GAAP stands for Generally Accepted Accounting Principles. The U.S. Securities and Exchange Commission (SEC) requires that GAAP be followed by all companies whose stock is publicly traded on the open market. However, non-GAAP financials are often created for internal management purposes and can be publicly disclosed as supplements to GAAP financial reports when management believes that non-GAAP financials provide a better picture of the health of the “core” of the company.
Non-GAAP financials allow those inside a company to look at the numbers in a way that helps to analyze the results in order to make decisions. Non-GAAP reporting typically excludes one-time items and non operations related items such as one-time charges; restructuring expenses; amortization of intangibles; and deferred revenue.
One example of the way non-GAAP numbers might be used is as follows. Let’s assume that a new CEO has taken over a company and wants to restructure, reorganize, close plants, and maybe lay off people. Normally, such a restructuring entails a lot of costs—paying off leases, offering severance packages, disposing of facilities, selling off equipment, and so on.
Now, accountants always want to be conservative. In fact, they’re required to be. GAAP recommends that accountants record expenses as soon as it is known that expenses will be incurred, even if they have to estimate exactly what the final figure will be. So when a restructuring occurs, accountants need to estimate those charges and record them. However, accountants have a lot of discretion, and they’re liable to be off the mark in one direction or another.
- If their estimate is too high—that is, if the actual costs are lower than expected—then part of that one-time charge has to be “reversed.” A reversed charge actually adds to profit in the new time period, so profits in that period wind up higher than they would otherwise have been.
- Or, maybe the restructuring charge is too small. Then another charge has to be taken later. That clouds the numbers, because the charge isn’t really matched to any revenue in the new time period.
So, the management and accountants of a company undergoing a restructuring might prepare GAAP financials, as required, that are in line with the conservatism principle and thus show all estimated restructuring charges for current and future periods as a one-time charge in the current period. In addition, it might prepare non-GAAP financials which carve these restructuring charges out of the income statement, thus showing what its expenses and profits might have been without the effects of the restructure clouding the picture.
(Excerpts from Financial Intelligence, Chapter 6 – Cracking the Code of the Income Statement)
Most income statements are “actual,” and if there’s no other label, you can assume that is what you’re looking at. They show what “actually” happened to revenues, costs, and profits during that time period according to the rules of accounting. (We put “actually” in quotes to remind you that any income statement has those built-in estimates, assumptions, and biases.)
Then there are what’s known as pro forma income statements. Sometimes pro forma means that the income statement is a projection, but pro forma can also mean an income statement that excludes any unusual or one-time charges. Say a company has to take a big write-off in a particular year, resulting in a loss on the bottom line. Along with its actual income statement, it might prepare one that shows what would have happened without the write-off.
Be careful of this kind of pro forma! Its ostensible purpose is to let you compare last year (when there was no write-off) with this year (if there hadn’t been that ugly write-off). But there is often a subliminal message, something along the lines of, “Hey, things aren’t really as bad as they look—we just lost money because of that write-off.” Of course, the write-off really did happen, and the company really did lose money. Most of the time, you want to look at the actuals as well as the pro formas, and if you have to choose just one, the actuals are probably the better bet.