GAAP Vs Non-GAAP measures for CEO's & Entrepreneurs in a nutshell

Haim Ratzabi
Oct 16, 2022
4 min read

If you are a CEO or entrepreneur and you have tried to understand your competitors you have probably tried to go over some of their financial statements. If those companies are US GAAP (Generally Accepted Accounting Principles) reporting companies, you have probably noticed the lines of the Non-GAAP measures in their financial statements.

WHAT IS NON-GAAP?

There is no specific definition of non-GAAP. It generally refers to any accounting method that is not GAAP, meaning free of charge measures (information) that provide information for investors about the Company.

There are several ways that companies call to their Non-Gaap measurements using the "Adjusted" and "Excluding" terminology, such as: "adjusted Gross Profit", "adjusted EBITDA", "adjusted Net Earnings", "adjusted Earning per share", "Operating profit excluding special Items", "Net income excluding non-recurring items" and so on.

Some companies called the non-GAAP Information "core profitability", "normalized profitability", "underlying profitability", or "proforma" measures.

Companies must offer reconciliation between the adjusted and regular results, explain the difference between GAAP vs non-GAAP figures.

WHY COMPANIES USE NON-GAAP?

In addition to GAAP, most public companies also report their regular quarterly financial numbers in the non-GAAP format as well. They primarily do this to provide cash flow information in a better way or give a better understanding of their financial results to the investors. For instance, some companies prefer non-GAAP reporting to show the profitability and cash flow after excluding some large ticket expenses.

Non-GAAP reporting has a significant place because, on certain occasions, GAAP reporting fails to give a clear picture of the operations of a business. For instance, non-GAAP figures do not include irregular and non-cash expenses. These expenses could relate to one-time balance sheet adjustments, acquisitions, restructuring, and so on. Excluding such non-recurring expenses smoothens the extremely high and trough in the earnings. And, this gives a better understanding of the business.

COMMONLY USED NON-GAAP MEASURES

EBIT - Earnings before interest and tax.

EBITDA - Earnings before interest, tax depreciation, and amortization.

Adjusted EBITDA - it is EBITDA without including the cost of stock-based compensation and non-cash charges related to the acquisition in the past.

Free Cash Flow - cash flow after deducting reinvestment in working capital and capital expenditure.

Operating Income - to calculate it, the company deducts non-recurring expenses and revenue from the core operations earnings of the company. The non-recurring expenses might include intangible assets, repairment charges, impairment, and restructuring charges.

In order to understand better the concept of the "adjustment" I will go over two common adjustments:

Cost of stock-based compensation

A company may compensate its employees with shares in the business. The intent is to align their interests with those of the business in enhancing the share price. When these payments are made, the essential accounting is to recognize the cost of the related services as they are received by the company, at their fair value. The offset to this expense recognition is either an increase in an equity or liability account, depending on the nature of the transaction. The upcoming of the above is that the "non-cash cost" of the cost of stock-based compensation is allocated under several sections in the P&L increasing the costs. The adjustment of such expenses (like the adjustment of depreciation expenses) gives a better outlook regarding the "real" operating expenses of the specific section.

Free Cash Flow

Free Cash Flow (FCF) or Free Cash Flow to Firm (FCFF) forms a part of the working capital analysis of a firm. Working Capital refers to the cash available to invest in the normal operations of an entity’s business. The Operating Profit of a firm is used to make capital expenditures to expand the asset base. After making such capital expenditures, the residual amount is available for distribution to all the owners of the entity, i.e. shareholders.

The adjustment made under the Non-Gaap measures gives a better look for potential investors. For the shareholders of a company, FCF is an important investment guide because it represents how much the company gives back. It also helps in the growth of its investors. A company with steady growth in FCF is a good indicator of financial health.

WHEN IS NON-GAAP REPORTING CONSIDERED MISLEADING?

Highlights of a few of the SEC’s “Answers of General Applicability” to non-GAAP financial measures are:

· Presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.

· A non-GAAP measure that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods could violate Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it explained.

· A non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Rule 100(b) of Regulation G.

· Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G.

An Example of Nasdaq software public traded company historical financial date ( Including non-GAAP adjustments):