Monday, December 7, 1998
A Graham of Sense
As previously mentioned in this space, despite what a company's management might claim, restructuring charges and asset write-downs are invariably an admission that a firm has misallocated capital. Some of the common justifications for the move to restructure or write down assets are overcapacity in the industry (making certain existing facilities unprofitable) and the emergence of low cost competition.
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."
Much of Graham's early valuation work was balance sheet intensive, so he definitely had a masterful understanding of the accounting regime and the nuances of accounting treatments that could "artificially" pump up earnings. In 1936 (yes, that date is correct), he wrote what has been billed as "A Satire on Accounting Shenanigans" entitled, "U.S. Steel Announces Sweeping Modernization Scheme." Of course, the "modernization" strategies that he writes about in such a Voltaire-like fashion have little to do with the substantive changes that drive real business development, but instead entail the manipulation of financial accounts. As Graham writes at the outset, "Contrary to expectations, no changes will be made in the company's manufacturing or selling policies. Instead, the bookkeeping system is to be entirely revamped."
Citing comprehensive survey results from a fictitious outside consulting firm Price, Bacon, Guthrie & Colpitts (undoubtedly hired to explore the company's "strategic alternatives"), Graham forcefully argues that U.S. Steel should immediately adopt the following strategies:
1. Writing down of Plant Account to minus $1,000,000,000.
2. Par Value of Common Stock to be reduced to $0.01.
3. Payment of all wages and salaries in option warrants.
4. Inventories to be carried at $1.00.
5. Preferred stock to be replaced by non-interest bearing bonds redeemable at 50% discount.
6. A $1,000,000,000 Contingency Reserve to be established.
What follows is a hilarious and insightful look at the details concerning the implementation of the above strategies -- and all the while Graham pokes fun at firms that shuffle accounts and preach the gospel of modern accounting (thereby avoiding capital allocation decisions that might actually create enduring value).
"In setting up this arrangement, the Board of Directors must confess regretfully that they have been unable to improve upon the devices already employed by important corporations in transferring large sums between Capital, Capital Surplus, Contingency Reserves and other Balance Sheet Accounts. In fact it must be admitted that our entries will be somewhat too simple, and will lack the element of extreme mystification that characterizes the most advanced procedure in this field."
Taking a look at number one and number four on Graham's modernization list -- since they relate to our opening discussion of asset write-downs -- serves as a neat lesson in logical extremes. Since some companies write down the value of their PP&E to "relieve" their income accounts of depreciation, why not write down the value to a negative number? In that way, instead of taking a depreciation charge, a company can, in fact, take an "appreciation credit" as the plant wears out, because as Graham sarcastically observes, "It is now a well recognized fact that many plants are in reality a liability rather than an asset, entailing not only depreciation charges, but taxes, maintenance, and other expenditures."
As well, Graham notes that some companies -- especially in the metal and cotton textile industries -- have suffered serious losses during the depression due to the fact that they need to adjust the value of their inventories to reflect market conditions. How about a more "progressive" policy? In order to eliminate the possibility of further inventory depreciation as well as boost earnings, inventories should be carried at a dollar -- and the write-down can be affected by dipping into the newly established Contingency Reserve (which in turn is replenished by funds transferred from the Capital Surplus account, which itself grows through the exercise of Stock Option Warrants). It's really a brilliant model for the "modern" company to follow.
Kind of eerie, these words from the past, huh? Investors shouldn't merely draw a "nothing new under the sun" conclusion from this discussion though, but rather, the more important point that financial reality is not necessarily the sum of the accounting parts.
(A copy of the full text of Graham's satire can be found on pp. 159-165 of The Essays of Warren Buffett: Lessons for Corporate America available from The Cardozo School of Law for $25 -- edited by Lawrence Cunningham.)
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