One of the most important reasons why Generally Accepted Accounting Principles (GAAP) exists is so that there can be a standardized way to track the effects of business transactions that take place over an extended time period. If someone signs up for a $120 one-year magazine subscription, should you report the money as though it arrived in $30 increments every quarter? Should you report $120 in the quarter in which the sign-up occurs? Should you report $120 in the quarter in which payment is received?
These are all decisions that affect how we evaluate the “E” part of the P/E ratio and is supposed to give us a latticework for quickly figuring out where each company stands without having to wade into details to determine the rules of each company’s self-constructed accounting universe. Because GAAP accounting (necessarily) requires discretion, you end up finding bits of a self-constructed accounting universe.
Boeing’s use of program accounting for its commercial aircraft creates a large disparity between the earnings per share that get reported to investors and the actual amount of cash flows that are coming into its Chicago headquarters. There are approximately 5,700 planes that Boeing is contracted to produce, and this requires an upfront cost (R&D and actual production) of nearly half a trillion dollars (~$420 billion.)
If it were to use the most conventional accounting methods, its earnings reports would look like an oil company in that you would see large losses coupled with obscene profits over the years. Obviously, businesses don’t like to report ginormous losses that could weigh on stock prices. And plus, in this case, it feels somewhat punitive–you secure a $100 billion contract, which is going to create some substantial wealth for shareholders, and you’d have to clobber your earnings statements in the short term with the high preparation costs before the money arrives on the back-end. This reality is distinguishable from an oil company which really is in some trouble while $30 oil conditions (or whatever it may be) persists.
In 1981, the American Institute of Certified Public Accounts stated that it would be permissible to count some of those expected profits before they arrive, provided that: (1) they are contracted for; (2) the business type has a high barrier to entry; (2) the costs of product development are substantial; and (4) there is a repeatable, per unit nature to the project so that the distribution of profits can be stated with specificity and itemized. Those are a summaries of the elements, but you can understand why commercial aircraft providers like Boeing find this attractive.
This method was hugely popular at St. Louis-based McDonnell Douglas in the 1990s, and after its 1997 merger into Boeing, the Boeing executives picked it up as a trick of their own.
Instead of having to take a quick $200 million hit upfront and then see $1 billion pour in over the course of a ten-year term, you see $80 million in profits stated over a decade. If the contract executes as planned, you get a smoothed-over view of the contract’s bargain as a shareholder rather than a snapshot view of the terms as they are executed.
The issue of concern is that contract formation and reality aren’t always the same thing. Boeing contracts for costs absorption for overruns that frequently materialize, and purchasers of aircraft sometimes seek to modify their orders which Boeing may feel pressure to accommodate to ensure future contracts. And plus, sometimes specifications aren’t met, and project parts need to be redone.
The critical yet fair view says: “Yeah, ok, you book a contract that will generate $800 million in profits, but by the project’s competition you will only generate $500-$600 million in profits and those previously stated profits under program accounting will need to be revised downward years after the fact. Plus, this method of accounting completely ignores counterparty risk in which the buyer goes bankrupt shortly after you invest heavily into development and perhaps a new purchaser doesn’t materialize to pick up the contract on nearly the same terms.”
What is interesting is that Boeing is actually conservative with its balance sheet. It has $9 billion in cash on hand compared to $11 billion in debt, only half of which is due over the next five years. That is one the conservative side for a company that deals in heavy machinery. Usually, companies that are aggressive with one aspect of their accounting tend to push it when it comes to debt as well, but there is no publicly disclosed indication that this is the case at Boeing.
The thing I find interesting is that shareholder’s best interests and management compensation incentives are a bit at odds here. Considering that Boeing repurchases such a significant amount of stock each year, it would actually benefit from ugly numbers that understate economic reality as a lower stock price would really benefit the accretive earnings per share effect of the repurchases. However, it would of course be at odds with management incentives that tie the stock’s price to the issuance of stock bonuses.
As a company, Boeing is doing all right here. The balance sheet is fine. There is a large backlog of projects that lead to 10% operating margins on hundreds of billions of dollars in aerospace commerce. There is available cash to support buybacks. But Boeing is choosing to pursue program accounting gives a false impression of actual cash flows, and sets up the possibility for past earnings figures to get revised downward sharply in the event that significant contract expectations are not met.
Originally posted 2016-10-12 05:00:06.