No Hard-and-Fast Rules
Most entrepreneurs watch expenses closely. But did you know that there are plenty of estimates and biases on those expense lines? Let’s examine the major line items.
As you probably do know, expenses on the income statement fall into two basic categories. The first is cost of goods sold, or COGS. As usual, there are a couple of different names for this category—in a service company, for instance, it may be called cost of services (COS). We’ve also frequently seen cost of revenue and cost of sales. (For simplicity’s sake, we’ll use the acronyms COGS or COS.) At any rate, what matters isn’t the label; it’s what’s included. The idea behind COGS is to measure all the costs directly associated with making the product or delivering the service—the materials, the labor, and so on. If you suspect that rule is open to a ton of interpretation, you’re on the money. Your bookkeeper or accountant has to make decisions about what to include in COGS and what to put somewhere else.
Some of these decisions are easy. In a manufacturing company, for instance, the following costs are definitely in:
And plenty of costs are definitely out, such as:
Ah, but then there’s the gray area—and it’s enormous. For example:
Are all these directly related to the manufacturing of the product? Or are they operating expenses, like the cost of the office manager? We know of one company that includes direct selling costs in COGS. Its owners believe that doing so is appropriate for their business. There’s the same ambiguity in a service environment. COS in a service company typically includes the labor associated with delivering the service. But what about the group supervisor? You could argue that his salary is part of general operations and therefore shouldn’t be included in the COS line. You could also argue that he is supporting direct-service employees, so he should be included with them in that line. These are all judgment calls. There are no hard-and-fast rules.
The fact that there aren’t any, frankly, is a little surprising. GAAP—the generally accepted accounting principles that govern how U.S. accountants keep their books—runs for some four thousand pages and spells out a lot of detailed rules. Public companies are required to follow GAAP. Privately owned companies aren’t, but most do. If you use debt financing in your business, such as a line of credit based on accounts receivable, most banks and other financial institutions will require accounting procedures that adhere to GAAP.
Cost of goods sold or cost of services is one category of expenses. It includes all the costs directly involved in producing a product or delivering a service.
Operating expenses are the other major category of expenses. The category includes costs that are not directly related to making a product or delivering a service.
You’d think GAAP would say, “The plant manager is out” or “The supervisor is in.” No such luck; GAAP only provides guidelines. Companies take those guidelines and apply a logic that makes sense for their particular situations. The key, as accountants like to say, is reasonableness and consistency. So long as a company’s logic is reasonable, and so long as that logic is applied consistently, whatever it wants to do is OK.
Why should a company owner care what’s in and what’s out? Consider the following scenarios:
GAAP stands for “generally accepted accounting principles.” GAAP defines the standard for creating financial reports in the United States. It helps ensure the statements’ validity and reliability, and it allows for easy comparison between companies and across industries. But GAAP doesn’t spell out everything; it allows for plenty of discretion and judgment calls.
Again, these changes are legal, so long as they meet the reasonable-and-consistent test. You can even take an expense out of COGS one month and petition to put it back in next month. All you need is a reason good enough to convince the accountant (and in a public company, the auditor, if the changes are material to the company’s financials). Of course, changing the rules constantly from one period to the next would be bad form. One thing we all need from our accountants is consistency.
The “line” generally refers to gross profit. Above that line on the income statement, typically, are sales and COGS or COS. Below the line are operating expenses, interest, and taxes. What’s the difference? Items listed above the line tend to vary more (in the short term) than many of those below the line and so tend to get more managerial attention.
And where do costs go when they are taken out of COGS? Where is “below the line”? That’s the other basic category of costs, namely operating expenses. Some companies refer to operating expenses as selling (or sales), general, and administrative expenses (SG&A, or just G&A), while others treat G&A as one subcategory and give sales and marketing its own line. Often a company will make this distinction based on the relative size of each. Rocky Mountain Chocolate Factory chooses to show sales and marketing on a separate line—sales and marketing are a significant portion of the company’s expenses. By contrast, Ultralife Batteries includes sales and marketing with G&A, the more typical approach. Your company should follow the model of these companies: separate out whatever is most important so that you can track it easily.
Operating expenses are often thought of and referred to as overhead. The category includes items such as rent, utilities, telephone, research, and marketing. It also includes management and staff salaries—the office manager, accounting, IT, and so forth—plus everything else that the accountants have decided does not belong in COGS.
You can think of operating expenses as the cholesterol in a business. Good cholesterol makes you healthy, while bad cholesterol clogs your arteries. Good operating expenses make your business strong, and bad operating expenses drag down your bottom line and prevent you from taking advantage of business opportunities. (Another name for bad operating expenses is “unnecessary bureaucracy.” Or “lard.” You can probably come up with others. Even small companies are not immune.)
One more thing about COGS and operating expenses. You might think that COGS is the same as variable costs—costs that vary with the volume of production—and that operating expenses are fixed costs. Materials, for example, are a variable cost: the more you produce, the more material you have to buy. And materials are included in COGS. The salary of the office manager is a fixed cost, and that’s included in operating expenses. Unfortunately, things aren’t so simple here, either. For example, if supervisors’ salaries are included in COGS, then that line item is fixed in the short run, whether you turn out one thousand widgets or fifty thousand. Or take selling expenses, which are typically part of SG&A. If you have a commissioned sales force, sales expenses are to some extent variable, but they are included in operating expenses, rather than COGS.
Another expense that is often buried in that SG&A line is depreciation and amortization. How this expense is treated can greatly affect the profit on an income statement.
We described an example of depreciation earlier in this part—buying a delivery truck and then spreading the cost over the three-year period that we assume the truck will be used for. As we said, that’s an example of the matching principle. In general, depreciation is the expensing of a physical asset, such as a truck or a machine, over its estimated useful life. All this means is that the accountants figure out how long the asset is likely to be in use, take the appropriate fraction of its total cost for a given time period, and count that amount as an expense on the income statement for that time period.
In those few dry sentences, however, lurks a powerful tool that financial artists can put to work. It’s worth going into some detail because you’ll see exactly how assumptions about depreciation can affect any company’s bottom line.
To keep things simple, let’s assume we start a delivery company and line up a few customers. In the first full month of operation, we do $10,000 worth of business. At the start of that month, our company bought a $36,000 truck to make the deliveries. Since we’re expecting the truck to last three years, we depreciate it at $1,000 a month (using the simple straight-line depreciation approach). So a greatly simplified income statement might look like this:
| Revenue | $10,000 |
| Cost of goods sold | 5,000 |
| Gross profit | 5,000 |
| Expenses | 3,000 |
| Depreciation | 1,000 |
| Net profit | $ 1,000 |
But our accountants don’t have a crystal ball. They don’t know that the truck will last exactly three years. They’re making an assumption. Consider some alternative assumptions:
Hmm. In the former case, we’re suddenly operating in the red. In the latter, we have increased net profit 50 percent—just by changing one assumption about depreciation. Accountants have to follow GAAP, of course, but GAAP allows plenty of flexibility. No matter what set of rules the accountants follow, estimating will be required whenever an asset lasts longer than a single accounting period. Your job is to understand those estimates and know how they affect the financials.
If you think this is purely an academic exercise, consider the sorry example of Waste Management Inc. (WMI), which we mentioned in the preface. WMI was one of the great corporate success stories of the 1970s and 1980s. So it came as a shock to everybody when the company announced in 1998 that it would take a pretax charge—a one-time write-off—of $3.54 billion against its earnings. Sometimes one-time charges are taken in advance of a restructuring, as we’ll discuss later in this chapter. But this was different. In effect, WMI was admitting that it had been cooking its books on a previously unimaginable scale. It had actually earned $3.54 billion less in the previous several years than it had reported during that time.
What was going on? WMI had been a darling of Wall Street since the 1980s, when it began to grow rapidly by buying up other garbage companies. When the supply of garbage companies to buy began to dwindle, around 1992, it bought companies in other industries. But while it was pretty good at hauling trash, it didn’t know how to run those other companies effectively. WMI’s profit margins declined. Its share price plummeted. Desperate to prop up the stock, executives began looking for ways to increase earnings.
Their gaze fell first on their fleet of twenty thousand garbage trucks, for which they had paid an average of $150,000 apiece. Up to that point, they had been depreciating the trucks over eight to ten years, which was the standard practice in the industry. That period wasn’t long enough, the executives decided. A good truck could last twelve, thirteen, even fourteen years. When you add four years to your truck depreciation schedule, you can do wonderful things to your bottom line; it’s like the preceding little example multiplied thousands of times over. But the executives didn’t stop there. They realized that they had other assets they could do the same tricks with—about 1.5 million Dumpsters, for example. You could extend each Dumpster’s depreciation period from the standard twelve years to, say, fifteen, eighteen, or twenty years, and you’d pick up another chunk of earnings per year. By fiddling with the depreciation numbers on the trucks and the Dumpsters, Waste Management’s executives were able to pump up pretax earnings by a whopping $716 million. And this was just one of many tricks they used to make profits look larger than they were, which is why the end total was so huge.
Of course, the whole tangled web eventually came unraveled, as fraudulent schemes usually do. By then, however, it was too late to save the company. It was sold to a competitor, which kept the name but changed just about everything else. As for the perpetrators of the fraud, no criminal charges were ever filed against them, although some civil penalties were assessed.
Depreciation is a prime example of what accountants call a noncash expense. Right here, of course, is where they often lose the rest of us. How can an expense be other than cash? The key to that puzzling term is to remember that the cash has probably already been paid. The company already bought the truck. But the expense wasn’t recorded that month, so it has to be recorded over the truck’s life, a little at a time. No more money is going out the door; rather, it’s just the accountants’ way of figuring that this month’s revenue depends on using that truck, so the income statement better have something in it that reflects the truck’s cost. Incidentally, you should know that there are many methods to determine how to depreciate an asset. You don’t need to know what they are; you can leave that to your accountant. All you need to know is whether the use of the asset is matched appropriately to the revenue it is bringing in.
A noncash expense is one that is charged to a period on the income statement but is not actually paid out in cash. An example is depreciation: accountants deduct a certain amount each month for depreciation of equipment, but the company isn’t obliged to pay out that amount, because the equipment was acquired in a previous period.
Amortization is the same basic idea as depreciation, but it applies to intangible assets. These days, intangible assets can be a big part of some companies’ balance sheets. Items such as patents, copyrights, and goodwill (to be explained in chapter 9) are all assets—they cost money to acquire, and they have value—but they aren’t physical assets like real estate and equipment. Still, they must be accounted for in a similar way. Take patents. If you run a biotech firm, you may have one or more patents in your portfolio. Your company had to buy those patents, or it had to do the R&D itself and then apply for the patent. Now the patents are helping bring in revenue, so the company must match the expense of the patents with the revenue the patents help generate, a little bit at a time. When an asset is intangible, though, accountants call that process amortization rather than depreciation. We’re not sure why—but whatever the reason, it’s a source of confusion.
Incidentally, economic depreciation implies that an asset loses its value over time. And indeed, a truck used in a delivery business does lose its value as it gets older. But accounting depreciation and amortization are more about cost allocation than about loss of value. A truck, for example, may be depreciated over three years so that its accounting value at the end of that time is zero, but it may still have some value on the open market. A patent may be amortized over its useful life, but if technology has advanced beyond it, the patent’s value may be close to zero after a couple of years, regardless of what the accountants say. So assets are rarely worth what the books say they are worth. (We’ll discuss accounting or “book” value in greater detail in part 3.)
Accounting is like life in at least one respect: there’s a lot of stuff that doesn’t fall neatly into categories. So every income statement—particularly in larger companies, but also in smaller ones—has a group of expenses that do not fall into COGS and are not operating expenses or overhead, either. Every statement is different, but typically you’ll see lines for “other income /expense” (usually this is gain or loss from selling assets or from transactions unrelated to the operations of the business) and, of course, “taxes.” As the business owner, you should know what is going into these numbers, but most of the time they are small and therefore don’t have a big impact on profit. There is one line, however, that often turns up after COGS and operating expenses (though it is sometimes included under operating expenses)—a line that we think you should understand even though you may never run into this phenomenon in your own business. The most common label for this line is “one-time charge,” and it is often critical to profitability. It’s worth knowing about just in case you do come across it as you are studying other companies’ financials.
You may occasionally have seen the phrase taking the big bath or something similar in the Wall Street Journal. That’s a reference to these one-time charges, which are also known as extraordinary items, write-offs, write-downs , or restructuring charges. Sometimes write-offs occur, as in Waste Management’s case, when a company has been doing something wrong and wants to correct its books. More often, one-time charges occur when a new CEO takes over a company and wants to restructure, reorganize, close plants, and maybe lay people off. It’s the CEO’s attempt, right or wrong, to improve the company based on his assessment of what the company needs. Normally, such a restructuring entails a lot of costs—paying off leases, offering severance packages, disposing of facilities, selling equipment, and so on. Anytime a business is forced to cut costs by laying off personnel, the costs associated with the layoff would likely fall into the one-time-charge area. Even small companies may want to delineate those charges in such a situation.
Now, accountants always want to be conservative. In fact, they’re required to be. GAAP recommends that accountants record expenses as soon as they know that expenses will be incurred, even if they have to estimate exactly what the final figure will be. So when a restructuring occurs, accountants need to estimate those charges and record them.
Here is a big yellow flag—a truly terrific place for bias in the numbers to show up. After all, how do you really estimate the cost of restructuring? Accountants have a lot of discretion, and they’re liable to be off the mark in one direction or another. If their estimate is too high—that is, if the actual costs are lower than expected—then part of that one-time charge has to be reversed. A reversed charge actually adds to profit in the new time period, so profits in that period wind up higher than they would otherwise have been—and all because an accounting estimate in a previous period was inaccurate! “Chainsaw Al” Dunlap, the notorious CEO of Sunbeam, was said to regard his accounting department as a profit center, and this fact may suggest why. (Incidentally, if you ever begin referring to your accountants in this manner, you and your company might have a problem.)
Of course, maybe the restructuring charge is too small. Then another charge has to be taken later. That clouds the numbers because the charge isn’t really matched to any revenue in the new time period. This time around, profits are lower than they otherwise would be, again because the accountants made the wrong estimate in an earlier time frame. In the early 1990s, AT&T took “one-time” restructuring charges every year for several years. The company kept saying that earnings before the restructuring charges were growing—but it didn’t make much difference, because after all those restructuring charges, the company was in pretty rough shape financially. Besides, if a company takes extraordinary one-time restructuring charges for several years in a row, how extraordinary can those charges really be?
Most of the shenanigans with restructuring occur in large, publicly traded companies. They’re the ones, after all, that care about what Wall Street thinks. But if you ever intend to go public, or if you are looking at the income statement of a company you might acquire, you better understand one-time charges. They’re an essential tool of accounting, but they easily lend themselves to financial obfuscation and mischief.