Graham gives an example of using the balance sheet to detect a misleading income statement to illustrate the important of relating an analysis of income statements to an examination of the corresponding balance sheets. In addition, he suggests a further check upon the reliability of the published earnings statements by the amount of federal income tax accrued. The taxable profit can be calculated fairly readily from the income-tax accrual and this profit compared in turn with the earnings reported to stockholders. The two figures should not necessarily be the same, since the intricacies of the tax laws may give rise to a number of divergences. He suggests not to make any effort to reconcile the amounts absolutely but only that wide differences be noted and made subject to further inquiry.
Graham also cautions on including leasehold appreciation in the current earnings. Leaseholds are essentially as much a liability as they are an asset. They are an obligation to pay rent for premises occupied. If leaseholds had really increased in value, the effect should be visible in larger earnings realized from these favorable locations. Any other recognition given this enhancement would mean counting the same value twice. Whatever value is given to leaseholds must be amortized over the life of the lease. If leasehold values had really appreciated and the balance sheet reflects the increased value, then the subsequent operating profits would be reduced by the increased amortization charge.
Graham recommends that when an enterprise pursues accounting policies, all its securities be shunned by the investor, no matter how safe or attractive some of them may appear. Investors confronted with one manipulation might have reasoned that the issue was still perfectly sound, because when the overstatement of earnings was corrected, the margin of safety remained more than ample. Such reasoning is fallacious. You cannot make a quantitative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.
2. Operations of subsidiaries or affiliates: The analyst must endeavor to adjust the reported earnings so as to reflect as accurately as possible the company’s interest in results of controlled or affiliated companies. In most cases, consolidated reports are made, so such adjustments are unnecessary. But there can be cases where they fail to reflect any part of the profits or losses of important subsidiaries or they include as income dividends from subsidiaries that are substantially less or greater than the current earnings of the controlled enterprises.
The analyst should adjust reported earnings for the results of non-consolidated affiliates, if this has not already been done in the income account and if the amounts involved are significant. The criterion here is not the technical question of control but the importance of the holdings.
Subsidiary losses: Graham poses the question if the loss of a subsidiary necessarily a direct offset against the parent company’s earnings? Why should a company be worth less because it owns something? Could it not at any time put an end to the loss by selling, liquidating or even abandoning the subsidiary? Hence, if good management is assumed, must we not also assume that the subsidiary losses are at most temporary and therefore to be regarded as non-recurring items rather than as deductions from normal earnings?
There is no one, simple answer to the questions raised. If the subsidiary could be wound up without an adverse effect upon the rest of the business, it would be logical to view such losses as temporary. But if there are important business relations between the parent company and the subsidiary e.g. if the latter affords an outlet for goods or supplies cheap materials or absorbs an important share of the overhead, then the termination of its losses is not so simple a matter. It may turn out, upon further analysis, that all or a good part of the subsidiary’s loss is a necessary factor in the parent company’s profit.
From the standpoint of proper accounting, that as long as a company continues to control an unprofitable division, its losses must be shown as deductions from its other earnings. The analyst must decide what the chances are of terminating the losses in the future, and view the current price of the stock accordingly.