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Fog of Corporate Accounting By Stephen J. Butler |
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The
Fog of Corporate Accounting
By Stephen J. ButlerArchives
Choosing the
subject matter for this column is not entirely random. As a general
rule, the process starts with the week's financial event that
prompts me to feel the most indignant.
In the middle of a golf game, an investment banker upset a friend
of mine by pointing out that major U.S. companies have been "cooking
the books" routinely for years. General Electric, a highly venerated
company, was one of the worst offenders. Coincidentally, when
I heard this I had just finished reading Jack Welch's autobiography,
"Straight From the Gut." As the former CEO and Chairman of GE,
Jack is quite full of himself, so I found the book to be tedious
but still compelling.
One passage recounts the time that Jack made one of his few really
bad decisions when GE bought Kidder Peabody, the brokerage firm.
Soon after the purchase, GE had to take a $350 million loss because
of some fraudulent activity. Welch points out that managers elsewhere
at GE were understanding and offered to fill in the Kidder gap.
"Some said they could find an extra $10 million, $20 million,
and even $30 million from their businesses to offset the surprise."
How does someone in the corporate world "find" an extra $30 million
dollars? On a personal level, when we look at our checkbooks,
we either have cash in our account or we don't. In the world of
accounting, however, there are two acceptable formats for keeping
track of a company's accounting, "cash" or "accrual."
Cash-basis accounting determines a company's well-being by simply
measuring whatever cash is in the account at the end of any period.
A company sells products or services, collects revenue, and meanwhile
pays what it costs to manufacture, stock, or service what they
sell. Any cash left over is profit.
The government argues that this doesn't really reflect what the
company might have in profit because it is too easy for a company
to adjust its billing at the end of a year. In the small business
environment, companies can leave checks in the drawer and cash
them after the end of the year to avoid having that last few weeks
of revenue which could otherwise have amounted to their entire
year's taxable profit.
Accrual-based accounting forces companies to recognize a sale
(and income) when they receive an order rather than when they
actually get paid. Using this accounting technique, companies
also recognize expenses when they receive, for example, the raw
materials they use rather than when they pay for them. In theory,
accrual-based accounting can be more accurate in a world where
companies are paying for services and selling their products with
"90-day terms" or substantial delays in the receipt or payment
of money.
Unfortunately, accrual based accounting offers more opportunity
to "cook the books" in an effort to make a company look more profitable
than reality or cash accounting would dictate. Enron, as part
of an experimental high-tech service, wired one building for Blockbuster
at a cost of a few hundred thousand dollars and booked a "sale"
worth $150 million. Companies in the computer industry routinely
implore customers to place orders by the end of the quarter for
as much product as their collective conscience will allow. The
promise is that the orders will be rescinded after the end of
the quarter if the customer wants to reverse a portion of the
deal. In the meantime, no product goes anywhere but the quarterly
numbers will look good enough to support bonuses and prop up stock
prices. Finally, the most egregious by-product of accrual-based
accounting is the occasional practice of filling boxes with bricks.
This has been known to trick auditors into believing that real
sales are going out the door. Cash-basis accounting would have
left no room for this misrepresentation.
When it comes to measuring a business success, then, there is
no substitute for a record of the cash actually flowing through.
Sooner or later, regardless of the accounting treatment, a company
will either be running out of cash and having to borrow more,
or it will be awash in extra excess cash.
Accrual-based accounting just conditions the atmosphere for a
corporate version of Napoleon's "fog of war." Sooner or later,
however, the chickens come home to roost, and that's when companies
announce their massive layoffs, the spin-off of unprofitable ventures,
or bankruptcy. Fortunately for many in management, this usually
happens after they have managed to take their bonuses and have
moved on to other opportunities. We stockholders, however, are
rarely so fortunate, because those roosting chickens can come
as a big surprise after a compounding accumulation of inflated
quarters.
Our Securities
The flood of letters from market timing advisors has increased its pace since the market decline began last year. If you have even a touch of bi-polar disorder you do not want to open these envelopes. They will trigger a severe bout of depression. I think it is
terrific when company employees, from top to bottom, get rich
because of their success over time as reflected in the price of
their stock. My bone of contention is with the payment of nine-figure
incomes to a growing number of managers recruited from outside
who appear on the scene and receive instant, disproportionate
gratification for just a few years' work. When this happens, it's
as if the "invisible hand" of free markets is just waving "goodbye."
In the end,
the mutual fund industry should step up to the plate with a collective
effort that will spread the cost of activism and benefit all who
invest through that industry. After all, the industry has a lot
to gain. It controls 10% of all the money in American stocks,
and that market share will only grow. It's time to set up a clone
of Institutional Shareholders Services (ISS) to flex some muscle
and pressure directors who are in a position to directly influence
one of the major cost components of an operating company. Directors,
otherwise pressured by management, might appreciate having an
opposing view to blame when they have to "just say no."
BUYandHOLD does
not recommend any securities. The securities mentioned above are
being used for illustrative purposes only and should not be regarded
as an offer to sell or as a solicitation of an offer to buy. Copyright
© 1999 – 2012 Freedom Investments. All Rights Reserved.
Lost Money? Get Over It
By Stephen J. ButlerArchives
For example, a solicitation for an investment letter called Bob Brinker's Marketimer came this week, which really makes me wish I had spent the $185 and listened to Bob. Bob, predictably, advised everyone to be 60% in cash as of January 2000.
The advertising piece points out that he was also committed to stocks throughout the '90's when many market timers were banking their fires with investments in cash. As market timers go, Bob has a huge following because he does appear to be one of the best, and there is much to learn from what he has to say about the markets and investing in general. As to his results? Who can ever know for sure. His model portfolio barely beat market averages from 1990 through August of 2000 (just 3/10th% per year better). Through August of 2001, his results improve dramatically to results that are 2.6% per year better, but his model portfolio does not include a recommendation in his newsletter that called for an investment in the QQQ (a NASDAC Index fund.) So who are we supposed to believe? The model portfolio or the letter?
Meanwhile, none of these results take into effect the cost of timing's tax impact and loss of capital from selling funds and paying taxes on gains as we move into cash periodically. Fortunately, in retirement
plans, this is not an issue. However, for those timing their taxable assets, the tax costs alone makes this strategy very expensive and easy to beat with a passive investment strategy. Remember, with an index fund that rarely sells assets, there is no annual taxable event to speak of. You pay capital gains taxes eventually but only on what you take out -- much like a retirement plan. We can argue until the cows come home (as we used to say back in Vermont) about whether or not it matters WHEN you pay taxes. I, for one, want to get to retirement with the largest possible amount of money. If I have to pay more in taxes at that point, and I have more to pay because I didn't chew into my ca any panacea, it is the steady accumulation of company stock. Key
management should just be content to be paid major portions of
a reasonable compensation in stock that the company buys in the
open market. Lou Gerstner, in his turnaround of IBM, insisted
that his 300 senior mangers own at least as much IBM stock as
their annual salaries. The cost gets reported as an expense like
any other cost of running the business. Stock OPTIONS, by comparison,
are a loose cannon on the deck that substantially dilutes the
ownership of existing stockholders at an uncontrollable rate.
Microsoft, at one point, had unexercised stock options that would
have diluted by one-third the company's entire outstanding share
value.
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