The Accounting Topic

[Phaceliacapital]

Hi all,

 

as most of you are already aware, for us investors it often pays off to go the extra mile in terms of digging through the financial statements to find and correct for those accounting adjustments that distort the true business picture/profitability etc. This can go from the noncash/cash adjustments such as basic intangibles amortization to inventory step up purchase accounting. It can also include determining a true free cash flow by substracting all the acquisitions that take place in the CFFI statement or adjusting for stock compensation expense. Some of these are straightforward, other less so (like the contra intuitive way of accounting for earnouts after an acquisition).

 

In addition, we could discuss the proper treatment for NOLs, deferred revenue, cash (be it domestic or foreign) and so on.

 

I don't know if there is place for such a topic on the board (I couldn't immediately find something similar) but given the interests of other board members it could become a nice "accounting" peculiarities database. If the topic becomes very popular I will try to update my second post with all the topics discussed so we can have a quick content overview.

 

For educational purposes it might be best if we take some kind of Company XYZ / Accounting ABC question, what do you guys think?

 

 

[Phaceliacapital]

//Post for content overview should this thread gather any interest//

[ageofsocrates]

read case studies from value investors club. Plenty of accounting material that's covered.

 

cheers

[usdtor05]

I'm down...spent 5 years in public accounting and then another 3 in financial due diligence so if anyone wants to dig into accounting irregularities, outside of Financial Services, feel free to let me know.

[SharperDingaan]

This is a very broad area, & the accounting in some sectors (banks, o/g, mining) is unique & extremely specific.

 

IFRS - not US GAAP, is the global standard; & has been in place in many countries for many years. Reviewing US GAAP case studies is also not very useful as US GAAP switches over to IFRS next year - you would be making decisions based on obsolete understanding.

 

Focus on just your sector of interest.

 

SD

 

[Hielko]

Understanding those differences will remain relevant for the foreseeable future because you need to be able to understand old financial statements.

[rayfinkle]

I'm down...spent 5 years in public accounting and then another 3 in financial due diligence so if anyone wants to dig into accounting irregularities, outside of Financial Services, feel free to let me know.

 

Would love to pick your brain on securitization accounting....

[jschembs]

I'm down...spent 5 years in public accounting and then another 3 in financial due diligence so if anyone wants to dig into accounting irregularities, outside of Financial Services, feel free to let me know.

 

USDTOR, here's a general question I've been curious about:

 

My understanding of GAAP is that a sales discount should be booked either as a contra account to gross revenue (resulting in a net revenue figure), or perhaps go in COGS. Either way, the discount is reflected in gross profit. How easy/difficult is it for companies to convince their auditors that such discounts should be considered operating expenses? Such a maneuver obviously doesn't affect EBIT, but it would artificially boost revenue and gross margin, two metrics upon which the valuations of many of today's rapidly-growing market darlings are based.

[usdtor05]

@jschesmbs Discounts will almost always be in net revenue and a company would have to have a really good reason why this wouldn't make sense....there are a few ones lately where net revenue vs. COGS/SG&A have popped up (Groupon) but in general the profession is very conservative on this subject.

 

@Sharper it is my understanding that convergence between IFRS and GAAP has been put on hold although I may have missed something over the last year. This was primarily due to issues on revenue accounting with IFRS in general being much more liberal than GAAP. There are some areas where they are moving towards convergence (lease accounting although even with this you basically will see bank covenants revised to take into account the effects of treating everything as a capital lease, etc.) but I thought the large project was on hold and/or coming to a close without some large issues resolved.

 

 

 

[SharperDingaan]

IFRS-US GAAP conversion is voluntary as of Jan 01 2015. Voluntary has different meaning in different sectors.

 

BIS capital requirements drive off IFRS, not US GAAP, so that everyone speaks the same financial language. BIS itself sets the global rules for banks, but has no force of law - each sovereign takes the BIS requirements & codifies it into its own legal structure. If you claim to be a global bank you have to be using IFRS, or suffer wanna-be ridicule. Hence, every major global US bank will cut over Jan 01; because if they don't convert - & their competitors do, they will have just proved that they actually are a wanna-be - & 2nd rate at best.

 

IFRS is more stringent on valuation. Many US GAAP asset valuation practices do not qualify under IFRS, & the valuation differences (write-offs) will be transitioned over 5-10 years (10-20% write-off/yr) for regulatory capital determination purposes. If you have more of this junk than your peers (BAC), or there is an expectation that you will be slower to convert than your peers, you will be penalized.

 

SD   

[TonyG]

I was curious about how people go about and read income tax footnotes and what to look for? My main reason is because I was reading an article where Bob Olstein said the first thing he does is go to the income tax footnote and see if they are actually paying any tax and he read Enron's income tax footnote and found something wrong right away. I have tons more questions about accounting but thought that I'd start with this.

[SharperDingaan]

In simple terms you are looking at a note explaining the deferred tax on the BS, which is the cumulative income difference since day-1 between the P&L and the tax book, times the tax rate. The firm pays people to ensure that the tax rate, and taxable income is as low as possible, & the consequent deferred tax as high as possible. A good result is a tax bill lower than that of a secretary.

 

The balance itself is an interest free loan from the taxman. It does have to be repaid, but in the meantime the deferred liability is recorded as the asset that it actually is. In most cases if the firm BKs tomorrow, the loan comes due immediately, & the tax bill will rank ahead of most trade payables.

 

It is a good place to go shopping ... but if you don't know IFRS & tax accounting, you will hurt yourself far more than you will benefit. Manipulation of timing differences & transfer pricing is everyday fare.

 

SD

[KCLarkin]

Owner's Earnings and Stock Compensation:

 

How should I think about stock compensation, especially related to Owner's Earnings? Buffett has made a pretty compelling case that options are a real expense but I often see investors and companies back out the stock expense when calculating owners earnings and adjusted net earnings. Since these aren't cash expenses, and the dilution will factor into EPS, this makes some sense. But I feel this is just voodoo. How should I think about the dilution expense of stock compensation?

 

For example, say I am looking at a company that has $1 EPS (GAAP) but $2 EPS (adjusted) due to $1 per share stock expense.

 

 

[jschembs]

Owner's Earnings and Stock Compensation:

 

How should I think about stock compensation, especially related to Owner's Earnings? Buffett has made a pretty compelling case that options are a real expense but I often see investors and companies back out the stock expense when calculating owners earnings and adjusted net earnings. Since these aren't cash expenses, and the dilution will factor into EPS, this makes some sense. But I feel this is just voodoo. How should I think about the dilution expense of stock compensation?

 

For example, say I am looking at a company that has $1 EPS (GAAP) but $2 EPS (adjusted) due to $1 per share stock expense.

 

look at it from a FCF per share perspective...the toughest aspect is estimating future shares outstanding, as that will be a major factor in future equity value...

 

for some reason, GAAP doesn't require firms generating GAAP losses to calculate diluted shares outstanding (i understand they're antidilutive, but that still makes no sense to me why the firm shouldn't have to disclose the effect), so in today's environment, it's very difficult to truly understand the near-term dilution. analyze the footnotes related to unvested stock options, warrants, and restricted stock to get a better sense of future dilution.

 

another thing to consider, as a recent NYT article re CRM pointed out, is that to the extent a share price begins to decline, companies will find it increasingly difficult to pay employees with stock, and so again looking at it from a FCF perspective enables you to determine a firm's ability to meet future opex with a much higher cash component.

[SharperDingaan]

Assume a bonus paid in stock vesting over 5 yrs.

When the stock is granted the firm will Db B/S liability & Cr owners equity at the days value, to record existence of the liability. 1 year later the firm will Db P&L expense & Cr B/S liability, to record that 20% of the bonus has now been earned. If you are no longer at the firm, the firm will Db owners equity, & Cr the B/S liability to remove it.

 

Investors adjust earnings by charging the entire unearned B/S liability to earnings, & dividing by the stated FD share count which already includes the total number of shares that the Bonus entails. Buffet approach. Lower EPS.

 

If the bonus is paid in phantom shares (common practice) the B/S liability will not be set-up & the firm will just pay out the vested share value at that point in time; Db retained earnings, Cr comp expense. This is no set-up because it is not possible to adequately quantify the expense, but there may be a disclosure note. Investors adjust the expense by the total value of the bonus, & increase FD share count. Lower EPS.

 

Good analysts will routinely adjust for these; the poorer ones - not so much.

 

SD

 

 

[randomep]

Owner's Earnings and Stock Compensation:

 

How should I think about stock compensation, especially related to Owner's Earnings? Buffett has made a pretty compelling case that options are a real expense but I often see investors and companies back out the stock expense when calculating owners earnings and adjusted net earnings. Since these aren't cash expenses, and the dilution will factor into EPS, this makes some sense. But I feel this is just voodoo. How should I think about the dilution expense of stock compensation?

 

For example, say I am looking at a company that has $1 EPS (GAAP) but $2 EPS (adjusted) due to $1 per share stock expense.

 

That's a great question and I am not an accounting expert like some of the others. But I can give a simple layman's explanation.  I have followed Cisco for a long time and the company is a stock option printing press. So before the days of accounting for options as an expense, look at their earnings, it is huge. But then again, look at the book value per share, it is not growing anywhere as high as it should and they pay zero dividends. So the dilution share holders suffer is where you realize stock options suck for shareholders.

 

I think that's basically what other posters have said in more technical terms....

[randomep]

 

Ok there is my question. I am unclear about how unrealized capital gains are treated. In general I understand that when an asset is for short term trading, the unrealized gains are more likely to be included in the income statement. However, I have seen real estate marked to fair value with the unrealized gains counted in the income statement.

 

What is the general rule for this? Is it up to the company to decide? Or is there a rule under US GAAP? IFRS?

[KCLarkin]

I have followed Cisco for a long time and the company is a stock option printing press.

 

For a mature cash cow like Cisco, Shareholder Yield is a good way to sanity test valuation.

 

Shareholder Yield = (Dividend % + Net Buyback % + Net Debt Repayment %)

 

[JSArbitrage]

IFRS-US GAAP conversion is voluntary as of Jan 01 2015. Voluntary has different meaning in different sectors.

 

BIS capital requirements drive off IFRS, not US GAAP, so that everyone speaks the same financial language. BIS itself sets the global rules for banks, but has no force of law - each sovereign takes the BIS requirements & codifies it into its own legal structure. If you claim to be a global bank you have to be using IFRS, or suffer wanna-be ridicule. Hence, every major global US bank will cut over Jan 01; because if they don't convert - & their competitors do, they will have just proved that they actually are a wanna-be - & 2nd rate at best.

 

IFRS is more stringent on valuation. Many US GAAP asset valuation practices do not qualify under IFRS, & the valuation differences (write-offs) will be transitioned over 5-10 years (10-20% write-off/yr) for regulatory capital determination purposes. If you have more of this junk than your peers (BAC), or there is an expectation that you will be slower to convert than your peers, you will be penalized.

 

SD 

 

As someone who works at a Big 4, I can assure you US banks won't be converting to IFRS any time soon.  Don't hold your breath.

[TonyG]

What about the proper way of analyzing and calculating how NOL's will affect income going forward? For example, GM's latest 10K had operating loss and tax credit carryforwards of $19,342(Billion) and DTA of $32,478. Which number would we use and how would we do it? and when calculating enterprise value would we subtract it from the equation? It's a couple questions in one but like i said I have a lot.