A modest proposal to revise GAAP requirements
It would make life easier for everyone if GAAP requirements themselves were adjusted to require what companies and investors already use, after making all their adjustments, instead of making everyone do twice the work. That wouldn’t require big changes. Simply separate operating and non-operating items in a standardized manner and combine acquired intangible assets with goodwill without amortizing them. Such an approach would enable investors to quickly understand a company’s true earnings and operating performance. It would provide them with the detail they need to assess the economic significance of non-operating and nonrecurring items and decide for themselves how to treat them. And it would enable them to notice trends and patterns and compare performance reliably with peers.
The treatment of non-operating items may warrant some additional transparency relative to today’s reporting. Many are obvious and clearly identified in the current income statement, such as interest income, interest expense and goodwill impairments. Others should be treated differently. For example, gains and losses from asset sales should be treated as non-operating items, with detailed explanations in footnotes. Costs related to closing plants or restructuring operations should be highlighted in their own line items, once again with detailed disclosure in footnotes so investors can assess whether they are truly one-time costs or will be recurring. Pension-related items, such as revaluation of liabilities due to changes in interest rates, expected earnings on the portfolio of assets, and interest on the pension liability, should be separated into their operating and non-operating components. The operating component would be what is currently called the current-year service cost. Everything else is related to the performance of the pension portfolio and changes in the value of the pension liability and thus should be classified as non-operating.
Several leading companies have already started to report their non-GAAP results this way, with approval from investors. The effect can be substantial. For example, IBM reports the non-operating component of pension expense (after taxes) ranged from negative $1.2 billion in 2001 to $400 billion in 2012, with both positive and negative effects in between. Before IBM introduced non-GAAP reporting, investors had to hunt through the footnotes to see what the effect of the pension items was. This also made communication about results quite complex. Now the results and communication with investors are much simpler. It would be even easier if GAAP statements reflected this change.
Changing financial-reporting standards is a slow and complex process, of course. At a fundamental level, U.S. reporting depends on a rules-based system with a strong preference for bright-line definitions, whereas what we’re calling for would require some judgment.
Stringent rules on the disclosure of non-GAAP metrics do prevent companies from using them to mislead investors. Yet the issue remains that companies already provide investors with these data — though investors do need to dig for it in financial statements and public filings. If anything, the current practice of spreading out non-operating adjustment information increases the likelihood that something critical will be overlooked and makes it harder for investors to make informed decisions.