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.
To reverse the adulterating impact of asset write-downs, I add back cumulative after-tax asset write-downs to my calculation of invested capital. Given the computational difficulties of doing so for too extended a period, and the utility of doing so, I exercise some judgement to assess how far back this accumulation must go. With regards to the after-tax form of the write-downs, this is because the tax benefits of write-downs are real benefits to the business that allay the destructive impact of the write-downs.
Accumulated other comprehensive income (OCI) is a sea into which various unrecognized gains and losses are poured. In the United States, largely consists of currency adjustments, unrealized gains and losses on available for sale securities, gains and losses on derivatives held as cash flow hedges, actuarial gains and losses on defined benefit plans recognized, and changes in the revaluation surplus. For example, in its 2023 10-K filing, HF Sinclair Corp. reported an accumulated other comprehensive loss of $11.78 million, whose breakdown is given on page 122:
IFRS also recognised an accumulated OCI account within shareholder’s equity, although each reserve is reported separately.
It is obvious that the nature of the items within the accumulated OCI are both volatile and not immediately available for deployment by management. Therefore, accumulated OCI is removed from my calculation of invested capital. A note must be made of the impact of the Financial Accounting Standard Board’s (FASB) Accounting Standards Update (ASU) 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities,”which was voted in in 2016 and came into effect in 2018. Warren Buffett excoriated the update in his 2017 letter to Berkshire Hathaway’s shareholders, saying,
Berkshire’s gain in net worth during 2017 was $65.3 billion, which increased the per-share book value of both our Class A and Class B stock by 23%. Over the last 53 years (that is, since present management took over), per- share book value has grown from $19 to $211,750, a rate of 19.1% compounded annually.*
The format of that opening paragraph has been standard for 30 years. But 2017 was far from standard: A large portion of our gain did not come from anything we accomplished at Berkshire.
The $65 billion gain is nonetheless real – rest assured of that. But only $36 billion came from Berkshire’s operations. The remaining $29 billion was delivered to us in December when Congress rewrote the U.S. Tax Code. (Details of Berkshire’s tax-related gain appear on page K-32 and pages K-89 – K-90.)
After stating those fiscal facts, I would prefer to turn immediately to discussing Berkshire’s operations. But, in still another interruption, I must first tell you about a new accounting rule – a generally accepted accounting principle (GAAP) – that in future quarterly and annual reports will severely distort Berkshire’s net income figures and very often mislead commentators and investors.The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report to you. That requirement will produce some truly wild and capricious swings in our GAAP bottom-line. Berkshire owns $170 billion of marketable stocks (not including our shares of Kraft Heinz), and the value of these holdings can easily swing by $10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s “bottom-line” will be useless.
Before the update, firms could class equity securities as either trading securities, available-for-sale securities, or cost-method securities. Changes in the fair value of trading securities were recognised through net income, while those of available-for-sale-securities were recognised in OCI, with dividends recognised through net income. Cost-method securities, which had no easily determinable fair value, were reported at cost minus impairment, with dividends and impairment losses recognised in net income. Under the update, equity securities are now all be measured at fair value through earnings and classed as equity investments, or as equity investments accounted for using the equity method. Where equity investments are not part of a firm’s consolidated financials or accounted for under the equity method, firms will have to either recognise changes in fair value through net income, or at cost, minus impairment, and plus or minus subsequent adjustments for observable price changes, with changes in the basis of these investments ported in the firm’s current earnings. The import of this is to treat equity securities as if they were all trading securities under the ancien régime, except for those without readily determinable fair values, which are accounted for under the modified cost method. The fair values are, nevertheless, adjusted to reflect observable price changes in similar equity investments.
Non-financial companies disclose unrealised gains and losses from equity investments under “Other income (expense) on the income statement, while financial companies disclose them in the notes to the financial statements. “Other income (expense) does not form part of my calculation of NOPAT, so, for post-2018 results, there is no impact on my treatment of the income statement. Because financial companies disclose unrealised gains and losses in more idiosyncratic ways, changes have to be made by first going through the notes and finding them.
Because unrealised gains and losses are now recognised through net income, accumulated OCI is artificially decreased, affecting my calculation of invested capital. Under the old rules, the fair value was reported on the balance sheet and the cost basis, the capital deployed to make the investments, was disclosed in the notes, along with the fair value and net unrealised gains and losses of their equity investments. To reflect the cost of the equity investments, one merely had to deduct the accumulated OCI from fixed assets. With ASU 2016-01, unrealised gains and losses are no longer in accumulated OCI. Where firms disclose the cost basis, fair value and net unrealised gains and losses of their equity investments, I can recalculate accumulated OCI under the old rules, adding back the cumulative net unrealised gains and losses to accumulated OCI, net of taxes and minority interests, which allows for more consistency in treatment of both accumulated OCI and fixed assets. However, this is not always the case. Without quarterly reporting of these components, I have to add the incremental unrealised gains and losses through the reporting periods, net of estimated taxes, minority interests and gains on sale of equity securities, to the prior net unrealised gains and losses figure, to try and ape how accumulated OCI was formed under the old rules.
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.
The logic of discontinued operations is that they are not a component of core operations and therefore, not only do their earnings not belong in a calculation of net operating profit after tax (NOPAT), they also do not belong in a calculation of the invested capital that generates NOPAT. So, I banish them from my calculation of invested capital.
Companies create reserves in anticipation of probable future costs or losses whose amounts can be reasonably estimated, as happens with inventory reserves and loan-loss provisions, or, in order to ensure comparability across accounting methods as happens with LIFO reserves.
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).
The worries expressed in my short note on the change in reserves, pertain to the balance sheet as well, with managers well capable of adulterating asset values through the innocent exercise of the discretion that the rules allow. Reserves are added back to assets as part of my invested capital calculation.
Taxes incorporate operating, non-operating and financing items. One wants to assess the core operations of a business, free of any financing effects, in order to estimate net operating profits after tax (NOPAT), and so, one must break off operating taxes, from taxes on non-operating accounts, and other non-operating taxes. This gives us the taxes the firm would pay if it only engaged in its core activities and was wholly equity financed.
I start with reported provision for income taxes or income tax expense, and then subtract the change in the deferred tax account in order to convert taxes from an accrual to cash basis. When a company pays less in cash taxes than it reports in book taxes, it earns a deferred tax liability, a source of cash, and when it pays more in cash taxes than it reports in book taxes, it earns a deferred tax asset, a use of cash. The deferred tax account can be found on the balance sheet, but when they are not separately detailed, the relevant information can be found in the cash flow statement under the “Cash flows from the operating activities” section, as part of the adjustments to reconcile net income to net cash provided by operating activities; or, it can be found in the footnotes.
Then, I unlever cash taxes by adding back the debt tax shield from from net interest expense and operating, variable and not-yet commenced leases. This is done by multiplying the debt expense by the marginal tax rate, and adding the sum to cash taxes. Finally, I reverse the impact other non-operating accounts. Where there is information on tax benefit of non-operating items, with pre and post-tax values given, I reverse the impact of that as well. This process gives us an estimate of cash operating taxes.
This whole process can be seen in the example below in which I calculate Diamond Hill’s cash operating taxes.
These are the result of currency revaluations or devaluations and do not appear on the face of the income statement. These currency fluctuations force firms to assume non-recurring charges or gains. An example is the $12 million Tesla gained in 2013 when the Yen’s plunge reduced Tesla’s Yen-denominated liabilities. David Trainer, the CEO and founder of New Constructs, notes that,
The Bolivar Fuerte was adopted as the national currency of Venezuela in 2008. Companies operating in Venezuela must obtain government approval to exchange Bolivars to US Dollars at the official exchange rate. Effective January 1, 2011, the Venezuelan government established a fixed rate of 4.30 per dollar. Again, effective February 13, 2013 the currency was further devalued to a rate of 6.30 per dollar. This change caused many companies to take large charges on the remeasurement of their Venezuelan operations for their 2013 fiscal years. Such a charge is a one-time, non-operating expense and is not indicative of the operations of the company.
Reported net non-operating charges and gains are those non-operating items reported on the face of the income statement. According to the paper, “Core Earnings: New Data and Evidence” by Ethan Rouen, Eric So, and Charles C.Y. Wang, they are “similar in magnitude… to those reported off the face of the income statement”. Examples of such items are interest expense/income, minority interest income, preferred dividends, asset impairments, and losses on debt extinguishment, as this except from the Commercial Metals Company’s 2023 10-K shows:
These items are added back to net income in order to arrive at a measure of net operating profit after tax (NOPAT).
The Financial Accounting Standards Board (FASB) eliminated goodwill amortisation from 2002 and the International Accounting Standards Board (IASB) followed in 2005. Before that, goodwill, the capitalised value of the excess of purchase price over fair value of identifiable assets, required an annual charge to earnings for up to 40 years until the value of goodwill was eliminated. (Warren Buffett’s essay, “Goodwill and its Amortisation: The Rules and The Realities” in the appendix to his 1983 chairman’s letter, is an excellent discussion of goodwill amortisation). Since those accounting changes, goodwill is now subjected to impairment testing, which, unlike goodwill amortisation, is a real economic cost to the firm. Following “Core Earnings: New Data and Evidence” by Ethan Rouen, Eric So, and Charles C.Y. Wang, for years before the rule change, I add the goodwill amortisation charge to net income and for years after the rule change, the goodwill impairment charge, so as to arrive at a better measure of net operating profit after tax (NOPAT).
Effective 2005, the IASB required employee stock options (ESO) to be expensed in the income statement, with the FASB following a year later. Until then, firms could treat ESO compensation as if it was not a cost, inflating their reported earnings. Consequently, for the era before this accounting change, one must dig up data from the footnotes in order to calculate the cost of ESO issuances and ensure that results are comparable across periods and add the charge to net income so as to arrive at a better measure of NOPAT.
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
