them once more:
1. Reliance On Historical Cost
A significant downside is its reliance on the idea of historical cost. Its reliance on this leads to unreliability in market values. This can lead to a disconnect between a firm's financial position and true economic value.
2.Complexity Regarding Gains and Losses
Under the accrual principle, gains are to be recorded when the transaction occurs. Not when the revenue is gained. This principle is not consistent with regard to losses.
Costs are recorded when they become likely, regardless of whether they have occurred or not. The inconsistency between the two can be confusing and lead to recording issues.
3. Restrictive Nature
GAAP's rules and principles might not always align with specific situations, especially in the needs and circumstances of certain industries or companies. So, adhering to it might not allow an accurate representation of a company's financial health.
An example of this is the tech industry. Due to the nature of their businesses, they cannot report high income, regardless of the performance of their product/service.
4. Subjectivity
GAAP often involves subjective judgment calls, especially regarding estimates, valuations, and the recognition of certain transactions. This is due to some of these figures being developed by the company themselves.
Their incentives may not always align with that of shareholders and can lead to manipulation or bias.
In these cases, the need for a non-GAAP standard arises; companies can display their figures as long as they state their exceptions. These exceptions usually take the form of one-time charges and non-operating expenses.
However, their inclusion is important to the accurate portrayal of certain companies. Therefore, they prefer the use of non-GAAP sources of accounting as they provide a clearer view of the company's financial trajectory.
GAAP vs. Non-GAAP Earnings
So now that we have established the theory behind and need for both, How do companies choose? In general, publicly traded companies are required to adhere to GAAP.
But even then, some exceptions exist, especially when a company wants a clear picture of its financial well-being. There are three things to consider before choosing which.
| Basis | GAAP | Non-GAAP |
|---|---|---|
| Reporting Discrepancies | GAAP earnings must adhere to the strict accounting standards set forth by the FASB. These encompass elements such as depreciation, amortization, and inventory write-downs. | Conversely, non-GAAP earnings may exclude these items. This can offer a version of financial performance that better represents their ongoing operations. Although adjustments can vary significantly, certain adjustments are common across all. |
| A Clearer Picture | Non-GAAP, by definition, does not follow any standardized guidelines, making it harder to compare results for investors. These issues can be detrimental to many companies and outweigh their benefits most of the time. | Non-GAAP measures allow for a more tailored insight into a company's health, identifying its finances and communicating it better to investors. Firms can also choose to align it with their objectives to appear healthier than they may be. |
| Misinterpretation | The GAAP has certain situations that call for more subjective decisions. These decisions can be misleading for the investors as the company itself makes them. Although accidental, they lead to misinterpretation. However, these cases are rare. | Sometimes, the lack of standardization can have side effects. A major issue is the prevalence of misinterpretation as companies choose which items to exclude and which not to. This can create a distorted view of their financials. |
| Manipulation | The subjective exceptions of GAAP can sometimes be tweaked on purpose to distort a firm’s health. However, the strict standards of if, allow for regulators to spot these situations and clamp down. | Non-GAAP measures present a much more confusing landscape for regulators to monitor, allowing firms to get away with purposefully cherrypicking which financials to report. |
| Regulatory Scrutiny | GAAP generally is immune to this problem as its strict rules and standards ensure sufficient reliability and trust. | Regulators often scrutinize non-GAAP measures to prevent misleading or deceptive financial reporting. This is due to the fact that non-GAAP does not follow a set standard. |
Conclusion
There is no clear winner when deciding between GAAP and Non-GAAP methods of reporting earnings. It is instead a strategic decision based on the firm's context and goals.
The GAAP aims to uphold the principles of consistency and reliability, ensuring trust between investors and companies.
However, even this is not perfect. Its reliance on historical cost and inconsistent reporting on gains/losses stand out. These blind spots are where non-GAAP measures shine.
They provide an alternative to the rigidity of GAAP, which is especially useful for companies aiming to communicate their financial story efficiently.
However, its freedom is also its biggest downside due to its lack of standardization. The messy and confusing picture presented allows companies to manipulate investors and makes it harder for regulators to stop this.
Both approaches contribute to the intricacies of the financial reporting tapestry, which, admittedly, can sometimes be confusing. These measures exist to guide investors and companies to maneuver through them.
However, the landscape is ever-changing, and mastering it will prove to be indispensable.
Considering the topic of GAAP and non-GAAP, maybe you'd like to check out our course on accounting foundations. This course will help you navigate through the basics of accounting and will build a practical base for the usage of GAAP.
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