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.