“Extraordinary Losses and Other Special Items in the Income Account”
- Historically, companies varied greatly in their treatment of extraordinary losses and special items. For example, in the 1932 depression, companies charged inventory write-downs to surplus, while in 1938 a majority charged write-downs to income. (pg 424).
- However, inventory losses are “by no means extraordinary”, as they are a part of general business. This shall be treated with in detail in a later chapter.
- Earnings can be “manufactured” with great ease. For example, an inventory write-down charged to surplus a year prior will serve to inflate profit by the amount written down in the following year. The hit to surplus is hardly accounted for by mainstream investors, while a boost in earnings will have a significant affect on price. (pg 425).
- Reserves created for inventory losses, typically charged to surplus, require an adjustment to ensure those inventory losses are properly (at least partially) charged to income. “…in no year does the income account reflect the inventory loss, although it is just as much a hazard of operations as a decline in selling prices.” (pg 426).
- See page 427 for an example of the type of adjustments Graham would make to compare earnings given inventory losses in previous years.
- Inventory costing methods, such as FIFO, LIFO, or averaging, affect profits in a particular year in different ways; however, in the long-run, the variance is eliminated. (pg 429).
- Idle plant expenses charged to income presumably are only temporary, or at least can be terminated at will by management. Thus, it is more appropriate to adjust them to be charged to surplus, rather than be considered a permanent drag on income. (pg 430).
- Deferred charges, if charged to surplus, understate operating expenses for a large period of time, thus exaggerating income in a serious way. (pg 432).
- The amortization of a bond discount is “part of the cost of borrowing money”, and thus should be amortized over the life of the bond with charges against earnings, rather than surplus. (pg 433).
Chapter Analysis and Thoughts
- Strictly speaking, some of this analysis is dated. For example, charging the amortization of a bond discount against surplus is no longer the standard; rather the discount is established as a contra-liability, which is then amortized and charged to interest expense over the course of the bond. However, Graham is insightful for his time in recognizing items such as this. Overall, it seems he sets the example of treating any item charged to surplus with great scrutiny.
- This chapter is the first quantitative, mechanical advice Graham offers for valuation. And again, while not all of his quantitative recommendations are valid in this day and age, it is more his analytical process of identifying cause/effect relationships on financial statements that the analyst must channel.
- The discussion of idle-plant expense as a non-temporary affect to earning power should perhaps be treated with a touch of caution. Questions must be asked, such as what is the reason for idleness, what solutions are management proposing on the issue, and in what time frame can one realistically expect it to be resolved. The answers to these questions may justify a partial charge to income.