Pension accounting rules permit certain expense items to be smoothed into income. However, the required disclosures allow investors to adjust the income statement to reflect the true underlying economic cost related to pension plans. The economic cost should equal any change in the plan liability other than benefits paid or employer contributions.

Consider the following pension disclosures from KLA-Tencor’s 10K.

The pension obligation increases by 4,175, and benefits paid of $1,519 should be added back to that amount to determine the underlying economic change in obligation. 4,175 + 1,519 = 5,694.

The fair value of assets rose by $1,255. The contributions and benefit payments were a net $789 which should be deducted from this. Notice that in this case the benefits paid figure differs between the asset side and the liability side. It is possible some benefits were paid as a lump sum settlement. At any rate, the net change in assets was 1,255 - 789 = 466.

The net change in the economic liability, then, was 5,694 - 466 = 5,228. Contrast that with the reported pension expense.

The economic change in the value of the pension was $5,228, but the income statement showed an expense of just $2,280. An investor might want to adjust the income statement by adding $2,948 to pension expense, reducing operating income by the same amount. The effect on net income would be smaller due to the tax effects.

For KLA-Tencor, reported operating income was 589,868 in 2007. After this adjustment it would have been$586,920 - approximately half a percent lower. Earnings per share for the year would have been at least a penny lower. In this case, I wouldn’t consider the difference material.

I recently published this article at Financial Education, and thought Stock Market Beat readers might also find it interesting.

The balance sheet typically includes all debt maturing in more than 12 months as a single line item. However, additional disclosures can be found throughout the firm’s financial reports. As an example, I examine the recently filed 10K for Gerber Scientific (GRB - Annual Report. More »

I have commented before that Large Cap Watch List (Track at Marketocracy) member NII Holdings (NIHD) appears better than others at negotiating financing deals that don’t favor one class of investors over another. But that doesn’t mean that its creative financing deals won’t end up being expensive:

NII Holdings, Inc. announced that it has commenced a tender offer with respect to its 2 7/8% Convertible Notes due 2034 in which it is offering to pay a cash inducement premium of $80.00, plus accrued and unpaid interest up to (but not including) the conversion date, for each $1,000 principal amount of Notes that are validly tendered and accepted for conversion into shares of the Company’s common stock pursuant to the terms of the Offer and the Notes.

The Notes are currently convertible into shares of the Company’s common stock at a conversion rate of 37.566 shares per $1,000 principal amount of the Notes. The outstanding Notes have an aggregate principal amount of $300,000,000 and are redeemable by the Company beginning on February 7, 2011. Assuming all of the outstanding Notes are tendered for conversion pursuant to the Offer, the Company’s total cash payment to the holders of the Notes, including the inducement premium and accrued and unpaid interest, would be approximately $28.2 million and would be funded from cash on hand. The total number of shares of the Company’s common stock issuable upon the conversion of all of the outstanding Notes would be approximately 11,269,800 shares. Based on the number of shares of the Company’s common stock outstanding on June 10, 2007, if all of the outstanding Notes are converted into shares of the Company’s common stock pursuant to the Offer, the number of outstanding shares of common stock would increase to approximately 163,157,450 shares. Full conversion of the Notes also would reduce the Company’s total consolidated debt by $300.0 million and annual interest expense attributable to the Notes of approximately $8.6 million would be eliminated.

The Notes were issued in January 2004, when NII’s stock was trading at a split-adjusted $15 per share. The $26.62 conversion price may have seemed distant, but over the 30-year life of the bond a 2% annual rise in the stock price would have left the conversion option in the money.

So now, three years later the company decides to close out the financing deal, and are willing to pay $80 per note as an inducement to convert the bond into shares early. To do so they will pay $28.2 million in cash for the interest and conversion premium, and issue stock worth $912.3 million - total consideration of $940.5 million for $300 million worth of notes when issued.

So how did the bondholders do on the “2 7/8%” notes? How does an annual return of more than 49% sound? And in hindsight, the convertible note offering looks too clever for its own good.

You haven’t been looking very hard recently if you haven’t seen a chart comparing the rally in the Dow Industrials to what it would be if priced in gold or Euros. Eddy Elfenbein’s got a problem with that.

Don’t let anyone tell you that this rally isn’t for real. And especially, ignore all the phony comparisons (to gold, to euros, to inflation, to Swedish kronor). Who cares? I don’t use euros anyway. Why not compare it to bandwidth? I use lots of that. Anyone can use clever comparisons to show what they want.

It is fair enough to say that for US investors the framework for investing is the US dollar. Why should we care, for example, if European investors aren’t getting a good return? If all our liabilities and our income is dollar-based, why compare our returns to anything else?

Well, fine. Let’s compare the rally to other potential investments in dollar terms. I sorted the Yahoo! ETF browser by 1-year returns and the S&P 500 didn’t even crack the top 100 (it was 101). Instead of earning the (quite respectable) $15 per $100 invested here, wouldn’t you have rather had Malaysia’s $49.22, or even Germany’s $32.38?

Not fair, you say, to look at 1-year returns when it has been more recently that the US markets have been on their record streak? Fine. Year-to-date the S&P 500 ranks 228th among ETFs. Over the last 3 months it is 238th. These rankings are barely average.
The charts comparing the stock return in anything other than dollars is simply a way of showing that other investments performed better. Unfortunately, presenting it that way can prove confusing to those who ask why they should care. It is not a very good illustration when it doesn’t make the point.

Disclosure: Author is long STREETTRACKS GOLD (GLD) at time of publication.

Design software maker Adobe Systems (ADBE) is rightly proud of its headquarters building, which it lauded last December in a press release:

Adobe Systems Incorporated today announced the U.S. Green Building Council (USGBC) has awarded Leadership in Energy and Environmental Design-Existing Building (LEED®) Platinum certifications for Adobe’s East and Almaden headquarters towers in downtown San Jose, distinguishing Adobe as the world’s first commercial enterprise to achieve a total of three Platinum certifications under the LEED program.

However, the pride in its building is more muted when it comes to showing the property and its associated debt on the balance sheet, as disclosed in a recent SEC filing:

On March 26, 2007, Adobe Systems Incorporated (the “Company”) renewed its lease arrangement for one of three buildings the Company occupies as part of its corporate headquarters, known as the Almaden Tower, located in San Jose, California (the “Property”).

Pursuant to a lease agreement (the “Lease”), dated March 26, 2007, between the Company as Lessee and SELCO Service Corporation as Lessor, the Company has leased the Property for a new five year term that extends to March 26, 2012, with an option to extend for an additional five years at the Company’s sole discretion. Rent payments under the Lease are a function of LIBOR; payments for the initial term are currently estimated to be $29.7 million. The Company has the option to purchase the Property at any time during the term of the Lease for approximately $103.6 million. The maximum recourse amount (or residual value guarantee) under this obligation is approximately $89.5 million. The Lease will continue to qualify for operating lease treatment under Statement of Financial Accounting Standards No. 13, “Accounting for Leases,” and as such, the Property and related obligations will not be included on the Company’s consolidated balance sheet.

With a value of $104 million and annual lease payments of approximately $6 million, the payments do not appear all that different from those the company would pay in a mortgage. It’s not like Adobe needs creative financing arrangements, either. With $2.2 billion in cash and short-term investments as of December, they could buy 20 such buildings without taking out a mortgage against any of them. We’re actually more concerned that management is spending time drafting arrangements like this than we are about the arrangement itself. But that’s not the least of it:

As part of the financing of the Lease, the Company purchased a portion of the Lessor’s receivable under the Lease for approximately $80.4 million, which will be recorded as an investment in lease receivable on the Company’s consolidated balance sheet for the quarter ended June 1, 2007. This purchase may be credited against the purchase price if the Company purchases the Property, or may be repaid from the sale proceeds if the Property is sold to a third party.

So rather than carrying the property on the balance sheet and taking a charge for depreciation and interest expense, the company keeps it off the balance sheet and pays rent. With the investment in the lease receivable, it makes us wonder why they even bothered.

Our sister site, Financial Education, has announced the following project:

We’d like to build a resource library of financial texts that have entered the public domain. Right now we have one: Jesse Livermore’s Reminisces of a Stock Operator. (Sorry - we wish we could remember where we found it to give proper credit but we can’t.)

At any rate, we hope the Internet community can help us find other useful financial books that can be uploaded as pdf or word documents for everyone to enjoy. If you know of any, please contact us.

Let’s put together a terrific free resource!

When you own your own business you can make sure that any managers working for you are acting in your interest. It is different for public companies, where management is not directly answerable to shareholders. In corporate governance terms, this is called the agency problem. How can a shareholder be sure management, who acts as the shareholder’s agent, is acting in the shareholder’s interest? In theory this is done through the Board of Directors.

For the board to be an effective guardian of shareholder interests, it should strive to mitigate conflicts of interest between stakeholders, and in particular between management and shareholders. Managers left to pursue their own agendas unchecked can grant themselves excessive pay, use shareholder funds wastefully, engage in nepotism and do many other things that could potentially be harmful to the shareholders. More »

As accounting geeks, we are always on the lookout for examples of misleading company financial reports.  In particular, it is a neat find when a company has beaten earnings by a penny or two for several consecutive quarters due to accounting items over which management has discretion. Examples of such discretionary items include the allowance for doubtful accounts and warranty reserves.

Accounting rules require companies to recognize sales and the related expenses in the same period. However, if a product is warrantied for three years after the sale (as DELL products often are) this can be difficult. In such cases, management is required to estimate the future warranty expense and charge the estimated amount when the sale is made. The charge is accounted for as a warranty reserve, and future actual warranty costs act as a reduction to the reserve rather than showing up on the income statement directly. If management’s estimate turns out to be incorrect (intentionally or unintentionally) the amount reserved will be adjusted in the future periods when necessary.
Because management has a good deal of discretion when estimating the costs (especially during quarterly reports - which are not audited as are the annual ones) skeptical investors call reserve accounts “piggy banks.” If management has a good quarter and beats earnings by several cents they could estimate higher than normal warranty expenses, and smooth out the earnings by reporting less in the good time. Then, in a bad quarter they could estimate a lower warranty expense to take some of it back. Which leads us to the following article we found regarding DELL.
Research Firm: Dell Warranty Accounting ‘Troubling’ - Warranty Accruals - CRN

New questions are being raised about the way Dell accounts for its warranty accruals.Friedman, Billings, Ramsey Research (FBR), an Arlington, Va.-based research firm, on Friday said its study of Dell’s books “points to at least three troubling conclusions” in the way that the computer hardware giant has handled warranty accruals in its financial reports.

FBR said in its report that Dell’s accounting for warranty accruals “has caused [earnings per share] overstatement of 2 cents to 8 cents in five of the last 12 quarters for which data is available.” The study comes as Dell faces investigations by the U.S. Securities and Exchange Commission, the U.S. Attorney for the Southern District of New York and the audit committee of its board of directors.

“First, it appears that Dell regularly uses warranty accruals to materially manage margins and earnings, rendering the reported results less useful for gauging actual margin trends,” FBR said in the study. “Second, as of the last quarter for which a 10-Q [report with the SEC] is available, the cost of actual claims as a percentage of products sales was rising steadily — up 30 percent [year over year in Dell’s 2006 fiscal year] and costs may be heading higher.

“FBR also said Dell’s way of disclosing how it manages the money it collects from product warranties, the money it sets aside in reserve for warranty expenses and how much it accrues in warranty funds, is unusual, making it difficult to identify the Round Rock, Texas-based company’s warranty accruals based on public financial reports alone. The research firm said Dell could be headed for a restatement of earnings if the SEC probe includes a focus on warranties.

Since that would be pretty serious manipulation, we decided to check things out for ourselves. We come away unconvinced.

We’ll take the last point first. In its reports DELL discloses its warranty costs and reserves using a table very similar to this one:

“Revenue deferred and costs accrued for new warranties” is the line management estimates. The obligations honored represent actual warranty expenses while the amortization of deferred revenue represents amounts DELL has collected for service agreements that it recognizes over the term of the agreement.

As FBR notes, by lumping deferred revenue and warranty estimates into a single line it is difficult to tell which is which. This can be important, as the warranty reserves are recognized as a product-related expense while the deferred revenues are recognized as service revenue. So we looked at several quarters of management estimates as a percentage of both total revenue and service revenue, which we condensed to the following chart:

Other than the big spike up in Q306 (the quarter that ended in October 2005) there isn’t too much of a trend in either ratio. As a percentage of total revenue the accruals are rising over time, which actually means that the company is reporting lower profits than they would if the accruals were held constant. As a percentage of service revenue there may be a very mild case that the company is being more aggressive.

Still, there doesn’t have to be a trend in order for the quarterly fluctuations to affect earnings. So we took the average ratio of our nine quarters reported as a “normal” percentage of sales that should be accrued. We see that the fluctuations in accruals were indeed enough to affect EPS. Further, there were more quarters in which the adjustment would have reduced EPS than those in which it would have increased EPS. If the company beat estimates in those quarters by a smaller amount than the warranty accrual, there would be some cause for concern. For example, in the April 06 quarter (Q107) the company reported earnings that met consensus estimates, but normalizing warranty accruals to service revenue they would have missed by $0.02.

However, Friedman’s second point (about the rising actual warranty expenses) seems somewhat frivolous. We noted that the reserve spiked in the October 2005 quarter. Looking at that filing, we learn that:

During the quarter, Dell recognized a product charge of $307 million for estimated warranty costs of servicing or replacing certain OptiPlex^tm systems that include a vendor part that failed to perform to Dell’s specifications. At October 28, 2005, $274 million of the accrued warranty obligation remains outstanding for servicing or replacing additional OptiPlex^tm systems.

Having a $307 million expected warranty expense is certainly unfortunate. However, as per the accounting requirements DELL recognized the charge as soon as the problem was discovered, and the higher current expenses at least partly relate to the remaining expenses associated with servicing and replacing those systems as needed. It is hard to argue that this is anything more than the accounting system functioning as it was intended to (matching the expenses to the associated revenues as much as possible.) The charge was taken in October 2005 and disclosed at the time as a way of covering the future expenses. Now, as the expenses are recognized they come out of the reserve rather than the income statement (since they were already charged to the income statement in October.) No big deal. In fact it seems to confirm that management is using the process appropriately. (It would be inappropriate for them to put a big deposit in the piggy bank if they weren’t going to have higher actual expenses.)
Furthermore, since the most recent cases of adjusted earnings falling below reported earnings are due to the timing of recognizing this specific issue, we are less concerned about the adjusted-earnings miss in the April quarter.

Finisar’s (FNSR) announcement that it was exchanging some of its convertible notes for contingent convertible notes generated some interest in our case study on contingent converts. Given the interest, we figured we would reward it with a study of the specific Finisar transaction. We’ll start with the company’s spin:

Overall, the exchange provides the Company with more flexibility to utilize its cash flow from operations between now and 2010, while also minimizing dilution to shareholders.

If you think this sounds too good to be true, you would be correct. Let’s start by looking a little more closely:

The New Notes contain provisions known as net share settlement which require that, upon conversion of the New Notes, Finisar will pay holders in cash for up to the principal amount of the converted New Notes. Any amounts in excess of this cash amount will be settled in shares of Finisar common stock.

What this means is that the old notes were convertible into stock (270 shares per $1,000 of bond principal) or the company could settle in cash if it preferred. The new notes, by contrast, require the company to settle the first $1,000 of each bond’s ending value in cash rather than shares. This does not provide the company “more flexibility to utilize its cash flow.”  In fact, just the opposite. So we can surmise that some cash flow covenants were restricted “between now and 2010″ to give the company more flexibility in the short term. Specifically:

The New Notes do not contain the put option provisions of the Outstanding Notes which provide the holders of those notes the one-time option to require the Company to repurchase the Outstanding Notes on October 15, 2007.

So instead of being required to repurchase the notes next year, they get a reprieve until the notes expire in 2010.

Now let’s tackle the dilution aspect. The company tells us:

The New Notes also are convertible into 35 more shares of Finisar common stock per $1,000 principal amount than the Outstanding Notes.

Hmm. Instead of 270 shares, the bondholders can get 305 shares worth of value for their bonds. That doesn’t exactly sound like “minimizing dilution to shareholders” to us. What they really mean is that, because the principal will be settled in cash, the reported diluted share count will be lower. This is just accounting sleight-of-hand. The economic reality is that bondholders are getting more value for their money, and this value will come directly out of shareholder’s pockets.

What Finisar has done is this:

1. They agreed to settle the first $1,000 of each bond’s value in cash in exchange for being able to reduce the reported (not the economic) dilution to shareholders.
2. They sweetened the notes by making them convertible into 35 additional shares (a $125 value per bond.)
3. In exchange, bondholders have to wait until 2010 to cash in the bonds instead of having the option to do so next year.

Who do you think got the better end of this deal?

Motley Fool tells investors to Steer Clear of Accounting Shenanigans. So far, so good. However, we found their advice on how to do so a bit lacking:

So what’s an investor to do? A lot, actually. For starters, look for small caps with conservative accounting practices, positive free cash flow, responsible management, and a history of underestimating and overdelivering on promises to shareholders.

If the average investor was able to discern conservative accounting from aggressive accounting, the advice would be wholly unnecessary. We at least give solid tips and case studies on aggressive accounting practices in our forensic accounting category. You can also check out sites like Financial Education to get some tips on basic accounting practices. “Free cash flow” has so many definitions that looking for it to be “positive” is nearly meaningless.

But the last bit may be the most useless. WorldCom and Enron had long histories of overdelivering on promises to shareholders because they were committing fraud. In fact, one earnings quality study showed that the strongest warning signal is when a company has beaten estimates by exactly one penny for a number of consecutive quarters.

The fact is, monitoring accounting practices is not easy, which is one reason many investors are better off indexing than trying to pick their own stocks. However, it isn’t all that hard either. For investors who are interested in learning more about it and spending some time reading the financial satements it can be a rewarding hobby.