Accounting and Valuation: How Helpful Are Recent Accounting Rule Changes?

The longstanding debate over the proper definition of “earnings”—whether investors when setting stock prices focus primarily on GAAP earnings or other measures like operating cash flow—is both misguided and theoretically unresolvable. The biggest problem faced by investors in evaluating earnings reports is not their inability to understand the effects of the different accounting methods companies use when aggregating accounting line items into reported net income. More challenging, and more critical to the investment process, is getting complete and reliable information about the line items themselves. The authors' underlying premise is that investors, when provided sufficient information about these “components” of earnings, can combine or reconfigure them in whatever way they find most useful. But without sufficient and reliable information about the individual line items, investors will find it difficult to understand how earnings are generated and thus to produce the forecast of future earnings necessary to value a company. In the past few years, there have been significant rule changes in accounting for employee options, derivatives, and special purposes entities. The authors evaluate the extent to which the new rules encourage disclosures that are helpful from a valuation perspective. Although there has been some progress, financial reporting in each of the three areas continues to fall well short of providing the complete, disaggregated data required to value a firm with confidence.