"You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject."



~~~Warren Buffett from his 1983 Annual Letter



When I was a young college student I would have never imagined that one day I would be pondering the amortization of intangibles and the effects of FIFO and LIFO accounting practices on financial statements. In fact, after I took a grand total of two introductory accounting classes I was so beset with boredom that I switched my major from business to anthropology.



Fortunately for me, my interests turned back to finance since very few "bone diggers" or "human ethologists" can rub two nickels together in their old age; although they probably have more interesting things to talk about at cocktail parties.



Today's article will deal with inventory accounting, goodwill impairment, and amortization of intangible assets (try to say that three times real fast). More specifically, the article will explain how the aforementioned accounting principles affect the free cash which a business produces and how a proper understanding of these principles lends itself to a more accurate portrayal of a companies' true profitability than accrual accounting.



At the end of the article I will divulge "the formula" which I believe describes the proper method for calculating the earnings yield of a business. I bet that just put you on pins and needles.



Inventory Accounting and Free Cash Flow



The following chart provides a summary of how FIFO and LIFO inventory accounting affects the financial statements of a company.















Sales



EBIT



Depreciation



Total Net Income



EPS



Tax Rate (%)



12/10



257.01



-3.07



6.5



-5.23



-0.46



0.0



12/09



214.07



-31.46



7.9



-33.31



-2.93



0.0



12/08



345.01



-31.26



9.0



-34.31



-3.04



0.0



12/07



356.32



21.44



9.45



14.93



1.4



30.37



12/06



326.62



18.52



9.2



13.95



1.6



24.66



12/05



289.93



11.85



8.3



7.01



0.81



20.03



12/04



232.05



10.37



8.48



4.39



0.5



34.17



12/03



185.3



4.46



7.92



-11.28



-1.3



329.15



12/02



169.01



1.68



8.18



2.0



0.23



-51.64



12/01



209.52



-31.77



9.28



-21.85



-2.51



0.0





Period End Date



12/31/2010



12/31/2009



12/31/2008



12/31/2007



12/31/2006



Period Length



12 Months



12 Months



12 Months



12 Months



12 Months



Stmt Source



10-K



10-K



10-K



10-K



10-K



Stmt Source Date



03/14/2011



03/14/2011



03/14/2011



03/15/2010



03/16/2007



Stmt Update Type



Updated



Restated



Restated



Reclassified



Updated



Net Income/Starting Line



-5.23



-33.31



-34.31



14.93



13.95



Depreciation/Depletion



7.04



8.5



9.44



9.45



9.55



Amortization



0.0



0.0



0.0



0.0



0.0



Deferred Taxes



-1.98



0.35



1.28



0.25



-0.04



Non-Cash Items



-0.79



11.22



33.95



-2.15



-1.23







Unusual Items



-1.72



1.89



24.3



-1.37



0.0



Other Non-Cash Items



0.93



9.33



9.65



-0.77



-1.23



Changes in Working Capital



18.1



42.39



-0.04



-15.02



-15.5







Accounts Receivable



-0.61



20.43



10.02



8.06



-2.83



Inventories



0.62



41.47



2.91



-21.45



-10.47



Prepaid Expenses



-3.08



-2.19



-3.85



2.4



-2.52



Accounts Payable



12.52



-3.57



-6.04



-4.86



4.25



Accrued Expenses



9.39



-12.74



-3.16



1.26



-3.36



Other Liabilities



-0.74



-1.01



0.08



-0.43



-0.58



Cash from Operating Activities



17.14



29.15



10.32



7.46



6.72

About the author:

John Emerson I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies. I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Note that using LIFO inventory valuation is generally more conservative that using FIFO since the cost of inventory going forward is likely to increase. As costs increase, current earnings and gross margins tend to be overstated when using FIFO rather than LIFO inventory accounting. Furthermore, cash flow is reduced since taxes are a cash charge and an increase in accrual earnings results in higher payments to Uncle Sam. If taxes are factored out, cash flow is not affected by FIFO vs. LIFO inventory valuations; however in the real world taxes are a major consideration.One of my favorite quotes by John Maynard Keynes states: "The avoidance of taxes is the only intellectual pursuit that carries any reward". So why do many companies choose to employ FIFO rather than LIFO inventory valuations. The most likely answer is due to the nature of of management compensation plans. Plans which reward the management based upon return on equity (ROE) or other accrual measurements as well as the issuance of stock options provide incentive for the management to report the highest possible net income rather that attempting to produce the highest amount of free cash for the business. See my article on Duckwall-Alco ( DUCK ). http://www.gurufocus.com/news/137041/be-a-stock-detective-read-the-proxy-statements-and-footnotes-for-duckwallalco-duck It is important to note that the chart assumes that the cost of inventories is rising which is generally the case for most businesses. However in certain cases, such as extended periods of deflation, the cost of replenishing inventories may actually drop. During such times the figures listed in the chart would have to be reversed.Suppose I sell bags of salt to melt ice on sidewalks, driveways and parking lots during the winter months. I buy the road salt by the truck-load to defray my costs. Since some winters are warmer than others, I sometimes have a substantial amount of inventory to carry forward into the next year.Let's say last year due to an extremely mild winter salt was in over supply and selling at 50% of its normal cost as spring approached. Being an astute businessman I find out that I can buy an extra trailer full of salt at 50 cents on the dollar and it will only cost me about 10 cents on the dollar for the additional storage. For the sake of simplicity say the bags generally cost $10 dollars, while my cost for this inventory is only $6 dollars a bag.Imagine that I now own two trailers full of salt, the first I purchased at the regular price of $10 a bag, the second I purchased at cost of $6 dollars a bag after I added in the additional storage cost. When I resume my sales next year, LIFO accounting will result in a lower cost ($6 vs. $10 per bag) for the inventory when I figure my initial Cost of Goods Sold (COGS); therefore LIFO accounting will actually reduce the cash flow of my mythical company for the next year.In this odd example, the cost of purchasing inventory actually decreased but only temporarily. Businesses which require high amounts of commodities to produce their products frequentlyexperience dramatic swings in the costs of their inventories, particularly if they do not hedge their commodity requirements. The most conservative method of accounting for inventories involves valuing inventory as closely as possible to its future cost. In most cases that will be LIFO.It is important to note that FCF can rise precipitously when a business is reducing its inventory even if the inventory is being sold below its cost. The act of liquidation is a cash generating philosophy which "clears the shelves" and allows a business to start anew while creating additional liquidity.I am sure that all readers have purchased merchandise during clearance sales at some point in their life. In my mind, clearance sales represent one of the few bargains a consumer can find. In most cases merchandise is "cleared" at a substantial discount to its actual cost. That can result in temporary surges in cash flow at the same time the business is displaying a large loss in net income.Let's examine the case of Hardinge ( NASDAQ:HDNG ) following the most recent economic meltdown. The following is a 10 year summary of the Income Statement of HDNG:The companies' accrual results for 2008 and 2009 appear disastrous, losing nearly 78 million dollars for the two years; however the companies cash flow from operations was not nearly as bleak. In 2008 the company recorded positive cash flows from operations of 10.32 million, while 2009 showed positive cash flow of 29.15 million, followed by 17.14 in 2010.The increase in cash flow from operations in 2009 was primarily a result of inventory reduction in excess of 40 million dollars. The company was moving its inventory at very low gross margins but in the process HDNG management was liquefying the company and using to excess cash to pay down debt. The move was clearing old inventory and preparing the business for the next up cycle in machine tool sales.In earlier articles I alluded to the importance of separating actual business costs from ones which are merely accounting write-offs. I discussed the importance of understanding that depreciation is a real cost: although it may not show up on the cash flow statement for many years, you may recall the example of the one-rig trucker. http://www.gurufocus.com/news/137384/understanding-free-cash-flow-series-depreciation-and-accounts-receivable Accounting goodwill is defined as the difference in price between the amount paid for an acquisition over and above the value of its tangible assets. For instance, if Company A buys Company B for two million dollars and Company B has tangible assets of only one million dollars, then one million in goodwill is recorded on the balance sheet under long term assets. If this goodwill is eventually impaired, it would provide a perfect example of an accounting cost which most be addressed on the income statement and balance sheet which is not a real business cost.Until accounting rules changed in 2001, accounting goodwill was amortized over a period of up to 40 years. Most companies took a 2.5% expense off their annual income statement which was added back into the statement of cash flows. Since 2001 that process has changed, businesses are now required to conduct annual goodwill impairment tests or immediately impair goodwill if a material change occurs which will affect the carrying value of a business. Goodwill is left on the books so long as it passes the annual test, if it fails then a percentage or all of the goodwill is written down. The write-down shows up on the income statement and balance sheet but not on the statement of cash flows.The following is the two-step procedure used to test goodwill for impairment:- Under the first step, the fair value of the reporting unit is measured through a discounted cash flow analysis, or other appropriate method. The fair value is compared to the reporting unit’s carrying amount, or book value. If the reporting unit’s fair value is greater than its carrying amount, the reporting unit’s goodwill is not considered to be impaired. If the unit’s fair value is less than its carrying amount, then goodwill impairment is a possibility, and the second step is required.- Under the second step, goodwill’s implied value is calculated by subtracting the sum of the fair values of all of the tangible and other intangible assets less liabilities existing on the measurement date from the fair value of the reporting unit. The calculation of implied goodwill includes all assets and liabilities existing on the test date, whether or not they were previously recorded. If the implied, fair value of goodwill exceeds the carrying amount of goodwill, there is no impairment. If goodwill’s carrying amount exceeds its implied value, goodwill is impaired and the difference must be written-off.During the economic meltdown of 2008 and 2009, many companies who had previously recorded significant goodwill assets on their balance sheets were forced take large impairment charges. These charges showed up on the companies' income statements and balance sheets but they had no effect on their statement of cash flows.Back to the Hardinge example, in 2008 all the goodwill which HDNG listed was required to be impaired by the aforementioned accounting rule changes which began in 2001. In other words, the acquisitions upon which the goodwill was based, failed the impairment test in 2008 and all goodwill was required to be fully removed from the balance sheet.It occurs to me that Hardinge and many other intensely cyclical companies were forced to take impairments which resulted in a categorical understatement of the underlying value of their assets. Additionally and more importantly these undue impairment charges rendered the retained earnings section of the balance sheet virtually meaningless.Suppose I own a company which has earned an average of 10 million dollars per year in after-tax earnings. For the sake of argument let's assume that its free cash flow is the same. Let's further assume the company is an internet retailer which sells expensive fruit bouquets delivered any where in the country. The business requires little in the way of fixed assets and it possesses an excellent brand. When I purchased the business I paid 10 times tangible book (100 million) as the purchase price. The price was 100 million, the tangible assets were 10 million so I have 90 million listed on the books as Goodwill.In 2008 my business takes a tumble due to the recession, the company quickly turns unprofitable losing 10 million dollars for the fiscal year, assume the business also recorded a negative 10 million in FCF. I run the goodwill impairment test and I conclude that I have to impair the entire 90 million in goodwill. The book value of the business suffers a 90 million dollar hair cut.I am left with a business that now shows a 100 million dollar loss for the year and zero in retained earnings, even though it has produced 90 million in free cash for the trailing 11 years. When the recession ends the business will likely return to its prior profitability but in terms of a 10 year cyclically-adjusted PE ratio and its retained earnings the business now appears worthless.Lets take this a step further. For the prior years the ROE of the business was under 10% based upon its high amount of intangible assets. If the business returns to its former profitability, the ROE will quickly increase to around 100% simply due to the goodwill impairment. In reality, the accrual earnings and the ratios which determine the profitability of the business, in accrual terms, have now been converted to the equivalent of horse manure. However measures based upon free cash flow have not been affected one bit.If I measure my return on my investment in terms of net income the business made nothing in eleven years. On the other hand if I measure my return in terms of FCF, the business produced 90 million. The difference was entirely a function of the goodwill impairment and the pen of the companies' accountant who was merely following FASB mandates.I hope that in the course of these articles that I have established that depreciation is a legitimate expense which needs to be factored into all FCF earnings equations. Additionally, I hope that today's discussion has sufficiently pointed out that goodwill impairment can severely distort the true profitability of a company. The reason being that goodwill is rarely an economic expense.How about amortization of other intangible assets; do amortization expenses need to be accounted for in FCF equations? The answer is an unequivocal, yes and no! Some intangible assets have clearly defined life spans such as patents; while others such as the formula for Coke have life spans which are virtually timeless.Intangibles which have clearly defined durations need to be amortized over the period of their useful lifetime. The average yearly amortization cost needs to be listed in the FCF formula as a cost, just as a property lease is amortized over its duration.Lets say that I purchase the right to sell hot dogs at a stadium for 10 years. In exchange for that right I have to pay the stadium 100 thousand dollars up front and 10% of my revenues for the duration of the contract. Clearly the right to sell hot dogs during the games is an intangible asset which will expire in 10 years time. I need to amortize the $100 thousand over the ten year period using a straight-line basis to assign a legitimate cost to my yearly operations.On the other hand, let's say that I own a bar in a downtown area and the city decides to build a stadium adjacent to my business. Lucky me, I have just stumbled into a windfall and I decide it is time to cash in on my windfall. I sell the bar at a large premium to its tangible assets.The new owner is now faced with the dilemma of determining whether to list the excess price he paid for the bar as goodwill or an intangible asset listed as "proximity to sports stadium". For the sake of argument let's say this is a college football team so the possibility of the team moving to another city is diminished.The new owner chooses the intangible asset route and selects a forty year time period (the former stadium was used by the team for 40 years) to amortize the cost at an average of 2.5% a year. In such a case the amortization is more of a tax deduction than an expense since in the foreseeable future the value of the intangible asset is not likely to dissipate; although the extent of his profits will may very well be a function of the team's success. Clearly, the life of the intangible asset is long term in duration and impossible to discern with any degree of certainty. In such a case I would not choose to add the amortization cost into my FCF equation.After three long articles it is now time to divulge the proper formula to use in determining the earnings yield of a company. Drum roll please------The earnings yield amounts to Modified Free Cash Flow divided by Modified Enterprise Value (MFCF/MEV). The equation represents a combination of Warren Buffett 's concept of Owner/Earnings and Joel Greenblatt 's EBIT/EV.I like to examine the companies' proxy statement to assess the amount of options which are currently in-the-money. If a significant amount of options are very close to being in the money, they should be added into the current share count as a margin of safety.The most difficult part of the formula is approximating maintenance capex since it is routinely goes unreported. See my suggestions on estimating maintenance capex in the prior article. http://www.gurufocus.com/news/137623/understanding-free-cash-flow-series-growth-vs-maintenance-capex Disclosure, long HDNG, no position in other the other securities mentioned