Unacceptable Accounting

I don't trust GAAP.

There. I've said it.

The problem with GAAP, better known to its practitioners as "generally accepted accounting principles," is that it simply doesn't reflect reality as it relates to investors and the companies in which they invest.

One way that GAAP distorts reality -- and it's the point I want to address today -- is that it tries too hard to show what's really going on at a company. I'm referring to depreciation and amortization -- processes that take one-time, major cash outlays, break them down into bite-size chunks, and subtract them from earnings over a period of time.

Let's look at an example. "Joe Fool" earns a comfortable, $48,000-a-year salary somewhere in middle America. He owns a modest home, complete with a $1,000-a-month mortgage payment, and a fancy car, for which he has a $500-a-month payment. If Joe viewed his world according to GAAP (a tip of the Fool's cap to John Irving), this is how he might spend his earnings.

Like most Americans, Joe would spend at least as much as he earns every year. He'd figure out how much his expenses run him over the course of a year, divide by 12, and dole out $4,000 every month: $1,000 to the tax man, $1,000 to the bank, $500 to the car company, and $1,500 on things such as utilities, food, and medical insurance. He'd do quite well 10 months of the year, but twice a year, he might be in for a surprise.

Waiter, there's a lump in my expenses
The problem is that twice a year, there's a lump in Joe's expenses: his car insurance bill. Every six months, his insurance company sends him a bill for $600 to cover the annual $1,200 premium. Under GAAP, this shouldn't happen. Under GAAP, the $1,200 annual insurance premium would be amortized into equal $100 increments over the course of the year. The two lump-sum payments would be flattened into a smooth, continual drain on Joe's "earnings."

This is where GAAP ceases to imitate real life. In real life, spending $4,000 every month subjects Joes to a twice-a-year dilemma: the $600 car-insurance bill. Unless Joe has carefully tucked away $100 per month in anticipation of his lump-sum cash outlays, he could be in for a nasty surprise. In months six and 12, he might have to cut back on his discretionary spending, and the extra expense might even threaten his ability to pay the mortgage on time.

Accounting imitates life
An individual's car insurance is a special case, of course. Most of us insure our cars for a year at a time and pay premiums twice a year, just like Joe. But companies depreciate their car fleets, equipment, property, and so on over terms that generally range from five to 40 years. GAAP's aim in permitting these extended periods of depreciation is to "imitate life" -- to reflect the reality that a company can spend $1 million on a piece of equipment in 2005 but use that equipment in its business through 2015.

If the company "expenses" its equipment's entire cost in 2005, its reported earnings seem to take an immediate $1 million hit (making 2005 a "bad" year), while most of the profits that result from that expense won't be seen for years to come. Conversely, years 2006-2015 will see all of the benefits of the investment and none of the costs. By permitting the depreciation of the equipment over its expected service life, therefore, GAAP aims to smooth out and evenly distribute both the equipment's cost and its benefits -- in other words, to better reflect reality.

What's wrong with that?

Life imitates accounting
This is where Joe comes in. Joe reminds us that GAAP's version of reality may differ markedly from the real-world facts. A company's GAAP income statement does an adequate job of describing its big-picture performance, but it does a lousy job of reflecting a company's cash profitability today. For that, you need to examine the cash flow statement.

Reading a company's cash flow statement is the next best thing to watching in real time as cash comes in through the front door and is deposited in the bank, and then seeing that same cash get withdrawn and spent on inventories, equipment, and debt reduction.

A cash flow statement gives you the present-day view of the situation, and because it shows you the company's costs as they're incurred, it provides you a preview of how reported GAAP earnings might be depressed in the future.

On the flip side, the cash flow statement lets you see how well a company's past investments are paying off in real cash earnings today. For example, a company that invested heavily in building capacity and improving efficiency in years past may still be "paying" for this investment today, in the currency of market perceptions. Its GAAP net income may be depressed by large depreciation costs that are still being written off from past cash outlays. Yet the company may be making far fewer cash outlays to maintain its infrastructure today -- boosting its cash profitability.

Take a look, for example, at a few well-known tech names. You may be surprised to see just how much more cash-profitable these companies are today than their GAAP accounting profits suggest:

At the end of fiscal 2002, these companies' cash profits (free cash flow) were running at better than twice accounting profits (GAAP net income). Seeing this, savvy stock shoppers might have been able to anticipate the next year's stock market revival. Fiscal 2003 marked the beginning of a 55% rise in the S&P 500, as accounting profits closed the gap with cash profits, growing 68% year over year.

In other words, fiscal 2003 was the year that GAAP began to imitate real life.

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Microsoft is a Motley Fool Inside Value recommendation. eBay is a Motley Fool Stock Advisor pick.

Fool contributor Rich Smith has no position in any of the companies mentioned in this article. The Fool's disclosure policy would require him to tell you if he did.