GAAP vs. Non-GAAP: What’s the Difference?

GAAP is the U.S. financial reporting standard

financial reporting standard
International Financial Reporting Standards (IFRS) are a set of accounting rules for the financial statements of public companies that are intended to make them consistent, transparent, and easily comparable around the world. IFRS currently has complete profiles for 166 jurisdictions.

for public companies, whereas non-GAAP is not. Unlike GAAP, non-GAAP figures do not include non-recurring or non-cash expenses. Also, because there are no standards under non-GAAP, companies may use different methods for financial reporting.

Non-GAAP measures, which are not subject to generally accepted accounting principles and must be compared to more recognizable GAAP measures, are being reported by more and more businesses. Non-GAAP measures are supported as better performance indicators, while detractors claim they obscure issues and make comparisons more difficult. The authors examined a wide range of non-GAAP measures and discovered that while these reports did offer some insightful information about the businesses that used them, they did so at the expense of clarity and transparency.

The most directly comparable GAAP measure included in the audited financial statements is adjusted using a non-GAAP financial measure by excluding items the company feels are not reliable indicators of its performance. One such measure is non-GAAP earnings. This measure’s calculation is highly arbitrary and not industry- or entity-specific. Non-GAAP earnings are not required to be disclosed, and they are not audited. The first SEC regulation pertaining to this disclosure, titled “Conditions for Use of Non-GAAP Financial Measures,” was published in 2003. The SEC’s “Non-GAAP Financial Measures Compliance and Disclosure Interpretations” updated the original rule in 2010 and 2016 Regarding how non-GAAP earnings should be reported and presented, this guidance has provided varying degrees of rigor.

Regulators, practitioners, and investors are faced with a dilemma. If the latter, how does a corporate preparer fairly present non-GAAP earnings? Does the reporting of non-GAAP financial measures enhance or detract from investors’ database of information used to make portfolio decisions? Should the SEC enforce tighter regulation over non-GAAP financial measures, or should companies be permitted to report these performance measures as they deem appropriate?

SEC Chairman Jay Clayton spoke at the AICPA Conference on Recent SEC and PCAOB Developments in December 2018. He advised that key performance indicators (KPI) and non-GAAP numbers be reported with the same consistency that GAAP numbers are expected to be reported with. When non-GAAP numbers and KPIs change in terms of how they are calculated, it can aggravate investors, as we are aware of. As businesses disclose non-GAAP financial measures more frequently, concerns about their reporting, particularly non-GAAP earnings, have drawn attention. This increase was particularly notable after the SEC relaxed its non-GAAP earnings disclosure rules in 2010. In 2016, the SEC issued an updated interpretation that tightened the rules on non-GAAP reporting.

The 2016 disclosures of IBM and HPE are shown in Exhibit 1 as an illustration of the wide variations in the ways that companies report non-GAAP earnings. The two disclosures’ presentation and methods for calculating non-GAAP earnings are very different. Unlike HPE, which only makes adjustments to the bottom line total, IBM presents the non-GAAP counterpart for each line of the income statement. Over the course of our research period, IBM consistently reports two adjustments; HPE consistently reports many more adjustments, some of which are new. An investor’s ability to compare one company to another is severely hampered by the absence of standards and the resulting disparities in reporting. As a result, the consistency and comparability that ought to serve as the foundation for financial reporting are jeopardized.

When the SEC released its guidance in 2003, it adopted Regulation G, which required public companies to provide a quantitative reconciliation of the differences between the non-GAAP financial measure presented and the most directly comparable GAAP financial measure whenever they disclose a non-GAAP financial measure. Public companies are prohibited from “adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent, or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur within two years, or there was a similar charge or gain within the prior two years,” according to a crucial clause. Additionally, the SEC amended Item 10 of Regulations S-K, S-B, and Form 20-F to offer public companies that report non-GAAP financial measures in their SEC filings additional guidance.

The Division of Corporation Finance of the Securities and Exchange Commission (SEC) moderated its Compliance and Disclosure Interpretations (C&DI) regarding non-GAAP financial measures in 2010. Due to the initial stricter guidance, the SEC was concerned that companies were not providing investors with meaningful information. The original rule, in particular, made it challenging for a business to explain and defend the disclosure of a non-GAAP financial measure that doesn’t include a recurring item. The modified C&DIs specifically stated, “A registrant may adjust for a charge or gain even though the registrant cannot describe the charge or gain as non-recurring, infrequent, or unusual.” Subject to Regulation G and other requirements of Item 10(e) of Regulation S-K, Registrants may make changes they deem necessary. ”.

The SEC revisited the guidance in subsequent years due to growing concerns regarding the inconsistent nature, lack of comparability, and potential misleading effects of non-GAAP measures. Non-GAAP measures are widely used and, in some cases, may be a source of confusion, according to former SEC Chair Mary Jo White, who addressed the subject in her keynote address to the AICPA National Conference in December 2015. ”.

The SEC released new C&DIs and amended others in May 2016, demonstrating its discomfort with the disclosure of non-GAAP financial measures and the kinds of adjustments made to GAAP measures. In particular, “a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Regulation G,” and “A non-GAAP measure that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior period,” were stated in these provisions, which reaffirmed the 2003 regulation and further specified reporting practices that could violate Regulation G. ”.

Wesley Bricker, the chief accountant for the SEC, spoke at the 2018 Baruch College Financial Reporting Conference in April 2018, and it was clear that there was still concern about the reporting of non-GAAP financial measures. According to Bricker, SEC regulations mandate that companies have disclosure controls and procedures, which typically include appropriate governance practices for the measures and policies and controls that prevent error, manipulation, or mischief with the numbers, as well as a policy that addresses how any changes in the non-GAAP measure will be reported and how corrections of errors will be evaluated.

Companies that disclose a non-GAAP earnings measure are considered non-GAAP reporting companies for the purposes of this article. Public companies report a number of additional non-GAAP financial measures in their earnings releases; some companies report these measures only, while others report additional non-GAAP financial measures in addition to non-GAAP earnings. Free cash flow, net debt, constant currency, tangible common equity, net interest, organic sales growth, and a number of financial ratios are some of the additional non-GAAP financial measures.

The authors noted a wide range of terminology used by companies to describe their non-GAAP earnings measure throughout the study. (Exhibit 2 provides a list of some of the most typical terms.) Analysis of non-GAAP earnings across companies and years is difficult due to the varying styles, calculations, and terminology, which also hinder comparability and consistency of the disclosures.

The S&P 100 companies’ reporting behavior over the study period is summarized in Exhibit 3 One immediate finding is that the proportion of businesses disclosing non-GAAP earnings seems to have increased significantly between 2010 and 2011 and again between 2011 and 2012 before leveling off. In light of the modification to Regulations G and S-K made in 2010, this pattern seems significant. Additionally, from 2010 to 2011, and then again from 2011 to 2012, there is a decline in the number of companies disclosing non-GAAP measures other than annual earnings. After that, the numbers level off until returning to the 2011 level in 2016. This might be because non-GAAP earnings are now reported as the main non-GAAP financial measure rather than non-GAAP financial measures other than earnings.

Exhibit 4 compares companies that only reported GAAP earnings to those that reported non-GAAP earnings in one or more years, showing the median sales, total assets, and market capitalization for each group. The median sales, assets, and market caps of GAAP-only reporters were almost always higher than those of non-GAAP reporters. Maybe bigger businesses are generally less significantly impacted by nonrecurring or infrequent items, which makes them less likely to disclose non-GAAP earnings.

GAAP vs non-GAAP

What is non-GAAP?

Both private and public companies may use non-GAAP accounting measures, though the latter must also adhere to GAAP accounting principles. A company must disclose when it uses non-GAAP reports. These kinds of details must be noted if you want others to fully comprehend how your business operates.

Non-GAAP can provide more details on any differences, inconsistencies, and situations that are not typically found in a GAAP report. Items like unusual expenses or non-cash costs, such as those incurred when a company undergoes restructuring or acquires another business, may be included in or excluded from non-GAAP reports. They could also indicate when a business makes a specific adjustment to its balance sheet.

What is GAAP?

Every publicly traded company must use GAAP for accounting, which includes submitting reports using GAAP practices. Although they have the option to use their own procedures in addition to GAAP,

Private companies do not have to use GAAP. But many private businesses prefer to use GAAP because it offers a standardized way of recording financial information. The use of GAAP by private companies may also be advantageous if they intend to go public in the future.

Companies that comply with GAAP use accounting principles like expense matching, accrual accounting measures, and revenue recognition that the majority of people are familiar with. Companies can compare themselves to one another thanks to GAAP’s standardized rules, and investors can view reports with confidence that they are truthful and accurate.

GAAP vs. non-GAAP

Understanding the distinctions between GAAP and non-GAAP is crucial if you want to start your own accounting business. The two accounting measures are different from one another in the following ways:

Companies frequently complete and provide both GAAP and non-GAAP reports so creditors and investors have a clear picture of a company’s financial health before lending money or approving lines of credit. When a company uses both types of accounting reports, it should think about outlining both its GAAP and non-GAAP procedures to ensure that it complies with SEC rules.

Other accounting measures

Companies may choose to use additional or alternative accounting measures in addition to or in place of GAAP or non-GAAP practices. Other accounting measures include:

This metric may be used by an organization to better understand its operating performance, and it is frequently used in place of cash flow. Operating income and EBITDA are similar, but operating expenses are not taken into account in EBITDA. Instead, it enables a business to assess its performance without being influenced by the way the company is set up.

This accounting metric is the same as EBITDA less the cost of stock-based compensation paid to employees and any charges resulting from prior acquisitions the business has made.

Free cash flow is exactly what it sounds like; it refers to the funds available to a business to pay obligations such as debt to creditors, dividends, and interest to stakeholders and investors. Since non-cash items are not included in FCF reports, you can accurately determine how profitable the company is.

If stakeholders want to know how profitable the company is, a company may use the EPS accounting measure. EPS is determined by dividing the net profit of the company by the number of shares distributed to shareholders and employees. An EPS figure is helpful when appealing to investors. Investors should pay more for shares of a company with a higher EPS because it signifies the company’s value.

FAQ

What is a non-GAAP?

Non-GAAP earnings are a different way to calculate a company’s profits. In addition to their earnings determined using generally accepted accounting principles (GAAP; see US GAAP (Generally Accepted Accounting Principles)), many businesses also report non-GAAP earnings.

What is GAAP and non-GAAP measures?

Most public companies and corporations report their financial information in accordance with a set of guidelines known as generally accepted accounting principles (GAAP). Non-GAAP is an alternative method for calculating a company’s profits.

What is GAAP to non-GAAP reconciliation?

The United States Securities and Exchange Commission mandates that publicly traded companies, like Energen Corporation (the Company), reconcile related GAAP financial measures to non-GAAP financial measures. After-tax Cash Flows is a Non-GAAP financial measure.

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