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Financial reporting, especially in the US, with its very public capital markets, has reached the point where "accrual-based" earnings are almost meaningless. Reported earnings are driven as much by "earnings expectations" as they are by real business performance. Balance sheets fail to reflect the major drivers of future value creation. And, cash flow statements are such a hodge-podge of operating, investing and financing activities that they obfuscate, rather than illuminate, business cash flow performance. Financial statements need marked overhaul to be useful for analysis and decision-making in today's knowledge-driven and shareholder value-creation environment. The proposed changes fall into 3 categories: 1. Move to a much more explicit shareholder value creation and cash orientation. 2. Expand the definition of investments to include intangibles. 3. Change the title to "operating statement" and other "housekeeping" of financial statements.

Financial reporting is broken and has to be fixed - and fast! If it isn't, we will continue to see more cases such as Xerox, Lucent, Cisco Systems, Yahoo! and Enron. Xerox's market value is down 90 percent, or $40 billion, in the past two years. In the same period other market losses include; Lucent, down more than $200 billion; Cisco Systems, off more than $400 billion; Yahoo!, more than $100 billion; and Enron, down more than $60 billion in the largest bankruptcy of all time.

Some argue that these are extreme examples of "irrational exubuerance." Some in the accounting profession say that such cases represent a small percentage of the aggregate number of statements audited - some 15,000 public company registrants. Perhaps. But a financial reporting framework that permits these companies to suggest that they are doing well, and, by implication, to justify market valuations which, subsequently, cost investors trillions in the aggregate, is unconscionable.

Financial reporting, especially in the U. S., with its very public capital markets, has reached the point where "accrual-based" earnings are almost meaningless. Reported earnings are driven as much by "earnings expectations" as they are by real business performance. Balance sheets fail to reflect the major drivers of future value creation - the research and product, process and software development that fuel high technology companies, and the brand value of leading consumer product companies. And, cash flow statements are such a hodgepodge of operating, investing and financing activities that they obfuscate, rather than illuminate, business cash flow performance.

The FASB, in its Concept No. 1, states, "financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions." This is simply not so.

The primary financial statements income statement, balance sheet and cash flow statement - which derive their foundation from an industrial age model, need major redesign if they are to serve as the starting point for meaningful financial analysis, interpretation and decisionmaking in today's knowledge-based and value-driven economy. Without significant redesign, ad hoc definitions such as pro forma earnings, returns and cash flows will continue to proliferate. So will significant reporting "surprises!"

Starting Point:

Market Value Creation

The objective of a business is to increase real shareholder value what Warren E. Buffett would call the "intrinsic value" of the firm. It's a very basic idea: Investors get "returns" from dividends and realized market appreciation. Both investments and returns are measured in cash terms, so individuals and investors invest cash in securities with the objective of realizing returns that meet or exceed their criteria. If their judgments are too high, and that later becomes clear, the market value of the firm will drop. If judgments are too low and cash flows turn out to be stronger, market values increase.

From a managerial viewpoint, the objective of increasing shareholder (market) value really means increasing the net present value (NPV) of the future stream of cash flows. Note, "cash flows," not "profits." Cash is real; profits are anything, within reason, that management wants them to be. If revenues are recognized early or overstated - and expenses are deferred or, in some cases, accelerated to "clear the decks" for future periods, resulting earnings may show a nice trend, but do not really reflect economic performance.

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There are only three ways management may increase the real market, or "intrinsic," value of a firm. First, increase the amount of cash flows expected at any point in time. Second, accelerate cash flows; given the time value of money, cash received earlier has a higher present value. Third, if a firm is able to lower the discount rate that it applies to its cash flows which it frequently can - it can raise its NPV.

Given that cash flows drive market value, financial statements should put much more emphasis on cash flows. The statement of cash flows now prescribed by the accounting community and presented by management is not easily related to value creation. Derived from the income statement and balance sheet, it's effectively a reconciliation statement for the change in the balance of the cash account. A major overhaul of the cash flow statement would directly relate to market valuations.

Cash Earnings and Free Cash Flows Managers and investors should focus on "cash earnings" and the reinvestments that are made into the business in the form of "working capital" and "fixed and other (including intangible) investments." The net amount of these cash flows represent the business's "free cash flows."

With negative cash flows - frequently the case for young startups and high-growth companies - a business must raise more capital in the form of debt or equity. The sooner it gets its free cash flows positive, the sooner it'll begin to create value for shareholders. Positive free cash flows provide resources to pay interest and pay down debt, to return cash to shareholders (through stock repurchases or dividends) or to invest in new business areas.

The traditional cash flow statement purportedly distinguishes between operating, investing and financing cash flows, and has as its "bottom line" the change in cash and cash equivalents. In fact, the operating cash flows include the results of selling activities, investing in working capital and interest expense, a financing activity. Investing cash flows include capital expenditures, acquisitions, disposals of assets and the purchase and sale of financial assets. Financing cash flows consist of what's left over.

Indeed, the bottom-line change in cash is not a useful number, other than to demonstrate that it may be reconciled with the change in the cash account. If one wants a positive change in cash, simply borrow more. These free cash flows ultimately drive market value, and should be the focus of managers and investors alike.

Replacing Income With Cash Earnings

The traditional "profit and loss," or "income," statement needs modification in three ways, two of which are touched on above, along with a namechange, to "Operating Statement." That would suggest a representation of the business' current operations, without the emphasis on accrualbased profits.

Interest expense (income) should be eliminated from the statement, as it represents a financing cost rather than an operating cost. A number of companies do this internally to determine "net operating profit after taxes" (NOPAT).

Also, NOPAT needs to be adjusted for the various non-cash items, such as depreciation, amortization, gains and losses on the sale of assets, taxtiming differences and restructuring charges - which affect income but not cash flows. The resultant "cash earnings" better represents the current economic performance of a business than accrual income and, very importantly, is much less susceptible to manipulation.

A third adjustment is the order in which the classes of expenses are displayed. Traditional income statements report cost of goods sold or product costs first, frequently focus on product gross margins, and then deduct, as a group, other expenses such as technical, selling and administrative expenses. This order made sense in the industrial age when product costs dominated. It does not for many of today's high-tech or consumer product companies. It would be more useful for companies to report expenses in an order that reflects the flow of the business activities. One logical order that builds on the concept of a business' value chain, is to categorize costs into development costs, product (service) conversion costs, sales and customer support costs and administrative costs.

Reinvesting in the Business

For most companies - especially those with significant investments that are being depreciated or amortized cash earnings will be significantly higher than NOPAT. Unfortunately, cash earnings are not free cash flows because most businesses have to reinvest in working capital, property, plant and equipment and intangible assets, just to sustain - let alone increase their productive capabilities.

As a business grows in sales volume, assuming that it offers credit to its customers who pay with the same frequency, accounts receivable will increase proportionately. As sales volumes increase, so, too, will product costs, inventories and accounts payable balances. Working capital principally receivables, inventories, and payables - will tend to increase proportionately with sales growth, and will require cash to finance it. The degree to which it grows is a function of receivables terms and collection practices, inventory management and payables practices.

Companies such as Dell Computer Corp. collect payments up front, turn inventories in a few days and pay their vendors when due. The net effect is that as Dell grows it actually throws off cash, rather than requiring it to support increases in working capital. Most companies are not as efficient; the amount of cash needed to support increases in working capital can be as much as 20-25 percent of any sales increase. The degree to which working capital increases as sales increase is an important performance metric. Lower is better, which absolutely flies in the face of such traditional measures of liquidity as "working capital" and "quick" ratios, for which higher has been considered better.

Balance sheets ought to reflect investments that represent future value. What drives value for many businesses in today's knowledge-based economy - pharmaceuticals, high technology, software and brand-driven consumer product companies - is the investments in R&D, product, process and software development, brand equity and the continued training and development of the work force. Yet, based on generally accepted accounting principles (GAAP) accounting, these "investments" in the future are not reflected on balance sheets, but, rather, expensed in the period in which they are incurred.

A frequent argument for "expensing" is the unclear nature of the investments' future value. Apparently, investors believe otherwise, evidenced by the ratio of market values to book values having exploded in the past 25 years. In 1978, the average book-tomarket ratio was around 80 percent; today it is around 25 percent. In the early 1970s, when accounting policies were established for R&D, product lines were narrower and life cycles longer, resulting in R&D being a much less significant element of cost. Expensing was less relevant. Now, with intangible assets having become so central and significant, expensing - rather than capitalizing and amortizing them over time - results in an absolute breakdown of the principle of "matching," which is at the heart of accrual accounting. The world of business has changed; accounting practices must also change.

Financial Statement Overhaul Financial statements need marked overhaul to be useful for analysis and decision-making in today's knowledge-driven and shareholder valuecreation environment. The proposed changes fall into three categories:

First - Move to a much more explicit shareholder (market) value creation and cash orientation, and away from accrual accounting profits and return on investment calculations predicated on today's accounting policies. Start with a shareholder perspective for cash flows, then reconstruct the statement of cash flows to clearly provide the free cash flows that the business' operations are generating. Cash earnings and reinvestments in the business comprise free cash flows.

Second - Expand the definition of investments to include intangibles, which should be capitalized as assets and amortized according to some thoughtful rules. This will better reflect investments that have potential future value.

Third - Change the title to "operating statement" and other "housekeeping" of financial statements, to include categorizing costs in a more logical "value chain" sequence and aggregating all financial transactions, such as interest and the purchase and sale of securities, as financing activities.

Value creation is ultimately measured in the marketplace, so it stands to reason that if a firm's market value increases consistently, over time, and can be supported by improvements in its cash generation performance, real value is being created. For this to happen, the place to start is by fixing the financial statements.

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