To start, I shall offer a disclaimer: Despite the shortcomings of generally accepted accounting principles (GAAP), it would be a tough job to devise a better set of rules. The limitations of the existing set, however, need not be hindering: Managements are free to treat GAAP statements as a beginning rather than an end to their obligation to inform owners and creditors – and indeed they should for it is their morale duty. After all, any manager of a subsidiary company would find himself in hot water if he reported barebones GAAP numbers that omitted key information needed by his boss, the parent corporation CEO. Why, then, should the CEO of the parent company himself withhold information vitally useful to his bosses – the shareholder-owners of the corporation?
What needs to be reported is data – whether GAAP, non-GAAP or extra-GAAP – that helps financially-literate readers answer three important questions: 1) Approximately how much is this company worth? 2) What is the likelihood that it can meet its future obligations (whether to owners or creditors)? and 3) How good a job are its managers doing, given the hand they have been dealt?
In most cases, answers to one or more of the three questions are somewhere between difficult and impossible to glean from the minimum GAAP presentation. The business world is simply too complex for a single set of rules to effectively describe economic reality in a wide variety of businesses, especially conglomerates.
Twisting the problem yet further is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to be overcome. Too often their accountants willingly assist them – “How much,” says the client, “is two plus two?” Replies the ever cooperative accountant, “What number did you have in mind?” Even honest and well-intentioned managements sometimes stretch GAAP a bit in order to present figures they think will more appropriately describe their performance. Both the smoothing of earnings and the “big bath” quarter are “white lie” techniques employed otherwise by upright managements.
Then there are managers who actively use GAAP to deceive and defraud. They know that many investors and creditors accept GAAP as the gospel truth. So these charlatans interpret the rules “imaginatively” and record business transactions in ways that technically comply with GAAP but actually display an economic illusion to the world.
As long as investors – including supposedly sophisticated institutions – place fancy valuations to reported “earnings” that march steadily upwards, you can be sure that some managers and promoters will exploit GAAP to produce such numbers, no matter what the truth may be. Over the years, there were many accounting-based frauds of staggering size. Few of the perpetrators have been punished. Many have not even been censured. It has been far easier to steal large sums of money with a point of the pen than small sums with the point of a gun.
An interesting accounting irony lies in the treatment of controlled companies and those of minority holdings such as marketable securities. For controlled entities, all the earnings the subsidiary declares will flow to the parent’s income statement. The reverse is true for marketable securities where a business holds a minority stake. Only dividend declared by the marketable stock will be reflected in the business income statement. Thus, all other retained earnings will not be shown. However, accounting rules provide that the carrying value of these minority holdings of marketable stocks must be recorded on the balance sheet at current market prices. The result: GAAP accounting allows business to reflect in their net worth the up-to-date underlying values of the businesses they partially own, but does not allow businesses reflect their underlying earnings in their income statement.
The reverse is true for controlled entities. Here, businesses are allow to show full earnings in their income statement but never change the asset values on their balance sheet, no matter how much the value of a business might have increased since it was purchased.
Therefore, the mental approach to such accounting schizophrenia is to ignore GAAP figures and to focus sorely on the future earning power of both controlled and non-controlled businesses. Using this approach, we are able to establish our own ideas of business value better, and keeping these independent from both the accounting values shown on the books for controlled companies and the values placed by a sometimes foolish market on the partially-owned companies. It is this business value that investors should hope to increase at a reasonable rate in the years ahead. After all, what a stock price should represent is buying for all the future earnings of a business at a safe margin.
What needs to be reported is data – whether GAAP, non-GAAP or extra-GAAP – that helps financially-literate readers answer three important questions: 1) Approximately how much is this company worth? 2) What is the likelihood that it can meet its future obligations (whether to owners or creditors)? and 3) How good a job are its managers doing, given the hand they have been dealt?
In most cases, answers to one or more of the three questions are somewhere between difficult and impossible to glean from the minimum GAAP presentation. The business world is simply too complex for a single set of rules to effectively describe economic reality in a wide variety of businesses, especially conglomerates.
Twisting the problem yet further is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to be overcome. Too often their accountants willingly assist them – “How much,” says the client, “is two plus two?” Replies the ever cooperative accountant, “What number did you have in mind?” Even honest and well-intentioned managements sometimes stretch GAAP a bit in order to present figures they think will more appropriately describe their performance. Both the smoothing of earnings and the “big bath” quarter are “white lie” techniques employed otherwise by upright managements.
Then there are managers who actively use GAAP to deceive and defraud. They know that many investors and creditors accept GAAP as the gospel truth. So these charlatans interpret the rules “imaginatively” and record business transactions in ways that technically comply with GAAP but actually display an economic illusion to the world.
As long as investors – including supposedly sophisticated institutions – place fancy valuations to reported “earnings” that march steadily upwards, you can be sure that some managers and promoters will exploit GAAP to produce such numbers, no matter what the truth may be. Over the years, there were many accounting-based frauds of staggering size. Few of the perpetrators have been punished. Many have not even been censured. It has been far easier to steal large sums of money with a point of the pen than small sums with the point of a gun.
An interesting accounting irony lies in the treatment of controlled companies and those of minority holdings such as marketable securities. For controlled entities, all the earnings the subsidiary declares will flow to the parent’s income statement. The reverse is true for marketable securities where a business holds a minority stake. Only dividend declared by the marketable stock will be reflected in the business income statement. Thus, all other retained earnings will not be shown. However, accounting rules provide that the carrying value of these minority holdings of marketable stocks must be recorded on the balance sheet at current market prices. The result: GAAP accounting allows business to reflect in their net worth the up-to-date underlying values of the businesses they partially own, but does not allow businesses reflect their underlying earnings in their income statement.
The reverse is true for controlled entities. Here, businesses are allow to show full earnings in their income statement but never change the asset values on their balance sheet, no matter how much the value of a business might have increased since it was purchased.
Therefore, the mental approach to such accounting schizophrenia is to ignore GAAP figures and to focus sorely on the future earning power of both controlled and non-controlled businesses. Using this approach, we are able to establish our own ideas of business value better, and keeping these independent from both the accounting values shown on the books for controlled companies and the values placed by a sometimes foolish market on the partially-owned companies. It is this business value that investors should hope to increase at a reasonable rate in the years ahead. After all, what a stock price should represent is buying for all the future earnings of a business at a safe margin.
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