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| Generally Accepted Accounting Principles (GAAP) |
What it is:
"GAAP" is an acronym that stands for Generally Accepted Accounting
Principles. GAAP is a framework of accounting standards, rules and procedures,
defined by the professional accounting industry, which has been adopted by
nearly all publicly traded U.S. companies.
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How it Works/Example:
GAAP principles, which are updated regularly to reflect the latest accounting
methodologies, are the definitive source of accounting guidelines that companies
rely on when preparing their financial statements. The standards are established
and administered by the American Institute of Certified Public Accountants
(AICPA) and the Financial Accounting Standards Board (FASB).
GAAP rules and procedures are what govern corporate accountants when they present the details of a company's financial operations. These details can be found in such places as quarterly balance sheets or income statements, 10-Q filings, or annual reports. Examples of GAAP measures include net earnings, gross income, and net cash provided by operating activities.
Investors should always review a company's GAAP financial results, as the
standardized methodology provides a reliable means of comparing financial
results from industry to industry and from year to year. However, GAAP rules are
sometimes subject to different interpretations, and unscrupulous companies often
find a way to bend or manipulate them to their advantage. Furthermore, it is
commonplace -- even for accurate results where GAAP principles were
conservatively applied -- for financial results to be restated at some point in
the future.
Often, the most insightful way to compare a company's performance against prior periods is to review its non-GAAP financial measures. Management, analysts, and investors routinely use these metrics to gauge a firm's progress. A few widely used examples of non-GAAP measures include free cash flow, pro-forma earnings, and adjusted income from continuing operations. Sometimes, certain non-GAAP figures are common within an industry, and these tools often prove especially useful when comparing competitors. Many companies, for example, often use earnings before interest, taxes, depreciation, and amortization (EBITDA) as a core measure of performance. However, non-GAAP financial measures exclude operating and statistical measures such as employee counts and ratios calculated using numbers calculated in accordance with GAAP.
The SEC requires companies to reconcile
their non-GAAP financial measures with the closest comparable GAAP measure.
Because they can vary widely from firm to firm, non-GAAP calculations do not
always provide an apples-to-apples comparison. For this reason, these
alternative measures are not meant to replace GAAP, but should instead be used
in conjunction with it.
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