Lesson 1 of 9
Why the numbers are chosen
Total profit equals total cash over a company's life, and accounting only decides which year each dollar lands in.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Over a company's whole life, total profit equals total cash, and accounting only decides which year each dollar lands in.
- Conservative accounting is not high-quality accounting: expensing depresses profit now and leaves a higher return on capital later than capitalising does.
- Two companies can report the same loss for opposite reasons, and the statements cannot show whether the spending built anything durable.
Reported profit is a choice as well as a measurement. Over a company's whole life, total profit equals total cash generated, and no accounting policy changes that sum. What a policy decides is which year each part of it belongs to, and the company reporting the result makes that decision itself.
Return on capital under two accounting policies
- Expensed immediately
- Capitalised and amortised
Show the numbers
| Expensed immediately | Capitalised and amortised | |
|---|---|---|
| Year 1 | 25.0% | 37.5% |
| Year 2 | 25.0% | 29.6% |
| Year 3 | 25.0% | 24.1% |
| Year 4 | 25.0% | 20.0% |
| Year 5 | 25.0% | 16.7% |
Why a period needs estimates
A reporting period is a line drawn across a business that keeps running past it. Matching revenue to the cost of earning it means guessing. How many sales will come back, how long will an asset last, how much of a receivable will be collected?
Each estimate is defensible, and each one moves income from one period to another. Penman argues in Financial Statement Analysis and Security Valuation that accounting rules shift income between periods, and create none.
Conservative is not high quality
Two different things get called earnings quality. One is conservatism: costs recognised early, revenue recognised late, so profit is understated now. The other is persistence: whether this year's earnings say anything about next year's.
They can point opposite ways. A company that expenses everything it spends carries a smaller asset base than one that capitalises (Records spending as an asset, then charges it against profit over the years it serves.) the same spending, because the spending never became an asset. Divide profit by that smaller base for long enough, and the conservative company reports the higher return on capital (profit divided by the capital the business uses), on identical cash.
A reader who takes that return as a sign of quality is admiring a number a policy made.
One loss, two meanings
A young company investing heavily and a company with no prospects can both report a loss. Under a policy of expensing, neither balance sheet shows what the spending built.
Damodaran's The Dark Side of Valuation treats such companies by forecasting the path to a mature margin explicitly, rather than reading the current loss. If you cannot say what the spending is building, you have a copy of the loss, not a view of the company.
Do it on a real 10-K
- Open the significant accounting policies note in Item 8, and read it beside last year's.
- Circle every sentence that changed. That is where a number moved.
Check yourself
Over a company's whole life, what does total reported profit equal?
- Total revenue
- Total cash generated
- Total assets
Show the answer
Answer: B.
Every accounting policy only allocates that cash across periods, pay in shares aside. None of them creates or destroys any of it.A company expenses everything it spends. An identical rival capitalises the same spending. After several years, which one reports the higher return on capital?
- The one that capitalised, because its asset base is larger
- The one that expensed, because its asset base stayed smaller
- Both report the same return
Show the answer
Answer: B.
Expensing depresses profit once, in the year of the spend, but keeps the asset base permanently smaller. Dividing profit by a smaller base eventually gives the higher return.Two companies report the same loss. One is investing heavily in something new; the other has no prospects. What can the statements not tell you?
- Which one spends more on research
- Whether the spending is building anything durable
- Which one has the larger loss
Show the answer
Answer: B.
Under expensing, neither company's spending appears as an asset, so the statements record how much was spent, not what it bought.Sources
- Penman, Financial Statement Analysis and Security Valuation: accounting rules shift income between periods, not into existence; a conservative choice depresses earnings now and raises them later.
- Damodaran, The Dark Side of Valuation: young and loss-making companies, valued by forecasting the path to a mature margin rather than abandoning the model.
What this leaves out
- The example above assumes the business ends, because a going concern never reaches the year when every allocation has reversed.
- The two-policy comparison and the return-on-capital chart use round invented numbers, chosen so the arithmetic can be checked by hand.
- The chart assumes flat spending; while spending grows the gap narrows, and very fast growth can reverse it.
- Lifetime profit equals lifetime cash only when costs are paid in cash: pay in shares lowers profit and never touches cash, which the next lesson measures.
- This lesson describes US GAAP for a domestic filer on Form 10-K; a company reporting under another framework follows its own rules.
- Nothing here is advice about any security.