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.

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.

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.

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10 responses to “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. 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.

  6. 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”..

  7. 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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