In his latest paper titled, Intangibles And Earnings – Improving The Usefulness of Financial Statements, Michael Mauboussin explains why one size does not fit all when it comes to financial statements. Here’s an excerpt from the paper:
The goal of accounting, the language of business, is to provide financial information to allow managers and other claimholders to make informed decisions about a company.
The Sarbanes-Oxley Act of 2002 requires the chief executive officer and chief financial officer of a U.S. public company to certify that the firm’s financial statements are true and without material omissions, and to present fairly the operations and financial condition. The executives must also certify that the necessary internal controls are in place to make sure that that they receive material information.
In recent decades, the ability to interpret financial statements has been complicated by the shift from tangible to intangible investments. Tangible assets are physical, such as factories or trucks. Intangible assets are non-physical and include brand-building or employee training.
This is a problem because accountants primarily reflect tangible investments on the balance sheet and intangible investments on the income statement. Tangible assets are depreciated over their useful lives, which shows up as an expense on the income statement.
And intangibles are recorded on the balance sheet and amortized only following an acquisition. But that today’s investments do not show up in the same spots as in the past means that financial statements do not provide the same information.
A sensible solution to this challenge is to capitalize the investments that appear on the income statement and amortize them over their useful lives. This means treating an intangible investment the same as a tangible investment. But this raises two big questions: which income statement items are appropriately considered investments and what is a proper useful life for those assets?
This report takes up those questions by leveraging recent academic research. The main finding is that one size does not fit all. These adjustments recast profitability for some companies and are inconsequential for others. Overall, we estimate that earnings for the S&P 500 would be about 12 percent higher with consideration of these changes.
You can read the entire paper here:
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