A company owned by more than one person whether a publicly traded company or a privately held company, a business looking for funding or even a charitable organization are all required to report quarterly or annual financial statements that accurately represent their performance.
Financial statements reflect the financial situation of a business or organization at a specific time. These provide essential information regarding investments, credit decisions, and cash flow assessment to various interested parties including present and potential investors and creditors. The primary focus of financial reports is a company’s earnings as well as its current and continuing ability to generate earnings.
Difference between GAAP and non-GAAP
Companies in the US must follow the Generally Accepted Accounting Principles (GAAP) to make sure that they measure and disclose financial information in an accurate, consistent, fair and honest manner. GAAP is a set of accounting principles, procedures, standards and rules for financial reporting that are commonly followed by companies.
GAAP is created by the Financial Accounting Standards Board (FASB), a private non-profit organization designated to establish financial accounting and reporting standards.
Financial reporting under GAAP is based on several accounting principles like accrual accounting, revenue recognition and expense matching. In the accrual basis of accounting, revenues and expenses are recorded when they are incurred rather than when cash transactions occurred.
However, some believe that earnings reported based on GAAP do not fully reflect the performance of a company’s underlying operations. That is why some companies supplement their financial reports with non-GAAP (also called pro forma) earnings which, they believe, provide a more accurate picture of a company’s financial performance.
Non-GAAP earnings include operating earnings, cash earnings, adjusted earnings, as well as earnings before interest and taxes (EBIT), and earnings before interest, taxes, depreciation and amortization (EBITDA).
Risk and benefits of non-GAAP reporting
Over the years, the use of non-GAAP measures has become more liberal and more companies are using it in addition to their GAAP-based financial reports. This sharp rise in the number of companies reporting non-GAAP measures has resulted in a close scrutiny by the SEC.
Critics of the non-GAAP measure argue that the reporting of non-GAAP earnings per share (EPS) may be abused by companies and result in fraudulent reports that are aimed to increase profit margin figures or meet earnings targets.
According to a study of the 30 companies in the Dow Jones Industrial Average (DJIA), 20 companies reported non-GAAP EPS in addition to the GAAP EPS for the fiscal year 2015. Eighteen out these 20 companies showed a higher non-GAAP EPS that, on average, exceeded GAAP EPS by 30.7%, up from 11.8% in FY 2014.
This wider gap between the non-GAAP EPS and GAAP EPS resulted in the companies reporting a smaller year-over-year decline based on the non-GAAP EPS than on a GAAP EPS. In FY 2015, the 20 companies reported an average year-over-year decline in non-GAAP EPS of -4.8% and an average year-over-year decline of -12.3% in GAAP EPS.
Skeptics are also wary of companies that may provide prohibited or inappropriately labeled, defined, and described non-GAAP measures that may mislead the users of the financial information.
Despite its risks, supporters of the non-GAAP measure stand by the benefits that the additional information non-GAAP earnings present to investors and other financial information users. These non-GAAP measures provide a more complete and accurate picture of the financial performance of a company which helps investors compare companies easily.
According to Marc Siegel, board member at the Financial Accounting Standards Board (FASB), the key to optimizing the use of non-GAAP measures is for investors and regulators to focus on the overall narrative that the non-GAAP earnings are telling about the company, and make sure that it is similar to the narrative being told by the GAAP-based financial statements.
If reported correctly, Siegel said that these non-GAAP metrics can provide “context and color” to “audited financial statements”. Non-GAAP offers an opportunity for companies to show another side of their financial story that GAAP doesn’t tell.
Nielsen, a consumer research company, is among those that set the example in using non-GAAP measures by clearly identifying which non-GAAP metrics they use, how they are calculated, and why they are included.
For companies and accounting teams who choose to report non-GAAP earnings in addition to their GAAP earnings, they should make sure to present non-GAAP metrics in a clear and complete manner that compliments the GAAP measures and adds value to whole financial performance company. Companies reporting non-GAAP metrics are also required by the US Securities and Exchange Commission (SEC) to reconcile it with the GAAP financial measure that is closest or most comparable to the non-GAAP measure issued.
Whether a company chooses to include non-GAAP earnings in its financial report or not, the most important thing to take note of is the accuracy and transparency in how the company presents its financial statement.
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