It’s vital for all companies to have policies and practices for tracking and accounting. There are several ways for companies to reflect financial information. To provide the clearest picture, some companies include several different measures of earnings in their financial statements.

All public companies are required to use the Generally Accepted Accounting Principles (GAAP) that were set forth by the Financial Accounting Standards Board. Public companies can also report earnings based on their own logic and practices, but non-GAAP reports may not be a substitute for GAAP reports.

Private companies are not beholden to GAAP, but many companies opt to use them for standardization purposes or in preparation for taking their company public. Some private companies opt to publish non-GAAP reports only.

There are plenty of pros and cons to both types of accounting measures and both have value in their own right. The discrepancies between them can be quite large. To get the most comprehensive picture of a company’s financial health, it’s vital to understand what each of the reports is trying to tell you.

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Understanding GAAP vs. Non-GAAP

The SEC devised GAAP as a means for standardizing financial information so that investors can more easily compare them. GAAP is a way for public companies to report their earnings using time-honored accounting principles, including accrual accounting, revenue recognition and expense matching. Companies that use GAAP are required to report expenses in the same period as they report related revenue.

GAAP also aligns quite nicely with financial reports from state and federal agencies. The standards for GAAP are the minimum standard that companies must include in their reports. Companies may add supplemental information for clarity such as a non-GAAP report. In the interest of creating transparency and accountability for investors, many of them provide multiple reports.

GAAP reports are optional for private companies. There’s really no true definition for what constitutes a GAAP versus a non-GAAP report. Any reports that fall outside of GAAP standards can be construed as non-GAAP financial reports.

Non-GAAP reports may also be referred to as adjusted earnings. When a public company lists a financial report for adjusted earnings, the report should provide an explanation of GAAP versus non-GAAP in order to be in compliance with SEC regulations.

While GAAP reporting guidelines are considered the industry standard, there is a place for non-GAAP financial reports. Non-GAAP reports have value in that they can be a way to reflect true expenses by providing a clearer picture of the day-to-day expenses and cash flow.

Non-GAAP reports have the benefit of being able to explain discrepancies and unusual circumstances. At times, companies may need to spend more money than other times. Companies may also consider restructuring things so that the company can grow. The process of restructuring may cost some money up front before it yields a larger return later on. In this case, the company would show a substantial drop in earnings for a time and then a period of strong growth. The GAAP financial report might show a more gradual increase in revenue.

In a perfect world, companies would be committed to accuracy on both GAAP and non-GAAP reports. The past has shown us that some companies have used non-GAAP reports to mislead investors. Companies have done this by making it appear as though they’ve met their revenue targets. Non-GAAP reports make it easier to reclassify ordinary operating expenses, reduce accruals, and mischaracterize line items.

Some companies are not at all suited for the data that GAAP requires. That means that the data is irrelevant and not meaningful. These are the situations that appropriately call for non-GAAP reports.

Alternative Accounting Measures

While there is currently no perfect solution to accounting reporting, Strategic Finance magazine describes the following alternative performance measures and descriptions that some companies use:

  • EBIT—earnings before interest and taxes.
  • EBITDA—earnings before interest, taxes, depreciation and amortization.
  • Adjusted EBITDA—EBITDA without including costs of stock-based compensation to employees or non-cash charges associated with past acquisitions.
  • Free cash flow—Cash flow from operations less required reinvestment in working capital and capital expenditures to preserve the firm’s earnings capacity.
  • Operating income—Earnings from core business activities less revenue and expense items deemed nonrecurring or from peripheral operations. Adjustments may include removing restructuring, impairment and intangible asset amortization charges. Some companies also exclude litigation costs and foreign currency translation charges.
  • Operating earnings per share (EPS)—Operating income divided by the time-weighted number of shares outstanding over an accounting period. Some managers argue this measure may give a better view of the “run rate” of current earnings. Skeptics counter that “bad stuff” that occurred in the past is likely to occur again.

Reconciling GAAP and Non-GAAP Financial Report

GAAP is the industry standard and it was designed as a means to provide a clear picture of how a business operates from a financial point of view. Non-GAAP reports deviate from the standard and make adjustments as needed to more accurately reflect information about the company’s operations.

Savvy investors have caught on to the fact that some companies have used non-GAAP reports to misrepresent the facts. The general consensus of investors is that they don’t favor non-GAAP reports unless a company expresses good reason for using them. Investors are aware of situations where companies have used non-GAAP reports as a shield to hide financial issues or to mislead people who read the financials. Some investors are aware that non-GAAP reports fit the circumstances for some companies better than GAAP reports.

Overall, GAAP is the most preferred accounting model because it provides a consistent set of guidelines that are used extensively in the business world. In certain situations, companies may have to include information in the GAAP report that isn’t at all relevant to its operations. Some companies may need to show GAAP versus non-GAAP financial reports to provide the full scope of their company’s financial landscape. For companies and investors, knowing the differences between GAAP and non-GAAP principles can help them choose the best option for sharing information.