As you advance up the ladder in your Finance career, it is almost certain that you will arrive at a level of responsibility for the numbers where your judgment become key in determining outcomes. At the same time, you will be confronted with one of the two most common issues – numbers not being smooth or what looks like a temporary operations issues that can be fixed by some smart accounting.
There is no requirement to qualify for sainthood while being a CFO. You are part of the management and public image of the company, and investors and employees are relying on you properly present the historical results of the company and the expected future performance. You do not have to be the most conservative person in the country and report and book every possible downside and flagellate yourself publicly over every single misstep. Honesty is important but you also need maturity and respect for your audience. No one expects that you were perfect or that you will be perfect. Being overly optimistic is not good but being overly pessimistic is also a problem. Your investors will be expecting a fair accounting of results and possibilities so they can make choices in who to invest in. An immature management team that does not promote their company somewhat will result in an additional valuation hit because of a perception that management is not strong and does not believe in their company. Even in bad times, if you are still there with the rest of the management team, you must believe that you are part of the solution. Therefore, mention the issues but focus on the solutions.
I can give a specific example from earlier in my career. The GAAP accounting for stock options granted to employees used to make expensing the options optional. This was an option that Silicon Valley companies did not take. Almost no companies expensed options, but Silicon Valley greatly depended on options and fought against changing the accounting. During that time, I believed that they should be expensed. In accounting discussions with other accountants, I would question the basis for not expensing them. Even with my strong belief that they should be expensed, I did not do it in the books I was responsible for. It simply was not the accepted practice and it was proper under GAAP to not expense options. There was absolutely no reason to “punish” my company compared to others just because I could get on my high horse about the proper accounting for options. Once GAAP changed, technology companies either reported non-GAAP numbers without the options expense or they provide the information so outside analysts could do the same. I provided the information just like others in the industry did because investors expected it.
This is actually an important concept to understand. US GAAP is very specific in many ways but judgment is still a key foundation on the accounting that is done. As I explained in an earlier entry on when I would do a prerelease, the SEC and FASB have both put judgment calls firmly on the shoulders of management. As the CFO, you will be making most of the calls. Other management team members including your boss will come to you with transactions they would like to get booked. You can wrap yourself in a holy mantle of GAAP and always say no, or you can listen to what they are trying to do and try and find a solution.
This brings me back to the original choice I started with. The world is random and bumpy. Investors prefer smooth results that fit an easy to understand framework. Closing the books means making a lot of accruals and valuation judgments and it is really easy to smooth everything out. Be very careful here. Sometimes GAAP really does result in smoother results. If you have a constant production base and higher demand at the end of the year and less at the beginning, you can naturally smooth out the unit cost by building inventory at the beginning of the year and thereby absorbing overhead that otherwise might be expensed and then not overdriving production at the end of the year and over absorbing overhead which results in lower unit costs. You essentially borrow the good news at the beginning of the year and repay it at the end of the year. The accounting matches actual production and you do incur a risk of falling costs at the end of the year or dropped demand meaning your working capital investment may not pay off in better over all results, but the results will be smoother.
Then there is the actual issue that sometimes business just doesn’t match arbitrary quarter end boundaries. It really should not make much difference in the valuation of your company is a deal actually closes January 1 instead of December 31, especially if it was supposed to close earlier and you and rest of the management team forecasted it in good faith to close before December 31. It shouldn’t, but it does. Even if your business does not have big contracts, there might be a snow storm or a flood at your main warehouse and you may miss a week of shipments right at at quarter end. Even in a regular quarter, you may run into a shipping bottleneck and customer orders may not make it out in time even though they were ready.
Sometimes the plant operations group misses their cost takeout targets. Could be an operational issue or maybe the market just didn’t correct quite fast enough but should be ok a few months from now. The shortfall easily can be made up via a slight change in inventory valuation.
Believe it or not, sometimes you get too much good news. A big customer moves up an order and suddenly this quarter is way exceeding goals. Currency moves in the right way and your gross margin now exceeds expectations. Of course, now the next quarter doesn’t look quite as good in comparison and you are wondering if you should burn some of the current good news to smooth out the next few quarters?
Finally, you can often see an issue coming a quarter or two in advance. Does it look like your sales team is making the quarter numbers more and more by borrowing from the next quarter? Did you start this quarter with a vacuum of sales and opportunities because most were recognized the quarter before? Did costs go up and a lot of the cheaper inventory from a prior quarter get used up? If so, expect results that are not smooth or within expectations are probably coming soon.
Like all good CFOs, you probably has a few accounting ideas or changes in the back of your mind that you have been thinking about for a while. Maybe just some tidying up of some overaccruals from prior quarters. Maybe a tweak in inventory accounting that you have been considering. Is this the time you should step in and do it?
I was given some very good advice by a boss early in my career when I had the first exposure to being able to suggest accounting changes. He told me “Never solve an operational problem by moving it onto the balance sheet. All you do is make an Operations problem a Finance problem and when it does come off the balance sheet no one will remember that you were a hero in the past. You defer changes that might be needed and hide the problem so it might not get priority.” This came from someone that I considered to be a very good accountant who had championed a change in accounting that resulted in a better results for a decade into the future. I had also suggested an accounting charge at the start of the planning process (salvage value) that was accepted by him as a good idea to be implemented. The advice was not by someone that was not able to look for better and more accurate accounting, but from someone that had already made that mistake himself and seen others going it in the past and where he wanted to warn me of the consequences.
So now I always replay that advice in my mind when making a quarter end accounting judgment call. Is Sales now asking about bill and hold after the quarter has already ended to handle that inventory that did not make it over the finish line, or was this planned in advance and did the request come in before quarter end and is documented properly? Is cost higher than hoped for and your COO is looking for more expenses to capitalize into inventory to make the target? Did you just figure out that you beat expectations and now you are looking for extra reasons to boost up reserves that you felt were adequate last quarter or even last week?
I have not been afraid my whole career to make sure that our accounting is as advantageous as the accounting in my industry normally is. However, that good advice early in my career when I was at AlliedSignal still sticks to me. I don’t think that any CFO doesn’t know when the are pushing the accounting too hard.
Try to remember that no one really will think you are a hero today. That entry will be in the background and you will not get any credit for it. Remember that your boss and the rest of the management team will not remember why you capitalized those items a year ago, they will just be mad that you are expensing them now. Remember that your integrity is even more on display when you publish the numbers to the outside world. If you push the accounting too hard you could lose standing with your auditors, if there is an operations blow up and a miss and you get sued, it will come out in discovery later. If the rest of the management team gets cynical about the reported numbers, then they may start messing with them without you even getting involved.
Do the right thing for your company. Try and get the best accounting results where it makes sense and is part of a plan in advance. Otherwise, don’t try and fight the random world too much by double entry bookkeeping. Life is not smooth. Expectations do get exceeded or missed sometimes. Make sure that investors who do their work can at least rely on you and your numbers.
——
Some books on the effects of “Number Smoothing”
Confessions of a Wall Street Analyst
The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America
The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron
Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition
