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7.14 Accrual Accounting Adjustments to Capital Expenditure

Under US GAAP each firm must disclose certain items in their change to Stockholders Equity section that may not flow through the regular income statement.  These additional items flow in the concept of “Comprehensive Income.” 

Conceptual Note on Capital Expenditure:

In dirty surplus accounting some items are adjusted to the stockholder’s equity as opposed to the income statement.  The main three items are:  foreign currency translation, pension liability and hedge accounting adjustments.  Of these three major items the pension liability represents the cost of human capital component of capital expenditure.  This item can fluctuate from year to year and so we will take the average over the three years provided in the 10-K as a first pass for “Other Comprehensive Income.”

For example for the case of IBM inspection of the 10-K reveals the following:

Looking at the last three years for the Retirement Related Benefit Plan which is the sub component of Other Comprehensive Income, it is evident that the year to year fluctuations are large.  As a result, by taking the average:

Retirement Related Benefit Plan = (229+994-93-107+704) +( -136-15245+16-132+640) +(44+3611-85+1110-2)/3 = (2819) billion.  As a result, an additional adjustment is made to Capital Expenditure to reflect the human capital and other components of Capital Expenditure. 

CAPEX

Payments for plant, rental machines and other property (3,447)

Proceeds from disposition of plant, rental machines and other property 330

Investment in software  (630)

Total CAPEX before Retirement benefit adjustments = 3,747

Adjusted Capital Expenditure = 3.747 + 2.819 = 6.566 billions

 Adjusted FCFF =$15.1 – 2.819 = 12.381 billions (up to approximate rounding)

From the consolidated statement of earnings the weighted average number of common shares outstanding for 2009 was 1,341,352,754 (assuming dilution).

FCFF per share = 12.381/1.341 = $9.233

Remark:  Note that in IBM’s Consolidated Cash Flow Statement from their 2010 10-K the following line item is present in relation to retirement benefits.

 

This results from the fact that pension expense under GAAP is less then IBM’s pension funding and so the corresponding entry is an increase in the Prepaid Pension asset on IBM’s balance sheet from 2008 to 2009:

 

So the above adjustments have cash flow implications and are appropriately accounted for in IBM’s financial statements.  So this leaves the question: what are “Retirement Related Benefits” in Other Comprehensive Income?  Basically the answer to this arises from defined benefit retirement plans.  Accounting for retirement related Benefit Plans is based upon actuarial gains and losses arising from current defined benefit plans.  This does not have cash flow implications but it does have economic implications for assessing CAPEX and sustainable FCFE because it represents a cost associated with human capital.  As a result, the treatment provided in the above example was to average the amounts relating to retirement benefits in Other Comprehensive Income across the three years resulting in 2.819 billon additional adjustment to CAPEX.

We next turn our attention to the measure that is relevant for valuing a stock – this is FCFE.