Assets or liabilities that do not appear on a company?s balance sheet are known as off-balance sheet items. OBS items are important for investors when assessing the financial health of the company.
Darvas Box system Every great trader/investor in the history of the markets had a specific method to approach the markets, which eventually led them to create a good fortune, Darvas Box system is one such method. It is a trend following strategy developed by Nicholas Darvas in the 1950s to identify stocks for good upside potential. This is one of the few methods to trade the markets which uses the combination of both the technical analysis and fundamental analysis for a much more refined decision. The fundamentals were used to identify the stocks, and technical analysis was used to time the entry and exits. Who was Nicholas Darvas? Nicholas Darvas was arguably one of the greatest stock traders/investors during 1950s – 1960s, but surprisingly he was a ball dancer by profession and not a professional stock trader. Even while trading and building his fortune, he was on a world tour for his performances in many countries and took up trading as a part-time job. In November 1952 he was invited to a Toronto Nightclub for which he received an unusual proposition of getting paid in shares by the club owners. At that time, all he knew was there is something called stocks which moves up and down in value, that’s it. He accepted the offer and received 6k shares of a Canadian mining company Brilund at 60 cents per share, with the condition that if the stock falls below this price within six months, then the owners would make up the difference. This was the introduction of a professional ball dancer to the stock market. Nicholas Darvas couldn’t perform at the club, so he bought those shares as a gesture. Within two months, Brilund touched $1.9, and his initial investment of $3000 turned to $11400, netting in almost three times of his investment. This triggered a curiosity into the stock markets, and he started to explore trading. Origin of the Darvas Box theory Initially, he was trading on his broker’s recommendation, tips from wealthy businessmen, he even approached some advisory services or any source that he could get his hands on for the tips, but all led him to losses. After losing a lot of money, he decided to develop his own theory, and after a lot of trial and error, his observations and continuous refinements he eventually invented his theory “The Box Theory”. So what exactly is the Box Theory? Fundamentals Analysis As stated earlier, the box theory uses a judicious bend of both the technical and fundamentals. Darvas believed that in order to spot a good stock or even a multibagger, there should be something brewing up in the respective sector as a whole or some major fundamental change in that specific company. Generally, the fundamentals that Darvas used to study were on a broader sector level, and not the company-specific fundamentals. Even for the specific company Darvas used to look from a general perspective like, is the company launching a new product which could be a blockbuster hit. He completely refrained from looking at numbers and financial statements as his initial experiment with ratios and financial statements didn’t yield any good result. To know more on the three financial statements read: Income Statement (P&L) Balance Sheet Cash Flow Statement Technical Analysis Darvas was a big believer in price action and volume of the stock. He believed if some major fundamental changes were to take place in a company, this soon shows up in the stock price and its volume of trading as more people get interested in buying or selling the stock. With his observations here realized by just observing the price action, he can participate in the rally which gets triggered by some major fundamental development without actually knowing about the change. Using the box theory, Darvas used to scan stocks based on rising volume as he needed mass participation in the rally. Also, he only picked up those stocks that were already rising. His theory is all about “buy high, sell higher” instead of the conventional belief of “buy low, sell high”. After the stock satisfies both the parameters of increasing price and volume with major underlying fundamental change, Darvas looks to enter the stock. Good read on momentum trading. How and where to enter? Major part of the box theory is based on entry and exit levels. To enter a stock, Darvas looked for a consolidation phase preceded by a rally. A consolidation phase is the price action wherein the price moves up and down in a tight range, that is, a non-directional move. He would then mark the high and low of the consolidation phase with the horizontal line, essentially making it a box-like structure, hence the name “Box Theory”. The high point is called the ceiling, and low is called the floor. Whenever the stocks break above the ceiling, Darvas would look to buy one tick above the ceiling with one tick below floor as a stop-loss point. Pyramiding Darvas discovered early on, in order to become successful in the market your winning bets should yield much more profit than the loss in the losing bets. This led him to do pyramiding in his winning trade, which is clearly defined in the box theory. Pyramiding means to increase the existing position if the stock is going in the favour, which leads to a much higher profit in the winning trades. According to the box theory, the repetition of the entry criterion is the new signal for adding onto the existing position. In other words, after a position, if the stocks stage the same setup, that is, a consolidation after a rally, then the break above the ceiling of this new box would signal to increase position with the revised stop loss of 1 tick below the new floor. In any case, whenever the stock falls below the current floor, the entire position would we sold off at once. This is the only exit condition in the box theory, and there is no method of booking profit upfront as Darvas believed in holding on to a rising stock. The only way to book profit is to let the stock to take out the revised stop loss.
What is depreciation? Depreciation is an accounting method used to allocate the cost of a tangible asset to the books of accounts over the useful life of the asset. It is essentially the accounting for wear and tear on the asset over its useful life. Depreciation also refers to the value of the asset that has been used over time. Assets of a firm that are used for over a one-year period largely include physical assets. Although firms incur expense while purchasing these assets, the expenses are not charged in the income statement. Such assets are recorded in the balance sheet of the firm and are expensed on the income statement as depreciation expense over time during the life of the asset. The tax authorities also decide the useful life of assets because overstating depreciation expense can lower tax liability. Now assets come in two variety: tangible assets and intangible assets. As the name suggests tangible, the tangible assets can be touched, such as equipment, machinery, computers, vehicles etc. Depreciation is used to expense the tangible assets of a firm. Intangible assets cannot be touched and include assets like licenses, copyrights, patents, brand names, logos etc. Amortisation of assets is an accounting method similar to depreciation used to expense intangible assets. Long-term assets are the source of generating revenue for firms over a long period of time, therefore the cost of acquiring tangible long-term assets is not expensed fully at the time of purchases and is expensed over the life of the asset. As the asset is used over periods, the carrying value of an asset in the balance sheet is reduced over time. Carrying value of an asset is the original cost minus accumulated depreciation on the asset over time. Since the cost of acquiring the long-term tangible asset is not expensed fully at the time of purchase and is expensed over its useful life, the depreciation expense is a non-cash charge because actual cash outgo was incurred at the time of purchase. But depreciation expense reduces the reported earnings of the company as it is charged on the income statement of the firm. Since the expenses are deducted from the revenue of the firm, the tax liability of the firm is also reduced. What are the methods of depreciation? Straight-line method The straight-line method is the most common method of depreciating an asset over its life. Under this method, the recurring depreciating amount of the asset remains constant and is not changed over the life of the asset. For example, a firm buys a machine for $10000 with a salvage value of $2000, and the useful life of the asset is ten years. The depreciable value of the asset will be $8000, which is the cost of machine minus salvage value. Now the firm will depreciate the $8000 each year at a rate of $800 per year. The per-year depreciation charge of $800 is the depreciable value of the asset divided by the useful life of the asset (8000/10). Double declining balance depreciation method It is an accelerated type of depreciation method. Under this method, the depreciation expense in higher in the beginning years and gradually reduces over the life of an asset. It also reflects that assets are more valuable in the early years of production compared to later years. In this method, the subsequent depreciation charges after the initial charge are calculated using the ending balance of the asset in the last period. Ending balance of the asset is the original cost of the asset less accumulated depreciation. Also, the depreciation factor in this method is twice of the straight-line method. Depreciation expense = (100%/Useful life of asset) x 2 Why is depreciation due diligence important? Depreciation can be used to manipulate the financials of the company. Overstating and understating depreciation charges directly impacts the profit of the company. When a firm is charging less depreciation than required, it would directly increase the profits of the firm. When depreciation expense is lesser than the actual expense, the income statement will record lower amount of expenses, therefore the deductions from revenue will lesser and profits will increase. Investors also assess whether the useful life of asset used in calculating the depreciation of firm is appropriate or not. The companies should use an appropriate useful life of the asset. When the useful life of the asset is increased, the depreciation charges will spread across an increased number of years. As a result, the depreciation expenses during the life of an asset would be understated since the actual life of an asset is less than recorded. Investors prefer checking the number of years used as the useful life of an asset. Sometimes firms may choose to change the method of depreciation. Although it could be appropriate when actual business conditions don’t match the method adopted, there remains a possibility that the decision to change the method could be driven by the motive to manipulate depreciation expenses. Companies may seek to keep the assets in the balance sheet even though the asset is of no use. This will help the company to keep incurring depreciation expense on the income statement and reduce the tax liability of the business. When the value of assets of the company has appreciated in light of the market environment, the balance sheet value of the asset will also increase. When the balance sheet value of an asset is increased, the depreciation charges should also increase. Therefore, appreciation in the value of an asset should also increase depreciation expense for the company.
It refers to the company's asset whose market price is below the price mentioned in its balance sheet.
What is an impairment? Impairment is accounting write off of a company’s asset, which can be an intangible asset as well as a fixed asset. An impairment loss is incurred when the fair value of the asset is lower than the carrying value in the balance sheet. Alternatively, impairment charges can be incurred when the recoverable value of the asset is lower than the book value. Impairment charges are recorded in the income statement of the company as an expense. Image Source: © Kalkine Group 2020 A widespread economic crisis is followed by a recession, which usually impacts the value of assets held by a company. Such events force companies to test the value of assets in the balance sheet, and this often leads to an impairment charge. IFRS accounting standards ensure that a company’s carrying value of assets depicts a value which is not in excess of the recoverable amount. Why are impairments charged by companies? As per the accounting rules, a business is often measured by its book value of assets. Specifically, the assets of the company carry the capability to generate future cash flows for the firm. When the ability of an asset to deliver expected future returns is hampered, the value of assets is decreased. Therefore, it becomes an ethical responsibility of the companies to show a fair picture of the assets. Goodwill generated at the time of business combination is required to be tested for impairments annually. Companies are required to assess any indication that could cause a potential devaluation to the asset. When a company is holding intangible assets with an indefinite life, they are required to test the assets for impairments annually. Cash generating units are often valued on the discounted value of future cash flows. Consequently, when market interest rates are rising, it impacts the discount rate used in estimating the recoverable amount. Assets can be impaired because of other reasons as well. Suppose the plant and machinery of the company were damaged due to earthquake, it would result in a reduction in the value of an asset or even full write-off of the asset. Image Source: © Kalkine Group 2020 Companies often avail consulting services to improve the performance of the business. Consultants may advise companies to shut down operations at any plant, which could result in the sale of the asset at a consideration lower than carrying value. Oftentimes, internal reporting of the companies indicate that the performance of the asset may not yield expected benefit. This would force the management to undertake impairment testing for the asset. Impairment vs amortisation Amortisation is a systematic decrease in the value of an intangible asset. Amortisation of intangible assets is a process of capitalising the expense incurred on the acquisition of the asset, and then periodically recording the expense on the income statement. Impairment, on the other hand, is an irreversible decrease in the value of the asset, which is shown as an expense in the income statement. It is charged when the recoverable amount from the asset is lower than the carrying value of the asset. Impairment vs depreciation Depreciation is a periodic devaluation of fixed assets. It is undertaken by the companies to account for the wear and tear caused to the asset during its useful life. When a firm seeks to sell an existing asset, the buyer of the asset will deduct the depreciation from the cost of the asset before adding any premium or discount to the value for arriving at the purchase price. Impairment on fixed assets could be related to an unusual fall in the fair value of the asset. For instance, the fair value of the machinery could be impacted significantly when a new and more efficient machine is available in the market. Similarly, an earthquake or fire can also devalue the value of the fixed asset in the balance sheet. Reversal of impairment loss Under the reversal of impairment loss, the approach used to determine reversal is similar to the approach used in identifying the impairment loss. Reversal of impairment loss cannot be undertaken for goodwill, and it is prohibited. Companies assess whether any impairment loss recognised in the prior periods may no longer exist or have decreased. Impairment losses can only be reversed when the estimates used in determining recoverable amount are changed. Individual asset Previously incurred impaired individual asset can be reversed only when the estimates used in calculating the recoverable amount have changed. For instance, the changes in market interest rates could impact the discount rates used in calculating the recoverable amount. Unless the reversal relates to a revalued asset, the reversal of impairment loss is recognised in the income statement. The revalued asset should not be more than depreciated historical cost without impairment. Cash generating unit In a cash-generating unit, the reversal of impairment loss is allocated on a pro-rata basis with the carrying amounts of the assets. The carrying value of an asset must not be increased above the lower of: recoverable amount and carrying amount should have been determined without any prior impairment loss, net of amortisation and depreciation.