Creative accounting
04/01/2002
by Robert Haavind
Editor in Chief
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Many years ago while having dinner at the home of one of IBM's financial executives, I foolishly mentioned that I had read that accounting was not really a science, like, say, economics, because it was a closed system that had been all worked out and there was nothing more to discover. I was almost sent home without dessert.
Over the years, but long before the recent sensational collapse of Enron Corp., it became clear to me that accounting can sometimes be a lot more creative than most of us think. It is not a closed system at all, but a field where creativity can make a big difference. There are, of course, generally accepted accounting principles (GAAP) aimed at achieving uniformity so that financial performance is fairly reflected in reported data. But all of us are learning that lots can happen around the edges of GAAP, and because of the test of "materiality," it all doesn't necessarily even show up in the footnotes. Our industry has become well aware of what a burden following GAAP can be with the imposition of SAB 101 — but more about that later.
The creative bent of accountants became clearer to me while on the road to a night-school MBA. My cost accounting instructor mentioned that he worked on international transfer costs. (Often, real practitioners, not professors, teach night school.) The course itself was pretty dull: to calculate the cost of goods sold, put in the costs for identifiable inputs, like raw materials and labor, and then proportionately divide up everything that's left (the overhead costs or burden) over some units, whether products, worker hours, or whatever.
This struck me as totally arbitrary. To try to learn a little more, I pressed the instructor on his expertise. He explained the idea. If you have parts, subassemblies, system components, etc., that get shipped from country to country, you can charge almost whatever prices you want from port-to-port, because, after all, you are selling them to yourself! I began to think about all the electronics companies that did this very thing, setting up subassembly and assembly operations around the globe and shipping parts and pieces around. With the varying tax rates and duties among these countries, it seemed that there could be lots of accounting high jinks along the way. Yes, indeed, the instructor agreed, but he wasn't going to tell us anything about THAT, because that's what he got paid very well for in his consulting practice.
The cost accounting we actually learned in the course turned out to be of limited utility. It was geared to factories with large outputs, where the "burden" was such a small percentage of the cost of goods sold (electricity, heat, rent, administrative costs) that spreading it out arbitrarily made sense. Some bright Harvard Business School professors went beyond this approach to what is called ABC, or activity-based cost accounting. As labor costs fall and services become a larger part of doing business, the work of marketing, public relations, purchasing, etc., can be assigned to particular products, or customers, to do a more detailed analysis. One ABC study of a Scandinavian company showed that it actually lost money on its biggest customers! This was due to a combination of special discounts, sales and executive attention, and other benefits showered on them. The real money was made on mid-sized customers that asked for regular shipments of known amounts over extended periods, requiring little special attention. This was an example of where creative accounting produced real insight into the dynamics of a business, and that company changed its pricing policies as a result.
By contrast, Japanese technology companies, the Harvard profs found, had little interest in ABC accounting. They were more interested in investing to gain global market share, and in parlaying similar, well-designed products over several marketplaces, like small motors for lawn mowers, boats, go-carts, and the like.
The semiconductor equipment industry currently faces a particularly tough accounting burden. When is a multimillion dollar piece of equipment actually SOLD, so it can be entered on the books? In many industries you can install a machine, turn it on, and if it works, it's sold. But not in the semiconductor business. Chip companies want to characterize the equipment, and maybe even get it running on a target process, before final acceptance. This can easily take months.
Under SAB 101 — an SEC bulletin that changed how companies record and report sales — even though two-thirds of the price may already have been paid, the vendor can't record the sale until that last sign-off step. This can move sales between quarters, giving a totally inaccurate picture of a tool company's actual business performance — the exact opposite of the goals of GAAP.
With SAB 101 came war stories about companies insisting on a discount to sign off on a tool within a reporting quarter, so the books looked better and the sales rep got a commission sooner. Was this what the accounting board had in mind? "General" principles might not work so well in specialized market niches, and there should be some accommodation for this when the rules change.
Good accounting gives true insights into a business, and enables executives to make more measured and objective decisions. It also gives outsiders a valid picture of the health of the business, and helps them make comparisons to other companies in the same industry. Creative accounting can sometimes be useful, helping the bottom line at critical times, mollifying creditors and investors, and keeping growth on a smoother curve. It may work like a charm in a rising market. But when it gets too cute, and the market tanks, things can get REAL nasty. Just ask the folks from Enron ...