GAAP stands for Generally Accepted Accounting Principles, and this story about GAAP begins in a bar in Minneapolis.
Let's be up-front about something that I already touched on in my little perma-rant on Truth: I have a severe attitude problem as regards GAAP. Basically, I believe that these principles, which underly every financial statement from Enron's to your local barbershop's are basically kind of broken, and get in the way of doing business efficiently.
The Broken Floor · But back to that bar in Minneapolis. I was an independent consultant at the time, there to advise ROI Systems, who make manufacturing and planning software. After a day's back-and-forth, we hit the local bar and one of the firm's founder/owners came along. This guy had been a plant engineer for years until he got into software. Here's his story:
I was the plant maintenance engineer. Suppose some guy drops a crate off a forklift and breaks the floor; it happens. I would figure out how to fix the floor and write up a work order. I found out that if it said “repair the floor,” they'd write the expense off right then. If it said “rebuild the floor,” they'd write it off over three years. If it said “redesign the floor” they'd write it off over ten years.
I was getting into management but this time and responsible for budgeting, and this accounting juju was making me crazy, so I decided to start a software company.
Writing Off · For those of you who are uninitiated, let me elaborate on what “write it off” means. Suppose it cost $30,000.00 to fix the factory floor. If it was reported as a repair, the business showed the $30K as an expense that year, which in fact it was. If it was reported as a rebuild, the company pretended that they only paid $10K in the first year, and then reported another $10K in each of the two subsequent years. If a redesign, the company reported an imaginary $3K charge for ten years.
Some readers of this will be sitting in front of a computer at work. I supose you think that when the company bought that computer, they reported its cost as an expense. Nope; depending on the tax laws and accounting policies where you work, the cost of that computer will have been written off over several years according to some arbitrary mathematical formula.
Let's be clear about this. The factory can't make products with a hole in the floor, and you can't do your job without a computer. It's an expense of doing business just the same way that your salary, or the office rent, or the telephone bill is.
But by accounting theory, since you're buying something tangible and concrete, it goes not into the “expense” column, but into the “capital” column. The theory says that you've aquired something that initially has value (you could sell it) and then declines in value as it ages. Except for, you couldn't sell it if you wanted to go on doing your business, and if you did you'd have to replace it. And the idea that you can actually sell something for the value the typical depreciation rules give is generally silly.
Moving from Theory to Practice · Now, suppose that you're a CFO and you're a few weeks into the quarter and business is lousy, and you're looking for ways to improve the picture. Fortunately, you still haven't done the final reports for last quarter yet. Last quarter wasn't too bad. Suppose someone fixed a broken floor last quarter for $30K and you were going to write it off over three years. Well, why don't you just decide that it was an operational expense (who could argue?) and expense the whole $30K right into that quarter when it happened; that quarter can take it and you've just knocked a few thousand bucks off your problem this quarter.
Let's turn it around. Suppose you're in senior management in AOL in the early nineties; You're growing like crazy and it looks like you've got a good business here. The problem is, all those TV ads and disks you're sending out with breakfast cereal and so on are costing you an arm and a leg, and you're bleeding money. Well, all that marketing dough is being spent to acquire subscribers, right? And aren't subscribers a tangible asset? So why don't you just put them in the capital column and shift the accounting for most of those payments off into the future; does wonders for the bottom lines and the picture investors see.
Think I'm making this up? AOL did this for years, and their auditors signed off on it, until there were one too many incredulous news stories and they bit the bullet and retroactively ate all the expenses. Of course, this got all the bad accounting news over with in a few days, and didn't change the fact they were able to enjoy investor-fueled growth for years based on this accounting science fiction.
It Happens · Here's the ugly truth: things like this are happening all the time, every day, and if you're the kind of person who owns shares, they're probably happening at some companies whose shares you own.
Which is why a lot of sophisticated investors ignore profit-and-loss statements, which they regard as accountants' opinions (and we know who pays the accountants). Instead, they focus on cash flow, which is hard (but not impossible) to fake.
I may be a bit on the bitter and angry side on this issue; a couple of decades in business will do that to you, and one of the good reasons to start a company is so that you can try to make sure that the GAAP witch-doctoring doesn't entirely obscure the truth. I'm happy to report that I'm not entirely alone in my opinions; Warren Buffet, probably the most successful investor in recent history, has been known to remark on the fairy-tale nature of pushing expenses off because they're “capital,” as if they don't have to be paid with real money.
I'm happy to report that there are accountants who are honest and understand business and are part of the solution, not the problem. But the more I look at it, the more broken the basic theory looks.