The 3 Dirtiest Words in Investing

These three abused terms could be hiding some red flags

Don’t you love some of the accounting vernacular (I guess we’ll call it that) getting thrown around these days?

Gone are the times when a company’s bottom line was actually — you know — the company’s bottom line. You have to be a CPA to figure out how well a corporation is doing anymore (and considering the number of accounting-level scandals we’ve seen over the past few years, even “CPA” might be a worthless designation).

The good news is this: The accounting shell game has chosen three terms to use and abuse more than any other. If you can learn what those three really mean, you can decode these dirty words when it matters most.

In no particular order …

1. Non-Cash Charge

On the surface, the words seem benign: “non-cash charge.” Clearly it doesn’t cost anything, since the company doesn’t have to write a check or crack open the vault and take any money out. Don’t think for a minute it’s a mere “paper-only” maneuver, though. A non-cash charge now is usually the reckoning of wasted money in the past (though clearly it wasn’t deemed wasted at the time it was spent). Non-cash charges also are frequently used to account for the expense of stock options granted to company employees.

Owners of Citigroup (NYSE:C) are within a few months of learning how irritating a non-cash charge can be. The mega-bank announced last week it was likely to take a significant non-cash charge in the third quarter to reflect the surprise decrease in the value of its stake in Morgan Stanley Smith Barney — the brokerage firm it jointly owns with Morgan Stanley (NYSE:MS).

Morgan Stanley says the business is worth $9 billion, while Citigroup says it’s worth $22 billion. Considering they both list it as an asset, eventually they’ll have to come up with an agreed-upon number. Anything less than $22 billion means Citigroup’s balance sheet will be a whole lot smaller at the end of the third quarter.

So where’s the harm to shareholders? It actually took place back in 2009 when the deal was first set up. Morgan Stanley threw in $35 billion in funding, and Citigroup — through Smith Barney — threw in $55 billion. Though it’s not like all that cash is just down the drain, the joint venture never has been what it was supposed to be and actually has cost Citigroup revenues and earnings since its inception. Now it’s becoming an official lemon.

Oh, and the non-cash charges for stock option issuance adversely impacts shareholders because it sets up future dilution of earnings.

2. Off-Balance-Sheet Arrangement

In a perfect world, all assets and all liabilities are reflected on a balance sheet. We don’t live in a perfect world, though. And somehow, generally accepted accounting principles (or GAAP) allow companies to omit information that investors would love to know about — and probably deserve to know about — from the balance sheet.

Take Netflix (NASDAQ:NFLX), for instance. You know how it pays studios and distributors for all those television shows and movies available at its site, and then resells the digital content at a (hopefully) higher price to its subscribers? Interesting twist here … it knows what kind of minimum financial obligation it’s got in the pipeline for upcoming features. But, since those movies and shows aren’t yet available online, Netflix doesn’t have to post the dollar amount of those upcoming commitments.

Care to guess the price tag of upcoming content? It’s a whopping $3.7 billion, though you’d have to read the fine print and footnotes from the recent SEC filings to know it — you know, since it’s “off balance sheet.” And this is a problem, since the company only generated $3.2 billion in revenue last year, and only cleared $226 million in profit.

Fans of Netflix rightfully point out that the top line’s getting bigger at a rapid pace. Unfortunately, the expense lines are rising even faster. And that $3.7 billion obligation is only a minimum. The final bill could be much bigger.

3. Goodwill

Although a charge to “goodwill” is a subset of the term “non-cash charge,” it deserves some special attention of its own.

In simplest terms (and as defined by investorwords.com), goodwill is an “intangible asset which provides a competitive advantage, such as a strong brand, reputation, or high employee morale.” Needless to say, the judgment-call aspect of goodwill has made it something of an off-the-radar slush fund for major corporation, particularly when it overpays for an acquisition.

The good/bad news is that even assets being held in the goodwill bucket are subject to periodic valuation tests.

Microsoft (NASDAQ:MSFT) investors know that all too well. The software giant recently took a $6.2 billion charge — taken out of the listed value of goodwill — to wash its hands of aQuantive. Microsoft purchased Aquantive back in 2007 at a price of $6.2 billion, hoping the company would improve its online advertising business.

It didn’t. In fact, Microsoft lost money trying to make it work. Finally realizing it was a lost cause, the company file-13’d it last quarter, and reduced its goodwill balance by the purchase amount.

But if it’s a non-cash charge to goodwill, why should investors care? Because it still ultimately cost shareholders money. It just started to cost them money back in 2007, when the company wrote the check for the acquisition. Investors didn’t care so much when the cash became an asset, because it all still was under the Microsoft umbrella (and the asset was expected to be income-producing). Now it’s neither an asset nor cash.

Bottom Line

These aren’t the only words that raise red flags for investors, but they seem to be the three most abused. When you start to see them associated with companies you own, it’s time to start asking questions.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2012/07/the-3-dirtiest-words-in-investing/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.