The new dilemma of cash versus earnings.

• Author: Kelly, John F.
• Position: The affect of the Federal Accounting Standards Board's proposed Overview of Post-Employment Benefits on reportable earnings

The new dilemma of cash versus earnings Conventional wisdom says that cash flow must eventually translate into reportable earnings. The author explains how the OPEB exposure draft blows holes in that assumption. To get business and Wall Street investment evaluation standards in sync again, the FASB needs to eliminate the "transitional amount" concept. How does one reconcile the investment evaluation process of Wall Street with the investment evaluation process of business? This dilemma, which has long troubled me, has taken on increased importance as a result of the FASB exposure draft on other postemployment benefits (OPEB). Let me explain.

Wall Street uses its investment evaluation process to judge business performance and make stock buy/sell recommendations. Such recommendations impact the ultimate stock price of a company. Business uses its investment evaluation process to make monetary and capital investments aimed at maximizing return on assets and at convincing Wall Street that a given stock is worthy of a premium price versus the overall stock market.

On the surface, these two goals seem similar and compatible. Business simply has to show Wall Street how successful its investments have been over time, and both parties will have succeeded in their mission--Wall Street in identifying a solid investment opportunity for its clients and business in commanding a premium stock price for its shareholders. It seems so simple, right? Wrong.

Not everything is as it appears in today's complex accounting environment. Even though Wall Street and business seem to have similar goals, the analytical tools used by each party to accomplish these goals are quite different.

Wall Street focuses primarily on reported earnings. Practically nothing is as important to Wall Street (except takeover/restructuring rumors) as quarterly and annual earnings per share. Such earnings are Wall Street's bread and butter, the statistic from which the majority of other key statistics flow--such as price-to-earnings ratio and return on equity. Business, on the other hand, focuses its investment decisions primarily on discounted cash flow. As any MBA student knows, investment decisions are designed to achieve a present value cash flow return in excess of the business' cost of capital.

In summary, Wall Street utilizes reported earnings (and projections of future reported earnings) to make investment evaluations, and business utilizes cash flow projections to make investment...