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Normalizing the GAAP perspective on fundamentals

  • Wealth Management Systems Inc. Financial Communications
  • Accounting Method
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Every company faces unique and nonrecurring situations in its normal course of business. The impacts of these circumstances must be accounted for in the income statements and balance sheets that the companies provide to investors. But the adjustments and accommodations necessary to that process can also obscure the firm's normal business performance.

What is more, some categories of recurring costs and revenues may be disclosed differently by different companies. Even though each treatment may be considered appropriate, the results may not be comparable.

As a result, analysts often seek ways to normalize financial data. They may remove exceptional items to produce "core" or "operating" income, expense, and investment data that can consistently portray business-as-usual activities. They may also seek ways to reduce subjective variation from tallies by reformulating specific operating statistics. This can set the stage for comparing a company's performance from period to period more precisely and viewing the company and its competitors along a common, standardized baseline.

Items that may obscure consistency

Accounting treatments of noncash items such as depreciation, amortization, and impairment may vary from company to company, particularly for assets that may not have readily measurable rates of wear and tear or obsolescence, such as patents, copyrights, and trademarks. The dollar amounts associated with these noncash charges may appear as footnote or supplement items in some companies' reports, and line items in others.

Similarly, presentation of cash items such as overhead, taxes, and some production-related and sales-related expenses may vary from company to company. For example, some companies may tally any excise tax collected as part of a product sale in their gross revenue while others may exclude such taxes. In cases such as these, there could be no meaningful revenue comparison unless the revenue totals for all companies could be recalculated to reflect uniform assumptions. Similar issues could arise from differing treatments of continuing and discontinued operations, from differing policies for restructuring costs, and from treatments of pensions and other post-employment benefits.

Making use of standardized or normalized data

While an individual investor may be able to apply normalization principles to a few companies or a limited number of circumstances, broad use of standardized data is only possible when applied professionally across an investable universe and to a wide range of company data. In such cases, standardized data can be readily used to:

  • Assess long-term performance patterns by providing numbers for time series that are fully comparable to each other and relatively free of one-time-only variations;
  • Establish peer benchmarks and comparisons for market insight by putting all companies' data on equal footings with each other;
  • Make head-to-head comparisons that are more likely to show insights based on strictly analogous statistics;
  • Screen for potential investments efficiently by putting all members of the potential universe on a more generally equal footing.

Applying standardization principles with Standard & Poor's Compustat

The Compustat data service from Standard & Poor's Capital IQ provides standardized company financial information to financial institutions, hedge funds, asset managers, and investment professionals worldwide. These experts use standardized data to identify and evaluate investment opportunities, monitor market trends that could impact their portfolio performance, and support their proprietary computer models.

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Article copyright 2014 by Wealth Management Systems Inc. Reprinted with permission from Wealth Management Systems Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.
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