I wrote three posts discussing about (1) p/e ratio (2) discounted cash flows (3) owners earnings (4) residual earnings (5) leverage effects on residual earnings. You can find all of them here. If you haven’t read them, I strongly recommend that you read them before reading this post. In this post I will be discussing about the limitations of GAAP earnings including the treatment for expenses like advertising and R & D. This post is based on what I learnt from the book It’s Earnings That Count.
1. Hubris Cookers vs Humble Cookers
Imagine two pressure cooker companies Hubris Cookers and Humble Cookers. Both of them sell pressure cookers in the United States. I made up the financial statements for these two companies which can be found here and here. Throughout the post I will be referring to these financial statements. Given below is the sales and net income for both the companies. Both of them have 1,000 shares outstanding. From the table given below can you tell which company is more valuable?
If someone asked me this question in 2006 then I would have answered Hubris Cookers. I would have arrived at this conclusion by seeing that the sales for both the companies are the same and the net income for Hubris Cookers is higher than Humble Cookers. Charlie Munger would have laughed at my thought process. The right answer is that we don’t have enough data to answer this question. Net Income is arrived by the accountants using GAAP and the job of an accountant is to record and not to evaluate. The onus is on us to look beyond net income and evaluate the true earning power of a business.
Questioning GAAP figures may seem impious to some. After all, what are we paying the accountants for if it is not to deliver us the “truth” about our business. But the accountants’ job is to record, not to evaluate. The evaluation job falls to investors and managers. Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it. – Buffett; 1986 letter to shareholders
The term “earnings” has a precise ring to it. And when an earnings figure is accompanied by an unqualified auditor’s certificate, a naive reader might think it comparable in certitude to pi, calculated to dozens of decimal places. In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surface, but in the meantime a lot of money can change hands. Indeed, some important American fortunes have been created by the monetization of accounting mirages. – Buffett; 1990 letter to shareholders
2. Limitations of Accrual Income Statement
There are four limitations in an accrual income statement (1) fixed capital investments in plant, property, and equipment are omitted (2) working capital investments in receivables and inventories are omitted (3) growth producing intangibles like research and development and advertising are expensed fully in the year incurred instead of amortizing it over a period of time (4) shareholder’s equity is considered free.
A company with a positive net income can go bankrupt if it depends on external sources for long periods of time to fund for item (1) and (2). A company which is showing depressed net income due to research and development and advertising expenses could be building a strong moat. If we don’t account for item (3) then we might ignore it as overvalued. Everything in life has an opportunity cost. This is true for equity also. A company can grow its net income by retaining all its earnings but generating returns below the cost-of-capital. Why waste our time and money investing in companies earning below the cost-of-capital? In order to avoid this we need to account for item (4).
When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement. You can get the same result personally while operating from your rocking chair. just quadruple the capital you commit to a savings account and you will quadruple your earnings. You would hardly expect hosannas for that particular accomplishment. Yet, retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign—with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest. – Buffett; 1985 letter to shareholders
3. Defensive and Enterprising Income Statement
Long time back I came across the quote To finish first, you must first finish. If you translate this to investing it becomes The primary goal of value investors is to avoid losing money as Seth Klarman puts in his masterpiece book Margin of Safety. In order to avoid losing money we need to become a defensive investor. This means that we need to take care of item (1) and (2). For that we will be preparing a defensive income statement which will adjust for both fixed and working capital needs.
After making sure that we will not lose money our next step is to find out and own companies that are above average. What makes a company above average? The company which earns above average returns on invested capital. Is that enough? Of course not. Why? Capitalism guarantees that competitors will emerge like bees to honey and will try to take away your market share. We need to make sure that the company has a moat. Spending on research and development and advertising is one way to build a moat. In order to own companies that are above average we need to become an enterprising investor. This means that we need to take care of item (3) and (4). For that we will be preparing an enterprising income statement which will adjust for both cost-of-capital and intangible expenses.
4. Defensive Income Statement for Hubris and Humble Cookers
Take a look at the defensive income statement of Hubris Cookers. Even though its net income is positive its defensive income is negative. How is this possible? Let’s look at its working capital requirements. For every $1 of sales the company needs 0.20 cents in accounts receivable. When will this happen? This happens when it’s product might not be in high demand and it’s giving generous payment terms to its distributors. Also the company has a negligible accounts payable; no free float. When will this happen? The suppliers are demanding money immediately after delivering the raw materials. Also the company turns over inventory at four times. All of this requires capital which needs to be funded by the company. Let’s look at the fixed capital requirements. Let’s assume that all capital expenditure is related to maintenance. You can clearly see that the company is spending twice the amount of money in capital expenditure compared to depreciation. Why is there a huge difference? The company is depreciating it’s fixed asset over 20 years. By taking a longer period to depreciate the company is boosting its net income. Even though depreciation is not a real expense capital expenditure is and no tooth-fairy will pay for it.
But you have to know enough about it to understand its limitations—because although accounting is the starting place, it’s only a crude approximation. And it’s not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn’t make it anything you really know. – Munger; Elementary Worldly Wisdom
Take a look at the defensive income statement of Humble Cookers. It’s defensive income is much higher than net income. How is this possible? The company has negative working capital. When will this happen? The company has no accounts receivable and this happens when the distributors are paying cash to take its cookers. It’s accounts payable is very high which funds its inventories and some portion of its fixed assets. This could happen when the company products are in high demand and the distributors are paying cash even before taking any deliveries. The company is operating on a free float. Now let’s take a look at the fixed capital requirements. The company has very high depreciation compared to Hubris Cookers. Why? This is because it depreciates its fixed assets in 10 years. This will depress its net income but it seems to be correct as the capital expenditure matches the depreciation amount. Why is the company capital expenditure constant where as Hubris Cookers capital expenditure is growing. Humble Cookers paid $600,000 for a quality asset compared to Hubris Cookers which paid $500,000 for a clunker and it requires more maintenance.
5. Enterprising Income Statement for Hubris and Humble Cookers
Take a look at the enterprising income statement of Hubris Cookers. The company doesn’t spend any money on research and development and advertising. So there is nothing to capitalize and amortize. The only thing we need to account for is the cost-of-capital which I have kept it at 10%. You can clearly see that the company is earning less than the cost-of-capital.
Humble Cookers spends 20% of its expenses on research and development and advertisement. GAAP requires these expenses to be expensed immediately even though the companies reap benefits from these expenses several years into the future. Why is that?
Why, when it comes to intangibles, do accountants deviate from their basic policy of matching current sales with current expenses and future sales with future expenses? Why in the accrual income statement are bricks assets and brains expenses? First, self-preservation. Since accountants are more likely to be sued for overstating than for understating earnings (and assets), it’s in their best interest to err on the side of caution. Thus, intangibles are expensed in full when incurred rather than at some later date, even if most of the benefits will be booked down the road. Second, intangibles are a use of cash. Every dollar a firm spends on R&D or advertising is a dollar less that is available to pay down debt, increase the dividend, or repurchase stock. Third, if a company needs a few more pennies to meet Wall Street’s quarterly expectations, management might be tempted to include with R&D a portion of operating expenses, say, rent on a research facility. When a company converts an operating expense to a capital asset, the effect is to reduce the current period’s expenses and increase bottom-line earnings. (Of course, that capital asset will eventually make its way back onto the income statement as an expense.) Fourth, there’s no guarantee that intangibles will generate increases in future sales and earnings. – It’s Earnings That Count
Let us amortize the advertising expenses for Humble Cookers. The table given below should be self explanatory. Few questions that you will have are (1) how did I arrive at the amortization period of three years? It was an educated guess (2) what gets shown as an expense in the income statement? It’s the adjusted advertising expense (3) what happens to the net capitalized intangibles? It will be kept in the balance sheet. Spend some time to understand the calculations.
Before capitalizing the intangibles you need to make sure that they are adding value. In the case Humble Cookers the company is earning a gross margin of 40% compared to Hubris Cookers gross margin of 20%. Also the distributors are paying money before getting the deliverables. This is evident from its negative working capital. Prof Bakshi wrote about two rules that he uses before treating money spent on marketing as capital expenditure.
Take a look at the enterprising income statement of Humble Cookers. The details of how I arrived at the enterprising income statement can be found here. You can clearly see that Humble Cookers enterprising income is positive. This happens when it earns above the cost-of-capital. This means that the company is adding value.
Take a look at the quality of earnings charts for both Hubris and Humble Cookers. It should be clear by now that Humble Cookers is a better business than Hubris Cookers.
We have come to the end of this post. With this I am concluding the Accounting For Value series. The only thing that I have not covered is financial shenanigans for which I would strongly recommend this book.