Generally Accepted Accounting Principles (GAAP)

What it is:

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.

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 non-GAAP measures include net earnings, gross income, and net cash provided by operating activities.

Why it Matters:

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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