Money: A Penny Earned…

Davis Keeler | From the April 1973 issue

Most corporate financial reports appear to tell you more than you really care to know. You skip the arcana and look at the earnings figure. If it's more than last year you smile and if it's less you frown and wonder why you didn't sell the stuff when it was up in April. If your broker is trying to unload a hot one on you he'll tell you about how the earnings have been/are going to compound and what a low price-earning ratio it's selling at.

All of this turns on the company's present or future earnings and vast sums of money change hands on the basis of these figures. You know a company's earnings because they publish reports full of charts and numbers, and the honesty of the whole thing is attested to by independent auditors who say something to the effect that they think these figures are all right.

Basically, earnings is a fairly simple concept. You subtract your expenses from your income and what's left is your earnings. And you know it's there because the auditors certify that the company earned, say, $1,247,853.57 last year. Now if they said the company earned about one and a quarter million give or take a little you would be put on guard that maybe they were guessing, but a nice clear, black $1,247,853.57 has the ring of certainty and conviction about it, as if to say you could actually go down to the bank and count it all, down to the last fifty-seven pennies.

The only problem with this is that neither expenses nor income may mean the same thing that you think they mean, and that $1,247,853.57 almost certainly isn't there.

TREATMENT OF EXPENSES

Let's take the concept of expenses. The company gets a $50,000 invoice for a piece of equipment. That's an expense (never mind that you haven't paid the bill yet, the expense has accrued). Simple enough so far. But what if you are going to be using the equipment over the next several years. The reasonable practice would be to charge the expense against earnings over the period of years that the equipment is contributing to those earnings. How long will you be using it. Hard to say; there's not only the question of when it will wear out but the possibility that a change in the market or a change in technology would reduce the value of the equipment before it wore out. So you make an educated guess and say 5 years. That means that $10,000 will be charged against earnings each year. On the other hand, if you took 10 years your earnings would be reduced only by $5000 each year. Both periods might be acceptable, given the considerations mentioned before. In some of the new high technology glamour fields, nobody knows the useful life of the equipment because no one has even had any of the stuff long enough for it to wear out.

We note, however, that two companies with the same income and expenses will show different earnings simply as a result of the length of the depreciation period used on its equipment. And so, since earnings are what makes a company's shares go up, it is not beyond the range of possibility that management might tell the accountant to stretch out the depreciation of the drill presses in order to beef up reported earnings.

You don't have to do this with just capital equipment. You can capitalize the cost of installing capital equipment. You can even amortize what would otherwise seem to be everyday operating expenses. For example, research and development expenses could reasonably be capitalized and written off over a period of years since they will be benefiting the company in the years ahead.

A current controversy over this issue is being waged in the oil and gas industry over what is called "full cost" accounting. Under full cost accounting, all exploration and development costs are capitalized and written off over a period of years, whether the particular expense resulted in a producing well or not. This permits the company to write off its expenses over a period of years, rather than take them now (by "take" we mean show them for accounting purposes; the cash has already been paid out—maybe). This results, as you might guess, in a great improvement in the earnings statements of the companies using full costing. The system is currently used by firms accounting for 13% of the industry's production, and is spreading rapidly, according to the WALL STREET JOURNAL (4/28/72).

INCOME MANIPULATION

If expenses can be a slippery subject, so can income, thanks to the wonders of accrual accounting. Probably the most famous example of this type of creative bookkeeping occurred several years ago in the shell home industry. According to the shell home concept, a company would put up the outer shell of a home and the purchaser would work evenings and weekends to finish the interior work and save money by avoiding a lot of high cost craft unions. The shells were sold on installment contracts with a few dollars down and a century or so to pay. The builders, however, accrued the full sales price on their books when the contract was made and the down payment was received, on the theory that they had already "earned" the money and it was simply a matter of time before they actually collected it.

As you might guess, this bit of accounting sophistry didn't hurt their earnings at all, and their stock went through the roof. A few years later the fad died out; purchasers decided that doing their own plumbing was a dumb idea and began walking out, abandoning their $50 deposits. Needless to say, despite their marvelous reported earnings, certified by auditors, the shell home companies' investors took a bath.

Just about any company which enters into multi-year contracts could justify the practice, and unless you heed the footnotes in the annual report, there's no way you can tell whether what they call earnings is what you call earnings. Manipulation of income and expense items such as these are what analysts mean when they refer to the "quality" of earnings.

UNRESOLVED ISSUES

In the short term, the results of accounting techniques such as full costing will be to boost earnings and share prices in firms adopting the device. The accounting profession is in a turmoil at this time and there are strong currents pressing both ways in industry and government, so the matter is anything but resolved.

A longer term view raises certain problems. Most obviously, such devices as capitalizing expenses will result in inflating earnings and give the appearance of health to a firm which may in fact be sliding into bankruptcy. They may simply not have any money to show for their earnings.

A more serious problem arises from the interaction of inflation with these liberal accounting techniques. Because the value of the dollar is constantly declining, some portion of an expense item is lost each year that the item is deferred; consequently, costs will never fully be recovered and the real value of the company's capital base will be constantly diminished. The corporation will pay income tax on what is, in reality, a recovery of its capital.

On the other hand, it sometimes happens that a company gets in a position where it can't continue to defer expense items. The management may decide, 'what the hell, let's take a bath this year and be done with it'. So they recognize some extraordinary expenses, write off a bunch of stuff that should have been written off long ago, and take a big drop in earnings or even a loss. While this can be very disheartening if you just bought the stuff it may also mean that the company is now showing a more realistic balance sheet. If the public at large has dumped the stock and you see that these write-offs will probably be nonrecurring, this may be an opportunity to buy in at a bargain. On the other hand, it may also be a prelude to even bigger write-offs, or even a bankruptcy, so have a care.

RECOMMENDATIONS

So what's a body to do? The last thing in the world we need is a law to tell firms how to report their earnings. Companies are different and do need different approaches. In many cases these exotic accounting devices are used because they really are the best reflection of the company's situation; the fact that they hypo the company's reported earnings is purely a pleasant coincidence. Government intervention in the field has already spread as much darkness as light. As an example, the accounting profession decided that the tax benefit from the recent investment credit should be spread over several years rather than taken all at once and distort earnings. Well, Congress decided that distorted earnings were exactly what it had in mind when they adopted the tax credit and stepped in by law and required firms to take the credit all at once to boost corporate earnings and spending. As another example, the Federal Power Commission, against heavy industry objection, a few months back stepped in to require natural gas companies to use a form of full costing to encourage exploration for natural gas. In both cases, the government action was motivated by what must be called "political" considerations, rather than any disinterested desire for accurate bookkeeping. As the Psalmist tells us: "Put not your faith in princes."

So, if you care what the earnings of a company are, you'll have to get the annual report and read the footnotes and try to figure out what they really earned. The company probably paid their accountants a lot of money to keep you from figuring it out, so you may have some work ahead of you.