Accounting For Value – 4

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?

hubris-humble-sales-netincomeIf 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.

Hubris-Enterprising-Income 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.



Closing Thoughts

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.

9 thoughts on “Accounting For Value – 4

  1. Thank you for a very interesting article.
    I am trained in IFRS (/GAAP) accounting, taxation, auditing (not practising as an external auditor) and also, management accounting.
    Accountants do not capitalize internally generated intangible assets for a number of reasons, but specifically because of the potential for abuse. Most of the time, one just cannot be certain that future economic benefits from these types of assets are likely or to quantify them even if they were (as the cost is nearly always not equal to the fair value).
    That is why there are two distinct branches of accounting – the IFRS accounting and management accounting. Most managers are trained in management accounting. This means being able to adapt a set of financial statements to get useful information for prospective decision-making, as opposed to historical capturing of information.
    A set of financial statements have to comprise out of a Statement of Comprehensive Income (the traditional income statement with some adjustments and new fancy names); Statement of Financial Position (or balance sheet), Statement of Changes in Equity (the old equity statement) and the Statement of Cash Flows (the old cash flow statement). I believe that by educating non-accountants with regards to the importance of the other three statements, is crucial – because at the end of the day an income statement in isolation does not mean a thing.
    When considering the value of a business, trained management accountants will actually use a lot more information from the Cash Flow Statement than from the Income Statement. There are different valuation methods, but a good, comprehensive method is the Free Cash Flow Method. This means making adjustments for changes in working capital (debtors, creditors and inventory), as well as for various non-cash items. Not only one year is considered, a number of years are and then sustainable figures are determined. These results are then discounted at the Weighted Average Cost of Capital (or WACC). This adjusts for the fact that external IFRS statements do not assign a cost to equity.
    I would respectfully disagree that the job of an accountant is to record, not to evaluate. Accountants have very distinct roles within differing levels of organizations. We often assist with business valuations, business plans and internal control systems which are meant to increase business productivity while decreasing risk.

  2. Hi Jana,

    Thanks again for the excellent writing/teaching on Account for Value series.

    Have learnt about the amortizing advertising expense and factors / rules to be applied. It will be great to know your thoughts on amortizing R&D spend and amortization period to be used with an example.

    A related blog/note using “It’s earnings that count” here – It was presented using 4 quadrants.

    Wishing you an advanced very happy new year and expecting for the great set of writings.


    • Muthu,

      Thanks for your comments. The uploaded PDF at the very end contains the calculations for R & D. I used 5 years in the example. In the book author recommends using 5 years for a fortune 500 company. If not use 2 years.


  3. Hello Jana,
    Only a person who simply loves sharing his knowledge with others can come up with the quality & kind of detail oriented articles that you come up with!

    Been a silent visitor for quite sometime but your articles have become something that i feed on time and again. I keep re-reading your older articles on IBM, Value investing & accounting for value.
    There are many blogs out here but not many put the kind of effort that you put in presenting the data – AR statements, graphs coupled with clarity of explanation.. phew! hats off!

    My humble thank you note for your efforts. you are turning out to be a fundoo professor yourself🙂 if i may say so!


  4. Hi Jana, wonderful article with great clarity of thought as usual. Just wanted to check one thing, I think we will need to add the capitalized intangibles to the Shareholders equity as well which will increase the cost of capital a bit in calculating the Enterprising Income for Humble Cookers.


  5. Hi Jana,
    Great Article
    Can you email me Excel calculating defensive earnings for VST Tiller , Kitex
    I have prepared Excel model for screener
    But not sure about accuracy
    Thanks and regards

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