Have you ever sat back, while looking at a particular company's latest income statement, and wondered if there was anything in the company's bottom line that would skew your analysis? Or whether anything was missing form the company's net income that should be included as an operating and/or financing cost? The answer for most investors is almost invariably "yes."

A company's net income is affected by management's choices of financial and operational leverage, the company's working capital requirements, and many other typical operational expenses, such as wages paid to employees, any purchases used as inventory, and taxes paid and payable to Uncle Sam. Although many expenses are easy to see, measure and comprehend, other items affect the company's bottom line, but may not show up on the income statement. (Learn more in Zooming In On Net Operating Income.)

Tutorial: Advanced Financial Statement Analysis

Clean and Dirty Surplus
Net income, which does not contain any comprehensive income or unusual items, is called clean surplus net income. However, if there is other comprehensive income or unusual items in the company's net income, which will flow into the company's statement of retained earnings, this is called dirty surplus net income. Other comprehensive income and unusual items can skew net income they can make this metric harder to measure, and perhaps shouldn't be included in this figure at all.

The three most common examples of dirty surplus items are:

  1. Unrealized Gains and Losses on Securities Held for Sale
    Under Financial Accounting Standards Board (FASB) Summary Statement No.115, companies are required to report any unrealized gains and losses on any securities they are holding for sale. This process is called mark-to-market accounting, and takes place every time an income statement is created. These unrealized gains and losses are then recorded in the company's income statement at year-end. (To read about the dangers of this accounting technique, see Mark-To-Market Mayhem.)

    Although there are no measurement issues related to recording unrealized gains and losses in comprehensive net income, some analysts and investors wonder if it should included. These securities are marked to market every reporting period, even if they are not sold.

  2. Foreign Currency Translation Gains and Losses
    When a company has a controlling interest in a foreign controlled subsidiary, the consolidated income statement will include translating the subsidiary's financial statements into the same currency as the controlling parent uses. This is done to maintain comparability in the parent's financial statements from one period to the next.

    The process of calculating FX gains and losses is a difficult one that requires the skill and precision of an experienced accountant. Measurement errors can result because of this complicated process. Further, an FX gain or loss calculation might not accurately capture the costs of doing business internationally. (For more insight, see Corporate Currency Risks Explained.)

  3. Gains and Losses on Derivative Assets and Liabilities
    According to FASB 133, companies are required to report any gains or losses associated with derivatives used to hedge future transactions. Under FASB 133, derivatives are marked to market on every balance sheet date.

    There are some measurement issues related to marking to market derivative instruments every period. These gains and losses are also unrealized every reporting period, which can make their inclusion in net income questionable from the perspective of some analysts and investors. (Learn more in Are Derivatives Financial "Weapons Of Mass Destruction"?)

Reasons to Be Concerned About Dirty Surplus Items
Readers and analysts should be concerned about dirty surplus items for several important reasons. First, by knowing how each dirty item is treated, it is possible to make any applicable changes to the bottom line to adjust for these dirty items. Second, if several dirty items are hidden, or not included, in the income statement - this can further skew a reported net income amount. Analysts and users of financial statements must be aware of both dirty surplus and hidden dirty surplus items so they can be fully aware of each item's specific effect on reported net income.

As an analyst examining a company's net income, you can easily account for the three types of dirty surplus items previously mentioned. By simply reversing or taking out these amounts included in comprehensive net income, you will see a cleaner net income statement, and understand the applicable net income the company earned over the reporting period.

Employee Stock Options - a Hidden Dirty Surplus Item
Although known dirty surplus items are easily dealt with, hidden dirty surplus items are much more difficult. The major hidden dirty surplus item is employee stock options (ESOs).

If you are not familiar, ESOs typically function as follows: A company grants a call option to a qualified employee while the option is at-the-money. Some time must pass for the option to vest, and then the employee can exercise that call option as long as it is now in-the-money. Therefore, the company receives the strike price for underlying stock, and the employee will receive stock for less than what it costs in the open market.

Although these costs are difficult to calculate, it's worth investors' time to do so. Many companies have large stock option overhangs and use stock options as a major form of compensation. Therefore, in companies like these, it is important to know how much ESOs are actually costing shareholders, as this hidden dirty surplus item is likely to cost shareholders a substantial sum.

Calculating the Actual Cost of ESOs to Shareholders
Calculating the actual cost of ESOs to shareholders involves diving into the notes of the financial statements. Inside, you will find information on the weighted average number of stock options that were exercised over the reporting period, and the weighted average strike price. To calculate, start with the weighted average stock price of the company's stock over the reporting period. Subtract the weighted average strike price. Multiply the difference by the number of shares issued from stock options. The result is the cost to shareholders for all of the options exercised over the reporting period. (For more insight, see Accounting and Valuing Employee Stock Options.)

This is a cost to shareholders because under the balance sheet equation, a company's equity represents the shareholder's claim on the company's net assets; a company's net assets are simply the assets minus all liabilities. Therefore, when assets increase, so must equity or liabilities.

Conversely, if equity is to increase (perhaps as a result of exercising stock options), then the company's assets must increase in proportion. Since the company's assets will not increase in proportion to the value the stock option holder receives from exercising the stock, the difference is a cost to shareholders, but is not recorded in the income statement. (Learn the different accounting and valuation treatments of ESOs, and discover the best ways to incorporate these techniques into your analysis of a stock. Read Accounting and Valuing Employee Stock Options.)

The Bottom Line
As you can see, removing the more common dirty surplus expenses from a company's net income is relatively simple when compared to measuring the cost to shareholders of exercising ESOs. Although performing the calculation can be cumbersome and difficult, it will provide you with a more accurate picture of the true costs the company incurred over the reporting period.

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