The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [132]
The combination of widely (or should it be wildly?) diversified operations with the impulse to clean house at the end of 1970 has produced some strange-looking footnotes to the annual reports. The reader may be amused by the following explanation given by a New York Stock Exchange company (which shall remain unnamed) of its “special items” aggregating $2,357,000, or about a third of the income before charge-offs: “Consists of provision for closing Spalding United Kingdom operations; provision for reorganizational expenses of a division; costs of selling a small babypants and bib manufacturing company, disposing of part interest in a Spanish car-leasing facility, and liquidation of a ski-boot operation.”*
Years ago the strong companies used to set up “contingency reserves” out of the profits of good years to absorb some of the bad effects of depression years to come. The underlying idea was to equalize the reported earnings, more or less, and to improve the stability factor in the company’s record. A worthy motive, it would seem; but the accountants quite rightly objected to the practice as misstating the true earnings. They insisted that each year’s results be presented as they were, good or bad, and the shareholders and analysts be allowed to do the averaging or equalizing for themselves. We seem now to be witnessing the opposite phenomenon, with everyone charging off as much as possible against forgotten 1970, so as to start 1971 with a slate not only clean but specially prepared to show pleasing per-share figures in the coming years.
It is time to return to our first question. What then were the true earnings of ALCOA in 1970? The accurate answer would be: The $5.01 per share, after “dilution,” less that part of the 82 cents of “special charges” that may properly be attributed to occurrences in 1970. But we do not know what that portion is, and hence we cannot properly state the true earnings for the year. The management and the auditors should have given us their best judgment on this point, but they did not do so. And furthermore, the management and the auditors should have provided for deduction of the balance of these charges from the ordinary earnings of a suitable number of future years—say, not more than five. This evidently they will not do either, since they have already conveniently disposed of the entire sum as a 1970 special charge.
The more seriously investors take the per-share earnings figures as published, the more necessary it is for them to be on their guard against accounting factors of one kind and another that may impair the true comparability of the numbers. We have mentioned three sorts of these factors: the use of special charges, which may never be reflected in the per-share earnings, the reduction in the normal income-tax deduction by reason of past losses, and the dilution factor implicit in the existence of substantial amounts of convertible securities or warrants.1 A fourth item that has had a significant effect on reported earnings in the past is the method of treating depreciation—chiefly as between the “straight-line” and the “accelerated” schedules. We refrain from details here. But as an example current as we write, let us mention the 1970 report of Trane Co. This firm showed an increase of nearly 20% in per-share earnings over 1969—$3.29 versus $2.76—but half of this came from returning to the older straight-line depreciation rates, less burdensome on earnings than the accelerated method used the year before. (The company will continue to use the accelerated rate on its income-tax return, thus deferring income-tax payments on the difference.) Still another factor, important at times, is the choice between charging off research and development costs in the year they are incurred or amortizing