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The
Fog of Corporate Accounting
By Stephen J. Butler |
 Archives |
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
Exchange Commission, headed by a former lobbyist of the accounting
profession, is working surprisingly hard with limited resources
to ferret out corporate abuses. They have doubled the usual number
of inquiries within just the past few months. The SEC, like the
IRS, is probably one of the best investments we can make with
our tax dollars. A loss of public confidence in the stock market
takes years to recover, and some of us preparing for retirement
may not have that many years. If the SEC can help to boost public
confidence, we all benefit.
On another front,
institutional shareholders who met in New York last week are launching
an attack on the current inadequate tax and reporting treatment
on stock options. If these compensation tools continue to be issued
at their current pace, they will cost stockholders an estimated
3 to 4 percent PER YEAR of equity value. This could happen during
an era when high price earnings ratios dictate only 6-8% returns
(if we're lucky) for the foreseeable future.
All these factors
point to improved corporate governance and greater stockholder
value in the future. In the meantime, with markets slumping or
flat, there are continuing opportunities to load up on equity
investments. Frankly, I'm in no real hurry to see these issues
resolved as long as I'm seeing progress. If the uncertainty is
prolonged, today's buying opportunity will just last that much
longer.
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.
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