Treatment of Earnings

BY STANLEY F. DOLE

The accounting profession has had a long and unsuccessful history of trying to determine how to treat nonoperating and nonrecurring items on a financial statement. The current movement toward including most of them in GAAP earnings has led to an increasing disconnect between GAAP earnings and what stockholders want to know.

The concept of pro forma earnings emerged to address this problem. Now various people are attempting to define what pro forma earnings should include.

One of the main purposes in reporting earnings, as far as stockholders are concerned, is to project future income. These forecasts largely determine how much an investor is willing to pay for a company’s stock. For GAAP earnings to serve this purpose, they must not include nonoperating items, particularly if they are not disclosed. They also must not include items that occur randomly, such as a casualty or litigation loss, or items subject to management manipulation such as a gain on the sale of an investment.

I believe many of the problems we are experiencing today could be resolved by requiring companies to report GAAP earnings in two categories: operating and nonoperating. Financial statements would include both, with taxes allocated to each.

This change would require somebody to define what should be reported in each category, a difficult task. However, to avoid people rejecting GAAP earnings as useless, either the profession or FASB must do the job. I believe the nonoperating category should include items that are recurring in certain businesses, but that occur irregularly, and could be subject to management manipulation. It’s impossible to accurately forecast the future results of transactions of this nature based on past results, but it should be possible to project operating earnings. People could then make their own guess as to what future nonoperating items would be based on past history.

We must avoid introducing random variability into operating earnings by recomputing, as now proposed, pension expense, for example, using the current year’s actual return on pension assets rather than a normalized return. However it occurs, pension income is nonoperating and should be so treated.

Stanley F. Dole, CPA
Grand Rapids, Michigan

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