GAAP and non-GAAP: everything you need to know
When you read the financial statements, you may see both GAAP and non-GAAP numbers. All public companies in the United States are required to use generally accepted accounting principles (GAAP). The financial statements created according to these principles are filed quarterly. Many companies choose to report their own non-GAAP financial statements as well.
what is the difference between both? Let’s go over GAAP vs. non-GAAP and what to do if a company reports both.
What is GAAP?
GAAP accounting standards are created and administered by the Financial Accounting Standards Board (FASB) and regulated by the United States Securities and Exchange Commission (SEC). The purpose of GAAP standards is to create a consistent way to measure the financial health of a business. The principles of GAAP dictate:
- How a business can account for income and expenses.
- What types of expenses should actually be capitalized as assets.
- How information is presented to shareholders in an audited report.
- What things should be disclosed in the notes to the financial statements.
While we focus on public companies in this article, private companies that have audited their financial statements also use GAAP.
GAAP is very useful for investors and auditors. These standards mean that you don’t have to learn a whole new accounting and reporting system for every business. While there are certainly some differences from industry to industry, you can expect financial statements from similar companies to be the same.
However, there are limits. In some cases, GAAP reports do not give investors a true picture of the current situation or the long-term prospects of a company. When this happens, the company may also choose to report non-GAAP results.
What is non-GAAP?
While GAAP accounting covers the entire accounting process, from paying an invoice to creating financial statements, non-GAAP accounting is an adjustment to already existing numbers. You probably don’t have to worry that a business using non-GAAP accounting has an entirely different set of books to produce its non-GAAP bottom line. You should be able to reconcile the company’s GAAP and non-GAAP numbers fairly easily.
While the FASB created and made changes to GAAP, there is no direct creator of non-GAAP standards. However, non-GAAP financial data is still governed by the SEC. In fact, the SEC has taken action in the past against companies it deems too aggressive with non-GAAP numbers.
That said, don’t rely on the SEC to do non-GAAP due diligence for you. Be vigilant in your analysis and move on if a company is too aggressive, even if the SEC hasn’t done anything about it.
One of the most common forms of non-GAAP measures in accounting is EBITDA, or earnings before interest, taxes, depreciation, and amortization. EBIDTA is reported by most companies in press releases and financial statements. It’s not a true GAAP figure for revenue, but it makes it a bit easier to compare revenue year over year and business to business.
When using EBITDA, you don’t have to worry about whether a company has taken on more debt, which reduces income with interest expense. You don’t have to adjust depreciation because the capital costs are significantly higher. It’s an easy calculation on the back of the envelope.
Of course, many non-GAAP (also called pro forma) income reports aren’t that easy. Companies will make all kinds of changes to the bottom line to look better.
They will add depreciation because it is not in cash. They’ll add restructuring costs and say it’s a one-time thing. Insurance companies will add catastrophic losses if they believe the losses are unlikely to recur. Some companies will even adjust the reported figures of a recently acquired company to subtract expenses that they believe will be reduced through “synergy.”
As an investor, all of this makes it difficult to trust non-GAAP numbers, and there is a long history of companies using non-GAAP to mislead investors. As long as the company also publishes GAAP financial data, it can say whatever it wants (as long as it’s not wrong, of course) with non-GAAP numbers.
For example, one-time costs suddenly become recurring costs. The expected synergies do not occur. And non-cash expenses exist in GAAP for a reason.
Why Do Businesses Use Non-GAAP?
There are companies that legitimately use non-GAAP. They really have one-time expenses or they have a business model that doesn’t lend itself to GAAP reporting. Let’s take an example to explain why a company would deviate from GAAP.
In its report on the results for the fourth quarter of 2020, United parcel service (NYSE: UPS) reported adjusted earnings per share (EPS) of $ 2.66 per share. This is a non-GAAP number; actual EPS was ($ 3.75) per share. Take a look at the graph in the Business Results report that shows the difference:
That’s quite a difference (over $ 6 billion), and you can see UPS is no stranger to adjustments as it also reported much higher non-GAAP EPS in 2019.
What’s the story here? For UPS, the biggest addition over the two years is the fees that GAAP requires it to charge against net income for shortages in its pension plan. The charges are so high that the company made a separate presentation about them after reporting profits.
The gist of the charge is that UPS did not properly estimate the demographics of its employees and used too high a discount rate when calculating the amount it needed in its pension plan to make face up to its obligations. He missed the mark a bit and had to take a total of $ 7.72 billion in charges in 2019 and 2020.
The good news for investors is that the company has stopped making new pensions for non-union employees and will no longer be making pensions for employees after January 1, 2023. As most companies did ago. decades, it will switch to a defined contribution plan. .
It’s obvious why UPS chooses to report non-GAAP EPS (remember the company just calls it adjusted). Retirement costs are part of doing business, but with the changes UPS has made to the program, management does not believe these costs will recur. This is where you come in as an investor.
How Should Investors Handle Non-GAAP?
No one ever said learning to invest was easy. It seems perfectly reasonable, as an investor, to believe management’s assertion that these pension costs are a single contract and do not reflect the reality of UPS’s business.
But what if the stock market collapses? Or what if former UPS employees live even longer and UPS has to pay even more fees? Remember, although this is a one-time expense, it is a legitimate expense.
The first thing to do is to reconcile the numbers. Make sure you understand exactly how the business adjusts its GAAP bottom line and why. If you don’t understand how the numbers are calculated or if you can’t add them up, you might want to skip.
Once you understand the numbers and management’s arguments for using them, decide if you are okay with the case. And, even if you do, think about what the future holds if it turns out management is overly optimistic.