After a few years of accounting practice, and many years of researching earnings manipulation, I’ve learned a few basic rules, rules so fundamental that even a superstar like Apple can’t defy them. Here are two:
Rule 1: There is no such thing as an “accounting technicality”
Occasionally, in conference calls, CFO’s and CEO’s speak of “accounting technicalities.” I know US GAAP pretty well, and it never defines anything called a “technicality.” So what’s a technicality? Let’s just say that it’s a conspiratorial accounting rule that (1) lowers income, (2) confuses investors into thinking the company’s performance is worse than it really is, and (3) is too confusing and obscure for you to understand.
Take Apple. Gary Morton of Seeking Alpha wrote a thoughtful post evaluating Apple’s technicality, an unusually large 4th quarter “anomaly” that was caused by an accounting technicality in the OI&P line. Morton evaluates Apple’s quarterly numbers and discovers that, if it weren’t for that minor technical anomaly, Apple’s results would have beat expectations by $0.17.
GAAP isn’t so arbitrary that it just throws anomalies and technicalities around to hurt companies’ quarterly earnings reports. In fact, there was a loss, and Apple had to record it. Here are my first two questions:
1. Why is Apple engaging in ineffective cash flow hedges?
2. Why did Apple lose $658 million on these transactions?
Rule 2: Understating income this year causes you to overstate net income sometime in the future
Financial accounting is a lot like a shell game. You can move the ball around under the cups as much as you want, but try as you might, you can’t make that darned ball go away. This means that a company (like, say, Enron) can sometimes get away with hiding losses for awhile. But those losses don’t go away. Instead, they hang around on the balance sheet, waiting to get recorded.
This shell game can go in the other direction, too. If a company chooses to (or is forced to) record an expense early, then it won’t need to record the expense later. This reduces income now but raises it later.
Back to Apple again. Apple’s $683 million technicality loss hurt earnings in the Fourth Quarter. But this is $683 million worth of losses that Apple won’t have to record next year, thereby giving its earnings a greater boost next year. My final question:
How will Apple’s $683 million technicality boost earnings next year?
Companies sometimes engage in this kind of shenanigans when times are good, but not expected to stay good forever. Recording losses early (so-called cookie-jar reserves) allow companies to tuck profit away from the good years, so that they’ll have it when they need it during the bad years. I’m not alleging that Apple is trying to do this, and I’m skeptical that Apple is worrying about future earnings. Nonetheless, remember that today’s loss is tomorrow’s gain…