Monday Note

Apologies in advance: If you’re fluent in the language of accounting, please skip to the bonus Verizon iPhone feature at the end. What I’m about to describe will strike you as oversimplified and could bruise your professional sensitivities.

Companies sometimes (often?) manipulate their numbers. Today, we’ll look at a few examples of accounting sophistry and misdirection that may prove useful in fine-tuning your own BS (Bedtime Stories) detector. As always in these Monday Notes, any reference to real people, companies, or accounting principles and practices only have hypothetical connections with reality. Believe anything below at your own risk.

Let’s start with profit. At the most basic level, profit is the difference between what you take in, sales of products or services, and what you spend, salaries, rent, raw materials and the like. So, when that difference is positive, when you spend less than what you take in, you’ve “made money,” right? Profit is money, right?

No. It’s just a number. You can’t put it in your pocket and spend it as you see fit. To start with, you already owe some of that putative money in the form of taxes. The moment you cut an invoice could be a “taxable event.”

We say things like “DC&H is making money” when the company reports a profit, but this is delusional. If customers “buy” but don’t pay, there comes a moment when you run out of actual cash. That’s why some businesses pay a commission to their salespeople on remittances only (in English: only on what customers actually pay). This policy has a strange effect: The more experienced sales people nod sagely when marketing folks tell them what to sell and how, and then they go out and push the products they know customers will actually pay for.

Profit isn’t unimportant, certainly, but it’s not as important as cash. If your business suffers a downturn but has plenty of cash, you live to fight the next battle. If you’re ‘’profitable’’ but run out of cash, you don’t. And you can be profitable and still go bankrupt (and learn another kind of ABCs).

So far, nothing really new or complicated.  The trouble starts with reserves.

I use the word “reserves” to tweak my deceased father, an accountant. I would counter his protest that accounting is a science by uttering the magic word…and the discussion would descend into a lecture on the “accountant’s judgment,” which, in my opinion, makes accounting part of the storytelling category. (As an aside: Wikipedia’s storytelling article misses the excellent Amusing Ourselves To Death in which Neil Postman makes the all-important distinction between science and storytelling. Example: Math vs History.)

As a prudent businessperson, you have a jaded view of the stack of invoices sent in by the salesforce. You know customers. Even if your salespeople are as realistic as you are, you know some of your buyers won’t pay. As a result, you tell your bookkeeper to make a reserve for bad debts, invoices that won’t be collected. But how much? 1% of sales, 5%? It depends on…name your poison: An unreliable, unproven new product; the economy; a non-financial hurricane; an overly aggressive promotion campaign (a.k.a. “stuffing the channel”). You have to make a judgment call and reduce the number of sales you claim — and the profit you expose to the taxman.

Your sales and profit numbers are now an opinion. And this is what the owners of the company, your shareholders, expect. They don’t want a raw number, they want a good story, they want your best judgment on the state of the business. A small white lie for a greater good.

Now we stretch things — or we become more sophisticated. Reserving for bad debts falls into the broader topic of Revenue Recognition.

Let’s say you ship software. And customers pay for it. Should you report all the revenue (and the 90% profit margin)? Surprisingly, your software has bugs and you, being a forward-looking entrepreneur, decide to issue bug fix releases for free. (This means you’re not Oracle, SAP, or IBM who charge 18% per year for bug fixes.) By some accounting lights, you haven’t fully earned the revenue until you’ve delivered the fully-functional product and so you must put a portion of the dollars you received into a reserve. The real revenue is now less than the receipts.

You do the good deed, you fix enough bugs to declare victory after a few “dot releases” (7.1, 7.2, 7.2.1, …). You can now put the reserve back into the sales number you report and give yourself a momentary bump in profits.

Is this a good idea?

In a literal reading of the words, the question must be answered in the affirmative: Yes, it is a Good Idea. But it’s often abused. In the nineties, Microsoft was well-known — no, celebrated — for its smooth earnings growth, for never surprising Wall Street, for always landing just a penny above “Street consensus” estimates.

How did they perform such a feat? Reserves. As the company shipped humongous volumes of Windows and Office software, it stuffed “suitable” amounts in various reserves cupboards, and then, each quarter, withdrew exactly the right portion to make their earnings look “just so.” I’ll hasten to add that Microsoft wasn’t the worst offender; the company was merely “managing earnings”.

(The Revenue Recognition Wikipedia article is too encyclopedic, this About.com article is less arduous. See the last paragraph on page 2: How Management Can Manipulate the Income Statement Using Revenue Recognition…)

Last week, when discussing Microsoft earnings, I linked to a Gregg Keizer article in Computerworld. There you can find phrases like: “Rob Helm, an analyst with Directions on Microsoft, tried to explain Microsoft’s accounting.” Gregg Keizer proceeds to untangle reserves and, for good measure, makes a judgment call on the revenue spike associated with the release of Windows 7 a year before. He concludes that the “real” Windows business is down 30%, a number that will certainly be disputed.

But what matters, here, isn’t a specific number, it’s the process, the work that must be done to interpret the stories companies tell us through their numbers. One reading of an earnings release could be “Revenue and Profits Are Up, All Is Well.” Another interpretation: “Good Quarter, But Watch This Trend.”

Then there’s the meaning of words. Company X says “We shipped 2 millions gizmos!” It’s a success, gizmos are flying off the shelves. Or not. Does shipped mean sold? Or are the devices sent to a distributor who doesn’t consider the shipment a purchase and can claim return rights if the “sell-through” proves disappointing? Indeed, the Windows Phone 7 “shipment” figures convey little information about the number of phones that have actually been sold by handset makers and carriers. As another example, Samsung executives recently ‘‘clarified’’ their claims of 2 million Galaxy tablets “sold.” They had been shipped to distributors but actual sales were unknown (yet “smooth”).

This introduces the broader and murkier topic of naming, classifying. A fundamental part of accounting is putting things, events, in the proper bin. Or building appropriate bins, or coming up with elaborate language for transferring assets and events from a commonsensical category to a special-purpose bin designed for tax-avoidance…sorry, optimization…or other even darker purposes. And here we enter the hell of off-balance-sheets, synthetic leases, special-purpose entities and memories of the Enron/MCI/Worldcom era.

The complexity of these schemes is mind-numbing, and that’s exactly their purpose: To make people oblivious to reality. But as we know now — and as a few Cassandras had been saying before the fall — negative cash-flow revealed that these fancy entities and vehicles were bad, fraudulent stories.

(This University of Chicago course material, this Brigham Young University presentation and this book abstract will provide legal and inexpensive sleep induction. Don’t ask why fancy accounting got us in trouble again, in 2008 this time, only on a much grander scale.)

To paraphrase a gun lobby slogan: Numbers don’t lie, people lie. And to do so without going to jail, they use obfuscating, misdirecting language. If it’s unclear, it’s probably an attempt to hide something. But cash doesn’t lie.

[Pour mes lecteurs francophones, une traduction libre du titre: le liquide, c’est solide, mais le profit est un gaz…]

And now, the fun bonus feature: The iPhone on Verizon.

Depending on whom you believe, Apple’s partnership with Verizon is either the second coming of the “Jesus Phone” or a non-event. Analyst’s predictions vary wildly, from 11 million to 19 million units for this year. Others, such as Dan Lyons in a Daily Beast column, are more dyspeptic, that the iPhone on Verizon comes too late to avert its pre-ordained destination: a niche.

We’ll see. But, in the meantime, can we make a guess? Will the iPhone enjoy strong sales in Android territory, the Verizon network? (For reasons explained above, we’ll ignore Verizon’s claims of “record first-day pre-order activity” for its iPhone: there are no numbers attached.)

For an answer, we can turn to numbers and a little fable.

The numbers are Android sales at AT&T. In a word: weak. See below, from a New York Times Bits blog post by Nick Bilton:

The only network where the iPhone faced Android was AT&T’s. There, the iPhone won the mano a mano. Why?

I’ll answer with the fable:

My beloved spouse, Brigitte, decides she wants a smartphone. Not because I say so — she’s a normal human and carries a healthy disregard for her tech chauffeur’s views on hardware and software. No. Her friends tell her she needs one.

She enters the AT&T store on El Camino Real and tells the salesman she’s looking for a smartphone. “You’ve come to the right place, Madame. We have Android phones and we have the iPhone.” Inquiring about the difference in price and features, she gets a non-committal answer: “They’re priced about the same and they’re all very good.” She switches gears and plays the poor maiden lost in the high-tech maze and asks again. Suddenly chivalrous, the salesman confides: “Look, this one, the iPhone has an iPod inside, the others don’t.” And the sale is made.

“iPod inside” is symbolic of the difference AT&T customers perceive and pay for. The iPhone doesn’t sell more because it’s less expensive, or because competitors don’t offer incentives to AT&T and “spiffs” (commissions in goods or cash) to sales people on the floor.

We’ll see if the “iPod inside” will also be a factor at Verizon.

—JLG@mondaynote.com

Be Sociable, Share!

• 

Related columns:

1. Cash isn’t Cash Anymore TweetIn our Valley, the so-called subprime mortgage crisis has been more a rumble in the distance than the wolves at the door. We don’t like the noise but local real-estate prices aren’t collapsing and, in any event, we’re in the high-tech business, you see. Entrepreneurs come to us for help in building the next Facebook, [...]...
2. Kremlinology For Fun and Profit TweetI’m quite fond of kremlinology, the metaphorical one, not the literal sort. For me, it started as a hobby and ended up making me decades of fun and money. Allow me to explain before we proceed with an attempted decryption of recent Apple events and statements. Working in Paris in the seventies, I struck an [...]...
3. UK’s CityAM : profit and expansion TweetThe free business newspaper CityAM is growing slowly but steadily. Its circulation is now close to 102,000 copies, a 47% increase since its launch in September 2005, and it could now expand out of London. Financially, CityAM made a 59,000 Euros profit for the six months ended in March, on revenues of 4,4m Euros for [...]...
4. When non-profit empowers good journalism TweetLater this month a new website, based in New York, and devoted to investigative journalism will hit the net. It bears something special : ProPublica will be the first news organization entirely and generously funded by a private foundation. Three things will make this experience interesting to watch. - First is the scope of the [...]...
5. The Cash Is In The Topics TweetAll conversations I keep having about the economics of a news web sites revolve around two key ideas: how to increase both the duration and the depth of a visit. In this respect, much work remains. For August 2009, here are the numbers of page views, as measured by Nielsen Net Ratings on the French [...]...