My High Dividend Stocks Blog http://myhighdividendstocks.posterous.com Most recent posts at My High Dividend Stocks Blog posterous.com Thu, 16 Sep 2010 20:28:11 -0700 AGNC analysis of the income account> extraordinary losses> amortization of bond discount http://myhighdividendstocks.posterous.com/agnc-analysis-of-the-income-account-extraordi http://myhighdividendstocks.posterous.com/agnc-analysis-of-the-income-account-extraordi

American Capital Agency Corp. (AGNC) has not floated any bonds since it began operating in May 2008.  Therefore, no adjustments to its income account are necessary for amortization of bond discount.  You can see from their most recent quarterly 10-K filing that they have no bond liabilities.  Their biggest liabilities are repurchase agreements (6.6 billion dollars).  Repurchase agreements are not bonds.

 

The bottom line is that companies can manipulate their future earnings by charging amortization of bond discounts to their surplus instead of their income statements.

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Here is the relevant section from Securities Analysis:

 

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 these write-offs against surplus have become popular for the opposite reason, viz., to eliminate future annual deductions from earnings and in that way to make the shares more “valuable.”

 

Example: Associated Gas and Electric Company charged against surplus in 1932 the sum of $5,892,000 for “debt discount and expense” written off.

 

This practice has aroused considerable criticism in recent years both from the New York Stock Exchange and from the S.E.C. As a result of these objections a number of companies have reversed their previous charge to surplus and are again charging amortization of bond discounts annually against earnings.

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Tue, 14 Sep 2010 21:10:34 -0700 High dividend stocks – AGNC analysis of the income account> extraordinary losses> idle-plant expense http://myhighdividendstocks.posterous.com/high-dividend-stocks-agnc-analysis-of-the-inc-4 http://myhighdividendstocks.posterous.com/high-dividend-stocks-agnc-analysis-of-the-inc-4
American Capital Agency Corp. (AGNC) does not own any plant equipment; therefore, they have no idle-plant expenses.  No adjustment to the income account is necessary for this category of analysis.  Learn more about how idle-plant expense accounting can effect earnings by reading the section below.

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The cost of carrying non-operating properties should almost always be charged against income account.  Idle-plant expenses are of a different nature than ordinary charges against income.  The idle-plant expenses should be of a temporary and therefore non-recurring type.  The company’s management can terminate the 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.

Some companies in the past had charged their idle-plant expenses to their surplus.  That relieved their reported earnings of expenditures that most companies charge against income.  They should have charged to their income account.

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Sun, 12 Sep 2010 22:15:00 -0700 High dividend stocks – AGNC analysis of the income account> extraordinary losses> other elements in inventory accounting http://myhighdividendstocks.posterous.com/high-dividend-stocks-agnc-analysis-of-the-inc-3 http://myhighdividendstocks.posterous.com/high-dividend-stocks-agnc-analysis-of-the-inc-3

Different methods of inventory accounting can skew earnings reports.  However, the subject of this article is not applicable to AGNC.  I searched for the words “inventory”, “inventories”, “last-in”, “first-out”, and “costs of goods sold” in AGNC's 2009 annual report and most recent quarterly 10-K filing.  Those words do not appear in their SEC filings.

I decided to reprint the relevant section of Securities Analysis 2nd edition since the subject of inventory accounting is not applicable to AGNC:

Other Elements in Inventory Accounting. The student of corporate reports must familiarize himself with two permissible variations from the usual accounting practice in handling inventories. As is well known, the standard procedure consists of taking inventory at the close of the year at the lower of cost or market. The “cost of goods sold” is then found by adding purchases to the opening inventory and subtracting the closing inventory, valued as described.

Last-In, First-Out. The first variation from this method consists of taking as the cost of goods sold the actual amount paid for the most recently acquired lots. The theory behind this method is that a merchant’s selling price is related mainly to the current replacement price or the recent cost of the article sold. The point is of importance only when there are substantial changes in unit values from year to year; it cannot affect the aggregate reported profits over a long period but only the division of results from one year to another; it may be useful in reducing income tax by avoiding alternations of loss and profit due to inventory fluctuations.  

The Normal-stock or Basic-stock Inventory Method. A more radical method of minimizing fluctuations due to inventory values has been followed by a considerable number of companies for some years past. This method is based on the theory that the company must regularly carry a certain physical stock of materials and that there is no more reason to vary the value of this “normal stock” from year to year—because of market changes—than there would be to vary the value of the manufacturing plant as the price index rises or falls and to reflect this change in the year’s operations. In order to permit the base inventory to be carried at an unchanging figure, the practice is to mark it down to a very low unit price level—so low that it should never be necessary to reduce it further to get it down to current market.

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Wed, 08 Sep 2010 20:47:35 -0700 High dividend stocks – AGNC analysis of the income account> extraordinary losses> reserves for inventory losses http://myhighdividendstocks.posterous.com/high-dividend-stocks-agnc-analysis-of-the-inc-2 http://myhighdividendstocks.posterous.com/high-dividend-stocks-agnc-analysis-of-the-inc-2
Article_for_2010_09_08_agnc_ex

Definition for inventory: (accounting) the value of a firm's current assets including raw materials and work in progress and finished goods. Source “define: inventory” on Google.

AGNC’s current assets are mostly comprised of agency securities (over $6 billion in a $7.1 billion investment portfolio). These agency securities are toxic assets in my opinion. They will be viewed as toxic assets by AGNC’s shareholders the moment that Fannie Mae and Freddie Mac stop guaranteeing the pass-through principal and interest payments of the securitized mortgages that these agency securities are comprised of. You know they are toxic because the Federal Reserve bought over 1 trillion dollars of them from Fannie and Freddie over the course of a year ending in March 2010. The Fed buys toxic assets to bailout the largest banks.

I scanned through the most recent 10-K filing and the 2009 annual report to find out if AGNC’s management set up a reserve fund for future losses on their inventory/assets.  It turns out they haven’t set up such a reserve.  They do acknowledge the risks to their asset values under the banner of “spread risk” in the most recent 10-K filing.

Spread Risk
Our available−for−sale securities are reflected at their estimated fair value with unrealized gains and losses excluded from earnings and reported in OCI pursuant to ASC 320. As of June 30, 2010, the fair value of these securities was $7.1 billion. When the spread between the yield on our agency securities and U.S. Treasuries or swap rates widens, this could cause the value of our agency securities to decline, creating what we refer to as spread risk. The spread risk associated with our agency securities and the resulting fluctuations in fair value of these securities can occur independent of interest rates and may relate to other factors impacting the mortgage and fixed income markets such as liquidity or changes in required rates of return on different assets.

The whole ‘fair value’ accounting smells like government authorized fraud.

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Tue, 07 Sep 2010 20:11:31 -0700 High dividend stocks – AGNC analysis of the income account> extraordinary losses> manufactured earnings http://myhighdividendstocks.posterous.com/high-dividend-stocks-agnc-analysis-of-the-inc-1 http://myhighdividendstocks.posterous.com/high-dividend-stocks-agnc-analysis-of-the-inc-1
Today’s goal is to determine whether or not American Capital Agency Corp. (AGNC) wrote down any inventories or receivables as a charge to their surplus account since 2008.   Many companies did this during the Great Depression in order to make the next year’s income numbers look better than they really were.

“If the receivables and inventories were written down to an unduly low figure on December 31, 1932, this artificially low “cost price” would give rise to a correspondingly inflated profit in the following years.” – Securities Analysis chapter 32 section on manufactured earnings examples.

It appears to me that AGNC did not write down any inventories or receivables as a charge to surplus from 2008 to 2010.  Gains and losses in the values of its agency securities portfolio, hedges, and other assets appear on the current income statement for Q2 2010.  Therefore, I don’t think that AGNC is charging extraordinary losses to its surplus account in order to inflate its profit in the following year.  No adjustments to the income account are necessary for this category of analysis.

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