Daily Speculations
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James Sogi
Philosopher, Juris Doctor, surfer, trader, investor, musician, black belt, sailor, semi-centenarian. He lives on the mountain in Kona, Hawaii, with his family. |
8/11/2005
Accounting Risk, by
Jim Sogi
In addition to other exogenous risks to the market, companies and investors face accounting risks. Accounting risks include not only the specter of internal accounting fraud but of tax law legislative changes and changes to accounting rules under FASB which can materially affect the real after tax cash flows more than inflationary factors. EBITDA is nonsense. Real after tax returns are the ultimate gauge.
WorldCom and Enron are examples of internal accounting risk and fraud to the tune of billions of dollars. Analysts' and regulators' failure to uncover fraud on such a massive scale fraud shows their superfluity. Enron's downfall was described in Prof. Miller's book What Went Wrong at Enron. Super smart guys sometimes miss the big picture or suffer from hubris. The risk extends beyond fraud, to arbitrary rule changes. A good friend educated me on the effects of overseas profit repatriation breaks and accelerated depreciation, and how these might affect market prices.
The sword cuts two ways. In a stroke the tax change increased real returns from dividend paying companies and, under a Fed type model, increase the value of stocks and presumably their future real after tax rate of return in comparison to other assets,. Yet this does not seem to be reflected (yet?) in market prices, nor has it been factored into the Fed model analysis.
Gains on futures receive favorable tax treatment and favorable tax accounting preference over ETFs, yet that several hundreds of basis point advantage in real after tax is a real advantage in taxable accounts in the analysis of returns on market operations.
Sec. 302: Dividends of individuals taxed at capital gain rates. Under the Act, dividends received by an individual shareholder from domestic and qualified foreign corporations generally are taxed at the same rates that apply to capital gains. This treatment applies for purposes of both the regular tax and the alternative minimum tax. Thus, under the provision, dividends are taxed at rates of 5% (zero, in 2008) and 15%. The provision applies to dividends received in taxable years beginning after 2002 and before 2009.
To qualify for the capital gains rates, the shareholder must own the stock for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date. Also, the capital gain rates are not available for dividends to the extent that the taxpayer is obligated to make related payments with respect to positions in substantially similar or related property. Other anti-abuse rules apply.
Two links for IRS dividend information are listed here and here.
Under this theory, dividend paying stock prices, and the market in general, should rise faster than normal as a result of tax law through 2008, all else being equal.
The legislature in Hawaii raised the sales tax 1/2%, in effect lowering the entire value of the state by the cap rate times the decrease in output being nationalized by the socialists. These are the same people that legislated a cap on gas prices using a formula that will result in higher gas prices due to a faulty formula to compute the cap. This does not understand that it will lead to the oil companies' pulling out of Hawaii and not refining or retailing gas, creating an artificial shortage. So even as prices are cheap, huge gas lines will build up, just as at the food stores in the Soviet Union. I should buy all of them a copy of Paul Heyne's The Economic Way of Thinking.
Accounting is not a rigorous science, nor does it appear to have the kind of testing of our laws and common law, and it is more subject to arbitrary change and mischief wherein lays the risk.
Yishen Kuik adds:
Accounting standards are a valient attempt to standardize the rules we use to keep score for a business.
Leaving aside outright fraud for a moment, the rules for keeping score have great difficulty dealing with genuine subtle issues that don't lend themselves well to rule based systems : examples might be revenue recognition issues, when does a transaction become a loan? and how should recognition of revenue and balance sheet be split among interested parties?
This often leads to decisions being made that have positive accounting but negative economics. Companies that move things off balance sheet usually face fees and a higher funding rate. Companies that want to raise capital that doesn't show up in the capital structure also tend to face fees and a higher embedded funding rate. Opacity has its cost.
Companies that are very focused on quarter end results inevitably risk having salespeople give concessions to customers, usually with hidden and delayed consequences. A high performance sales culture has a tendency to make the salesmen weak and the buyers strong at the negotiation table. Just like how unscrupulous traders mark up their books at quarter end by placing strategic trades, salesmen mark up their books by agreeing to strategic concessions. These borrowings from the future will have to be reversed in time. And so impatience also has its cost.
In addition, the quality of information coming out of the business deteriorates, hurting the ability of management and investors to make decisions about the company and asset allocation in the economy respectively.
Just as how no amount of fancy position sizing or money management can turn around a strategy that just plain doesn't work, no amount of meetings with structured finance types and accounting whizzes can add to the economics of a company (although there are exceptions)
c
Jim Sogi, May 2005
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