Documentation

This blog was done on the

 2021-06-07

Background

The advanced accounting system was developed during the industrial revolution for manufacturing firms and since economies are shifting away from manufacturing to technology and service related businesses, accountants have had a tough job keeping up, you will see many inconsistencies reflect the shift away in the economy. Accounting created during a very different century with a different economy.

Taxes

Tax in the income statement might not match up to what the company pays out as taxes. So that difference shows up as a deferred tax and builds up over time either as an asset or liabilities.

On a company’s balance sheet, deferred tax assets & liabilities are reflections of expectations of taxes in the future or due for the current period. 

For example, if it's a money losing company, it obviously doesn't pay taxes (maybe that could change under the recent G7/French big tech revenue tax proposals for big companies, who knows). It also allows us to take those losses and carry them forward/backwards. You are allowed to take that loss and set it off against the income in a future year.

  • So one of the things to look at is to determine whether there’s a Net Operating Loss (NOL) and;

  • secondly, how much that NOL is; because it will affect your tax payments in the future.

Taxes that are paid in the income statement might not reflect what the company actually pays but the giveaway would be to look in the cash flow statement because it will reflect the difference. So combining a cash flow statement with an income statement will give a sense of taxes.

Stock based compensation

Some companies pay stock compensation to give employees an incentive to align them with the company, i.e a lot of the FAANG companies do this to align employees to the companies goals.

Also, if the company cannot afford (for not having enough cash) to pay salaries to their employees, then they pay with stock (giving away a piece of their company). This mostly occurs in startups though.

To the extent that you’re paying with stock to keep employees working for you, it has to be treated as an employee compensation thus means that it’s an operating expense.

In 2004, the rules changed for granted options as they were treated as giving away nothing because accountants valued options as exercise value. By looking at the income statements in US/EU companies, if companies do give employees compensation in the form of stocks/options then it will show a line item and that line item reflects the value of the grant at the time of the grant. So it is an operating expense and not a cash flow. 

When computing the cash flows for a company, we should not be adding back stock based compensation because you are giving away a slice of the equity which will not be attributable to shareholders. The rule now is that if you grant with stock it’s going to be treated as an expense which is the correct way.

Leases

Let’s assume that the company took the 10-year lease and the contract requires the company to make lease payments every year for the next 10 years. This is called contractual commitment and what that means is that the company has to pay in good and bad years. Because it's a fixed payment where your business will cease to exist if you don’t pay the lease it’s essentially a form of debt and should be treated as such.

The accountants made the ownership the center of their decision making, if you don’t have an ownership of an asset, they will not treat these lease commitments as debt. The latter were called operating leases. In 2019, US companies show capital leases as debt and operating leases as operating expenses. In non-US companies, all these lease commitments are often treated as operating lease expenses. So financing expenses were treated as an operating expense. A good example of this was Spirit Airlines 10K in 2020. It looked healthy on the balance sheets but in the footnotes it has a huge amount of leases attributable to Boeing that it was hiding.

A new FASB rule, effective Dec. 15, 2018, requires that all leases—unless they are shorter than 12 months—must be recognized on the balance sheet.

Now all lease commitments are treated as debt (unless they are less than 12 months). When you do the computation, make sure that all leases are treated as debt in your valuations including < 12 month leases. Otherwise your balance sheet won’t be balanced.

Research and Development

If you have an expense that creates benefits and generates future growth over many years, it’s a capital expense. If you have an expense that creates only this year, it’s an operating expense. So, R&D should be treated as capital expenditures (CAPEX) even though they are not by accountants.

To compute the R&D:

  1. specify an amortizable life, how many years does it take;

  2. collect R&D from past years. Let’s say it's been spread out over 5 years. How much of that expense is being written off this year and how much is still left over. The amount that’s being written off this year will be amortized will show up as an expense; the amount that’s not been written off from previous years will now show up in the balance sheet (capital invested in R&D);

  3. then you have to adjust your earnings, so that the entire perspective on a company can change by making those shifts. If we do not do R&D, we are going to get an asymmetrical vision of what these businesses are worth, how much the company is investing and what they are truly making.

Source: Accounting 101 by Aswath Damodaran.

We have done all this for you, check out iRobot example using our Discounted Cash Flow (DCF) calculator or do your own here.

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