Detect accounting fraud, invest safely.

When it comes to pleasing Wall Street, some companies would do anything to spruce up their books. One of the most common shenanigans management would use is one-time charges. One-time charges are expenses that do not recur. Because of this, one-time charges are usually reported separately to prevent any disfigurement of an otherwise pristine net income.

Needless to say, not all one-time charges should be charged against income. Some one-time charges such as mass layoffs may very well be valid. Other legitimate non-recurring expenses include damages caused by natural disasters, adverse legal, regulatory and tax rulings, changes in accounting principals and sales of discontinued operations. [2]

The Big Bath

But if the layoff charges kept showing up on the books every quarter for the past 12 quarters as in the case of Hewlett Packard [3], you ought to start questioning whether the restructuring cost should be considered an operating expense. Now, you can’t generalize and assume that any company that has recurring one-time charges every year is taking a “big-bath”; that is, frequent extraordinary charges. Although rare, annual one-time charges can be appropriate if they are for different things. For instance, a charge for discontinued operations in year one, followed by a material regulatory ruling in the second year and an investment gone south the next are reasonable.

Taking a “big-bath” can be an effective way to conceal management’s past mistakes. An overpriced acquisition that has gone south can be slipped under investors’ radar into a big pool of one-time charges, attributing the poor performance to the industry cyclic nature and economic downturn. Essentially, what management is doing is wiping the slate clean.

Shifting Future Expenses

During bad times as we are experiencing now, some companies opt to take huge restructuring charges that would reduce future depreciation charges. This in turn magnifies future income when compared to current performance. This accounting gimmick is also referred to as shifting future expenses to the current period.

IBM got especially creative in its 1999 10-K when it decided to boost its earnings by using a one-time gain on sale of its Global Network business to offset a one-time write-off of the huge losses from its DRAM business. But old habits are hard to break. In 2002, IBM reported earnings that beat analysts’ expectations by (hold your breath) one penny per share only because it included a one-time gain from the sale of its optical transceiver business.[4]

Be Skeptical

The line that separates legitimate from improper one-time expenses is anything but lucid. Every one-time charge has to be taken with a grain of salt. Discontinued operation charges at conglomorates whose primary operation is to trade businesses for profits should be treated as operating expenses instead of one-time charges. Even the occassional bad investments may need to be treated as operating expenses if management has a knack of making bad investment judgements.

Investors should always read the footnotes looking for more details about one-time charges. In the case of IBM, reading the footnotes would have uncovered a plethora of juicy tidbits that would have sufficed to deter any prudent investor. The gist of this is a one-time charge should be just that — a non-recurring expense. But if management keeps recording a similar charge year after year, it’s simply not a one-time charge. I’d err on the side of caution and find some other companies to invest in.

Think Independently

Remember, management shouldn’t be telling you what to include and what not to include in evaluating a company’s performance. As an investor, you need to decide on your own. A little known poet-cum-oracle in Omaha wrote this rhyme about pro forma earnings:

Don’t count this, don’t count that,
just count what makes earnings fat.

References

1. Investopedia Staff, Detecting Two Tricks Of The Trade, Investopedia.com, May 30, 2001.
2. Richard Loth, The One-Time Expense Warning, Investopedia.com, 2007.
3. Ashlee Vance, Hp Takes 12 ‘One-time’ Charges In a Row, The Regsiter, March 14, 2006.
4. Whitney Tilson, IBM’s Accounting Tricks, The Motley Fool, February 20, 2002.