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GAAP vs. Pro-Forma Earnings

June 19, 2017

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Companies use a couple of methods to do their sums. Journalists need to consider both. ("Abacus" image by JD via Flickr, CC BY 2.0)
Companies use a couple of methods to do their sums. Journalists need to consider both. ("Abacus" image by JD via Flickr, CC BY 2.0)

A company’s finances are sometimes presented in two forms: a more conservative form, which falls in line with generally accepted accounting principles (GAAP) and a more favorable form, called pro-forma. As a journalist, in order to get an accurate picture of a business it’s important to understand how information is being presented.

GAAP: conservative accounting

Conservatism in accounting means that wealth outflows (expenses and losses), are recorded sooner than wealth inflows (revenues and gains). So the money a company is spending is recorder earlier, even if it has to be estimated, than the money a company is acquiring.

GAAP financial statements are biased this way because humans, by nature, embellish reality. Firm managers will likely present an optimistic view of their firm’s performance, delaying and minimizing the reporting of wealth outflows while accelerating (and perhaps embellishing) wealth inflows. Generally accepted accounting principles act as a reality check on this kind of behavior.

Suppose a firm spends money on research. Even if it is likely or highly likely that the research will lead to new products that are salable, the money spent on research is an expense. Any money acquired is only recorded at a later date when the research generates new products and customers purchase them. Wealth outflows are recorded sooner than wealth inflows because of the conservative nature of accounting.

Pro-forma: optimistic accounting

Many management teams try avoiding the conservative nature of financial accounting by offering “pro-forma” earnings, sometimes called “non-GAAP” earnings, in addition to their regular financial statement disclosures. When managers present and discuss pro-forma earnings, they tend to exclude wealth outflows (expenses and losses). Pro-forma reports are also created in order to make projections about future losses or earnings.

Forming conclusions

Regardless of the reason, financial accounting restricts managers’ behaviors and helps you assess managers’ comments about their firms’ financial performances. Savvy journalists always compare a firm’s conservative GAAP financial statements prepared by accountants with any pro-forma, non-GAAP figures presented by managers or analysts. It’s the truest way to assess the business and form your own opinion of a firm’s financial performance.

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