What is GAAP?

If accounting is the language of business, as we often teach, it is essential to understand its high-level concepts.

Yet, when listening to insiders or stock market veterans, they often throw around the industry’s jargon and alphabet soup acronyms without explaining what each means.

In today’s lesson, we will tackle one of accounting’s most confusing terms, which is crucial to understand when going through a company’s financial statements: GAAP, which stands for generally accepted accounting principles.

GAAP accounting is a commonly accepted set of rules and procedures designed to govern corporate accounting and financial reporting within the United States.

GAAP rules were jointly established by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB).

This means that GAAP rules are applied to profitable corporations (overseen by the FASB) and government and non-profit organizations (regulated by the GASB).

What are non-GAAP accounting practices?

This raises an important question: Why do companies report non-GAAP results if GAAP rules are for corporations?

Non-GAAP refers to accounting practices that do not comply with the GAAP standards. As a result, these metrics aren’t audited and don’t have a standardized reporting format.

Many companies report non-GAAP results to shareholders (in addition to their GAAP results) to add important color and nuance to their numbers that the GAAP standard misses.

However, it’s important to note that non-GAAP numbers can also disguise weaknesses in a company’s results.

Therefore, a discerning investor must carefully comb through the numbers, comparing the GAAP with the non-GAAP results to see an accurate picture of companies’ finances.

Differences between GAAP and non-GAAP accounting

Let’s start by looking at stock-based compensation. Using the GAAP standard, stock-based compensation (SBC) should be counted as an expense, decreasing a company’s net income. SBC is often excluded on a non-GAAP basis, boosting a company’s bottom line.

SBC is a way of paying executives and employees with stock instead of cash. In theory, this aligns employee incentives with shareholders, as workers will be rewarded based on company performance.

From a business standpoint, one of the most significant advantages of using SBC is that it does not consume cash. When stock options are given to employees, the company doesn't pay anything, even when the employees “cash in” the shares. Because of this, SBC is referred to as a non-cash expense.

Under the GAAP standard, SBC is expensed in two places on the income statement:

1. Cost of goods sold (COGS), when it’s given to workers who created the product or service.
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2. Operating expenses, when it’s paid to executives, managers, sales, and other employees.

By reporting non-GAAP results, companies can remove SBC expenses from these two lines, making profits look better.

A second common non-GAAP category is non-recurring charges. Generally, expenses need to be reported in the period they occur, even non-recurring ones. Sometimes, management will back out expenses that are one-time in nature when reporting non-GAAP results. These can include a wide range of things, from fines and acquisitions to corporate restructuring costs and severance pay.

Early debt payments are an example of non-recurring charges. Paying off debt early is a net positive for the company. But using the GAAP standard, the money used to pay off the debt early is subtracted from its net income. Using non-GAAP practices, not all losses must be subtracted from a business’s bottom line (making non-GAAP earnings look better).

Moving on to the third major category, management often considers non-GAAP: Unrealized gains and losses.

This line item is highlighted when some companies’ stakes in other companies show a market gain or loss during a quarter.

Take the case of electric vehicle maker Rivian Automotive. When the company went public in late 2021, it was revealed that Amazon was its largest shareholder. Even though Amazon might not have any plans to sell its stake in Rivian, it still must report any gains or losses of its Rivian stock on its income statement.

Since unrealized gains or losses are non-operating, many companies exclude them when reporting non-GAAP results.

Lastly, EBITDA is probably the most popular non-GAAP metric that companies report. The acronym stands for earnings before interest, taxes, depreciation, and amortization.

The cable industry pioneer John Malone developed the metric in the 1970s to sell investors on his company’s true profitability, which he believed was not accomplished by GAAP figures such as earnings per share.

In addition to interest payments and taxes, the metric backs out depreciation, the reduction in the value of physical assets that occurs over time, and amortization, the lowering of the book value of intangible assets.

Key Takeaway

Understanding the nuances of GAAP and non-GAAP accounting is essential for anyone looking to navigate the complexities of financial statements.

While GAAP provides a standardized framework for reporting, non-GAAP metrics can offer valuable insights into a company's performance by highlighting factors that GAAP may overlook. However, investors must remain vigilant and discerning, as these non-GAAP figures can also mask underlying weaknesses.

By critically analyzing both GAAP and non-GAAP results, investors can gain a more comprehensive view of a company’s financial health and make informed decisions.