FOOL ON THE HILL: An Investment Opinion
Beware of Inflated Earnings

It's becoming fashionable to talk about recording certain expenses as assets, but this treatment could very well create worse problems for the average investor than the ones it's trying to solve, such as inflated earnings. Let's leave advertising expenses on the income statement.

By Richard McCaffery (TMF Gibson)
August 17, 2000

There's a lot of talk about accounting these days, about new-age companies dodging time-tested practices and about old-age accounting measures not reflecting the economic reality of today's companies.

There's truth on both sides of the aisle.

For example, many investors know how carefully they have to read earnings reports, considering the dizzying array of pro forma numbers, barter agreements, cash earnings, and misleading EBITDA (earnings before interest, taxes, depreciation, and amortization) ratios. It's a minefield created by crafty executives.

At the same time, the discrepancy between book values and market values of publicly traded companies has never been greater -- and it's widening. The accounting profession hasn't found a workable solution for this very difficult problem.

Consider drug maker Pfizer (NYSE: PFE), which recently bought Warner-Lambert for about $90 billion. At the end of the first quarter, Pfizer had a book value of $14.9 billion, yet its market value is about $255 billion.

Why the discrepancy? A big part of the problem is that it's very hard to judge the value of intangible assets, yet firms like Pfizer, Oracle (Nasdaq: ORCL), and Cisco Systems (Nasdaq: CSCO) aren't valued on net assets (total assets minus total liabilities), but on intellectual property such as patents, software systems, and even employees.

The accounting treatment of patents, for example, can lead to serious understatement of a firm's earnings potential. Products being developed in-house, such as Pfizer's Viagra, must be written off right away as R&D expenses on the income statement, leaving virtually no trace of its value on the balance sheet.

Only patents purchased from other companies get capitalized at cost, meaning the purchase price subsequently appears as an asset. Pfizer had $1.03 billion in Viagra sales last year, yet the value-creating ability of the patent isn't captured on the company's balance sheet.

Business magazine Fast Company ran the best story I've seen on this topic so far -- an interview with New York University's Baruch Lev, an accounting and finance professor who's addressing the shortfalls of accounting head-on. It's a must-read for anyone interested in learning more about the strengths and weaknesses of accounting and its relevance to the average investor.

I agree with much of what Lev has to say -- and I'd like to hear a lot more -- but I'm not on-board with everything he suggests, particularly the idea of capitalizing advertising costs. This is where America Online (NYSE: AOL) got into trouble in 1995 and 1996.

A little background: As a rule, expenses such as advertising costs get written off in the period they're expensed, which lowers net income. It's a basic rule of accounting. Under certain conditions -- namely, if a company can demonstrate that ad expenditures will create a future benefit -- it can keep the expenses off the income statement by capitalizing them.

AOL, which was fined $3.5 million in May by the Securities and Exchange Commission for employing this technique, capitalized advertising costs to reduce losses in 1995 and turn a profit in 1996.

Lev isn't the only one leaning toward this type of treatment. Fortune columnist Geoffrey Colvin (who's articles are always worth a read) argued that companies like Amazon.com (Nasdaq: AMZN) should get to capitalize expenses such as R&D, marketing, and advertising since they don't have to build stores and warehouses the way their real-world counterparts do.

I'm not buying it.

For every AOL that capitalizes $391 million and parlays it into a $125 billion market value, there will be 100 companies that overstate net income, capitalize expenses that fail to provide a future benefit, and vastly understate their true cost of doing business.

Online pet retailer Pets.com (Nasdaq: IPET) created a lot of buzz and brand awareness with its sock puppet commercials, right? That doesn't mean I want those pricey Super Bowl ads recorded as an asset. If accounting rules permitted this, the company, which spent $17.1 million on marketing and sales in the second quarter, could have put most of it back on the income statement, erasing a big chunk of its $24.1 million net loss.

From an economic standpoint, however, the company would be no more profitable, and no closer to meeting its financial objectives than under the current treatment. Taken as a whole, the income statement would become even more irrelevant.

A dearly held accounting principle called conservatism states that if there are two ways of reporting a transaction, use the one that puts the company in the harshest light. It's a technique that helps accountants avoid overstating assets and understating liabilities (thus creating nasty surprises).

I hope conservatism continues to be a guiding force in the world of accounting -- since there's so much hyperbole in the rest of it.

Related Link:

  • SEC Order Regarding America Online