October 1, 1998

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

Balance Sheet Checklist, Part 3

Today we conclude our look at the checklist of trouble spots to look out for when evaluating a company's balance sheet.

Capitalization Policies -- Remember when America Online's amortization of its subscriber acquisition costs caused such a frenzy -- mostly in the popular business press? This capitalized expense policy didn't pass the smell test for a lot of people, and was subsequently dropped by the company. Again, the big question is, how can a company justify expensing something over time when the competition doesn't? How does a firm account for its start-up costs, and what is the calculus involved in determining the amortization period? Management's rationale for any significant capitalization policy can be found in the accompanying "Accounting Policies" footnotes.

Restructuring Charges & Asset Write-Downs -- Despite what management might say, restructuring charges and asset write-downs are invariably an admission that the company has misallocated capital. Some of the common justifications for the move to restructure or write down assets is overcapacity in the industry (making certain existing facilities unprofitable) or the emergence of a low cost competitor that is eating a company's lunch. While the sale or liquidation of an unprofitable activity is not in itself grounds for going on hyper-alert, the prospect of a "big bath" and the fact that the activity might actually be continued (despite announcements to the contrary) -- with the inventory and PP&E written down resulting in lower expenses -- should be cause for concern. As Ben Graham offers in Security Analysis, "Once it is decided to take a major write-down, there is little additional embarrassment in charging off every possible doubtful asset, thereby preparing the way for accounting prosperity."

Allowance for Doubtful Accounts -- In a similar fashion to warranty reserves, the question that must be asked pertains to additions to the allowance. Are additions lower than they've been in the past? If this is the case, it can only be justified if the collections process is going gangbusters or if the allowance has proven "way" too conservative. Again, lowering the additions to the reserve is one method for boosting earnings in difficult periods.

Related Party Transactions -- A "related party" is one that can exercise control or significant influence over the management or operating policies of another party to the extent that one of the parties ends up being hindered in its pursuit of life, liberty and economic interest. Related parties can include management and their immediate families, owners and their immediate families, "equity method" investments, and beneficial employee trusts run by management. A problem can arise, for instance, if dealings take place with non-public companies that are controlled by management. In some cases these non-public firms actually get dumped on quite considerably in order for the public entity to shine -- in which case the analyst needs to take a closer look at these invisible supports that might be propping up the firm.

In-Process R&D Write-Offs -- All research and development costs covered by GAAP are expensed when incurred. Costs that are acquired in a business combination by the purchase method are assigned their fair values. The acquirer of these R&D assets accounts for the deal by determining whether or not there are "alternative future uses" for the assets -- in which case these assets are capitalized. All others are expensed at the date of the consummation of the deal. So you can see where this is headed.

A company ends up paying an exorbitant sum for a high-tech firm in order to acquire a technology. Since GAAP dictates that even acquired research and development needs to be expensed, the acquirer can deem very little worthy of future use and expense as much as possible. This serves the purpose of allowing the acquirer to, in essence, avoid the attendant amortization that goes along with the goodwill taken on during the "purchase" by allocating as much of the purchase price as possible to R&D (that it can reasonably justify). That amount is immediately expensed in one huge charge -- which will largely be ignored. What percentage of the firm that is being acquired is being categorized as "acquired," and what benefits will a company get down the road from the technology that it has deemed unworthy of alternative future uses? These are a some of the questions that careful investors should ask.

Related links:
-- Balance Sheet Basics
-- Balance Sheet Checklist, Part 1
-- Balance Sheet Checklist, Part 2

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