The generally accepted accounting principles (GAAP) is the standardized set of principles that public companies in the U.S. must follow. Thorough investment research requires an assessment of both GAAP and adjusted results (non-GAAP), but investors should carefully consider the validity of non-GAAP exclusions on a case-by-case basis. The reason is to avoid misleading figures, especially as reporting standards diverge. Internationally, the accounting standard is the international financial reporting standards (IFRS).
- GAAP standardizes financial reporting and provides a uniform set of rules and formats to facilitate analysis by investors and creditors.
- There are instances in which GAAP reporting fails to accurately portray the operations of a business.
- Investors should observe and interpret non-GAAP figures, but they must also recognize instances in which GAAP figures are more appropriate.
GAAP was developed by the Financial Accounting Standards Board (FASB) to standardize financial reporting and provide a uniform set of rules and formats to facilitate analysis by investors and creditors. The GAAP created guidelines for item recognition, measurement, presentation, and disclosure. Bringing uniformity and objectivity to accounting improves the credibility and stability of corporate financial reporting, factors that are deemed necessary for capital markets to function optimally.
Following standardized rules allows for companies to be compared against one another, results to be verified by reputable auditors, and investors to be assured that the reports are reflective of a company's true standing. These principles were established and adapted largely to protect investors from misleading or dubious reporting.
There are instances in which GAAP reporting fails to accurately portray the operations of a business. Companies are allowed to display their own accounting figures, as long as they are disclosed as non-GAAP and provide a reconciliation between the adjusted and regular results. Non-GAAP figures usually exclude irregular or non-cash expenses, such as those related to acquisitions, restructuring, or one-time balance sheet adjustments. This smooths out high earnings volatility that can result from temporary conditions, providing a clearer picture of the ongoing business.
Forward-looking statements are important because valuations are largely based on anticipated cash flows. However, non-GAAP figures are developed by the company employing them, so they may be subject to situations in which the incentives of shareholders and corporate management are not aligned.
Prevalence of Non-GAAP Use
Investors should observe and interpret non-GAAP figures, but they must also recognize instances in which GAAP figures are more appropriate. Successful identification of misleading or incomplete non-GAAP results becomes more important as those numbers diverge from GAAP.
Studies have shown that adjusted figures are more likely to back out losses than gains, suggesting that management teams are willing to abandon consistency to foster investor optimism.
In Q3 2019, 67% of the companies in the Dow Jones Industrial Average (DJIA) reported non-GAAP earnings per share (EPS). 14 out of these 20 companies (70%) reported non-GAAP EPS that was higher than GAAP EPS. Regarding net income, non-GAAP use has increased 33% from 1998 to 2017 and 97% of the companies in the S&P 500 used non-GAAP adjustments in 2017, up from 59% in 1996.
Technology companies have been large users of non-GAAP adjustments as these companies typically don't report high net income from the use of GAAP, due to the nature of their businesses. Some companies, such as UBER (UBER), remove recurring costs that are needed to grow in markets that are competitive. This practice makes it difficult to value public companies with one another.
The Bottom Line
GAAP and non-GAAP results are both important in many cases, and studies by academic and professional sources support this stance. Investors forced to choose a side as the two diverge should consider the specific exclusions in adjusted figures.
Companies that consistently purchase smaller firms and intend to sustain this acquisitive strategy often exclude certain acquisition-related costs that remain a material ongoing expense to the business, but should not be overlooked.
Studies have suggested that the exclusion of stock-based compensation from earnings results reduces the predictive power of analyst forecasts, so non-GAAP figures that merely adjust for equity compensation are less likely to provide actionable data.
However, non-GAAP results from responsible firms grant investors unparalleled insight into the methodology employed by management teams as they analyze their own companies and plan future operations.