Building a Better Income Statement

If neither companies nor investors find GAAP-reported earnings useful, it’s clearly time for a new approach.

Some users of financial statements may also be concerned, on an income statement like the one we propose, that recurring operating income typically would be higher than the current GAAP-reporting equivalent, which might give investors a rosier-than-warranted view of companies. However, if the new profitability metric were more closely related to continuing operations — and it likely would be — then it would still be more useful for valuation purposes than the GAAP equivalent. Furthermore, net income might end up being the same as current GAAP net income, but investors would have more information to work with in a consistent way. And adjustments won’t always work in a company’s favor; operating income can be adjusted down. From 2000 to 2004, and again in 2008, for example, IBM disclosed that its non-GAAP earnings would have been lower than its GAAP earnings due to negative pension-related adjustments. Finally, sophisticated investors armed with more detailed disclosure are unlikely to be misled.

To prevent abuse, the Securities and Exchange Commission and FASB can take additional steps to require more disclosure about items the company classifies as non-operating or nonrecurring expenses. This will also make for easier comparison across companies, as investors would be confident that items classified as a particular expense would be similar across peers.

Changing the way the GAAP income statement is structured will help investors find the information they need for decision-making in one place and in a format that is easy to understand and compare.

Ajay Jagannath is an analyst in McKinsey’s New York office, where Tim Koller is a principal.

This article was originally published on McKinsey.com. Copyright © McKinsey & Company. All rights reserved. Reprinted by permission.

10 thoughts on “Building a Better Income Statement

  1. Cost and management accounting emphasis is utmost essential in the global competitive environment where we often talk for sustainability and trasparency do we afford to stage a false picture for the sake presentation ignoring reality.

  2. I feel it is necessary to point out that acquisition accounting under GAAP does not require entities to, “…allocate part of the difference between the purchase price and current market value to intangible assets.” Rather, GAAP requires that an entity recognize ALL assets and liabilities (separately from goodwill), tangible or intangible, at their acquisition-date fair value. It is this net asset/liability amount which is compared to the purchase price to determine whether goodwill or a gain on bargain purchase resulted from the acquisition.

    While at first glance this may seem like a matter of semantics, but the accounting methodology prescribed by the authors places a theoretical cap on the value of intangible assets acquired. In a scenario where an entity was acquired for a purchase price exactly equal to the fair value of net assets and liabilities currently on the acquiree’s books, the authors seem to indicate that no intangible assets would be recognized.

    However, GAAP specifically cites that the acquiring entity may recognize, “acquired identifiable intangible assets, such as a brand name, a patent, or a customer relationship, that the acquiree did not recognize as assets,” with no limit based on the difference between purchase price and current market value. Using the above scenario (i.e., the purchase price is equal to the fair value of previously recognized assets/liabilities), the recognition of additional intangible assets would likely result in a gain on bargain purchase being recognized by the acquiring entity.

    Further, there is a chance that some of the acquired intangible assets would be classified as “indefinite-lived” (not to be confused with infinite-lived). If that were the case, there would be no amortization reducing the acquiring entity’s future earnings.

  3. Excellent article. Sounds like a case for reporting EBITDA. However, I have found that companies with shaky earnings like to refer back to EBITDA rather than focus on the total picture. Not to say I don’t think EBITDA is one way of looking at the Income Statement. It’s just a ‘let the buyer beware’ moment.

  4. The purpose of the income statement as defined is to present the current financial results of a company’s operations which, although not overly sophisticated in theory, still comprise at least one of the more important aspects for any operating entity to predict its future success. Sophisticated investors still require this information above all else to safely measure whether a company meets the most basic going-concern principles of general accounting. Financial accounting is supposed to evaluate and monitor the results of a company’s operations. It would seem to indicate better predictive value if a managerial and budgetary approach to analysis was utilized if the sophisticated investor’s objectives are to determine a company’s future success based upon key quantitative and qualitative metrics and their improvements and increases for future operations. Sometimes we are too literal with our utilization of cost accounting and CMA considerations just for manufacturing and production-oriented organizations instead of service firms or other vital industries that sell to other third parties. Social media companies are rife within this category. Would the sophisticated investor only anticipate recurring and non-recurring activities, income, and extraordinary item expenses with predicting market capitalization or stock trading prices. The answers are so easy that they become simplistic. Just look at the two recent NASDAQ and NYSE initial public offerings of Facebook and Twitter. Facebook is obviously the better and more comprehensive company especially for growth, innovation, strategic corporate objective and mission including sustainability whereas Twitter has to be the smaller entity with the smaller focus for its short-term and long-term success. A company so non-diverse that it requires or limits it’s customers to only a 120 character recourse. Aside from maintaining its computer RAM and networks, there are still those who believe that this company does absolutely nothing else aside from social media marketing yet its principals were overnight multi-millionaires. How did their stock prices fare subsequent to only one day of trading and why? Conversely, what happened at Knight Capital also requires no predictive analysis yet any natural investor would necessarily evaluate the monetary worth of the company’s high-tech electronic trading system. Perhaps the sophisticated investor would have gravely analyzed each companies income statements for more predictive value yet would not have begun to discover that day’s results or the staggering impact of their IPO’s or of the future of social media. Any accountant worth their own rye or hoagie bread and butter would admit, however, that these companies bottom lines, their profit margins, their actual revenues minus expenses would still reveal more about their operational and financial success for their futures.
    Non-cash expenses and goodwill are bad examples of FASB AND GAAP accounting undermining the necessity for streamlining information for income statement and balance sheet. The financials should still emphasize results instead of forecast because companies are more solvent because of short-term than long-term results. Understanding intangible assets and amortizations are easy for the prediction of future results even though they involve non-cash items because procedurally and from an operational viewpoint, a company’s transactions have to contribute to its accounting equation, thus, what is theoretically necessary for assets to equal liabilities plus owner’s equity has to shown and measured efficiently. Who would argue that a leveraged debt buy-out merger doesn’t also require measurements of intangible assets, net asset values, FMV’s, amortization costs, and estimates of value to a business especially when measuring debt assumed and acquired? The Time-Warner merger will never lose its historical significance just because of its debt quality and its inability to resolve or reduce the debt structure even with the assumption of intangibles, amortizations, and significant reductions of net asset values. Maybe the sophisticated investor needed those metrics to predict the future financial success and resolution of the troubled debt leveraged buy-out. Others did not.

    • Wow. You need to parse your ideas and learn to use paragraphs. After looking at your HUGE paragraph, I just skipped on to the next without giving you any credit at all for what you may be trying to say here.

    • Regardless of the length of the paragraph, the information you presented is valuable and logical. Thanks for your contribution. The article indeed is an extraordinary article that needs to be evaluated from different perspectives and like any other article, we should look at it and see if there is something we can learn from it and this article calls for a closer look and challenges what we know to be a fact, we just need to be more open to new concepts and if these new concepts can pass our logical and financial tests and give us a new avenue, we should explore it or better yet, put them to the test against all of the principles we hold dearly.

  5. Great article, I work for McGladrey and there’s a whitepaper on our website that discusses a few points in this article that readers will find it very useful. “Getting the full picture: Financial statement audits versus quality of earnings analysis“ @ http://bit.ly/1gjHLQP

  6. In general, I understand and can somewhat agree with the article. Of course, as with so many other issues, the devil is in the details. Management will generally try to show negative results as non-recurring so as to influence opinion on the financial results and future potential. Now that means that a more refined definition of non-recurring has to be developed. Again, this would add complexity. For public companies, the MD&A should discuss these unusual events and be used in conjunction with the statement of cash flows.

    The authors are wrong about the amortization matters. Too often, the investment community “forgets” that assets or equity were used in an acquisition, and a subsequent amortization or writedown is ignored as a non-cash issue. But, many times cash was used.

  7. It would have been nice if the joint project of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in 2010, aligning the Income Statement, Balance Sheet and Cash Flow Statement into the formats you suggest, had succeeded. (….predicting an entity’s future cash flows” and “portrays a cohesive financial picture of an entity’s activities.”)

    Now, there is a push towards sustainability (SASB) and integrated reporting (IIRC), presenting another challenge to re-sort business reporting information.
    In a recent comment letter to the IIRC http://www.theiirc.org/wp-content/uploads/2013/08/103_Kurt-Ramin-and-Stephen-Lew.pdf we suggested to segregate and focus business reporting data into objects and valuation and report historical and future related information (quantitative and disclosure) into three categories (objects times value): all People related expenses, Product data and Physical Infrastructure (including use of Natural Capital). By employing technology (such as XBRL) it would be a new approach to enhance the current “mixed attribute model of valuation” and be closer to what you suggest. A separate funding section (Working Capital, deferred tax assets and liabilities, loans and equity) would summarize Financial Capital.

    It will be interesting to watch how your suggestion and current international approaches (IIRC) will reduce the US legal fear on forward looking information and the over-emphasis and sensitivity of accrual accounting cut-offs.

    What is the source of the IBM numbers you cite regarding pensions? .. “negative $1.2 billion in 2001 to $400 billion in 2012”..

  8. I was a corporate controller of public company with 10 operating divisions.
    My experience in analyzing financial performance and developing meaningful data to measure value is to breakdown business units to measure risk and normalized cash flows to make investment decisions.

    While this was said in the above replies , this is the start to request a more meaningful indication of what management reporting systems are used to execute their strategies and to monitor/ adjust their activities and operations.

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