Pension information is usually deep in the Notes section, usually Note 10 or higher. These notes have become clearer in recent years, but are still pretty confusing. Check the fair value of pension assets, the projected benefit oblig- ation, and the difference between the two. Look at the assumptions and look for changes in accounting policy, especially those not mandated by FAS (accounting standards) bulletins. Large old-line companies are more suscepti- ble to pension stretch: the IBMs and AT&Ts of the world. Newer companies use the 401K approach, where few or no pension assets or obligations are carried directly by the company.
Write-offs: The big bath
Pundits say, “It’s better to ask forgiveness than permission.” This statement may play into another fairly old accounting gimmick: write-offs. Bundling large costs into extraordinary write-offs clears the books of bad assets and bad decisions. Why? To increase earnings in the immediate future. Write-offs are an expense, and perhaps should have been included in the list just com- pleted, but this topic is big enough to warrant its own heading.
GAAP is fairly specific in specifying that write-offs must be unusual and non- recurring. Unusualmeans not a part of day-to-day business, and nonrecurring means, well, nonrecurring. Still, these terms are subject to interpretation. Are
layoffs, plant closings, and restructurings unusual and nonrecurring? For some companies, yes, but such write-offs became almost annual events for automakers and other smokestack industries. For some companies, the December fourth-quarter write-off announcement became almost as depend- able as Santa Claus himself.
Be aware of the reasons for and any regularity in such write-offs. Have they gotten to be a habit? Are they truly a cost of doing business in disguise? If Cisco writes off $2.5 billion in unused raw material components, or if H-P writes off $100 million to trim staff, that’s an event, but who’s to say that it won’t happen again as technology changes and business cycles continue?
Arguably, at least some of that is a normal cost of doing business.
Investors should look carefully at write-offs, especially large ones, to see if they resulted from an obvious or clearly stated strategic shift in the business.
If write-offs occur repeatedly or have little in the way of explanation, beware.
The write-offs could be ordinary costs of doing business disguised as some- thing special.
Pro Forma Performance
Beyond accounting stretch, the once-ubiquitous “pro-forma” earnings release, such as the Sun Microsystems example at the beginning of the chapter, gave even more of a black eye to corporate financial reporting and trust. Pro forma reports had become almost a public relations alternative to the classic GAAP earnings statement.
Responding in part to investor and analyst pressure and in part to a fairly loose (to date) compliance environment, companies started using pro forma reporting as a press-friendly reporting alternative. The trend started in 1999 with Yahoo!, Inc. and expanded through the technology industry and occa- sionally beyond.
Actually, pro forma has been in the accounting vocabulary for a long time.
Pro forma statements were originally used as “unofficial” statements
designed to project — not report — company performance. Companies plan- ning to go public or merge with another company issued a pro forma set of statements to give an investor a clue to what forward-looking statements may look like.
Today, you may still see some pro forma reports done in parallel with GAAP reports, but they’ve largely returned to special situations. More likely, you may see a set of “non-GAAP” numbers alongside the GAAP statements, with a clear explanation of the differences. Like most of today’s financial reporting trends, this one is favorable.
“Everything but bad stuff”
Pro forma reporting allowed companies to spin their business pretty much as they pleased. They include certain things, but leave out others they consider irrelevant to assessing performance. Former SEC Chief Accountant Lynn Turner called it “EBS,” or “Everything but Bad Stuff,” reporting. From your perspective as a value investor, pro forma or other non-GAAP reporting not only undermines trust; it also makes it difficult to compare one company to another.
Pro forma is really an extension of the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) reporting concept made popular in the 1980s (see Chapter 8).
Although EBITDA made numbers look better than they were by excluding financing costs and asset recovery, at least the application of EBITDA was consistent from one company to the next.
Companies routinely omitted option costs, investment gains and losses, asset impairment or write-downs, goodwill amortization, and other “noncash”
items. In that these expenses are noncash, value investors can wink and turn their heads a little — for a while. But some very cash-real expenses, such as interest expense, get written out of the pro forma. EBITDA for most busi- nesses is more useful as an internal management decision tool than as an investing tool, especially for long-term investors.
Companies must provide GAAP-compliant numbers in releases and submit full GAAP-compliant reports to the SEC. So if a company provides non-GAAP statements, which reflects how the company wants to see itself, fine. But make sure to read the explanation of why the non-GAAP and GAAP state- ments are different — and try to understand why the company wants to maintain that difference.
What Should a Value Investor Look For?
Those of you who had an accounting course or two somewhere along the way are probably now recalling why you steered clear of a public accounting career. This stuff is complicated.
And it isn’t reasonable, practical, or even prudent to examine every financial statement in enough detail to ferret out the real story. It’s literally impossible if you’re trying to choose from among 2,000 or 3,000 companies to invest in.
The “cake test”
Some of you may be familiar with the technique of sticking a toothpick into a cake to determine whether it’s done. (For those of you who haven’t tried this, if you stick a toothpick in a cake and it comes out clean, it’s done.) Try it a few times in different parts of the cake to verify your conclusion. If you don’t believe it, or don’t bake, then call your mother. She’d be glad to hear from you.
Especially for time-constrained investors, the “cake test” approach makes sense to review financial statements. Poke here, poke there, read some of the notes, get a flavor for financial reporting quality. If you’re Warren Buffett, ready to commit $2 billion to a company, you may want to take a closer look.
But for most of us, the following will help.