Accounting inconsistencies

In the next few posts, I plan to focus on the accounting inconsistencies that bedevil analysts. In particular, here are the items that I will highlight:

1. Goodwill: When a company acquires another, goodwill shows up on the balance sheet of the acquiring company. While the name connotes something of substantial value, goodwill as it is currently computed is really a plug variable, designed to make the balance sheet "balance". Goodwill skews book values of equity and capital and wreaks havoc on earnings.

2. Minority interests: This is perhaps the most misleading item on a balance sheet, at least to the non-accountant. While it suggests something of value that you own (an asset), it is a by-product of another accounting practice termed consolidation. In effect, a company that owns more than 50% of another is required to "consolidate" its financial statements and report 100% of that subsidiary's earnings, capital and assets as its own. Minority interest reflects the value of equity in the subsidiary that does not belong to the parent company and is thus a liability. Not only is the treatment of minority interest a problem in discounted cash flow valuations but it is also an issue when computing enterprise value and related multiples.

3. Investments in other companies: With a firm with minority holdings in other companies (less than 50%), accountants face a different issue. What is the value that should be attached to these holdings on the balance sheet? Unfortunately, there is no one template in accounting and these holdings are sometimes shown at original cost (what was paid to acquire the holdings), sometimes at an updated book value (reflecting retained earnings since acquisition) and sometimes marked to market. Thus, an unsuspecting analyst can make significant mistakes in valuation, if he or she makes an incorrect assumption about accounting treatment.

4. Extraordinary gains and losses: This should be simple, right. Any items that do not comprise regular operating income or earnings should be consigned to this line item. If that were the case, dealing with extrardinary items would be simple. Since they are extraordinary, we can assume that they will not occur in the normal course of events and ignore them. In practice, though, companies use extraordinary income (expenses) for line items that are recurrent but with shifting effects (exchange rates gains and losses), related to operating adjustments (restructuring charges) as well as a device to show higher operating earnings (by shifting operating expenses into the extraordinary expense column). Thus, separating the truly extraordinary from the ordinary has consequences for both discounted cash flow valuations (by changing base earnings) and earnings multiples (PE ratios, EV/EBITDA etc.)

5. Deferred taxes: Deferred taxes can show up either as assets or liabilities. A deferred tax asset reflects a company's belief that it has paid too much in taxes over prior periods and can thus expect to get tax relief in future periods. A deferred tax liability is a measure of the opposite - a company that has been able to use the tax code to good effect and paid less in taxes (legally) than it should have (assuming the statutory tax code were applied to taxable income) can reasonably expect to pay higher taxes in future periods and has to show this as a liability. While the logic for both items is impeccable, it is worth noting that they reflect expectations of future tax savings (in the case of deferred tax assets) and tax liabilities (in the case of deferred tax liabilities). There is no contractual obligation or time line for these expected cash flows and that can create problems in valuation.

6. Intangible assets: In the last decade, accountants have discovered that accounting standards are not consistent about how they deal with intangible assets as opposed to tangible assets. The rules on capitalizing the latter are well established and the assets on a manufacturing firm's balance sheets reflect the firm's investment in land, buildings and equipment. For firms with intangible assets, which can range from technological prowess (Google) to brand name (Coca Cola) to patents (Amgen), the treatment of the assets has generally been benign neglect. As a consequence, the earnings and book capital at these firms is skewed and can affect both intrinsic and relative valuations.

7. Leases: The biggest source of off-balance sheet debt in the world is leases. A firm that leases its assets (rather than borrowing money and buying these same assets) can hide these assets (and the implicit debt in these assets) if it can meet the accounting requirements for lease expenses to be treated as operating expenses. As a result, we understate the debt ratios of retail firms and restaurants and misvalue these firms.

While the accounting logic behind the treatment of each of these items make sense to accountant, I think that they lead to poor measures of earnings and value. The post that highlights each item will examine not only the potential problems created by the current accounting treatment but also present  solutions to those problem.