A company’s annual income statement should be a transparent disclosure of its revenues and expenses that investors can readily interpret. Most aren’t, largely because income and expenses classified according to generally accepted accounting principles (GAAP) can be difficult to interpret. In fact, many sophisticated investors tell us they have to re-engineer official statements to derive something they’re comfortable using as the starting point for their valuation and assessment of future performance. In response, many companies — including all of the 25 largest U.S.-based non-financial companies — are increasingly reporting some form of non-GAAP earnings, which they use to discuss their performance with investors.
Eliminating that duplicated effort should be simple. A common-sense revision of GAAP-based income statements would divide the report into two parts: recurring operating income in the first, and non-operating income or expenses and nonrecurring items in the second. Such a structure would provide investors with a clearer summary of income and expenses. It would also be consistent with two core principles for financial-statement presentation proposed by a joint project of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in 2010, which state that financial-statement information should be presented “in a manner that disaggregates information so that it is useful in predicting an entity’s future cash flows” and “portrays a cohesive financial picture of an entity’s activities.”
The trouble with GAAP-based income statements
Strict adherence to the conceptual principles of accounting often leads to confusion and distortions in an income statement. When companies make an acquisition, for example, GAAP requires they allocate part of the difference between the purchase price and current market value to intangible assets. It then requires companies to amortize the value of those assets over some period of time, reducing their future earnings — in the same way they would depreciate physical assets. The calculation is theoretically consistent but provides no insight into future required cash investments. The annual amortization of acquired intangibles is a non-cash expense and, unlike physical assets, companies either don’t replace them or if they do invest in them, those investments show up as expenses, not on the balance sheet.
Not surprisingly, we haven’t seen any investors or companies using the amortization of intangibles for analysis or valuation work. Most sophisticated investors we talk to tell us they add the amortized value of these intangibles back into income when they analyze a company’s performance — as do most of the companies that report non-GAAP numbers.
A bigger problem with GAAP is its emphasis on producing a single number, net income, that is supposed to be useful to the company as well as its investors and creditors. But sophisticated investors don’t care about reported net income. They want to know its components — or, specifically, to be able to distinguish operating items (sales to customers less the costs of those sales) from non-operating items (interest income or interest expense). They also want to know which items are likely to be recurring and which are likely to be nonrecurring (that is, restructuring charges). Finally, they want to know which items are real and which, like the amortization of intangibles, are merely accounting concepts.