The Return Portion of the Return on Equity Ratio

 

         All the passages below are taken from the book, “Buffett and Beyond” second edition. It was written by Dr Joseph Belmonte and published in 2015

 

The return number used in the traditional accounting return on equity (ROE) ratio is the earnings number from the income statement. But the return number in clean surplus is not the earnings number.

The income statement (see the following section) shows money in, money out, and the amount left over.

 

The Income Statement: Return

 

Note: I understand the term "net income" may be used differently in the accounting profession than we are using it here. But to keep everyone on the same page, let's use it this way: Our net income is earnings before non-recurring items such as extraordinary items and future liabilities according to the American Institute of CPAs (AICPA) position.

I mentioned that the income statement shows money in and money out. Well, up to a point:

 

Income Statement

Revenues

minus all operating expenses including depreciation, interest, and taxes

=Net income

 

Here's what we have: Money in, which is revenues and/or sales, minus money out, which is all recurring operating expenses along with interest and taxes. The amount left over is called "net income."

By the way, net income is the return portion of Clean Surplus ROE, and is figured the same among all companies. However, net income is not the return portion of traditional accounting ROE. Please read on.

If this were all there was to it, we would use the net income as the return portion in the ROE ratio to compare one company to another because it is simply money in, money out, and thus, profit (net income). Net income is figured the same way for every company. One point: Depreciation is an expense. It is not money out, but depreciation is used as an expense to determine net income.

However, there are other items that must be taken into consideration for individual companies. These items are collectively termed "nonrecurring" items and include such items as extraordinary losses (or gains) and future liabilities, and they are deducted (or added) after net income.

 

Income Statement

Revenues

minus all operating expenses including depreciation, interest, and taxes

=Net income       

minus non-recurring items such as extraordinary losses (or gains)

=Earnings  

 

The earnings represent the return portion of the traditional accounting ROE. However, because earnings are calculated after the non-recurring items, which are unique to each individual company, earnings should not ever, ever be used to compare one company's earnings to that of another company’s earnings.

You can see by this income statement that something else has come into the picture. Just after the net income number, which is calculated the same way for all companies, we see non-recurring items, such as extraordinary losses and future liabilities, which are subtracted from net income to give us earnings. These unique non-recurring items are not the same for all companies and thus not comparable relative to the operations of a company.

Extraordinary losses (or gains) are extraordinary. In other words, they do not occur during the ordinary operations of the company. Here's the really important part.These items are unique to each individual company and thus, are not comparable.

Certainly, these unique events must be accounted for and they are. But in no way do these events show how efficiently you've been running your operation. And we're concerned with operating efficiency in our ROE ratio and not branches falling out of the sky because of a hurricane passing by.

Efficiency (or lack of) occurs every day. Unique items do not happen during ordinary operations and many may occur just once in a lifetime. The point is the earnings are very much affected by these unique events. They are not predictable and thus not comparable.

It is emphasized in Clean Surplus literature that the entries after net income do not lend themselves to predictability, because extraordinary events are not predictable.

 

         Clean Surplus Accounting tells us that the entries after net income do not lend themselves to predictability, because extraordinary events are not predictable.

 

Look at the other line under net income, labeled future liabilities. A future liability is a liability that will occur in the future and not today. In fact, there is no money outflow at the present time for this line item. A future liability may be future medical benefits for the workers who have not yet retired. This is a future liability, but it is not money flowing out of the company today. It is not an actual, present-day reduction in the asset base of the company.

         In accounting, we are given the choice of subtracting some liabilities from net income either all at once or slowly over a period of years and different companies may select different time periods.

We will look at a huge future liability for General Motors in just a minute. In fact, General Motors experienced a whopping 80 percent reduction in total company value because of this one item. However, it only experienced an 80 percent reduction on paper and not on its real asset value. More on this very important event a bit later.

Bottom line: All you must remember here is that the items which are listed after net income such as extraordinary losses and future liabilities are unique to each individual company. These items affect earnings so that the earnings number can have more (or less) items or events affecting Company A than those affecting Company B in any one reporting period. Thus, the earnings number does not constitute a good comparison number.

The earnings number is unique to each individual company because the earnings number contains items that do not lend themselves to the predictability of future earnings.

Since the earnings number is adjusted differently depending on the individual company choices and individual situations or events, it cannot be used as a number for comparison between different companies. Thus, it follows that earnings cannot be used as the return number in the ROE ratio when ROE is used as a comparison ratio.

A truer, more comparable number would be earnings before extraordinary write-offs and future liabilities, which is, of course, net income.

Clean Surplus literature tells us definitely and positively to use net income rather than earnings for the return number in the ROE ratio. In other words, use net income, which is earnings before non-recurring items.

This is exactly what the founding fathers of Clean Surplus told us to do: Use net income and not earnings for the return portion of the ROE ratio. So let's do what we're told.

Please remember that the founding fathers of Clean Surplus were trying to develop a statement that showed predictability of the future, and earnings doesn't show predictability if a company has items (non-recurring) on the income statement that do not lend themselves to predictability.

If you agree with this scenario so far, congratulations, because you are already one giant step ahead of most analysts.

 

SUMMARY

1. Earnings is the return portion of the traditional accounting ROE. However, the earnings number contains non-recurring items, which do not lend themselves to predictability. Therefore, the earnings number is not configured the same for all companies and thus cannot be used as a comparison number. And this is why most money managers cannot outperform the averages. They are simply using the wrong return number in the ROE ratio.

2. Net income is the return portion of the Clean Surplus ROE ratio because net income is configured in the same manner for all companies and is, thus, a truly comparable number.

3. Clean Surplus Accounting develops an ROE ratio that can be used as a comparison among all companies because the return number (net income) is calculated in the same manner for all companies.

4. Clean Surplus ROE is absolutely and positively configured the same way for all companies. This is why the followers of Clean Surplus outperform the averages.