One final observation concerning audited financial statements: The reported outcomes are based on the GAAP system, which means that the conclusions are far from accurate. You need to take steps to adjust re- ported results to identify likely future trends.
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Corporations often deceive investors by forcing specific ratios to look positive when the trends are, in fact, negative. An even larger problem: There is nothing in GAAP to prevent such practices.
Key Point
The results you see on an audited statement include everything, even profits from nonrecurring events. So if a company sells a major op- erating unit or has capital gains, those profits are included in the “bot- tom line” even though they won’t occur again next year. The GAAP system enables this to occur, so the reported earnings are distorted. It is the equivalent of a consumer going to the bank and requesting a loan, and including in “annual income” a $200,000 profit from selling a home a few months before. The banker would adjust the numbers and tell that person that the home sale cannot be included in “annual income.” That is precisely what corporations do in their financial statements—and it is acceptable under the GAAP system.
The reported profit and loss each year should be adjusted to remove all noncore earnings of the corporation. The core earnings that remain should be only those sources of revenue generated from the corporation’s primary (core) business.
The concept of core earnings was originated by Standard & Poor’s Corporation, and is used to rate corporate bonds. However, it makes equal sense to adjust core earnings when comparing two or more corporate financial statements. For exam- ple, if you are comparing two different corporate financial statements, are they actually comparable? One may have sub- stantial noncore revenues, while the other has none. So the GAAP-based operating statements will not be reliable or even comparable. Core earn- ings adjustments can be varied and complex, but the likely major adjust- ments usually involve a small number of items: capital gains or losses, profits from the sale of a subsidiary or operating unit, and one-time ac- counting or valuation changes, for example.
Corporate reporting is self-serving and exceptional, and the rules al- low distortions of reported profits. These practices deceive investors, so everyone needs to look beyond the official and auditor-approved statement to find the truth. One thing GAAP does not reveal in every instance is what is really going on.
Key Point
core earnings the revenues and profits a corpora- tion earns during the year from its primary business activity, and ex- cluding nonrecur- ring revenues.
One reason that there is widespread resistance among accountants and corporations to a realistic level of transparency is that it would reveal some unpleasant truths. Reporting core earnings leads to another issue:
the reporting of core net worth, which is the company’s real net worth including all liabilities. Today, corporations often do not list their pen- sion liabilities, for example. If they did, many corporations would have no net worth and even a large negative net worth. This is a very troubling idea, but it is not just a theory, it is reality. And before any investors de- cide to buy stock in a corporation, they should know, at the very least, whether that company is worth anything.
In June 2005 it was reported that General Motors, which has the nation’s largest pension fund, has inflated its net worth by $38 billion due to unlisted pension liabilities. If GM were to list this liability, it would have negative net worth. (GM’s most recently reported sharehold- ers’ equity was $27.7 billion, so an adjustment downward of $38 billion would result in negative net worth of over $10 billion.) Similar adjust- ments would move IBM’s equity from $30 billion down to $8 billion, and Ford Motor’s from $16 down to $4.7 billion.6
The problem is not just that liabilities are not reported on compa- nies’ balance sheets. These practices are acceptable and legal under GAAP. It is unlikely that the system will be changed any time soon as long as some of the country’s largest corporations might be shown to have no value whatsoever—or even a negative net worth. The very fact that GAAP allows corporations to omit important liabilities points to major flaws in the system.
Anyone can examine the financial statement footnotes to find major core earnings or core net worth adjustments and to recalculate reported profits and losses to make comparisons between companies more accurate.
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If corporations were required to report everything, it would come to light that many of the country’s largest companies—like General Motors—are worthless and have no net worth. An even bigger prob- lem is that under the GAAP system, leaving out major liabilities is allowed. Investors do not get an accurate picture of profits or even of the value of stock.
Key Point
It is unfortunate that the accounting industry has not stepped forward and made adjustments to its reporting standards to perform this obvious func- tion for investors. Eventually, GAAP may be reformed so that core earn- ings adjustments can be made. In the meantime, U.S.-based corporations continue to underestimate the importance of transparency, and may fall behind in the new global market that is emerging today.
For example, in the rapidly-growing market in China, an especially complex business environment includes publicly listed companies that may report its operating results on a number of different standards, in- cluding U.S.-style GAAP, international accounting standards (IAS), and Hong Kong GAAP. Because the three systems would create potentially different outcomes, many publicly listed companies report their results showing all three. This concept is sensible and it should be a logical form of corporate transparency, enabling anyone to compare corporate finan- cial statements without needing to delve into the complexities of financial statement footnotes. The same philosophy would make perfect sense in the United States.
Investors and analysts would be able to make complete sense out of audited statements of U.S. companies if the spirit of transparency were taken to its logical and reasonable end. Financial statements should be is- sued showing three different outcomes:
• GAAP. This is the version you get today, the interpretation of cor- porate valuation of assets and liabilities allowed by the rules, and summaries of sales, costs, expenses, and profits that may include noncore sources of revenue.
• Statutory. This version would be the same as what gets reported to the government for tax purposes. Corporations rarely publish their tax returns for investors to see; but it would be revealing in comparison, because many adjustments are possible. A compari- son between the GAAP-based report and the tax-based report would be enlightening to investors. Even though the differences may require a lot of explanation, it would provide investors and analysts with far better information than they get today.
• Core earnings. Finally, a summary of core earnings would be the most revealing. This version would be the one used to project fu- ture growth in profits and capital strength.
Why is it unlikely that corporations will shift over to full trans- parency without a fight? The fact is, today’s reporting environment is aimed at keeping stock prices as high as possible, so that institutional in- vestors like mutual funds, insurance companies, and pension funds, will want to hold shares of stock. So the motivation is focused on stock price rather than on honest disclosures and corporate transparency. The corpo- rate scandals hold important lessons for accountants, corporations, and securities analysts. Those lessons have not necessarily been learned. It is up to investors to find reality among the reported and often distorted num- bers. The next chapter provides you with information you need to begin your search for financial reality beyond the audited financial statement.
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Reporting profits and losses realistically would represent real trans- parency. The big question should be: Why is this not happening?
Key Point
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