The Difference Between GAAP And Non-GAAP Accounting
GAAP is the acronym for generally accepted accounting principles. These provide a regulatory framework for analysts and financial speculators to assess a company’s value.
Non-GAAP accounting refers to the practice of adjusting results. GAAP and Non-GAAP accounting can have massive implications for both corporate management and shareholders.
It’s customary for businesses and investors to understand what is GAAP revenue and non-GAAP reporting.
Knowing the difference between the two types of accounting can help prevent investors from becoming victims of misleading figures.
GAAP is a standardized set of principles that takes the international financial reporting standard (IFRS) as its regulatory framework. The Financial Accounting Standards Board (FARB) designed these principles to bring uniformity and standardization to the practice of accounting. Abiding by GAAP aids financial specialists and creditors in accurately estimating a company’s value.
GAAP’s guidelines include standard practices in the recognition, measurement, presentation, and disclosure of items and finances. For the capital market to function smoothly, businesses must remain objective. Additionally, the businesses must conform to an international standard of accounting.
A greater percentage of reported GAAP earnings will automatically bring credibility to corporate financial reporting. This attracts better investment, improves business value, and brings long-term stability.
The need for a standardized set of accounting principles is necessary to make a fair comparison between companies and their financial standings. When all companies abide by a fixed formula, it becomes easier for reputable auditors to weigh the pros and cons of possible investments.
Investors need to be ensured of a company’s true standings so they can make educated decisions and prevent fatal financial errors. The GAAP revenue is an objective estimate that enables investors to draw an accurate projection for the future.
Incorporation and adaptation of GAAP earnings are largely mandated for the prevention of dubious and fraudulent reporting practices.
Company valuations are contingent on the financial statements that lend important insights into the current and projected cash-flows. There are times, however, when GAAP numbers fall short of accurately capturing the true costs of business operations. In such a situation, companies can generate accounting figures as determined by their own set of accounting rules. The practice is granted so long as the earnings are disclosed as Non-GAAP and lead to a reconciliation between the regular and adjusted results.
Adjusted results help to more accurately portray the operations and value of an ongoing business.
Non-GAAP earnings are intended to smooth out short-term business volatility by excluding non-cash or irregular business expenditures. This usually includes expenses that are associated with one-time balance adjustments, restructuring, or acquisitions.
However, it’s a common practice among small businesses that sustain the acquisition strategy to rule out acquisition costs while reporting accounts. For such businesses, these costs are an ongoing expense. Ruling these out wouldn’ paint an accurate picture of business’ financial standings.
Since investors need honest numbers in order to gauge an accurate business appraisal, companies must define all of the included costs.
The Pervasiveness Of Using Non-GAAP
Various studies have revealed that companies incorporate non-GAAP earnings to increase investor optimism. The adjusted results in such instances underrate the company losses instead of gains. There are certain metrics that must be used when making important investment decisions. First, observe and interpret the implications of non-GAAP figures. Next, determine if the inclusion of non-GAAP figures was redundant. Moreover, check if it could be replaced by a GAAP revenue statement for a more accurate estimation.
The inclusion of non-GAAP earnings has become more common in the last couple of years. Last year alone, 67% of the companies in the Dow Jones Industrial Average included non-GAAP earnings per share (EPS) in their reports. The non-GAAP EPS was seen as higher than the GAAP EPS for fourteen out of the 20 companies listed on the Dow Jones.
The use of non-GAAP earnings for S&P 500 companies has increased from 59% in 1996 to 97% in 2017. Technology companies generally report higher non-GAAP earnings. The increased use of such adjustment is due to the inherent inability of businesses to report high net income while relying solely on GAAP earnings.
GAAP accounting was invented to make valuation comparisons fairer. It facilitates analysts and investors in the process of decision making.
Certain business conditions make it imperative to incorporate adjusted or non-GAAP earnings. The practice is granted so long as the figures are disclosed as non-GAAP.
Investors must be wary of overindulgence in non-GAAP revenue reporting since businesses are seen as leveraging these to understate losses and attract investment.