GAAP vs. Non-GAAP

The generally accepted accounting principles (GAAP) are 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 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.1 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. 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.

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.

In the fourth quarter of 2020, 77 per of the companies in the Dow Jones Industrial Average (DJIA) reported non-GAAP earnings per share (EPS). Seventeen out of these 23 companies (74%) reported non-GAAP EPS that was higher than GAAP EPS.

According to research conducted by Harvard accounting professors and MIT's School of Management, non-GAAP adjustments to net income increased by 33% from 1998 to 2017. Of the companies in the S&P 500, 97% used non-GAAP adjustments in 2017, a 38% increase from 1996. They concluded that as this trend continues, analysts and investors may find it more difficult to adequately forecast future performance.

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