GAAP vs Non-GAAP Accounting - Key Differences to Know

Understanding the distinction between Generally Accepted Accounting Principles (GAAP) vs non-GAAP accounting is crucial for investors, analysts, and business owners. The main difference is that GAAP represents a standardized framework for financial reporting while non-GAAP offers a more flexible approach.

Deciphering the nuances of GAAP and non-GAAP accounting means interested parties can make informed decisions about investing in a company based on a comprehensive overview of the company's financial performance. An accounting professional can explain which of these accounting methods to use in your business and the importance of reconciling the two sets of books if you use both.

GAAP and Non-GAAP Accounting Overview

GAAP and non-GAAP accounting serve different purposes. GAAP accounting is used to provide a standardized picture of publicly traded companies’ finances to make it easier to make cross-company comparisons. Private companies often use non-GAAP accounting to provide the most useful financial statements for their internal financial management needs.

What Is GAAP?

GAAP is an accounting method that establishes consistent accounting standards for businesses. The main purpose of the GAAP standards is to ensure a universal way of gauging a company's financial health. 

GAAP covers the whole accounting process from beginning to end, including specifications about the paper trail that must be preserved for invoicing and what must be included in financial statements.

Please note: While GAAP standards are relevant to publicly listed U.S. companies, International Financial Reporting Standards provide the framework for overseas companies.

What Do GAAP Measures Determine?

GAAP measures determine various aspects of how you record and report your company's finances. For example, GAAP dictates:

• Criteria for expense and revenue recognition (affecting net income calculations)

• What types of expenses must be capitalized as assets

• How the relevant information is presented to shareholders in an audited report

• What must be disclosed in the notes for financial statements

Pros of GAAP

GAAP is useful for investors, auditors, and publicly traded companies. GAAP offers a framework for companies in different industries to present financial statements that look and feel the same. Other advantages of GAAP are:

• Helps you make plans: GAAP offers a clear picture of your business’s financial health. This allows you to predict cash flow trends. These detailed financial statements help you stay on target and make sound decisions for the future.

• Consistency: GAAP ensures businesses always use the same accounting principles. This promotes consistency in financial statements and makes it easier for stakeholders to evaluate your financial data.

• Accountability: GAAP reduces the risk of data misrepresentation. GAAP means data is transparent and holds business owners accountable to stakeholders.

• Identifies weaknesses to address: GAAP allows you to compare your company’s performance with your competitors. Comparing like-for-like businesses can help you identify weaknesses and adopt more successful strategies. 

• Detailed information on spending: It’s easy to analyze how you allocate and spend funds in your business when the details are laid out following GAAP.

• Builds trust: Providing transparent and accurate data builds trust between you, your stakeholders, and investors.

Cons of GAAP

Critics of GAAP argue the method has some limitations that include:

• Lack of flexibility: GAAP standards are designed to be applied uniformly across different industries and business types. This means that two businesses with different products or services have to report in the same way even though they operate very differently.

• Complexity: Understanding GAAP standards can be complex, making compliance challenging for some businesses.

What Is Non-GAAP?

Non-GAAP accounting can be used by private companies and by publicly traded companies that feel it may be advantageous to add more financial information than is allowed for with GAAP. If this is the case, a company can offer its own accounting figures. The company must disclose that the figures they’re presenting are non-GAAP. They must also reconcile the standard and adjusted results.

Non-GAAP figures tend to exclude expenses related to acquisitions or restructuring that could be classed as irregular or non-cash expenses. This is because temporary conditions can distort the overall picture of a business’s financial health.

The use of non-GAAP reporting by public companies is overseen by the Securities and Exchange Commission (SEC). SEC prohibits the use of non-GAAP measures that could be misleading, for example reporting earnings between periods inconsistently.

Pros of Non-GAAP Reporting

Non-GAAP reporting offers another perspective that makes up for any shortfalls in GAAP-only reporting. Among its advantages are:

• Supplementary information: Non-GAAP measures provide additional information that GAAP doesn’t offer. This offers another perspective on a company’s performance and helps business owners make informed choices about everything from tax planning to budgeting.

• Aligns with internal management reporting: Non-GAAP measures are more reflective of the metrics used in internal management reporting and are therefore a better reflection of how companies see themselves.

Cons of Non-GAAP Reporting

Non-GAAP reporting also has some pitfalls to take into account:

• Lack of standardization: Because non-GAAP financial measures aren’t standardized, it’s difficult for investors to compare the performance of different companies solely based on these measures.

• Potential for manipulation: Some companies could use non-GAAP measures to highlight favorable aspects of their financial performance while downplaying weaknesses.

• Lack of transparency: Critics claim that non-GAAP reporting obscures a company’s financial health as it omits certain expenses.

Non-GAAP Accounting Could Add Value

According to the University of Chicago Booth School of Business, adding non-GAAP earnings to standard GAAP earnings can increase a firm's value by 3.4%. Supplementing GAAP reporting with non-GAAP reporting may therefore encourage higher investment when used judiciously.

How Are GAAP and Non-GAAP Accounting Different?

The following table details the most significant differences between GAAP and non-GAAP accounting:

	GAAP	NON-GAAP
LEVEL OF STANDARDS	GAAP is the industry standard across the U.S.	Non-GAAP isn’t standardized and will be used differently from business to business.
WHO USES EACH METHOD	Publicly traded companies must use GAAP. They can supplement it with non-GAAP measures.	Private companies aren’t obliged to use GAAP financial reporting.
ADJUSTED EARNINGS	GAAP reporting must include non-cash expenses like amortization, depreciation, depletion, and deferred charges.	Non-GAAP figures don’t have to include non-recurring or non-cash expenses like one-off real estate or equipment purchases. Companies can provide adjusted earnings. This could give more accurate insights into their operational performance.
COMPARABILITY	Easy to compare different companies as they’re subject to the same metrics.	Non-GAAP reporting doesn’t require adherence to any single finance measure. This makes comparing different companies more difficult.

Tip: Navigate the Options with an Accounting Professional

Small business accounting professionals offer entrepreneurs insights into how and when to use different accounting methods. For example, our accounting experts work with non-GAAP accounting and find this more than sufficient for most small business’s needs. 

We explain clearly to our prospective and new clients exactly how these methods are used and clarify the differences between tax basis and book basis accounting, the cash and accrual methods, and more, to help them find the best accounting system for their business.

GAAP and Non-GAAP Both Have Their Place

Understanding the nuances between GAAP and non-GAAP accounting is crucial for investors, analysts, and business owners. While GAAP provides a standardized framework for financial reporting, non-GAAP measures offer additional insights into a company's underlying performance.

Stakeholders can develop a more comprehensive understanding of a company's financial health and prospects with a careful analysis of both GAAP and non-GAAP metrics. Ultimately, the most effective accounting method for your business will be the one that best serves your purposes and needs.