The viable solution is to disassemble the financial statements and then reassemble them using globally consistent standards that repair the problems cited above.
Research shows more than 130 adjustments are necessary to create uniformity in financial reporting standards. As-reported standards are inconsistent in either rule or application across GAAP and IFRS to such a degree that any one of these 130+ adjustments has been shown to create a material inconsistency in reported assets, earnings, or even revenue when conducting trend analysis or comparing peers.
Another important issue regarding the necessary adjustments is that to attain uniformity, automated and manual adjustments are necessary. Thankfully, many adjustments to the reporting standards can be done on an automated basis. In other words, for those adjustments, one can simply create a formulaic rule for creating uniformity.
An example would be in the reporting of cost of goods sold wherein all companies would be set to a LIFO, last-in first-out method, to remove the distortion of some firms reporting on a FIFO first-in first out basis.
For firms where cost of goods sold is a significant portion of expenses, or the firm does not turn over inventory frequently, clearly varying LIFO and FIFO methods can create inconsistencies in assets and earnings. The fix is easy and automatable.
Manual vs. Automatable
Unfortunately, several of the necessary adjustments are manual in nature and require specific analysis to arrive at the proper adjustment to achieve uniformity. In other words, one cannot simply “add-back” or “subtract-out” a financial statement item to create an apples-to-apples comparison of company activity.
An example comes from mergers and acquisitions accounting, which even in “low” M&A environments can create massive inconsistencies in financial reporting.
Most of the world’s governing accounting bodies have disallowed the pooling of interests method of accounting for acquisitions. Under the governing “purchase method” rules, significant material distortions arise in assets, earnings, liabilities, reported cash flows, and even revenue. The problem is that the date of the acquisition drives the income statement and cash flow statement, while the balance sheet is unaffected. At the end of the year, the parent company reports an acquisition fully on the balance sheet, with goodwill.
However, the impact on the income statement and the cash flow statement is wholly dependent on the acquisition date. An acquisition early in the parent company’s fiscal year will show much of the target firm’s revenue, earnings, and cash flow. An acquisition at the end of the year will show almost none of it.
The mismatch between the balance sheet and the inconsistent income and cash flow statements is obvious. The fix requires an analyst to manually examine the data, and while systematic in nature, create a manual “fix.”
Unfortunately, many of the required adjustments to repair material inconsistencies require good old-fashioned elbow grease by a seasoned financial analyst. The quality of financial reporting is sufficiently inconsistent such that an automated “spreadsheet” will not repair many of the material distortions.
Accounting and financial reporting inconsistencies that require adjustments to reach Uniform Accounting standards under UAFRS listed below. This list is not comprehensive.
- Research and Development
- Pension Accounting
- Extraordinary Charges
- Tax Loss Carryforwards
- Working Capital Cash Balances
- Asset Life
- Excess Cash
- GDP Deflator Adjusted Gross PP&E
- Operating Long-term Investments
- Goodwill Impairment
- Acquisition Adjustments
- Asset Writedowns
- Insurance Settlements
- Dividend Income
- Pre-tax Profit/Loss from Asset Sales
- Pre-tax Profit/Loss from Investment Sales
- Discontinued Operations
- Restructuring Charges
- Merger & Related Restructuring Charges
- Non-operating Income/Expense
- Lease Capitalization
Research & Development Adjustments
There are many companies that have regular material investments in R&D each year that as-reported financial statements treat as expenses. This violates one of the core principles of accounting, which is that expenses should be recognized in the period when the related revenue is incurred. R&D investment is an investment in the long-term cash flow generation of the company, which is especially true for biotech companies where research work can take years to bear fruit.
Because as-reported metrics treat R&D investment as an expense, as opposed to an investment, net income is artificially decreased. Net income is then materially understated relative to UAFRS-based Earnings. As a result of this distortion, as-reported ROAs end up looking significantly lower than Adjusted ROA, showing a consistent variance. Investors may therefore believe that a company has less success with their R&D investments than they actually are. This leads to investors and management believing that the company has weaker performance than is justified, resulting in poorer valuations.
Many companies’ operating lease expense is material. The decision management makes between investing in capex and investing in a lease is not a decision between an expense and an investment, but rather a decision in how management wants to finance their investments. If they would rather spend cash up front for the asset, they will spend capex. However, if they want to spread the cost of the asset over several years, they will instead choose to lease the asset. That said, as-reported accounting statements treat one as an investment, and the other as an expense that does not impact the balance sheet.
When companies spend materially on operating leases, as-reported metrics like Total Assets and ROA materially overstate the company’s true profitability and capital efficiency versus UAFRS’s adjusted metrics. This can lead to investors and management believing that the company has a stronger performance than is justified, inflating valuations.
Working Capital Cash
Many companies make the decision to carry a material amount of cash on their balance sheet. Corporations inherently need some level of cash to operate their business, without which they would have liquidity issues and customers and suppliers would be hesitant to build long-term relationships with them. However, companies with substantial cash balances (above what one might view as “operating” cash) can see as-reported ROA diluted because of the substantial portion of the balance sheet that ends up being taken up by cash that is earning limited or no return, especially in the current environment. As such, if excess cash is not removed from the asset base of a company before looking at performance metrics, a company can appear to have substantially lower operating profitability (in terms of ROA) than it actually has.
When a company carries a material excess cash balance, as-reported metrics like ROA materially understate the company’s true profitability and capital efficiency versus UAFRS-based metrics. This can lead to investors and management believing that the company has weaker performance than is justified, depressing valuations.