When the accounting goes funny: pardon the rant—but I don't like how some people are adding up the numbers

Directors & Boards, Spring, 2007 by Gary Sutton

FORGET everything you thought you ever knew about accounting, because the SEC and FASB move the guidelines each year. This pursuit of accounting perfection, of course, messes up year over year comparisons.

Dummies like Warren Buffett figured this out long ago, and started looking at nothing but cash flows. Oh, yeah, earnings matter to most folks, but if you can ignore earnings, which are an abstract concept anyway, you just might join Buffett at the big table.

Only cash spends at the supermarket.

Revenue comparisons, for another example, go funny this year because starting now, nobody can expense customer trade shows or coop advertising. In 2007 those costs are simply deducted from the revenue figures.

This is another understandable move that attempts to uncover some promotional expenses that were more truly discounts. But it won't work for the aggressive.

Suppose you sell screwdrivers to Home Depot and your buyer "suggests" you display at their store manager's meeting in Las Vegas. Last year, you would have expensed this as a cost of sales on your books. This year you simply deduct the expense out of your revenue line. Unless....

Unless Home Depot sets it up so you pay for your booth and expenses to the Las Vegas Hilton. Then it's a real and GAAP-approved expense. But if you pay Home Depot directly, it's not an expense but comes off the top line.

And so FASB and the SEC chase their tails again--while the less conservative folks remain unscathed.

Last year's joke was, of course, expensing options.

Smart investors look at earnings per share after dilution. Smarter ones yet check cash flow per share, again after dilution. Dilution automatically and totally compensates for the expense of stock options. Do that and the math's all done. But last year's numbers double expense that by putting in an arbitrary cost for the options on top of the dilution. So the expense is double-counted.

Arbitrary cost?

Sure. Black-Scholes, among other things, assigns a value to each option based on stock volatility. Suppose you're Toll Brothers, a homebuilder. Housing hits a slump. The stock dives. Now your stock is more volatile, which, in the fuzzy logic of Black-Scholes, makes options more valuable, so the cost of the next options you grant go up. When things go bad this convolution makes them look worse.

(None of this is lethal, of course, since the expensing required for options is now merely excessively conservative. That'll dismay those who don't dig in, and creates buying opportunities for others who understand that it's an artificial hit against earnings. Again, stick with cash flow.)

What is shameful is that transparency and comparability is lost with each "improvement" the overseers make. And earnings become more volatile. Now goodwill impairment happens all at once when things dip, instead of being expensed from the day the overpayment was made. No cash effect there but a double-whammy for earnings. Tax credit carry forwards hit the earnings whenever the future starts to look murky. That can hurt cash and can be a disturbingly judgmental call.

Please, please don't confuse these references to cash flow with EBIDTA.

EBIDTA is one of the nastiest accounting inventions ever, since it pretends interest expense doesn't matter. Why ignore interest expense? To better show the "true, underlying operations" is the justification often given.

There's just one humongous problem with that. Interest expense is the only cost you've got that cannot be managed down unless you embrace bankruptcy. Therefore, the level of debt a business carries is clearly a bigger indicator of the "true, underlying" nature of a business than anything else.

To ignore debt shoves us back in the soup.

As FASB and the SEC keep adding rules, it gets tougher and tougher to understand. And these are supposed to be "public" markets? Spare me.

The author can be contacted at garysutton@san.rr.com.

Gary Sutton has been a CEO and director of a number of private and public companies in his career as a specialist in startups and turnarounds. He is the author of Corporate Canaries.

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