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GAAP requires companies to deduct non-cash expenses – the value of stock options granted to key employees is probably the most common example – to determine profits. Exhibit 3summarizes the reporting behavior of the S&P 100 companies over the period of study. One immediate observation is that the percentage of companies disclosing non-GAAP earnings appears to increase substantially from 2010 to 2011 and again from 2011 to 2012, and then levels off. This pattern appears meaningful in light of the 2010 change in Regulations G and S-K.
The financial measure calculated under GAAP that is most directly comparable to adjusted EBITDA is net income. When analyzing the company’s performance, it is important to note that our calculation of EBITDA may differ from other similar companies. Therefore, it is important to evaluate each adjustment in the reconciliation table and use the adjusted measure in addition to, and not as an alternative to, the GAAP measure. In our previous HBR articles, we claimed that financial statements are becoming less and less useful for assessing a firm’s performance.
Magnitude and Frequency of Non-GAAP Adjustments
This information can be helpful to investors in predicting future cash flows and valuing companies. However, in order for these non-GAAP financial measures or KPIs to be useful, they should be accompanied by disclosures that are transparent and explain the consistency and comparability of the measures.
Successful identification of misleading or incomplete non-GAAP results what is gaap becomes more important as those numbers diverge from GAAP.
Reconciling GAAP and Non-GAAP Financial Report
The building blocks for a modern company are investments in research and development (R&D), branding, customer relationships, computerized data and software, and human capital. The economic purpose of these intangible investments is no different from that of an industrial company’s factories and buildings. Yet these intangible investments are treated as expenses in calculation of profits, and not as assets. The more a company invests in improving its future profits by making knowledge investments, the higher its reported losses. The bottom-line number thus becomes an inaccurate indicator for future profitability. So, many firms present a non-GAAP number by adding back intangible expenses.
- Any reports that fall outside of GAAP standards can be construed as non-GAAP financial reports.
- KPIs also should be calculated consistently period over period to allow investors to assess the company’s performance in a consistent manner.
- IBM reports the same two adjustments each year throughout our period of study; HPE reports many more adjustments, some consistent with prior years and others for the first time.
- Due to this, it is hard to compare financial results across industries and companies.
- The use of non-GAAP earnings for S&P 500 companies has increased from 59% in 1996 to 97% in 2017.
One reason for such a change is if a securities regulator objects to a particular aspect of a non-GAAP measure. This happened to MicroStrategy, a US enterprise analytics and business intelligence company that is also well known as a significant investor in cryptocurrency. The SEC has instructed the company to remove an adjustment for Bitcoin impairments from its non-GAAP measures of operating profit, earnings and EPS. In addition, investors pay close attention to non-GAAP earnings, as it provides insight into how management believes its core operations are performing. A company may include significant non-recurring costs in every filing, which can suggest the company is attempting to inflate its non-GAAP earnings. Non-GAAP financial measures and metrics are used commonly by both existing registrants and companies seeking to gain access to the US capital markets through an initial public offering. The C&DIs also indicate that SEC staff will focus on the substance of a non-GAAP per-share measure rather than on management’s characterization of it as a performance measure (i.e., whether a per-share measure is a performance measure or liquidity measure).
GAAP vs Non-GAAP – All You Need To Know
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. 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. Knowing the difference between the two types of accounting can help prevent investors from becoming victims of misleading figures. Effective controls and procedures are important when disclosing material key performance indicators. 64 firms actually reported non-GAAP income lower than GAAP income, on average about $834.9 million lower. 196 firms reported non-GAAP net income higher than GAAP income, on average about $675.3 million higher.
You should, for example, reconcile non-GAAP measures to comparable GAAP measures and explain why someone might find the non-GAAP measures insightful. To help stakeholders analyze financial results over time, also be sure to present non-GAAP measures consistently. Arguably, companies using non-GAAP principles add a degree of variability and subjectivity to financial filings and disclosures.