Under both IFRS and US GAAP, assets and liabilities held for sale are reported separately on the balance sheet and their income and loss from them, or the result of their sale, are reported as discontinued operations separate from continuing operations. This forms part of the business’ net income, adulterating the firm’s earnings.
In my pursuit of core profitability, I strip away the impact of income and losses from discontinued operations. For example, in its 2023 10-K, the Commercial Metals Company reported a $2.3 million gain on the sale of assets, and net earnings of $859.76 million. In order to properly estimate the recurring, and repeatable profitability of the business, it is necessary to remove this $2.3 million gain.
Because real estate investment trusts (REITs), by their nature, dispose of property, I do not perform the same exercise for REITs, choosing instead to incorporate such income and losses into my calculation of NOPAT.
While operational excellence should be the lodestar guiding managers, there is a great temptation to use reserves to manage earnings. In order to ward off the effects of earnings management, ensure comparability across business, and reveal timing of recurring cash flows from operations, the change in LIFO reserves, other inventory reserves and loan loss reserves year-over-year are added to my calculation of net operating profit after tax (NOPAT).
David Trainer, CEO and founder of New Constructs, notes that,
Loan loss provisions can be manipulated to boost a company’s earnings by bleeding off reserves. Or they can cause problems when companies need to “catch up” and take big provisions to raise reserves to more appropriate levels.
Fannie Mae (FNMA) had the largest change in total reserves of any company for the fiscal year 2012. FNMA decreased its loan-loss provision from $72 billion in 2011 to $59 billion in 2012, despite increasing its total amount of loans outstanding. Under GAAP rules, FNMA is able to boost earnings by the amount of decrease in reserves as income. Meanwhile, the 2012 loan loss provision was $9.4 billion less than actual charge-offs.
David Trainer, Change in Total Reserves – NOPAT Adjustment
Firms, in order to attract and retain talent, offer one of two kinds of retirement plans for their workers, the defined benefit plan, and defined contribution plan. A defined benefit plan, as the name suggests, guarantees a set benefit to its workers upon retirement. Firms may contribute or deduct more to or from this plan than is possible under a defined contribution plan. Defined benefit plans are the most complex and costly type of plan that businesses can set up and manage. Defined contribution plans, on the other hand, guarantee that a business will match an employee’s contribution and the employee receives regular payments during their retirement. This is the most popular kind of employer-sponsored plan in the United States.
In calculating net operating profit after-tax (NOPAT), one takes the costs or income of defined contribution plans as operating, and subtracts them from revenue. Defined benefit plans require more manipulation.
One of the themes of investing is that accounting standards are not written with equity investors as the primary audience, mixing operating and non-operating items, and so, disguising the true economics of a business. Pension accounting echoes this theme. The net periodic benefit cost (NPBC) of a defined benefit plan comes from both operating and non-operating elements. One must then analyse pension expenses line by line. An example from Johnson & Johnson’s 2023 10-K will provide a concrete example:
Service cost and the amortisation of prior service cost represent benefits granted to the employee in return for service to the company. Interest cost on plan liabilities, expected return on plan assets, and recognized gains and losses represent the evolution of plan assets and liabilities over time. If the change in plan assets matched the change in plan liabilities each year, these accounts would cancel. Since markets are volatile, this is not the case. As a result, the investment performance of plan assets contaminates pension expenses. Curtailments represent changes to the pension plan that restrict benefits.
Before 2018, under Accounting Standards Codification (ASC) 715, firms reported the NPBC as an operating expense bundled under cost of sales and selling, general, and administrative (SG&A) expenses. Consequently, operating expenses and operating profit were tied to the performance of the firm’ plan assets. For example, in 2016, WK Kellogg Co. recognised a $304 million net loss on its plan assets, leading to a sharp increase in its pension expense to $199 million, and then in 2017, Kellogg recognised a $126 million net gain on its plan assets, leading to not only a $431 million benefit, but, because this was buried in cost of sales, the company’s operating profit rose from $1.4 billion to $1.95 billion. Accounting Standards Update (ASU) 2017-07, which went into effect in 2018, updating ASC 715, requires firms to
…report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost as defined in paragraphs 715-30-35-4 and 715-60- 35-9 are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. If a separate line item or items are used to present the other components of net benefit cost, that line item or items must be appropriately described. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed.
Accounting Standards Update (ASU) 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Post-retirement Benefit Cost, FASB
This disaggregation of service costs from the other components of NPBC reflects the Financial Accounting Standards Board’s (FASB) consideration that service costs are the only operating component of NPBCs. This is because service costs are the one component of NPBC that represents an annual compensation cost, and, therefore, not only is it reported within operating income, it also forms a part of my calculation of net-operating profit after tax (NOPAT). Whereas FASB considers amortisation of prior service cost as an non-operating expense, I treat it as an operating expense for historical benchmarking purposes, but because FASB considers this a non-operating expense, I adjust to reflect my own standards. When net benefit obligations decline, service costs are a net gain, and are treated as non-operating items and so, do not form a part of my calculation of NOPAT. The same logic applies to amortisation of prior service costs. These two are the only components of my calculation of NOPAT.
Interest cost, expected return on plan assets, and recognized gains and losses, treated as operating items before 2018, are now disclosed as non-operating items. Settlements and curtailments, which were inconsistently disclosed prior to 2018, are now disclosed as non-operating items. The impact of these non-operating items must be stripped away from any calculation of NOPAT, both prior to 2018 and after 2018. It must be said that, for reports prior to 2018, one has to read the footnotes and management discussion & analysis (MD&A) to verify, where possible, whether recurring items such as interest costs are indeed buried within operating expenses, and whether non-recurring items such as curtailments and settlements, are buried within operating or non-operating expenses. For example, in 2016, in their annual report, Johnson & Johnson broke down their NPBC as follows:
Curtailments and settlements were reported as non-operating items, and so, in order to determine the impact of non-operating NPBC on operating expenses, the appropriate calculation would be the following, which gives a $252 million increase in operating expenses:
Non-operating income is the complement of non-operating expenses, and are special items and one-time earnings that are not reported on the face of the income statement, and are instead hidden in other line items. The most common types of hidden non-operating expenses are gains on the sale of assets, some pension income, and income from legal settlements.
An example of non-operating income is the unusually large gain on property sale, $600 million, that Alexander’s Inc., a real estate investment trust (REIT), received in 2012, which was 89% of its $674 million GAAP income, as reported in the REIT’s 2012 10-K:
Non-operating expenses, such as asset write-downs, which I discussed in a separate post, are special items and one-time charges that are not reported on the face of the income statement, and are instead hidden in other line items. The most common types of hidden non-operating expenses are litigation charges, restructuring costs, amortization of acquired intangibles, some pension costs, and losses on asset sales. An example of a non-operating expense hidden in operating earnings is the $5 billion penalty that Meta Platforms paid as part of a settlement with the Federal Trade Commission (FTC) and which the company reported on page 22 of its 2019 10-K:
Academic research has investigated the persistence and predictability of these expenses, and, although nearly research found that year-on-year persistence and predictability was hard to discern, more recent research has found that across many years, there is persistence of special items for firms with strong core profits. Simply, firms with strong core profits and which report a series of restructuring charges, for example, are likely to do so in future, as Meta Platforms’ has done in recent years, whereas firms with low core profitability, are unlikely to repeat the trick. Researchers believe this is because firms may shift operating items into special items in order to manage their earnings. However, it is difficult to extend this research to any meaningful conclusions about individual companies.
Asset write-downs are nothing short of shareholder destruction. If wealth, as I contend, tends toward destruction in the long run, an investor has two choices: not to invest, or, to do something that shifts the odds in one’s favour. Not taking into account management’s destruction of shareholder value is not, one would imagine, an example of tilting the odds in one’s favour. One must always make a rigorous examination of the footnotes and management discussion & analysis (MD&A) of company reports, and make the appropriate adjustments to its reported data in order to determine the true state of the economics of a business and find economic activities such as asset write-downs.
Asset write-downs occur when the fair value of an asset, what it would fetch on the market, falls below its carrying value, the cost of an asset less accumulated depreciation or amortisation, forcing the book value, what appears on the balance sheet, to be written down, perhaps even completely, to its fair value. Write-downs and write-offs are important signals to debt investors of the deteriorating quality of collateral, but in sending those signals, they muffle another: the historical invested capital put into the business by its shareholders. So, a firm’s return on invested capital (ROIC) rises because invested capital, the denominator in ROIC, is shrunk after a write-down. In effect, this penalises firms with no write-downs when compared with firms with write-downs. The thing to do is to treat asset impairments as non-operating, adding their cumulative after-tax value to invested capital. The after-tax write-down expense should also be added to NOPAT. Given that firms receive a deferred tax benefit from writing down an asset, I include the after-tax impact of an asset-write down in my models.
The most common forms of write-downs are goodwill and intangible impairments, and write-downs of plant, property, and equipment (PP&E) and other long-lived assets. An example of an asset write-down is the $2.43 billion in write-downs that Meta Platforms reported on page 100 of its 2023 10-K.
David Trainer, of the revolutionary investment research firm, New Constructs, remarked in a report on asset write-downs that,
Given that management is paid to create value, not destroy it, an asset write-down represents management’s failure to allocate capital effectively.
“Red Flag: Asset Write-Downs Reveal Risk” by David Trainer
