Accountants and stock analysts often disagree on which expenses are “real” or relevant and which if any can be ignored.
For example, the accountant believes that goodwill and virtually every other asset (with the notable exception of land) should be depreciated or charged against income over a suitable number of years. In contrast, the stock analyst often argues that depreciation and amortization should not be deducted in arriving at the relevant net income for stock valuation purposes. Since the accountant has already deducted these items, the analyst often “adds them back” to net income.
The accountant believes that unusual gains and losses such as restructuring charges and gains on asset sales need to be accounted for in net income. The analyst argues that these one-time items need to be added back to arrive at the adjusted or recurring earnings.
Who is correct? the analyst or the accountant?
Actually both are correct. They each have different goals in measuring earnings and their different purposes require differing methods.
The accountant is interested in measuring the income earned by the original investors in a company. The accountant is always reporting historical figures.
In contract the stock analyst is interested in historical earnings only to the extent that they provide clues about future earnings and cash flows.
The accountant depreciates an asset to account for its original cost. The stock analyst in contrast considers the original cost of an asset to be irrelevant and instead is interested in the future capital spending that will required to replace the portion of assets that were worn out during the year.
Why analysts and investors care about earnings.
In theory, a share in a business is worth the “present value” of all future net cash flows that are expected to accrue to that share.
If companies provided useful figures on the net free cash flow generated each year then investors would probably be better served to focus on that figure, rather than on net income. The accountant’s cash flow statement reconciles beginning and ending cash but unfortunately mixes up the capital spending needed to replace worn out assets with the discretionary capital spending which is intended to grow the business. Therefore, the accountant’s statement of cash flows does not clearly reveal the amount of free cash flow generated. And companies (with rare exception) simply do not provide a supplemental disclosure of free cash flow.
Investors therefore tend to focus on net earnings because it is usually the best available estimate of sustainable free cash flow generation.
When a stock analyst looks at earnings or cash flow he or she (paradoxically) is not primarily interested in the earnings for that year. He is really interested in using current earnings to project the future stream of earnings or free cash flow since a share is worth the present value of future cash flows.
The analyst must always adjust reported net earnings for any unusual one-time gains or losses in order to arrive at the sustainable, recurring earnings.
The analyst has a completely different view of depreciation, as compared to the accountant. Depreciation as such is a non-cash charge. It does not affect cash flow and is therefore not directly of interest to the analyst. However, the analyst is very much concerned about assets wearing out and needing to be replaced. The analyst wishes to estimate the present value of capital expenditures to replace assets that were worn out in achieving the years net income. Therefore, ideally the analyst will add back depreciation to the accountant’s net income and then subtract off the present value of the capital spending that will be needed to replace the assets that were worn out or depleted in earning the year’s income. Unfortunately, in practice, there is usually no estimate available of the capital spending that will be required to replace worn out assets.The analyst will often accept the accountant’s depreciation as a reasonable approximation of the ultimate cash flow impact.
But there are a few notable exceptions. Goodwill is usually amortized for accounting purposes. But goodwill is usually not a wasting asset. It may never need to be replaced. On that basis the analyst can ignore this amortization as an expense. Depreciation of a building is charged by the accountant. But an analyst may determine that the actual capital spending to replace building after it is “worn-out” will not occur for say 35 years. In this case the present value of that capital spending (even after inflation) may be much smaller than the depreciation charge. In this case the analyst may add back most of the depreciation charge on the basis that it (and the ultimate capital spending 35 years hence) has no material impact on the present value of cash flows. This explains why real estate is usually analyzed on a cash flow basis rather than on net income. The net income of a real estate company may consistently under-state its cash flow, while for for many other companies, that would not be true.
The purpose and meaning of the net earnings reported by the Accountant under GAAP.
Accounting Net Income is meant as a performance measure. Over the life of a corporation the total net income is precisely equal to the net free cash generated by the business. Over any long period of years, the total net income is usually approximately equal to the net free cash generated by the business.
The major goal of accounting is, as the name implies, to give an accounting of the business during the year.
The income statement attempts to show in a fair manner the share of the total net cash that “belongs” to each particular year or period of time. However, income is measured on an accrual basis and not on a cash basis. For accounting purposes, we do not care when the cash will be received. To the accountant a dollar to be received in two years, is just as good as a dollar received now.
Accounting net income is very much affected by the historic cost of invested assets, and not at all affected by the future cost to replace worn out assets. For example the historic cost of a building may be amortized as an expense over (say) 20 years. Whether or not he building has to be replaced at the end of 20 years or what it will cost to replace the building at that time has no bearing at all on the Accounting net income.
The accountant measures the net income from the perspective of an original investor in a company. The accountant amortizes goodwill because it was paid for and must be charged against income over a period of years to arrive at net income.
Land is not depreciated on the assumption that it does not wear out and can be sold for (at least) its original cost at any time.
The accountant includes unusual gains and losses in net income because they do contribute to the return earned by the original investors in a firm.
Conclusion
The accountant and the analyst will always differ in their opinion of the “true” net income because they employ different methods driven by their differing goals. The accountant is historical oriented and asks how much did we make? The analyst is future oriented and asks what is the level of recurring income that can be used to predict future income? (and therefore the value of the shares).
Shawn Allen, CMA, MBA, P.Eng.
January 11, 2002