September 28, 1998

An Investment Opinion
by Alex Schay

Balance Sheet Checklist, Part 2

In last Thursday's column, we began our financial checklist by looking at revenue recognition considerations. Today we begin to review specific balance sheet items to keep an eye on.

Last In First Out (LIFO) Layer Reductions -- Since roughly 70% of the companies out there use First In First Out investory accounting method (although the scale is more than 100% because some firms use multiple inventory costing methods for different classes of inventory), the possibility of lower-costed layers of inventory boosting earnings without any concomitant gain in cash simply doesn't occur. However, investors should be aware that some LIFO "inventory reduction programs" can result in lower "cost of goods sold" figures slipping into the income statement -- numbers that don't adequately reflect current replacement costs. Management can intend to reduce the inventory layers (so there is no "last in" cost that in the current period becomes the "first out") to produce the desired result. However, a quick check of the inventory footnotes can make all of this clear.

Depreciation & Amortization -- Although it is difficult (if not impossible) for individual investors to track the depreciation schedules of various assets, it's important to know that they are a significant part of the earnings equation for some firms. Waste Management (NYSE: WMX) shareholders weren't having much fun in February of this year (until it was bought out by USA Waste) after the company announced a $1.5 billion fourth-quarter charge. This sum was added to the $2.9 billion in earnings that the company had to erase from its books in an earnings restatement back to 1992, thanks to faulty depreciation accounting for such things as garbage trucks and landfills. In this case, the lives were stretched in order to boost near-term numbers (by lowering the depreciation expense installments). The question to ask is, do the life spans make sense when compared to competitors within the same industry?

Tax Asset Valuation Accounts -- The rapid adoption of SFAS No. 109, Accounting for Income Taxes, in 1992 and 1993 has led to more and more firms recording deferred tax assets for the value of net operating losses. Tax assets must be stated at the value at which management intends to realize them. This presents a situation where management must assess when the firm will generate enough money to use up the asset. The ability to show better than "normal" earnings when the allowance is reduced (which increases the asset) and the subsequent income tax expense is lowered walks the fine line between quality of earnings and "earnings power." When a firm is 100% reserved for awhile, and then gets an earnings boost due to a sudden "optimism" about its future prospects -- which takes longer than stated to materialize -- take heed. One great reality check is the "Management's Discussion" section. If the outlook is glowing but a fully reserved tax asset exists, it's time to sort out what's really going on.

Warranty Reserves -- Many companies provide a warranty for the goods or services that they market. Since these warranties help a firm hawk its wares, warranty-related costs need to be matched with sales revenue in each accounting period. Companies usually base the estimated warranty expense that they record each accounting period on their past experience. However, sometimes companies conveniently overlook current circumstances that render historical circumstances somewhat ineffectual in determining outlays. In some cases additions to the reserves are reduced in order to make earnings targets. Can these reductions be justified by superior products, or is it just a crass attempt to hit the numbers?

Pension Income -- A defined benefit plan is one that provides for a determinable pension benefit paid at "retirement," or as a result of any other events that force the same outcome. The primary objective surrounding financial disclosures of defined benefit plans is to assess the present and future ability of the company to cough up the cash at the appointed time. Therefore, financial statements disclose information related to the resources of the pension plan, the accumulated plan benefits of participants, the transactions affecting the plan's resources and benefits, and finally, any other additional information that sheds light on the process.

So, the big question is how does the "expected return" outlined in the disclosure jibe with the return that has actually been earned on the plan assets. Expectations of a higher return will increase earnings immediately without any increase in cash for the coffers. Checking the pension plan footnote disclosures can help an investor discover whether or not an overfunded pension plan is producing pension income rather than expenses.

On Thursday we'll continue with this balance sheet checklist.

Related links:
-- Balance Sheet Checklist, Part 1
-- Balance Sheet Basics