By Gaurang S. Trivedi, CFA

The Art in Fundamental Analysis

Financial statement analysis, which represents the art in the fundamental approach to valuation of equities, enables creditors and investors to make better economic decisions. Statutory statements prepared for reporting purposes are a combination of accounting rules formulated to characterize the accrual process, management estimates based on past experience applied to projected events, and managerial judgment that is subject to cost-benefit rationale. An interested reader has to just glance through a corporate press release of a quarterly earnings announcement to assimilate what the aforementioned signifies. The net earnings per share number, which in the ultimate analysis increases shareholders’ equity, is mostly neglected in management discussions and analysis. A majority of the managerial analysis is concentrated on alternative numbers arrived at by massaging the earnings information. The current use of pro-forma (read alternate) numbers to represent true operating earnings stems from the very real need for corporate managements to meet earnings estimates and support stock prices for companies that have meager, if any, positive net earnings to report. The ensuing treatise is an endeavor to reconnect the economic implications of the accounting for depreciation, goodwill amortization/impairment charges (universally assumed to be non-cash charges), as well as other one-time charges, that are being neglected by most investors when analyzing manipulated pro-forma earnings reports from corporate managements.

Case for Pro-Forma Adjustments

The theoretical support for pro-forma earnings stems from the perception that they depict the real economics of a business. Accounting earnings, though universally accepted to be the uniform language of business, are not considered representative of true economic income. To substantiate this premise let me first walk through the accounting treatment of depreciation and goodwill amortization/impairment in the corporate books.

Depreciation may be defined as a fall in an asset’s value and a reduction in the future benefits to be derived from its ownership due to normal business usage. Since depreciation is a charged expense, it is accounted as a reduction in earnings. However, as no corresponding cash outflow takes place, there is justification to add to earnings for arriving at economic (cash) income or in computing cash flow from operations.

Table A – Depreciation Accounting

·         When an asset is purchased Asset = (Cash) (a)
·         When depreciation is recorded Depreciation = Asset – Depreciated Asset (b)
·         Substituting (1) in (2) Depreciation = (Cash) – Depreciated Asset (c)
·         From (3), always (Cash) > Depreciated Asset (d)
·         From (3) and (4) Depreciation = (Cash) (e)
·         Or, (Depreciation) = Cash (f)

Parentheses represent a negative number or outflow

Goodwill is created as a result of a merger or an acquisition when the purchase price (transaction value) exceeds the fair value of net assets acquired. Irrespective of the exchanged currency (cash, stock, or some combination of both), the goodwill amount recorded as a result of the transaction will be the same. It thus represents expected future benefits (intangible) to the acquiring entity as a result of integrating the target entity’s operations. Since amortization/impairment of goodwill symbolizes a reduction in the future benefits to be derived from ownership of the net assets acquired, it is charged as an expense to current income. However as no corresponding cash outflow occurs, there is a reasonable basis to add to earnings for arriving at economic (read cash) income or in computing cash flow from operations.

Table B: Goodwill Accounting

Assuming goodwill is created by a cash acquisition
·         When a company is acquired Net Assets Acquired + Goodwill = (Cash) (g)
·         By rearranging (1) Goodwill = (Cash) – Net Assets Acquired (h)
·         From (2), always (Cash) > Net Assets Acquired (i)
·         From (2) and (3) Goodwill = (Cash) (j)
·         When goodwill is written off (Goodwill) = Cash (k)


Building a Case against Pro-Forma Adjustments

Observe that both depreciation and goodwill amortization/impairment charges do reduce reported earnings and as a pass through effect via retained earnings result in a diminished equity accumulation. Therefore, in order to examine the validity of the premise of depreciation and goodwill amortization/impairment adjustments for reconciling accounting earnings to economic income (EBITDA and/or cash flow analysis), I have presented my ensuing arguments in economic terms. The espoused rationales are an attempt to shed new light in the controversy surrounding pro-forma earnings and its brethren cash earnings. Exhibit 1 summarizes the framework used in the presentation of different relationships that develop as a result of corporate activity to support my inferences.

Exhibit 1: Framework for Illustrating Corporate Activity Relationships

  • Asset accounts affected by the purchase of an asset or purchase method acquisition


Net Assets Acquired

  • Equity accounts affected by a purchase method acquisition

Shareholders’ Equity comprising Equity Share Capital, Share Premium (APIC) and Retained Earnings

  • Nominal account depicting a diminution in future benefits from a purchased asset


  • Nominal Account representing a diminution in future benefits from acquired net assets


Logic Gap

The above summarization of depreciation and goodwill treatment for cash flow computation involves converting accounting earnings to economic income. This conversion process, however, is a result of cognitive dissonance, which simply put, is lack of consistency in knowledge and belief. Economic theory is a decision enabling mechanism for rational allocation of scarce resources (cash for this research purpose) among alternative uses. Thus in economic analysis, investments in any tangible or intangible assets are just another form of holding cash. After all, the net worth of a corporate entity holding $1 million in cash, or immovable/intangible property of equivalent value, is the same. Excluding initiated bankruptcy protection proceedings, a corporate entity is theoretically expected to exist in perpetuity. Hence, asset liquidity is generally not regarded as a predominant issue when conducting a valuation exercise. Consequently, the corporate entity is indifferent between the nature of its assets as long as their ownership satisfies the shareholder objective of maximizing wealth. Also, recall that the purchase of any movable, immovable, or intangible property for cash affects only the asset side of the balance sheet. The individual asset values may change, but the total asset value remains the same. Now, with this knowledge, visualize the whole process from an economic perspective, absent the accounting language for business transactions and see how that translates in the economic (cash) income model and free cash flow computations.

Exhibit 2 Simplified Accounting Statements

Balance Sheet as at the beginning of a given financial year
Equity Capital 200 Cash 100
Retained Earnings 100 Fixed Assets 200
Total 300 Total 300
Income Statement for the given financial year
Sales 500
Costs 300
Depreciation 100
Net Income 100
Cash Flow from Operations for the given financial year based on above:
Net Income 100
Depreciation 100
Total 200
Balance Sheet as at the end of the given financial year
Equity Capital 200 Cash 300
Retained Earnings 200 Fixed Assets 100
Total 400 Total 400


Exhibit 2 enumerates the basic accounting statements used for reporting purposes in any given year. The accounts are simplified for purposes of enabling easier comprehension of the concepts to be discussed. The cash flow from operations is arrived at by adding back depreciation charges to net income. Exhibit 3 mathematically illustrates the enumerated income statement.

Exhibit 3 Mathematical Representation of Income Statement

S – C – D = N (01)
S = Sales
C = Costs excluding depreciation
D = Depreciation
N = Net Income
Also (01) can be rewritten as:
S – C = N + D (02)

A close look at the reformulation in equation (02) reveals that the right hand side of the equation is nothing but the cash flow from operations computation using the indirect method. However in reality, the cash flow of 200 in our illustration, is generated by the corporate activities represented on the left-hand side of the equation i.e. Sales minus Costs excluding depreciation. This can be confirmed by observing the difference in the values for cash on the balance sheets at the beginning and at the end of the year. However depreciation charges have resulted in reducing the net value of fixed assets by the booked amount i.e. 100. More importantly, the total asset and equity amounts have increased only by 100, an amount corresponding to net income for the period. This negates the notion that depreciation is a non-cash expense in the economic sense as currently perceived and previously described. Exhibit 4 and the supporting analysis that follows will further evince the above observations.


Exhibit 4 Depreciation in an Economic Framework

Assuming purchase of an asset is just another form of holding cash
·         When an asset is purchased Asset = Cash (03)
·         When depreciation is recorded Depreciation = Asset – Depreciated Asset (04)
·         Substituting (03) in (04) Depreciation = Cash – Depreciated Asset (05)
·         From (03), (04) and (05) Cash > Depreciated Asset (06)
·         Let Change in Cash (CC) denote CC = Cash – Depreciated Asset (07)
·         From (05), (06), and (07) Depreciation = CC (08)
·         From (08) when charged to income (Depreciation) = (CC) (09)
  • Parentheses represent a negative number or outflow


In the economic framework as presented in Exhibit 4, depreciation represents a reduction in cash. Consequently, the net effect of a depreciation charge is a cash outflow, and hence there is no justification to add to earnings for arriving at economic (or cash) income. A base case scenario of a subsequent disposal of an asset for book value (original cost less accumulated depreciation) will enable a better understanding of this analysis. Instrumental in this explication is the fact that the purchase of an asset has no bearing on the income statement i.e. the purchase is not recorded on the income statement as an expense. In the above referenced scenario, upon the disposal of an asset, the company will receive an amount that is less than the original cost. The difference in original cost and realized price represented by depreciation is thus a real cash reduction, and hence should be treated as a cash outflow. This analysis may generate a counter argument of incorporating the time value of money, which would necessitate that such treatment should be considered only when the actual event of disposal takes place i.e. when reduction in value is realized. As a resolution to this counter proposition, we need to recognize that theoretically, corporate managements are expected to act as fiduciaries of corporate assets and maximize shareholder value. Thus, any estimate of value erosion represented by depreciation should be considered as realized, accounted for, and analyzed in that context. Moreover, current cash based earnings valuation techniques do not reverse the positive adjustments to earnings from depreciation when assets are disposed or written off completely, thereby creating and maintaining a systematic upward bias in both income and valuation.


Exhibit 5 Goodwill as a Result of Merger or Acquisition in an Economic Framework

·         In case of acquisition for cash Net Assets Acquired + Goodwill = Cash -10
·         By rearranging (10) Goodwill = Cash – Net Assets Acquired -11
·         From (10) and (11) Cash > Net Assets Acquired -12
·         Let Change in Cash (CC) denote CC = Cash – Net Assets Acquired -13
·         From (10), (11), (12) and (13) Goodwill = CC -14
·         From (14) and when written off (Goodwill) = (CC) -15
·         In case of acquisition for equity Net Assets Acquired + Goodwill = Equity -16
·         By rearranging (16) Goodwill = Equity – Net Assets Acquired -17
·         From (16) and (17) Equity > Net Assets Acquired -18
·         Let Change in Equity (CQ) denote CQ = Equity – Net Assets Acquired -19
·         From (16), (17), (18) and (19) Goodwill = CQ -20
·         From (20) when written off (GI) = (CQ) -21
·         From (15) and (21) for all charges (CC) = (CQ) -22


As depicted in Exhibit 5, the entire process of goodwill creation and its attendant amortization/impairment charge can be economically modeled in the context of changing the form of holding cash (acquisition for cash), or new issue of equity for cash and the subsequent acquisition of net assets at a premium represented by goodwill with that cash (acquisition for equity). An acquisition using a combination of cash and equity can be analyzed similarly. As such, there is no justification to add the amortization/impairment charge to earnings for arriving at economic (cash) income. In materiality, equation (22) reveals that all charges appearing on the income statement can be modeled in the economic framework to represent a reduction in cash and therefore do not merit an upward adjustment in free cash flow computations. Implicit in this interpretation is the fact that cumulative past earnings and operating cash flows are virtually identical. The variance in operating cash flows and reported earnings associated with charges in one time period results from the difference in the timing of the flows, not the actual nature and value of the flows. Restructuring charges and other assorted non-recurring expenses (one-time charges) do matter to the equity holder as they reduce the accrual of profits (economic rent) to their ownership stakes and should therefore be incorporated in the valuation process when they’re recorded and not when they’re paid out, to negate any potential earnings management motivations.

Application for Investment Management

Concomitant with the foregoing economic rationale and the financial implications of the accounting of corporate activities, the computation of free cash flow supports the upward adjustment in earnings for depreciation because it considers the effect of capital expenditures (asset purchases) at the outset as a cash outflow. Recognize also, that it still does not require upward adjustments for goodwill impairment charges or other charges deemed non-cash (e.g. restructuring charges) in computing free cash flow. Although there are a number of predications for mergers and acquisitions such as taking advantage of tax loss carry-forwards of the target, increasing liquidity or to bring a better balance to the capital structure of the acquiring firm, etc., most of them are short term in nature. The fundamental economic premise underlying a majority of mergers and acquisitions is usually adding to current capacity (growth through increased market share) or expanding the product line (growth through diversification) and the associated cost savings from leveraging economies of scale. This is logically the same as incurring capital expenditures for expansion plans, albeit with the economic advantage of synergies and time savings realizable in bringing added capacity online and marketing the expanded product offering. Thus in analyzing the impact of mergers and acquisitions, subsequent goodwill amortization/impairment charge should be added back to earnings for free cash flow computation only after an initial cash outflow is recognized at the time of a merger or acquisition, i.e. the merger or acquisition is treated as a capital expenditure. A common justification against this interpretation in the case of mergers and acquisitions where equity is exchanged is that the initial cash outflow implication is considered by the increase in the number of shares outstanding. This assertion however is mired in fallacy. It takes into consideration only one effect of the transaction, i.e. an increase in equity. Ordinarily, when equity capital is raised, the ownership of shares is exchanged for cash. In the case of mergers and acquisitions involving exchange of equity, this cash is assumed to be expended on the purchase of net assets and goodwill (if any) i.e. a treatment akin to capital expenditure. Thus, currently practiced free cash flow based valuation techniques allow the acquiring company to have the cake and eat it too. Not only is the initial cash outflow not recognized, but also, goodwill amortization/impairment is added back in free cash flow computation as a bonus. The process systematically creates and maintains an upward bias in current and future free cash flows thereby manifesting into higher stock price of the acquiring company. It favors the growth through acquisition strategy over organic growth strategy. This treatment is analogous to viewing one ton of steel as heavier than one ton of cotton. The proposed methodology of computing free cash flow is thus strategy neutral, i.e. it treats companies that grow through internally generated funds equally with companies that grow through acquisitions thereby facilitating equitable comparisons for investment purposes.

Final Thoughts

Like a golfer who struggles with the putter, an investor lacking full cognizance of the interaction of accounting, finance, and economics makes decisions with a major handicap. The purpose of this research is to generate a healthy debate amongst accounting, finance, and other professionals who are consumers of company information to evaluate the efficacy of reported financial statements, management discussion and analysis that accompanies them, and current valuation methodologies practiced. Contrary to popular notions, if cognitive biases are removed, one may find that accounting earnings do mirror economic reality. The preceding analysis and proposed free cash flow computation methodology showcases the fallacy of pro-forma earnings presentation and the doctoring of earnings by corporate managements and analysts to meet estimates and justify high stock prices. It could well explain the observed frenzy in using bloated stock prices as a currency for a majority of unsuccessful mergers and acquisitions. It also brings to light ethical issues that managements face when preparing and reporting financial information. It is also an attempt to help streamline the analysis of corporate information; conforming it to a principles based approach to render it more objective and unbiased. All types of equity pricing methods are susceptible to manipulations in the short run. In the long run however, equity prices always reflect the underlying fundamentals and will adjust for any innovative accounting. Equities investment begins with computing expected returns and concludes with comparison and analysis of actual returns with the expected returns. Since earnings comprise an integral part of expected returns, a sound knowledge of accounting theory and concepts is essential for conducting insightful financial analysis. In conclusion, users of financial statements will be better served if they take cue from their animal friends and sniff before they consume anything given to them.

– GT

About IAIP

India Association of Investment Professionals (IAIP), which is established April 2005 and located in Mumbai, is an association of local investment professionals. As one of the 136 CFA Institute member societies, IAIP connects members to a global network of investment professionals. Consisting of portfolio managers, security analysts, investment advisors, and other financial professionals, IAIP promotes ethical and professional standards within the investment industry, facilitates the exchange of information and opinions among people within the local investment community and beyond, and works to further the public’s understanding of the CFA designation and investment industry.
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