Accounting is the language of business. Like any language there's a lot of nuance and jargon
that needs to be fully understood if you hope to speak the language
fluently one of the terms that confused me the most early on was the concept of
GAAP and Non-GAAP. What do those terms mean and why are they important? We'll
tell you in this video. My name is Brian Feroldi and my name is Brian Stoffel
thanks to Quartr for sponsoring today's video okay brian let's get out with it what the heck
does GAAP mean GAAP is like an acrostic poem that's an acronym it stands for
generally accepted accounting principles now what does that mean? these are commonly recognized
set of rules and procedures that are designed to govern corporate accounting and financial
reporting in the united states now in the u.s GAAP accounting practices were developed jointly by the
FSB and the GASB that stands for the financial accounting standards board and the government
accounting standards board that means that GAAP accounting rules are applied to governments and
non-profits as well as profitable corporations. So what does non-gaap mean? non-gaap just means using
accounting practices that do not comply with GAAP standards. so why would a company want to use
non-GAAP metrics? Well it doesn't make sense to have one size fits all rules GAAP accounting
rules are black and white and to try and apply them across the board misses some
important nuances by allowing companies to offer up their own Non-GAAP metrics investors can get a
much more detailed view of the complex nature of a business now there are several instances in which
GAAP and Non-GAAP accounting cannot comply with each other one of the biggest reasons why we see
this happen in today's environment is due to stock based compensation stock-based compensation is
simply when a company uses its own stock in order to pay its employees & its management. now there's
a huge debate within the investment community as to whether or not stock-based compensation
should count as an expense according to GAAP rules it should be counted as an expense which will
obviously then pull down the net income for that company however when looking at a non-GAAP basis
companies often exclude stock based compensation as an expense on their income statement
that obviously biases up their income statement to make it look better than it is another example
would be depreciation and amortization these are non-cash charges in nature however on a GAAP basis
they count as expenses in most cases if a company offers non-GAAP measures they will
back out depreciation and amortization because there's no cash going in or out of the company
based on this at the time another relatively new category is unrealized gains and losses under GAAP
accounting those gains and losses are accounted for on the income statement but oftentimes
they're non-operating in nature that's why they're often excluded when looking on a non-GAAP basis
and finally we've got to think about if a company decides to pay off its debt early obviously that's
a really good thing for the company however on a GAAP basis all the money that left its coffers
because of that count against the net income on a non-GAAP basis it's treated as a more positive
event and they don't count all the losses from that payoff now there are a lot of common metrics
that investors use when describing a business that often comply with non-GAAP accounting a
very common one is called EBIT EBIT simply stands for earnings before interest and taxes essentially
EBIT is a look at a company's operating income while excluding expenses such as interest and
taxes a close cousin of EBIT is EBITDA which is earnings before interest taxes depreciation and
amortization it means you're subtracting out the same things that you did in EBIT however you're
also pulling out depreciation and amortization from your operating expenses how about another
non-GAAP term that we both love and use all the time in this channel free cash flow that is a
non-GAAP metric but we think it's a wonderful way to look at how profitable a company actually is
or if you invest in software as a service or SaaS stocks you've obviously become familiar with the
dollar based net retention or dollar based net expansion rates this measures how much money a
cohort of customers spend from one year to the next while factoring out new customers that's
obviously important because it lets you know whether or not the product is resonating with
its customers finally let's talk about the big one non-GAAP earnings per share this is a very
common metric that a lot of companies report to show how profitable they were during a given
period now given all those charges that we talked about that are differences between gap accounting
and non-GAAP accounting there can often be a wide difference between a company's GAAP
earnings per share and its non-GAAP earnings per share often times under GAAP accounting a whole
bunch of expenses are included while on non-GAAP accounting those expenses are often excluded that
can lead to wide differences in the company's net income and hence its earnings per share all
right let's show an example that really hammers home the differences between GAAP and non-GAAP
accounting by looking at it easy to understand business Walmart before we do that we wanted to
give a shout out to this video sponsor quarter quarter's mission is to make every interaction
between companies and their investors meaningful Quartr does so by providing frictionless access
to conference calls investor presentations transcripts and earnings reports from markets
all around the world straight to your pocket for no cost i've personally been using Quartr for over
a year now because it makes it so easy to listen and track my favorite investors conference calls
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giving Quartr a try for free simply visit the app store of your choice and search for quarter that's
q-u-a-r-t-r thanks Quartr for sponsoring this video okay brian let's take a look at
Walmart third quarter earnings of 2021 in which it recorded earnings per share of a dollar eleven
that's on a GAAP basis right and Walmart did a great job of making it easy to see how a dollar
eleven doesn't really tell the whole story here's why first the company showed that it recognized an
unrealized gain in some of its equity investments in other words Walmart held shares of some other
companies and those shares went up between the end of the previous quarter and the end of the current
quarter they said that doesn't make sense to add on to our earnings per share because it doesn't
reflect our core business so we will subtract out that gain on the flip side Walmart also paid off
some of its debt during the period that resulted in an $0.86 hit to GAAP earnings per share during
the period or $0.67 after accounting for taxes this was a GAAP charge but management doesn't
believe that it should be penalized for that because of that it's adding back that $0.67 cents
when looking at its non-GAAP earnings so let's review what this means the company reported gap
earnings per share of $1.11 however it subtracted out unrealized gains that it recognized from some
of its investments bringing it down to $0.78 per share finally the company needed to add back in
money that it lost on a GAAP basis for getting rid of that debt early when you factor all that
in earnings per share on a non-GAAP basis were a dollar and $0.45 that's a $0.30 difference
from where it was on a GAAP basis and when looking at those two numbers me as an investor
i actually care a lot more about that $1.45 in non-GAAP earnings than i do about that a $1.11
GAAP earnings and obviously depending on which number you can use that plays a big difference
on the company's current valuation let's show another example that showcases that stock based
compensation thing that we talked about earlier brilliantly let's take a look at Fiverr recent
results in the third quarter of 2021 Fiverr reported a GAAP loss of $0.39 per share or about
$14 million dollars that sounds bad however during the quarter the company also paid out $15 million
dollars in stock-based compensation that was a non-cash charge if you exclude just stock based
compensation the company would have swung from a loss to a profit but that wasn't all the company
also had to account a $5 million charge on some of its convertible notes again a non-cash charge
that would have added to those gains so when you account for those two major differences the
company actually reported a non-GAAP net income of almost $8 million during the period that's a
$22 million swing from a GAAP and non-GAAP basis and when we're talking about non-GAAP earnings per
share the company reported $0.21 positive that's a huge difference from a loss of $0.39 per share now
we're not here to debate whether GAAP or non-GAAP accounting is better or should always be used
i personally always look at the GAAP and non-GAAP numbers myself and see what the differences are so
that i can make decisions as an investor however it is important that all investors understand the
vagaries of GAAP and non-GAAP accounting so they can make better investing decisions Brian's Out