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Financial Issues to Review in Difficult Times

Benefit Changes, Buybacks, Revenue Recognition, Mark-to-Market

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When I bought my first used car, Dad said “caveat emptor” — let the buyer beware. Great advice for buying a car and even better advice for buying stocks. Unfortunately for the casual reader of financial statements, many accounting methods and typical cost-cutting schemes may make results appear as if the company is clouding reality.

To be clear, these are allowable accounting methods under generally accepted accounting principles, or GAAP. Don’t consider the examples below to be manipulation, but rather issues to learn more about.
Each annual report has enough information to give you a complete picture of the company, and you always have the firm’s investor relations available to lead you through any rough spots. Let’s look at four issues to review in the financial statements, especially when the economy gets tough.

Changes in Employee Benefits

Although most benefit changes are small and have no significant effect on results, recent economic situations have seen pension plans frozen and 401(k) matching contributions eliminated. In the last year, over 240 publicly traded companies have reduced or eliminated the 401(k) match, and in 2008 — for the first time — there were more companies in the Fortune 100 with 401(k)s as their primary retirement program than traditional defined-benefit pensions, according to consulting firm Watson Wyatt Worldwide.
Benefit changes are difficult to see in the financials, as typically there aren’t lines on the income statement showing how much was spent on benefits. Instead, benefits are included on almost every expense line on the income statement. This is called full absorption accounting and is required by GAAP. So a large savings in employee benefits won’t appear directly on the income statement. For a manufacturing company, this can include a significant reduction in the cost of goods sold, which raises the margin on sales. These same savings can also offset and mask increases in selling, general and administrative (aka SG&A) expenses. Since you cannot see benefit changes directly, the investor has to ask whether the results were good, or were they good results that were paid for by the employees.
A 401(k) plan typically has company costs ranging from 3 percent to 6 percent of salaries, and salaries represent the largest single expense for most companies. General Motors has a history of skipping its 4 percent match to the 401(k) plan for white-collar employees. The match was suspended in 2006 and reinstated in 2007. The difference year over year was $60 million, which goes straight to the bottom line. In late 2008 GM again announced it would stop matching contributions to the 401(k) plan.
To find changes in benefits, you need to read the footnotes. Chances are you won’t find a footnote dealing with the 401(k) plan, so start with the pension or compensation plan footnote first. If you use an online copy of the annual report, search for the words defined contribution and compare the amounts contributed to the 401(k) plan during the year. Unfortunately, companies are required to disclose only the current year’s defined-contribution amounts, so you probably will have to access the prior year’s annual report to find the change.
Also check the pension footnote and learn whether the pension plan has been frozen or underwent some significant change. The key phrase to search is plan amendments. Companies might also change the definition of who’s covered by the plan or add new limitations. These sorts of plan amendments create large changes in pension expense and liabilities, even if the modifications don’t take effect immediately.
You can also tell whether the plan was frozen in the past by checking plan expense. The pension footnote breaks down pension expense into its actuarial parts. If “service cost” is zero, the plan is frozen. Should you find service cost is a fraction of what was spent in the prior year, some change likely was made to limit employees from earning new benefits that didn’t take effect at the start of the year.

Share Buybacks

A share repurchase plan can powerfully increase earnings per share if the repurchased shares aren’t used to cover stock option redemptions or other uses. Studies have shown that the more an option is “in the money,” the more likely it is to be exercised. During a period in which stock prices have fallen, fewer option redemptions will occur, and many of the ones that do are at less than the optimal price the executive anticipated.
Also, management may find a period of lower share prices a good time to increase repurchases. A CFO with available cash will buy shares with two thoughts in mind. First, lower-priced shares are a bargain for future stock option exercises. Second, reducing shares outstanding automatically produces a larger EPS value, even if it’s only temporary.
Many repurchase plans simply acquire shares to be used for stock option exercises. A company that has traditionally maintained a relatively flat number of shares outstanding will continue to buy back shares to maintain EPS rather than issue shares for the exercise of stock options that will dilute earnings. Read the equity footnote and check the equity roll-forward chart in the annual report to find the number of shares outstanding at the end of the current year and the last year.
If shares outstanding are lower than they were at the start of the year, EPS has been artificially increased. The larger the difference, the larger the effect on EPS. The equity roll-forward will provide details on the number of shares repurchased, shares issued and shares returned to the market in stock option exercises.

Revenue Recognition

Although it seems simple that companies recognize revenue when they deliver a product, the very nature of some businesses justifies their use of percentage-of-completion accounting. For example, companies with long-term contracts to supply customized products such as aircraft or contractors building miles of highways may record revenue after certain stages of completion milestones are reached or when a percentage of the contract is completed.
If you don’t like to read all the footnotes, look for the one titled “Significant Accounting Policies.” It’s generally the first or second note after the financial statements.
Although it’s long, this single footnote tells you about many significant issues in the financial statements, including:

•  the methods used for revenue recognition
•  how and when inventories are valued
•  how the company uses derivatives
Lots of great information, all in a single footnote. For an example of revenue recognition issues, take a look at what defense contractor General Dynamics (ticker: GD) said about revenue recognition in this footnote from its 2008 10-K:
We account for sales and earnings in our defense and aerospace businesses using the percentage-of-completion method of accounting in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We estimate the profit on a contract as the difference between the total estimated revenue and the total estimated costs of a contract and recognize that profit over the contract term. We determine progress toward completion on production contracts based on either input measures, such as costs incurred, or output measures, such as units delivered, as appropriate. Our contracts for the manufacture of business-jet aircraft usually provide for two major phases: the manufacture of the “green” aircraft and its completion. Completion includes exterior painting and installation of customer-selected interiors and optional avionics. We record revenue at two milestones: when green aircraft are delivered to, and accepted by, the customer and when the customer accepts final delivery of the fully outfitted aircraft. For services contracts, we recognize revenues as the services are rendered. We apply earnings rates to all contract costs, including general and administrative (G&A) expenses on government contracts, to determine sales and operating earnings.
We review earnings rates periodically to assess revisions in contract values and estimated costs at completion. We apply the effect of any changes in earnings rates resulting from these assessments prospectively rather than under the cumulative catch-up method. Under this method, the impact of revisions in estimates is recognized over the remaining contract term, while under the cumulative catch-up method, such impact would be recognized immediately. We charge any anticipated losses on contracts to earnings as soon as they are identified. Anticipated losses cover all costs allocable to the contracts, including G&A expenses on government contracts. We recognize revenue arising from claims either as income or as an offset against a potential loss only when the amount of the claim can be estimated reliably and its realization is probable.
In just two short paragraphs, General Dynamics has told you about several issues that could increase or decrease the period’s recorded revenue without a change in unit sales. But this isn’t a conclusive discussion of the details of revenue recognition. The report’s Note G discusses the contracts in progress and provides financial details of how much has been recorded, progress payments from customers and other relevant particulars.
Percentage-of-completion accounting and similar contractual methods are complications of reading financial statements. But you can become confused if you don’t read the footnotes and understand how the business operates.

Mark-to-Market Accounting

The recent financial press is full of articles about investment banks and issues related to mark-to-market accounting. Bank of America provided a great example of this when
it recorded an increase of $2.2 billion in net income by raising the value of the newly acquired Merrill Lynch assets. Those assets were held at a lower value before Merrill Lynch was sold. This transaction did very little to bolster confidence and shows that the process isn’t foolproof.
“Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” said Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, in a New York Times article.
But the process is better than showing the original cost of assets that have dropped in value. Let’s go through a high-level review of issues in mark-to-market accounting, which may apply to any company holding securities or commodities.
First, let’s say a company buys a bond as an investment and decides to hold that bond until maturity. Although the bond’s market value may vary over time because of interest rate changes, the firm doesn’t care because it’s willing to wait to be paid by the borrower at maturity. The company essentially says it isn’t exposed to interest rate risk with the bond and records its value at cost.
But if the company is holding a high-coupon-rate bond and may sell it if rates drop, the interest rate risk is real. So the company will adjust the bond’s value on the balance sheet based on what the market would have paid for the bond if it had been sold on the balance sheet date. That has been the typical extent of mark-to-market accounting.
Now consider that same bond held to maturity. Is it backed by mortgages in an area with the highest foreclosure rates and originated by the most unscrupulous lender?
In this case the mark-to-market issue becomes one of loan quality, not of interest rate risk. Although the loan may be held till maturity, this bond’s value should also reflect the probability of loan default and lower values of the homes as collateral.
Bankers have made the argument that the loan isn’t a loss until the borrower stops making payments and the house cannot be sold for the loan’s amount, but this isn’t a conservative position. If a bank, or any company, lowers the value of an asset and then raises it when the value is restored, the result is the same. Unless a gain or loss is actually recognized (that is, converted into a cash gain or loss), it’s just an entry on the books and doesn’t reflect future possibilities. Until we can predict the future with 100 percent confidence, mark-to-market accounting will provide the most conservative value for the balance sheet.
Commodities have the same issue. Consider utility companies and their inventories of coal or natural gas. Better yet, consider the value of “reserves” owned by oil and gas exploration companies. As the market price for these commodity items rise and fall, so does the value in the financial statements for these items. Mark-to-market accounting will offset the rising balance sheet with increased income and a declining balance sheet with lower revenue.
Used car dealers provide an interesting alternative to consider. The value of a used car on the lot changes as time passes and typically goes downward. Banks realize this in lending to used car dealers by requiring a payment after a car has been on the lot for 90 days and every 30 days thereafter. In this situation, the bank uses mark-to-market to control its own risks. But used car dealers don’t represent the majority of the banks’ business, so greed clearly is the reason for bankers’ objections to many of the mark-to-market rules on securities and loans, when they control the same sort of risks in other areas.
Without diving into the technical issues discussed by the Financial Accounting Standards Board, accept that the current mark-to-market accounting standards may not be easily reviewed and find where a company has exposure to this type of accounting. One thing to do is scan the financial statements for assets and liabilities that might require a mark-to-market adjustment. This can include commodities, loans, securities, precious metals and derivatives. But the easy way is to read the “Significant Accounting Policies” footnote to see what assets are involved and how inventories are priced. There may be some surprises.

Deception Not the Intent

Considering the volume of information financial statements have, some readers understandably might suspect that management is trying to hide something in the reports. But that isn’t the intent. You have an ally in the company’s investor relations group who can answer your questions. The best advice is to read the entire annual report, including the footnotes.

BetterInvesting member and Iowa resident Mark Eckman, CPA, is a manager in the health care and benefits areas at Rockwell Collins.

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