While there are many areas that this could affect, one that I have substantial personal knowledge of is the lack of easily accessible information that would allow an investor to separate organic revenue growth from acquired revenue growth. Since revenue growth is a common metric used in estimating a company’s valuation, this information is quite relevant as acquired growth won’t persist beyond one year. Purchase accounting, the current accounting standard for incorporating the financial results of the acquired company into the financial results of the acquiring company, does not consider the acquired company’s revenue from any period prior to the acquisition to be part of the consolidated company’s history. Disclosure of the information needed to separate organic from acquired revenue growth is not required and when offered is not standardized.
This means that one company can purchase another that has half as much revenue as it has, and for the following four quarters it will appear that the acquirer’s revenue growth rate is 50% higher than it actually is. Since no disclosure is required, companies can decide whether or not to put this in their footnotes. Without having the information, investors could overprice the stock as growth is a key factor in valuation.
While this may seem theoretical, as a Wall Street analyst I witnessed this exact situation when Compaq Computer acquired Digital Equipment Corp. The company took the position that the 36% reported growth in revenue (in Q3 of 1998) was going to continue where an examination of the apples to apples comparison (not required nor disclosed in their reporting) showed that organic revenue growth was actually negative (about -7%) for the combined entities. Consequently, the stock was over-valued until the company finally admitted (several quarters later) that it could not replicate this (artificial) growth the next year.
A more recent example of organic growth and reported growth differing widely is found in NetLogic’s 2011 10K. GAAP revenue is reported as $175 million in 2009 and $382 million in 2010, a growth rate of 119%. The actual organic revenue growth appears at most to be 48%. In this case, despite not being required to disclose it, the company revealed on page 47 of its 10K that 70% of reported GAAP revenue growth was from two of its acquisitions. While this implies that organic growth was the remaining 48%, I can’t be certain as there may have been other less material acquisitions not discussed or I may be misinterpreting the limited footnote.
Unfortunately, since footnotes of this type are not required, disclosures are not standardized and it is difficult to be sure of this information. Why is this relevant? Knowing the accurate organic growth rate helps predict the following year’s revenue and earnings and can substantially impact valuation. A company whose revenue is growing 119% could be valued at a much higher multiple then one growing 48%.
In summary, I believe that GAAP accounting often fails to provide investors (or other users of financial statements) with the information they need to make sound decisions. As a result, numerous companies provide pro forma (non-GAAP) financial statements in addition to the mandated GAAP statements. In many of these cases Wall Street research analysts ignore the GAAP reporting because they believe it to be misleading and instead do their work based on proforma reporting. However, as pointed out by Zynga, using pro forma results as a means of comparing results between companies can also be a problem due to the lack of standards and lack of consistency in pro forma reporting. If the goal of financial reporting is to provide investors with the information needed to make informed decisions, then we fall quite short of this goal. This can result in severely misleading information that could cause great financial harm to individual investors. It would be unfortunate if corrective action weren’t taken until a major issue erupts.