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Chapter 32: Extraordinary Losses and Other Special Items in the Income Account

g)    Extraordinary write-downs of inventory: Inventory losses are directly related to the conduct of the business and all losses on inventories and receivables must be considered part of the operating results. To the extent that the results for the period are taken into account at all (as during the great depression), the losses on inventories must be taken into account as well.

h)    Extraordinary write-downs of receivables: Graham cautions to watch out for excessive provision for losses being made in one year with the intention of benefitting future income accounts. This is essentially consists of taking sums out of surplus (or even capital) and then reporting these same sums as income.

i)    Cost of maintaining non-operating properties: The analyst should consider idle-plan expense as belonging to a somewhat different category from ordinary charges against income. These expenses should be of a temporary and therefore non-recurring type. Presumably the management can terminate these losses at any time by disposing of or abandoning the property. If, for the time being, the company elects to spend money to carry these assets along in the expectation that future value will justify the outlay, it does not seem logical to consider these assets as equivalent to a permanent liability i.e. as a permanent drag upon the company’s earning power, which makes the stock worth considerably less than it would be if these assets did not exist.

Deferred Charges: A business sometimes incurred expenses that may fairly be considered as applicable to a number of years following rather than to the single 12 month period in which the outlay was made. Under this heading might be included, organization expense (legal fees), moving expenses, development expenses (for new products, opening a mine), discount on obligations sold. Under approved accounting methods such costs are spread over an appropriate period of years. The amount involved is entered upon the balance sheet as deferred charge, which is written off by annual charges against earnings. Some companies write off such expense applicable to future years by a single charge against surplus. This is improper as it understates the operating expenses for a succeeding period of years.

Amortization of Bond Discount: Bonds are usually floated by corporations at a price to net the treasury less than par. The discount suffered is part of the cost of borrowing the money i.e. part of the interest burden, and it should be amortized over the life of the bond issue by an annual charge against earnings, included with the statement of interest paid. It was formerly considered conservative to write off such bond discounts by a single charge against surplus, in order not to show so intangible an item among the assets on the balance sheet. More recently this is being done to eliminate future annual deductions from earnings.

What the investor chiefly wants to learn from an annual report is the indicated earnings power under the given conditions i.e. what the company might be expected to earn year after year if the business conditions prevailing during the period where to continue unchanged. On the other hand, all these extraordinary items enter into the calculation of earning power as actually shown over a period of years in the past. Ordinarily the amounts involved in many of these transactions are not large enough to warrant the analyst’s making an issue of them. Security analysis is a severely practical activity, and it must not linger over matters that are not likely to affect the ultimate judgment.

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