GAAP versus Non-GAAP: Which is Closer to Reality?
In the United States, Generally Accepted Accounting Principles (GAAP) set the standard for how public companies report earnings. However, for many investors and other observers, this strict set of rules aren’t always the best measurement of performance, especially in newer industries like technology.
Many companies are now also publishing other measures of their financial performance, under the general heading of non-GAAP reports. A recent article on an investor website stated that Facebook’s net income over two years was $1.9 billion. Using the company’s non-GAAP measures, that figure doubled to $3.9 billion. So which measure is more accurate? Or more useful?
The Logic Behind GAAP
One of the fundamental ideas behind GAAP is that it makes it easy for investors to compare companies. GAAP standardizes things. The GAAP principles set out clear rules for how companies should state their accounts, including when to recognize revenue and how to value assets and liabilities on a balance sheet.
Is Non-GAAP Looking at the Accounts Through Rose-Colored Glasses?
Some of the key differences between GAAP and non-GAAP accounting include items like expensing of options and stock grants made to employees, and the amortization of intangible assets acquired through acquisition, which are included in GAAP financials but removed from non-GAAP financials. In general, these are non-cash activities, so investors often favor looking at the non-GAAP measures, on the argument that they provide a more accurate picture of the underlying profitability of the business.
Some observers argue that non-GAAP measures provide too much leeway for companies to present their financials in an excessively positive light. For example, restricted stock grants (RSUs) will predictably get awarded to employees every year and are part of the compensation package by which a company like Facebook woos and rewards its employees and some experts argue this is a compensation expense just like salary. The SEC reportedly set up a committee to look at non-GAAP measures last December, so there’s a chance that new, stricter, regulations could emerge.
A further complication is that even if non-GAAP measures make sense, and provide useful and additional information when read alongside the GAAP measures that are required, media reports and even analyst reports sometimes mix it all up into a soup that can mislead many investors. A good example of this is this article reporting on Tesla, where the story seems to confuse reported revenue with reported deferred revenue. According to the article, Tesla is reporting future lease revenue as deferred revenue. Analysts put their own spin on these figures, and the press then adds to the complexity with its own interpretation.
Of course, investors love Tesla. Its stock is one of the highest-valued in the U.S. Who wouldn’t want to follow their example? But today’s hero can be tomorrow’s sap, so the wary CFO has to tread carefully. This is an area where a CFO needs to keep an eye not only on the entire landscape, from the high-flyers to the traditional performers, and the regulatory bodies, as he makes his or her decisions on what and how to report performance.