Companies can adopt different ways to track and report financial information to the stakeholders. While in the United States, the companies follow the US GAAP (Generally Accepted Accounting Principles) method of accounting. There are instances when companies adopt non-GAAP standards as well to report their financial information. On the other hand, some companies prefer to report the financial statement both ways. To better understand GAAP vs non-GAAP, let’s look at each method in detail.
What is GAAP?
As per the requirements of the SEC (Securities Exchange Commission), companies have to follow the GAAP method of accounting for consistency in reporting. GAAP lays down a uniform set of rules and formats and guidelines for item measurement, presentation, disclosure, and recognition. These are the minimum standards companies need to include in their financial reports. GAAP reports are in-line with the requirements of state and federal agencies.
If a company wishes, it may add supplemental information, such as non-GAAP reports, for more information. This, in turn, helps analysts, shareholders, and other stakeholders to know about the true financial health of the company.
What is non-GAAP?
There is no specific definition of non-GAAP. It generally refers to any accounting method that is not GAAP, meaning measures that don’t follow the set standard calculation. One may also call non-GAAP as adjusted earnings.
Companies can report non-GAAP accounting figures, provided they classify them as non-GAAP. Also, they must offer reconciliation between the adjusted and regular results, or we can say explain the difference between GAAP vs non-GAAP figures.
One of the most popular non-GAAP measures is earnings before interest, tax, depreciation, and amortization (EBITDA). Through EBITDA, the analysts understand the operating performance of the company, exclusive of tax, financing, and accounting decisions of the organization.
EBITDA is calculated as – EBIT +Depreciation +Amortization.
Under EBITDA, the company adds back non-cash expenses such as depreciation and amortization to the firm’s operating income. Analysts, therefore, get a clear picture of the operating decisions made by the company by excluding the impact of non-operating decisions, such as interest expenses, external factors, and tax rates.
As per SEC guidelines, the companies need to reconcile their non-GAAP measures to the closest GAAP financial measure. For instance, a company looking to report EBITDA in its financial statement would also need to provide the reconciliation to report its net earnings as to GAAP.
Why Companies use Non-GAAP?
In addition to GAAP, most public companies also report their regular quarterly financial numbers in the non-GAAP format. They primarily do this to provide cash flow information in a better way or give a better understanding of their financial results to the investors. For instance, some companies prefer non-GAAP reporting to show the profitability and cash flow after excluding some significant ticket expenses.
Non-GAAP reporting has a significant place because, on certain occasions, GAAP reporting fails to give a clear picture of the operations of a business. For instance, non-GAAP figures do not include irregular and non-cash expenses. These expenses could relate to one-time balance sheet adjustments, acquisitions, restructuring, etc. Excluding such non-recurring expenses smoothens the extreme high and trough in the earnings. And this gives a better understanding of the business.
Commonly Used non-GAAP Measures
Apart from EBITDA, cash earnings, adjusted operating income, adjusted EPS, and more also come under non-GAAP earnings. Additionally, some non-GAAP measures are popular in specific industries. For instance, real estate companies prefer showing non-GAAP items such as Funds from Operations (FFO) in their financial reports to better understand the profits and cash available. Following are the popular non-GAAP measures;
EBIT – Earnings before interest and tax.
EBITDA – Earnings before interest, tax depreciation, and amortization.
Adjusted EBITDA – it is EBITDA without including the cost of stock-based compensation and non-cash charges related to the acquisition in the past.
Free Cash Flow – cash flow after deducting reinvestment in working capital and capital expenditure.
Operating Earnings Per Share – companies calculate it by dividing operating income by time-weighted the number of outstanding shares over an accounting period. Some analysts believe that this measure gives a better view of the run rate of current earnings.
Operating Income – to calculate it, the company deducts non-recurring expenses and revenue from the core operations earnings of the company. The non-recurring expenses might include intangible assets, repair charges, impairment, and restructuring charges.
When is non-GAAP Reporting considered Misleading?
As per the guidelines set forth by the Securities and Exchange Commission (SEC), non-GAAP measures are permissible only if the reporting company details it appropriately. SEC in its updated Compliance and Disclosure Interpretations, says that a non-GAAP measure can be considered as misleading if it;
- Does not include normal, recurring cash operating expenses that are significant for running the business.
- If a company discloses non-GAAP measures abruptly between periods without appropriate presentation and reasons for change, then it could be misleading.
- Any disclosure that inflates the revenue recognition is not acceptable, and thus, a company can’t present it publicly.
- If a company discloses non-GAAP measures more prominently than the GAAP measure, then the company must not file it.
- Suppose an organization presents the non-GAAP financial measure in tabular form without an equally prominent tabular representation or inclusion of the comparable GAAP measures. In that case, the non-GAAP measure is not acceptable.
- Not including quantitative reconciliation related to a forward-looking non-GAAP measure is also considered as misleading by the SEC.
GAAP vs non-GAAP – Which is Better?
The above explanation clears that the biggest difference between GAAP and Non-GAAP is that the former is industry standard. And that its objective is to provide a clear picture of how business is operating from a financial point of view. Non-GAAP reports, on the other hand, deviate from the set standards and make adjustments to give accurate information about the company’s operations.
Though GAAP is the preferred accounting model, there have been numerous academic and professional studies supporting the importance of non-GAAP reports as well. Relying on only one measure may not give an accurate picture of the company’s financial health. Therefore, if an investor is following non-GAAP figures, then they must also study why it is different from GAAP figures.