Generally Accepted Accounting Principles (GAAP) are a set of standardized principles that U.S. listed companies must follow. Thorough investment research requires evaluation of GAAP and adjusted results (non-GAAP), but investors should carefully consider the effectiveness of non-GAAP exclusions on a case-by-case basis. The reason is to avoid misleading figures, especially if there are differences in reporting standards. Internationally, the accounting standard is the International Financial Reporting Standards (IFRS).
- GAAP regulates financial reports and provides a set of unified rules and formats to facilitate analysis by investors and creditors.
- In some cases, the GAAP report cannot accurately describe the company’s operations.
- Investors should observe and interpret non-GAAP data, but they must also recognize when GAAP data is more appropriate.
Generally Accepted Accounting Principles
GAAP was developed by the Financial Accounting Standards Board (FASB) to standardize financial reports and provide a uniform set of rules and formats to facilitate analysis by investors and creditors. GAAP has developed guidelines for project identification, measurement, presentation, and disclosure. Bringing uniformity and objectivity to accounting can increase the credibility and stability of a company’s financial reports. These factors are considered necessary for the best operation of the capital market.
Following standardized rules allows companies to compare with each other, and the results are verified by a reputable auditor, investors can rest assured that the report reflects the true status of the company. The establishment and adjustment of these principles is mainly to protect investors from misleading or suspicious reports.
In some cases, the GAAP report cannot accurately describe the company’s operations. Companies can display their own accounting data as long as they are disclosed as non-GAAP and provide reconciliation between adjusted and regular results. Non-GAAP data generally does not include irregular or non-cash expenses, such as expenses related to acquisitions, restructurings, or one-time balance sheet adjustments. This eliminates high-yield fluctuations that may be caused by temporary conditions, resulting in a clearer understanding of ongoing business.
Forward-looking statements are important because valuations are mainly based on expected cash flows. However, non-GAAP data are developed by the companies that use them, so they may be subject to inconsistent incentives from shareholders and company management.
Universality of non-GAAP use
Investors should observe and interpret non-GAAP data, but they must also recognize when GAAP data is more appropriate. As these numbers differ from GAAP, successfully identifying misleading or incomplete non-GAAP results becomes more important.
Research has shown that adjusted data is more likely to make up for losses than gains, which shows that the management team is willing to forgo consistency in order to foster investor optimism.
In the third quarter of 2019, 67% of companies in the Dow Jones Industrial Average (DJIA) reported non-GAAP earnings per share (EPS). 14 of these 20 companies (70%) reported higher non-GAAP earnings per share than GAAP earnings per share. In terms of net income, non-GAAP use increased by 33% from 1998 to 2017, and 97% of S&P 500 companies used non-GAAP adjustments in 2017, up from 59% in 1996.
Technology companies have always been large users of non-GAAP adjustments because, due to the nature of their business, these companies generally do not report high net income using GAAP. Some companies, such as Uber (UBER), eliminate the recurring costs of growth in a competitive market. This approach makes it difficult to value listed companies.
GAAP and non-GAAP results are important in many situations, and research from academic and professional sources supports this position. Investors who are forced to choose one side due to differences between the two should consider specific exclusions in the adjusted figures.
Companies that continue to acquire small companies and intend to maintain this acquisition strategy usually exclude certain acquisition-related costs. These costs are still significant ongoing expenses of the business but should not be ignored.
Research has shown that excluding stock-based compensation from earnings results reduces the predictive power of analysts’ forecasts, so non-GAAP data adjusted only for equity compensation is unlikely to provide actionable data.
However, the non-GAAP results from responsible companies provide investors with unparalleled insight into the methods the management team uses when analyzing their company and planning future operations.