What Is GAAP?
There’s a reason most financial reports look the same
If you are an investor, it is important to have a clear understanding of a company’s revenues, expenses, and operations. You also must trust that whatever information you have about a company is accurate.
Fortunately, all public companies are required to issue frequent reports about their finances, which generally include details on revenues, ongoing and one-time expenditures, taxes, profits, and more. The information in these reports generally follows standardized accounting practices, known as generally accepted accounting principles, or GAAP.
For investors, the main benefit of GAAP is that it helps bring consistency and transparency to financial statements. That, in turn, may help bolster confidence in capital markets.
The History of GAAP
As long as money has changed hands, there has been some form of accounting. The practices familiar to us now emerged around the 15th century with the invention of double entry bookkeeping, in which credits and debits were logged in distinct columns.
Though companies began reporting financial information to the public during the Industrial Revolution, poor reporting procedures were partially blamed for the economic problems that led to the Great Depression.
One of the reforms spurred by the Depression was the establishment of the U.S. Securities and Exchange Commission (SEC), which was given the power in 1934 to oversee accounting methods. Today, the SEC relies on the Financial Accounting Foundation (FAF), an independent professional accounting group, to develop standards. The Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB), two organizations within the FAF, both work to oversee and improve GAAP.
Why GAAP Is Important
The goal of GAAP, according to FAF, is to ensure financial information is:
- Relevant, representationally faithful, and reflective of economics
- Comparable with other organizations or governments
- Verifiable and auditable by a third party
- Understood by lenders, investors, donors, taxpayers, and others
GAAP isn’t only used by public companies. The principles also apply to private companies, non-profits, and state and local governments.
What GAAP Means for Investors
If every company used different methods to report their income and liabilities on their financial statements, you’d have a difficult time evaluating them as an investor.
For any company that adheres to GAAP, you can be assured that it is at least following these basic reporting guidelines below.
- Recognition. GAAP offers guidance on what should be included in financial statements, such as revenues, assets, liabilities, and expenses.
- Measurements. GAAP outlines the amounts of each financial element that should be included in financial statements.
- Presentation. GAAP explains what line items, subtotals, and totals should appear and be aggregated within financial statements.
- Disclosure. Outlining additional financial information and bringing context to financial statements.
FASB offers a series of templates for companies to follow to ensure they are following the correct reporting guidelines. Keep in mind, though, that within GAAP, companies still have a fair amount of leeway in how they recognize expenses and revenue.
In addition, even if a company’s financial statement looks rosy, it still may not be a good investment for you.
Even companies that generally adhere to GAAP may still put out other, non-GAAP-compliant financial statements. These are known as “pro forma” statements.
With pro forma financial reporting, the company presents projected financial results based on how it believes a transaction might impact the business. For example, if a company makes an acquisition, a pro forma report will show profit figures based on the new business being fully incorporated.
Supporters of non-GAAP may argue that pro forma allows financials to be reported with more nuance and present a clearer picture for investors. The SEC, however, has expressed concern that pro forma statements can mislead investors.
In addition, non-U.S. companies often do not follow GAAP standards. Companies in over 150 countries follow standards set by the International Financial Reporting Standards (IFRS) Foundation, which are broadly similar to GAAP.
Many companies also report financials using GAAP and non-GAAP methods, though non-GAAP financials are more likely to appear in press releases or investor presentations than the audited documents sent to the SEC.
Under Armour included both GAAP and non-GAAP financial information in its press release for its 2019 second quarter report.
Audit Analytics, an independent research provider, issued a study based on three years of financial reporting and concluded that non-GAAP reporting was on the rise. It found that in 2017, 97% of companies in the S&P 500 had at least one non-GAAP metric in their reporting. However, only 76% of companies used non-GAAP metrics in 2006, and just 59% did in 1996.
McKinsey & Company, a global business consultancy, published a report arguing that income statements from companies that use GAAP reporting are hard to interpret. In fact, McKinsey notes that many companies already have reported some earnings differently in an effort to provide more clarity to investors.
And even supporters of GAAP note that using non-GAAP information to supplement official GAAP statements can be useful.
“In my experience, the combination of non-GAAP data outside the financial statements with information residing within the audited financial statements is more impactful than either dataset on its own,” wrote FASB member Marc Siegel in a blog on the organization’s website. “The non-GAAP information in a company’s communications with investors often provides insights into how management views their performance.”
The Bottom Line
As investors, we want to be sure that the financial information we receive from companies, non-profits, and the government is accurate and easy to understand. GAAP allows this to happen, and the standard is widely supported and used.
In recent years, there has been an increase in the use of non-GAAP reporting by some public companies, who argue GAAP principles don’t allow for the type of complete and nuanced reporting that investors prefer. In many cases, you will find both GAAP and non-GAAP metrics in financial reports. It is up to you as an investor to know what information you value the most and to scrutinize all financial reports with care.
Investor.gov. "Generally Accepted Accounting Principals (GAAP)," Accessed Dec. 4, 2019.
Financial Accounting Foundation. "Accounting Standards," Accessed Dec. 4, 2019.
Financial Accounting Foundation. "About GAAP," Accessed Dec. 4, 2019.
U.S. Securities and Exchange Commission. "Cautionary Advice Regarding the Use of "Pro Forma" Financial Information in Earnings Releases," Accessed Dec. 4, 2019.
IFRS. "Who Uses IFRS Standards?" Accessed Dec. 4, 2019.
Audit Analytics. "Long-Term Trends in Non-GAAP Disclosures: A Three-Year Overview," Accessed Dec. 4, 2019.
McKinsey & Company. "Building a Better Income Statement," Accessed Dec. 4, 2019.
Financial Accounting Standards Board. "For the Investor: The Use of Non-GAAP Metrics," Accessed Dec. 4, 2019.