GAAP to Non-GAAP Reconciliation
In this edition, we will be shedding light on ‘GAAP to Non-GAAP Reconciliation’, specifically covering the basic differences between the two methods of reporting earnings, which have its set of pros and cons. GAAP to Non-GAAP Reconciliation provides insights into the core-earning capability of the company, but it can also be used to mislead investors by inflating earnings through ‘window-dressing’.
In this topic, we will be covering the basic ‘What’, ‘Why’, and ‘How’ of this reconciliation, with illustrations and case studies. We will also give insights into how it can be misused by the company, and the basic means to measure a company’s earnings quality.
Firstly, all public companies in the US are required to report their earnings in accordance with the General Accepted Accounting Principles, which have been framed by the Financial Accounting Standards Board. If a company wants to report other metrics that accurately reflect its operational results or financial position or that are commonly used by investors to measure financial performance (which can be referred to as Non-GAAP), the company will need to provide a reconciliation between the two in its financial statements. In terms of basic definition, under GAAP, companies report earnings based on time-honored accounting principles, such as accrual accounting, revenue recognition, and expense matching, while under Non-GAAP, the company’s management may have alternative ways of representing the company’s “true” performance, which can be by including EBITDA, Funds from Operations, and Free Cash Flows to Firm.
Moving on to the advantages that are offered by Non-GAAP reporting; firstly, it addresses the disconnect between the needs of companies and investors, as smoother earnings or adjusted earnings are reported under Non-GAAP measures, which enable both the management and investors to measure the company’s performance in a better way. Secondly, as the economic environment is moving more toward fair value measures of reporting, investors are demanding more information about the present values of the company’s assets, and hence, the inclusion of a variety of Non-GAAP fair value-related metrics in financial statements. Another advantage is that GAAP, at times, provides noisy financials that are subject to ‘window dressing’, and similar companies, despite having the same financial capabilities and operations, can have substantially different earning results. This is where Non-GAAP reporting provides smoother financials to better measure the performance between comparable companies. Non-GAAP earnings may also reduce the company’s cost of capital as Non-GAAP earnings give investors a more relevant picture of the business that could be reducing the company’s cost of capital.
Some commonly used Non-GAAP measures include EBIT, EBITDA, EBITDAR, Funds from Operations, Adjusted EBITDA, and Adjusted Operating Income. Differences between Non-GAAP and GAAP earnings can be due to many reasons. Some of the items that can cause basic differences between the two can be restructuring cost, acquisition-related expenses, amortization of intangible assets, gain or loss on sales of investment, deferred tax adjustments, and income or expenses from discontinued operations
Below is an illustration of Company ABC’s financials showing the reconciliation between GAAP and Non-GAAP earnings. As we can see, the company has differences in its financials due to acquisition cost, impairment adjustment, a one-time settlement cost, non-cash interest income, gain on sale of investment, and benefit from tax credits. These differences have been shown in the FY2015 column in the middle to arrive at the Non-GAAP earnings on the right from GAAP earnings on the left. To reiterate, this is just an illustration, and there can be numerous other items that can be used to arrive at Non-GAAP earnings.
Next up, let’s talk about the misuse of Non-GAAP earnings. As we can see in this image, companies in S&P that were reporting GAAP earnings were showing an EPS decline of negative 1.3% YoY at the end of 2014. This figure compared with the Non-GAAP EPS growth was significantly lower, as the Non-GAAP EPS growth for the same time period was approximately 6.6%. Now, obviously, there can legitimate reasons for overstating the Non-GAAP earnings, but in this case, this may even be due to ‘window-dressing’. Another interesting fact is as follows: In the US, 40 companies that had IPOs in 2014 reported losses under standard accounting rules, yet those companies posted profits using their own tailor-made (Non-GAAP) measures.
Here are some examples of how companies misuse the Non-GAAP measures of reporting their earnings. As you can see, there can be revenue recognition differences, R&D cost differences, and various other disclosure-related measures to mislead investors. Additionally, some companies report Non-GAAP financials in such a way that it looks like a clean number, while in reality, it is just used as a measure to overstate earnings.
To address the potential issues that arise in GAAP and Non-GAAP reporting, there should be individual and universal ways to measure earnings quality.
Here are some of the steps that one should follow to measure a company’s earnings quality:
- Firstly, one must develop an understanding of the company and its industry – understanding of its functioning, economic environment, and financial metrics is a hygiene factor..
- Then, one must learn about the company’s management as to whether there is any incentive for the management to understate or overstate its earnings. For this, one must perform thorough diligence and must review the related party transactions.
- As next steps, one must study the company’s accounting policies and procedures in detail; should make comparisons with the company’s prior earnings, policies, and disclosures; and should also compare the performance of the company with its close competitors.
- One should also study the potential warning signs, which can be the following: Declining receivables turnover, which could suggest that some revenues are fictitious or recorded prematurely; declining inventory turnover, which could suggest obsolescence problems that should be recognized; and net income greater than cash provided by operations, which could suggest that aggressive accrual accounting policies have shifted current expenses to later periods.
- Also, one should study whether inventory, sales, and expenses have been shifted to make it appear that a company is positively exposed to a geographic region or product segment that the investment community considers to be a desirable growth area. Lastly, one should have all quantitative tools handy to assess the likelihood of misreporting by the company.
So obviously, reporting GAAP or Non-GAAP earnings by companies both have their set of limitations and advantages, as companies have a habit of ‘window dressing’ their earnings to make them more attractive from the investors point of view. On the positive side, with growing transparency and regulatory means across all developed and emerging economies, reporting Non-GAAP earnings mostly provides an added advantage, as what is non-recurring and is still included in the adjusted or clean earnings is anyways highlighted and rectified by the potential investor or whistle blower, and based on that the performance of the company is judged.
We hope you find the blog useful. Look forward to your comments 🙂
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