Company Analysis

Accounting loopholes to avoid in your valuation

Much of the accounting policies were developed in 20th century. As industries developed from manufacturing to services and technology, accountants have had a tough time keeping up. Although there are many new accounting standards such as the new lease standard, there are still several loopholes and pitfalls that investors should be aware of. The following articles addresses the most common ones.

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1. Taxes

Taxes have an impact on all corporate decisions from the use of debt (tax-deductible) to the location a company’s headquarters. But which tax rate should I in my valuation?

Marginal Tax Rate

According to KPMG’s Corporate Tax Rates Table, Egypt’s corporate tax rate for 2020 is 22.5% excluding companies that are engaged in the exploration and/or production of oil and gas which are subject to a corporate tax rate of 40.55%. But for most companies the effective tax rate is lower than the marginal tax rate because they operate in various countries with lower tax rates, receive tax cuts or use tax deferral and avoidance strategies (e.g., depreciation, bad debt expense, municipal bond interest).

Effective Tax Rate

The effective tax rate represents taxes divided by taxable income (both found in Income Statement). But this does not necessarily represent the actual taxes paid. Remember, the Income Statement (IS) is an accrual statement -accrual accounting does not accurately report a company’s cash flows- . This means that Tax Expense is not always equal to Taxes Paid.

Effective Tax Rate = Tax Expense / Taxable Income 

When there is a difference between expensed and reported taxable income, the difference is reported as a deferred tax liability/ asset. According to Investopedia, a “deferred tax asset is an item on the balance sheet that results from overpayment or advance payment of taxes. It is the opposite of a deferred tax liability, which represents income taxes owed”.

So remember, companies have two sets of books: One for Financial Reporting and one for Tax Reporting. This means that the number you see as a tax expense does not necessarily reflect the actual tax payment by the company.

2. STOCK-Compensation

Over the past decades companies have resorted to stock-based compensation to align the interests of employers & investors. Still, many companies use it to pay their employees without having to hand them any cash. Stock-based compensation is a way of paying employees, executives, and directors of a company with shares in a company (usually restricted shares) or options to buy shares at a fixed price in the future. According to the Financial Times, “Uber, for instance, reported $172m in stock-based compensation expenses in 2018, but the usage of employee options and restricted stock is widespread, with the cost tallying to $1.1bn at Amazon and $1.7bn at Apple in the most recent year.”

Should stock-based compensations be added back to cash flows?

Most companies and analysts argue that stock-based compensation is a non-cash expense like depreciation and hence should be added back to the cash flow. But that’s not entirely true! If you don’t account for stock-based compensation by adding it back, you are not accounting for the fact that you’re business will be worth less when you give away a percentage of your business to your employees. There is no free lunch in valuation and if a company decides to give its employees $1 million, you should account for it wether its cash, restricted-stock or stock options.

If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?

Warren Buffet

3. Reverse Factoring

Reverse Factoring  is when a financial institution, usually a bank, commits to pay a company’s invoices to the suppliers. The objective is to pay the supplier earlier than the due date, especially where the supplier offers an early payment discounts. Instead of appearing as debt, the factoring was treated like regular trade payables.

How Carillion Group used reverse factoring to deceive its investors?

In order to pay its own suppliers and bills, Carillion started to use the new “Early Payment Facility”. Under this scheme, suppliers owed money by Carillion could take their invoice to a number of partner banks, including RBS, Lloyds and Santander, and be paid in advance. The banks took a small fee on the invoice and the debt was transferred from Carillion owing its suppliers to Carillion owing money to the banks. The problem for investors was that this new and rising amount of debt the company was taking on did not show up in the main debt numbers on its balance sheet. From 2011 to 2016, Carillion’s published net debt rose from £839m to £850m but the actual debt was much larger.

Other examples of debt that is not treated like debt include:

  1. Content Commitments at streaming companies such as Netflix
  2. Player contracts for sports teams

4. Research & Development

R&D should be considered as a capital expense and not as an operating expense. Research & Development is clearly similar to CAPEX in a sense that its benefits are not just reaped in the current period but also in future periods. Accountants argue that R&D is too uncertain, so it should be considered as an operating expense. Remember, nothing in valuation is certain and CAPEX can also also be uncertain.

Conclusion

When analyzing a company you should start with accounting statements. But don’t hesitate to change and adjust the numbers in order for them to better reflect what you are trying to figure out!

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Written by: Marwan Darwish

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