Financial Education

The nature of business is always changing, and frequently companies find that they need to make major adjustments to the way they do business. This often results in additional charges to write off assets or lay off employees. Companies often list these separately on the income statement to call attention to the special nature of the charges, but investors must evaluate these carefully and assess whether these charges can be expected to continue in the future. For example, an impairment charge suggests that management did not depreciate assets enough in the past, and thus had to make a catch-up adjustment. This adjustment will reduce future depreciation expense and increase future income relative to the previous treatment. Analysts might justifiably wonder whether other assets are not being depreciated quickly enough as well, which would result in more of these charges occurring in the future.

In addition, some companies tend to take restructuring charges so frequently that they appear to be an ongoing expense, as suggested in this article at Stock Market Beat:

Xerox Reports Fourth-Quarter 2006 Earnings: Financial News - Yahoo! Finance

Xerox Corporation (XRX) announced today fourth-quarter 2006 earnings per share of 22 cents, including a restructuring charge of 16 cents per share. This compares to fourth-quarter 2005 earnings per share of 27 cents, which included a 5 cent restructuring charge. Excluding restructuring, Xerox delivered adjusted EPS of 38 cents, an increase of 19 percent over fourth-quarter 2005 adjusted EPS of 32 cents.

Sorry Xerox, but when you’ve taken restructuring charges in each of the last seven years (perhaps more - we didn’t bother going back farther) you stretch credulity by asking investors to take them out as “one-time” items. On an unadjusted basis, your earnings were $0.22 per share and far below expectations. At least the company finally had a year/year increase in cash from operations.

Further elaboration was provided in a subsequent post:

Stock Market Beat: In the earnings release for the third quarter, management gave the following guidance:

Xerox expects fourth-quarter 2006 earnings in the range of 21-24 cents per share, including restructuring charges of about 13 cents per share. Excluding restructuring, Xerox expects fourth-quarter adjusted EPS of 34-37 cents per share.

Right away we see two discrepancies: First, since Xerox guided toward the amount of the charge, the company was implicitly asking analysts and First Call to treat it as special. Given that Xerox has had restructuring charges in nine of the last ten years they are clearly anything but special, unique, unusual or uncommon. Why not insist that both analysts and first call include them and earn our plaudits as an example for others to follow? Second, the restructuring charge was $0.03 higher than expected, which resulted in “adjusted” earnings beating estimates while GAAP earnings were at the low end of the range. Did the analyst estimates incorporate the full $0.16 charge or the $0.13 for which they were guided? It brings to mind Warren Buffett’s admonition in the 1982 (we have long memories and access to search engines) letter to Berkshire Hathaway shareholders:

It was only a few years ago that we told you that the operating earnings/equity capital percentage, with proper allowance for a few other variables, was the most important yardstick of single-year managerial performance. While we still believe this to be the case with the vast majority of companies, we believe its utility in our own case has greatly diminished. You should be suspicious of such an assertion. Yardsticks seldom are discarded while yielding favorable readings. But when results deteriorate, most managers favor disposition of the yardstick rather than disposition of the manager.

To managers faced with such deterioration, a more flexible measurement system often suggests itself: just shoot the arrow of business performance into a blank canvas and then carefully draw the bullseye around the implanted arrow.

Given that Xerox’ bubble-era accounting practices landed the company a case study in the book, surely you are aware of Howard Schilit’s Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Second Edition (aff. link). Shenanigan number 7 is “Shifting Future Expenses to the Current Period as a Special Charge.” One way to do so is to inflate the amount included in a special charge, as Xerox appears to have done in this period.

Or consider the value investor’s bible, Graham and Dodd’s Security Analysis. They say:

The correct technique [for analysts adjusting for restructuring charges] is to place each gain or loss in the year or years in which it is believed to have occurred.”

Or how about White, Sondhi and Fried’s The Analysis and Use of Financial Statements, which has been a key part of the curriculum for the CFA Exam for many years. They have this to say:

If we ignore nonrecurring items, we permit companies to sweep their mistakes under the rug. The purpose of analysis is to understand, not to forgive…. Restructuring provisions require special scrutiny. Such provisions often contain both noncash writeoffs and provisions for future expenditures. The former indicate that prior-year income was overstated; the latter increase future-year income (that will no longer include those costs) and forecast future cash flows. Repeated writedowns suggest that depreciation is inadequate and the firm’s quality of earnings is low.

And here is a reference from Financial Statement Analysis: A Global Perspective by Robinson, Munter and Grant, presented in a study of Motorola’s financial statemtents:

Motorola had similar problems in years prior to 1999. The continuing nature of these charges is somewhat disturbing. One would hope that the restructuring is effective and that these charges would cease in the future, but the analyst must be careful when these expenditures occur continuiously.

The point of all these references is not to show how many books about financial analysis we have read, but to illustrate that there is a clear consensus that restructuring charges, particularly when they occur frequently, should not be ignored. In fact, they are “suspicious,” “disturbing” and indicate that “the firm’s quality of earnings is low.”

If investors don’t believe the restructuring charges should count against the current period, they should adjust them to show the charges as operating expenses in a different year than when the charges were taken. However, since there are charges in pretty much every year, there doesn’t seem to be much point. We think Generally Accepted Accounting Principles (GAAP) does that job quite well and no adjustments are necessary.

It is important to treat such charges individually to determine whether further adjustments are necessary.

For more information, see all articles on: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis

See also:

Cash Flow Return on Investment (CFROI)

Economic Value Added (EVA)

Upward Revaluation of Assets

Computing Free Cash Flow to the Firm from Net Income

Asset Impairment Charges