How to Distinguish Between GAAP Losers and Real Losers

Baruch Lev

By Baruch Lev and Feng Gu

The main lesson for investors is: Not all loss reporting companies are born equal.

By Baruch Lev and Feng Gu

Would you believe that roughly 45% of U.S. public companies are reporting annual losses? And that in a booming economy and record breaking stock market. The percentage of these loss-reporting companies didn’t change much in the past ten years, but was substantially lower in previous years. In the 1970s, less than 20% of companies reported annual losses, climbing to around 35% in the mid-1980s, and to 40% in the late 1990s. Returning to the present 45% loss frequency, how can the economy prosper with almost half of public companies losing money?

The answer to this conundrum lies in the realization that concomitant with the increase of loss reporting companies there has been a steep rise in corporate investment in intangibles, such as R&D, IT, brands, human resources, and business processes, like Amazon’s and Netflix’s recommendation algorithms. Presently the total U.S. corporate investment in intangibles surpasses $2 trillion and is roughly double the corporate investment in tangible (physical) assets. And here lies the crux of the issue: Due to arcane accounting rules, most of this huge corporate investment in intangibles is immediately expensed in firms’ income statements, depressing their reported (GAAP) earnings. Thus, important investments enhancing future growth, like pharma R&D, customer acquisition costs of internet, telecom, and media companies, brand enhancement of durable and nondurable producers, and the information systems supporting innovation and growth, are considered by accountants as regular expenses without future benefits, like rent, interest, and salaries. Dumb accounting to be sure.

To give you an idea of the impact on corporate earnings of the massive expensing of intangibles, we added back to annual reported earnings the R&D expense, and one-third of SG&A (sales, general and administrative expenses)—the latter representing other-than-R&D intangibles, such as IT and brands reported in SG&A. After these additions, the percentage of loss reporting companies drops from 45% to around 30%, a substantial drop to be sure. Tesla is a case in point. For 2018, it reported a loss of $976 million. But capitalizing its 2018 R&D of $1,460 million would have turned this loss to a profit.

Read the full Seeking Alpha article.

Baruch Lev is the Philip Bardes Professor of Accounting and Finance.