Accounting Assets: Here Today, Gone Today
MiBiz • November 14, 2005
by Jim Gillette
I remember sitting in the audience at the Automotive Management Briefing Seminar at Traverse City back in August 2002, listening to a speaker saying something like, “Aren’t you happy we work in an industry with clean accounting, unlike the Enrons and Worldcoms of the world.” I remember thinking at the time, stick around, eventually the skeletons will force their way out of the closet.
Funky accounting has been a part of the auto industry for years. Although it had been only a little over 12 years since Roger Smith retired as Chairman of General Motors, I’ll bet most members of the audience had either forgotten or were unaware of his shameless manipulation of the books during the late 1980s.
In one episode, Roger decided profits weren’t strong enough, so he took advantage of the loose rules of pension fund accounting. By shortening the assumed lifespan of GM retirees by two full years, Smith was able to significantly reduce the defined benefit pension contribution for 1988 thereby boosting net income for the year. I remember wondering at the time, how did Smith know that retirees were going to die earlier than previously expected? Did he have some secret plan to help them along to an early grave? Absurd thought, I know. But it does it does point out the foolishness of taking accounting numbers at their face value without examining the underlying assumptions. (By-the-way, Roger, I would never wish you dead two years before your time.)
The recent flood of earnings and balance sheet restatements by auto suppliers should come at no surprise if you understand how tenuous underlying assumptions for the accounting numbers can be. Some of the restatements are clearly the result of fraud or attempts at deception. But the really big dollar amounts more often result from adjusting assumptions to come into compliance with the rules.
Several people have asked me, for example, “How did the Delphi situation develop so quickly?” It didn’t. It just looked that way. The allegedly fraudulent accounting shenanigans were material, but relatively minor.
One of the really big events that came as a bit of a surprise was the disappearance of $4.7 billion from the asset side of Delphi’s balance sheet. $4.7 billion! “Why, that’s like Worldcom,” you say. Not at all. The Delphi transaction was perfectly legitimate. It does illustrate, however, the leeway that a company’s accountants have in making assumptions and reporting them as facts under the cover of GAAP.
The “deferred tax asset” that disappeared resulted from Delphi’s ability under the tax code to carryback losses three years and carryforward losses fifteen years. According to Delphi’s 10k filed with the SEC, company accountants said, “we determined that we could no longer support realization of such amounts under the application of U.S. GAAP.” In other words, “we no longer can imagine in our wildest dreams making enough money in this business to be able to take advantage of this extraordinary amount of tax write-offs.”
The net effect on the balance sheet was to transform $1.446 billion of book stockholder’s equity at the end of 2003 to a negative $3.539 billion at the end of 2004. No cash had actually disappeared; just a change in assumptions.
More recently, Dana announced a $741 million “valuation allowance” that writes down its deferred tax assets for exactly the same reason. It is important to reiterate that no cash was involved in either transaction. The only way that a shareholder is tangibly impoverished by this action is if the market assumed the deferred tax asset was realizable in the first place.
Here is another example of another balance sheet adjustment that has very little meaning in reality. For the quarter ending October 1, Lear reported a $670 million “goodwill impairment charge.” “Goodwill” is an asset is created when a company acquires another company for a market value greater than its accounting book. Prior to 2001, the acquiring company wrote down the value of goodwill by taking an annual charge against income. Companies hated this because it reduced reportable earnings.
The Financial Accounting Standards Board adopted SFAS No. 142 in July 2001 that eliminated the amortization and now requires periodic testing for impairment by the company. In other words, is the acquired asset still worth what was paid for it? When the impairment charge was announced on October 26, Lear’s stock dropped only slightly in value. The market evidently already understood that the value of automotive assets had declined dramatically since the acquisition binge of the late 1990s.
I’ve always felt it just as important to teach my finance students at the Seidman College of Business what creates value to the same degree as to how it is measured. Value is created when companies offer superior products with a competitive cost advantage in markets that have not already purged every ounce of profit. If you understand the fundamentals, you are less likely to be misled by the accounting numbers that may or may not be an accurate representation of reality.