“Misleading Artifices in the Income Account. Earnings of Subsidiaries”
- Management can play tricks with earnings via subsidiaries; Graham provides one example of write-ups to goodwill and trademarks of a subsidiary being deducted from expenses. (Note this surely is not legal today, but in extraordinary cases similar action by management can be caught in the same manner.) (pg 435).
- Expenses that are subsequently capitalized, no matter the justification, ought to be subject to extreme scrutiny and adjusted accordingly. (pg 437).
- Graham suggests taxable income of the corporation be compared with earnings reported to shareholders. Significant differences between the two figures ought to be investigated, as the two numbers should be relatively correlated. (pg 437). Page 438 offers a good example chart of the correlation.
- The capitalization of leaseholds, whether from a subsidiary or main company, is also questionable. “[They] are essentially as much a liability as they are an asset…an obligation to pay rent for premises occupied.” Any capital value ascribed to the leasehold is also highly intangible, thus this appreciation in most cases ought not to be recorded on a balance sheet, and especially not on an income statement. (pg 439).
- Additionally, if the leaseholds had appreciated in value, then “the effect should be visible in larger earnings realized”, thus recording the appreciation on an income statement would be akin to double counting the value. (pg 440).
- Keeping a close eye on depreciation/amortization figures is also important in cases of fixed asset appreciation. (pg 440).
- A company following extremely questionable accounting practices “must be shunned” by investors, no matter how attractive it may seem. (pg 441.)
- “You cannot make a quantitative deduction to allow for an unscrupulous management”. (pg 441).
- Stock dividends, particularly in closely held companies with subsidiaries, are also subject to dramatic manipulation. The stock price of the subsidiary is strongly controlled by the parent, thus, a stock dividend from the subsidiary to the parent should be reviewed to determine if it is an effective pyramid scheme for earnings. (pg 443).
- Study the “degree of consolidation” for parents and their subsidiaries. It is key to understand the different levels of ownership in all aspects of the business when considering making an investment. (pg 444).
- Special dividends paid by subsidiaries to parent companies are a method of concealing bad earnings. (pg 447).
- A certain allowance to earning power of the parent must be made in situations where subsidiaries are generating a loss, as that loss is generally non-permanent, whether through sale of the subsidiary or improvement of profitability. Graham suggests that if the subsidiary can be wound up without “an adverse effect upon the rest of the business”, it is more logical to view the loss as temporary; however, if the subsidiary is important strategically for the business, this obviously hurts earning power. (pg 449).
- If it is predicted that continued operations of the unprofitable subsidiary is likely, a deduction from earnings is appropriate.
Chapter Thoughts and Analysis
- It is quite interesting that GAAP standards have developed since Graham’s time to allow the capitalization of leases under certain requirements, of which are fairly arbitrary in my opinion. An analyst could determine value much more accurately by determining for himself if it is appropriate to capitalize, rather than applying GAAP’s broad, unspecific standards. I would personally think justification of capitalization would be reserved for only clear-cut cases of extremely long-term leaseholds, but perhaps a reduced percentage of capitalization value would be appropriate in other, less obvious cases.
- As with the former chapter, some of Graham’s accounting examples are dated. But it is the spirit; the analytical mind-set of breaking down each accounting aspect applied to a company’s financial statements that remains relevant today.
- I am curious to research whether or not Graham’s concept of matching reported earnings to taxable income is still valid. My suspicion is that it is, due to the slow rate of change in taxation policy; however, further investigation is warranted.
- In my opinion, it is unfair to reject a company entirely because of questionable accounting. It would be more accurate to demand a greater margin of safety from the company. Particularly in the case of companies where an accounting scandal is uncovered, the natural reaction of the market would be to panic and exit the position. This could make for some interesting discounts on a value-investing basis. However, extreme caution should certainly be exercised in these cases to determine if the scandal was a one-off, or more structural an issue.