This is the second article of a comprehensive list looking at Ben Graham’s seven steps (from Security Analysis) for adjusting the accounting numbers in the analysis of the income statement in order to arrive at indicated earnings power. They are as follows:
1. Deal properly with nonrecurring items – SEE HERE
2. Eliminate unjustified income recognition
3. Direct entries to surplus
4. Use comparable inventory and depreciation methods
5. Consolidate affiliates
6. Provide for income taxes
7. Record absent assets and liabilities
I’m going to skip the second step (eliminate unjustified income recognition) for a later date because it is associated in some way with nearly every step above, and will be more useful in the closing discussion. For this article, I will focus on the third step, which deals with earnings adjustments to deal with inappropriate direct entries to surplus.
DIRECT ENTRIES TO SURPLUS
Direct entries to surplus are generally in the form of reserves, which are set aside by management to provide for contingencies. Reserves are commonly used to describe three accounting items: valuation accounts, liabilities, and reserves against future developments. The reserves to reduce assets in valuation accounts include receivables (for uncollectables), inventories (say, for a tech company adjusting below cost), and loans/mortgages (as many banks have recently done), to name a few. Reserves for accounting liabilities are for those items that are noncurrent and uncertain in regards to timing or amount, such as for taxes or pensions. The final item, reserves against future developments, is to provide for probable losses on items like plant impairment (via restructuring, discontinuation of product line, etc.).
The transaction for reserves will appear on the balance sheet in one of three ways: An asset will be eliminated/reduced, a liability will be created/increased, or stockholders’ equity will be reduced. As discussed in the section on nonrecurring items, Graham suggests accepting as is any reserve items that effect net income by less than 5%.
With write-downs and write-offs, the bookkeeping entry might include both a reduction in carrying cost of assets, or setting up a liability. What should an analyst do when a company has a slew of non-recurring transactions, including write-offs, provisions for losses, and gains on sale of assets? Here is what Graham thinks: “The correct technique is to place each gain or loss in the year or years in which it is believed to have occurred. The proper procedure is to examine each loss or gain, seek its cause, and deal with it individually.” As we have seen previously, the analyst must use subjectivity to select the number of years to spread the value over and the pace (even, accelerated, etc.) at which to allocate it.
The use of big bath accounting, which occurs when a company takes major write downs on inventory, plant, and equipment of continued operations, is something investors should keep their eyes on. As a result of the huge write-down, the company can have lower COGS and depreciation in the coming years, leading to higher profits and a stronger return on capital in the future. As always, the investor should analyze a period of no less than 7-10 years (when available) before making any judgments about the efficiency or profitability of a company’s operations.
Graham’s discussion points to three basic tools that the analyst must carry in order to effectively adjust the income statement: knowledge of financial statement accounts, an understanding of business activities like restructurings and discontinued operations and how they are recorded through GAAP, and how these items affect “true” economic earnings over periods of time. Without a doubt, these things are not common knowledge among most investors; in addition, it is timely and boring to sit around rewriting company financial statements. However, for the intelligent investor, both of these are necessary if the income statement is to accurately represent the economic reality of the enterprise, an essential piece of the process in equity valuation.
1. Deal properly with nonrecurring items – SEE HERE
2. Eliminate unjustified income recognition
3. Direct entries to surplus
4. Use comparable inventory and depreciation methods
5. Consolidate affiliates
6. Provide for income taxes
7. Record absent assets and liabilities
I’m going to skip the second step (eliminate unjustified income recognition) for a later date because it is associated in some way with nearly every step above, and will be more useful in the closing discussion. For this article, I will focus on the third step, which deals with earnings adjustments to deal with inappropriate direct entries to surplus.
DIRECT ENTRIES TO SURPLUS
Direct entries to surplus are generally in the form of reserves, which are set aside by management to provide for contingencies. Reserves are commonly used to describe three accounting items: valuation accounts, liabilities, and reserves against future developments. The reserves to reduce assets in valuation accounts include receivables (for uncollectables), inventories (say, for a tech company adjusting below cost), and loans/mortgages (as many banks have recently done), to name a few. Reserves for accounting liabilities are for those items that are noncurrent and uncertain in regards to timing or amount, such as for taxes or pensions. The final item, reserves against future developments, is to provide for probable losses on items like plant impairment (via restructuring, discontinuation of product line, etc.).
The transaction for reserves will appear on the balance sheet in one of three ways: An asset will be eliminated/reduced, a liability will be created/increased, or stockholders’ equity will be reduced. As discussed in the section on nonrecurring items, Graham suggests accepting as is any reserve items that effect net income by less than 5%.
With write-downs and write-offs, the bookkeeping entry might include both a reduction in carrying cost of assets, or setting up a liability. What should an analyst do when a company has a slew of non-recurring transactions, including write-offs, provisions for losses, and gains on sale of assets? Here is what Graham thinks: “The correct technique is to place each gain or loss in the year or years in which it is believed to have occurred. The proper procedure is to examine each loss or gain, seek its cause, and deal with it individually.” As we have seen previously, the analyst must use subjectivity to select the number of years to spread the value over and the pace (even, accelerated, etc.) at which to allocate it.
The use of big bath accounting, which occurs when a company takes major write downs on inventory, plant, and equipment of continued operations, is something investors should keep their eyes on. As a result of the huge write-down, the company can have lower COGS and depreciation in the coming years, leading to higher profits and a stronger return on capital in the future. As always, the investor should analyze a period of no less than 7-10 years (when available) before making any judgments about the efficiency or profitability of a company’s operations.
Graham’s discussion points to three basic tools that the analyst must carry in order to effectively adjust the income statement: knowledge of financial statement accounts, an understanding of business activities like restructurings and discontinued operations and how they are recorded through GAAP, and how these items affect “true” economic earnings over periods of time. Without a doubt, these things are not common knowledge among most investors; in addition, it is timely and boring to sit around rewriting company financial statements. However, for the intelligent investor, both of these are necessary if the income statement is to accurately represent the economic reality of the enterprise, an essential piece of the process in equity valuation.
