Integrity

One of the great personality traits of my son (Soren) is that he always tells the truth, even to his own detriment at times. Example:

We were riding in the van (Soren was 4 years old at the time). I heard some commotion in the back. Then Soren tries to tell on his sister:

“Daddy, Svea hit me after I hit her first.”

Clearly, he would have benefitted from a slightly shorter sentence. But I like his consistent integrity. Now 10, he has become known for truth-telling amongst neighbors and teachers.

Kids are crying. Feelings are hurt. Want to know what really happened on the playground?… ask Soren. You’ll get an unbiased, (sometimes self-condemning), factual answer. Everyone knows this about him. What a great reputation to have.

Integrity in Business

Integrity in business is such a fundamental concept that we need not discuss its virtue. While most agree that integrity is a prerequisite for “good” business, not everyone behaves that way. We all know people who miss the mark in this area. In fact, sometimes the culture of business believes that the end justifies the means. It does not.

Reputations are built in the “means” more than the “ends”.

Screwing Suppliers & Partners

Early in my career, a work colleague from the purchasing department (he was also a lawyer), explained to me that Contract Law states that if it is more advantageous (financially or otherwise) to break the contract than to honor it, the company should break it.¹

He argued this is just smart business.

It almost makes sense when presented as a logical argument, but it’s a short-term view. What is not counted in this calculation is the reputational damage. The scar to the company’s integrity. The lost future opportunities that never got presented to the company because someone told someone, who told someone, that the company couldn’t be trusted.

To play the long-game in business, honor commitments, even when it may not be immediately advantageous.

Gaming the Accounting

Similarly, some publicly-traded companies incur negative-integrity-impacts by bending accounting rules to meet quarterly targets.

Below are three examples of “gaming the accounting” from General Electric. I write about these specifically, not because I’m picking on GE, but because I used to work there. So, these are just my personal observations. ²

Gaming the Accounting #1 – Revenue Recognition

While at GE Appliances in the 1990’s, I noticed that periodically, a third of the parking lot would be occupied by semi-tractor trailers. The first few times I saw this, I really didn’t think much about it but after a few observations, I asked a colleague. I was surprised by the answer.

The explanation revolves around an accounting rule.

In accounting, a company must state exactly how and when it recognizes revenue. GE Appliances recognized revenue the moment the product was loaded on the truck for shipping. You can see where this is going.

This definition is common and works fine to determine when to recognize revenue… except when someone in finance gets the bright idea to use the rule to boost a quarterly result.

Some quarter in the past, the company needed to juice the revenue – perhaps it was slower than normal but more than likely, some executive’s bonus was tied to the quarterly financials (and perhaps he was leaving soon anyway). Regardless, someone figured out how to play accounting games – leased additional tractor trailers, loaded them full of product and parked the trailers out front parking lot. The process:

1. Load product on the trucks.
2. Count product as sold.
3. Recognize revenue.³
4. Shareholders happy.
5. Executive bonuses paid.

Over the next day or two, trucks would take the trailers from the parking lot instead of the shipping dock and the parking lot would return to normal.⁴

The convoluted part of this scheme – the company actually incurred additional expenses to lease the unneeded trailers and wasted labor to coordinate and load them. The company probably paid overtime for it as well (it was a union plant).

The irony doesn’t stop there because once this starts, the company must continue this practice in future quarters just to break even. I suppose they were waiting on a stellar quarter to cease this practice.

Impact on corporate integrity – definitely negative.

Gaming the Accounting #2 – Pension Discount Rates

In the 1990’s, General Electric was famous for hitting quarterly numbers with eerie consistency. If Jack Welch made projections for the next quarter, which he did, GE hit them. But how? How could a company so accurately predict its future performance?

GE was known for being a well-managed company. Speaking from personal experience, the company really was well-managed with some outstanding business leaders.

That said, one method GE employed to hit their earnings consistently, year-after-year, was to manage the expected return on future pension liabilities. Because pension payment obligations are many years into the future (on average), changing the expected return for the pension fund even by small amounts can swing the projected future pension valuations considerably. In this way, the pension could easily be either under- or over-funded.

Under GAAP rules, public companies are allowed to count gains from pension funds as operating earnings. To understand how this is manipulated, I first need to explain a bit more about self-funded pensions plans and the related accounting.

Warning – this next part could get boring for normal humans

Pension Plans

There are generally two type of pension plans: (1) a defined benefits plans – which the company promises to provide a certain fixed benefit for an employee’s retirement and (2) a defined contributions plan – where the company sets aside the contributions for each employee in a separate account and does not promise a fixed benefit.

In the first case, the company is liable for any shortfall. In the second case, the individual employee is liable for any shortfall for their own retirement needs. The issue is primarily with the first one – the defined plan – where the company manages a large fund that is invested and grows over time.

The company anticipates the fund will grow into the forecasted future pension obligations that the company has promised its current and former employees in their retirement. That is, the value of the fund today is smaller than the future payment obligations, but the fund is expected to grow into the needed amount of money promised as employees retire.

That’s the basics about the pensions. Now the accounting.

Pension Plan Accounting

To determine if the current pension is over-funded or under-funded, the company must:

1. Project the expected future liabilities to determine how much the company has promised to payout over time as its employees retire.
2. Forecast the expected growth of the fund over time based on how the money is invested. This is the “Discount rate” used to determine the required size of the fund in today’s dollars to meet the fund’s future obligations. Will the fund grow into its obligations? Will there be a shortfall or an excess in the fund?

The issue isn’t so much with the first point – projecting the future liabilities. For sizable populations (and GE’s employee pool is sufficiently sizable), future liabilities are well-understood, based employee ages and actuarial tables.⁵

The issue arises with point #2, discussed below.

Point #2 – GAAP allows companies to choose the expected rates of return for their pension plans, even if this value does not align with the current real rates of return. If the company selects a higher rate of return in its calculation for the growth of the fund, then the company will need fewer dollars today to fund those future, promised liabilities. You can see the temptation and misaligned incentives at play here. If a company simply nudges up it’s expected return, suddenly, the pension needs less capital today to fulfill the future payment obligations.

Said another way (in the form of discount rates) – GAAP allows public companies to select the discount rate to get the projected, future liabilities into present value. If the company chooses a higher discount rate to apply to the future obligations, the size of the fund needed today to fulfill those obligations is much smaller.

Because the projected liabilities are many years out, small changes in the discount rate produce significant changes in the capital required by the fund today. With such a long time horizon (decades), the required value of the fund in today’s dollars is very sensitive to the discount rate.

Back to the Story (Normal Humans Re-Enter Here)

With all that as a backdrop, how does a public company manage earnings in practice by manipulating the expected rate of return and the discount rate? Most annual reports will have a very small-font footnote buried deep in the back of the annual report that tells the discount rate the company chose to apply to pension fund obligations. At GE, this discount rate would change over time. Some small changes over time are perhaps legitimate as market conditions change. But a lot of the time, it is clearly adjusted up or down as needed to manage earnings.

How sensitive are pension funds to the discount rate at a company like GE? Looking at GE’s 2013 annual report,⁶ the company changed the discount rate from 3.6% to 4.85% and “earned” a cool $6.8 billion. That was easy. I quote:

Our underfunding at year-end 2013 was significantly reduced as compared to 2012 as the effects of higher discount rates and higher investment returns (14.6% return in 2013) more than offset liability growth. Our principal pension plans discount rate increased from 3.96% at December 31, 2012 to 4.85% at December 31, 2013, which decreased the pension benefit obligation at year-end 2013 by approximately $6.8 billion.⁷

If assumptions need to be changed to reflect reality, obviously, they can and should be changed. But this… hmmm.⁸

Impact on corporate integrity – dubious.

Gaming the Accounting #3 – Capitalizing Expenses

To hit our division’s quarterly numbers at GE, I remember that we were not allowed to expense anything one quarter.⁹

The accounting policy only allowed the company to capitalize items that cost more than $2,500. Amounts below this were expensed. As part of controlling expenses, the finance team encouraged us to ask our suppliers to raise their prices on certain items so we could buy them. If we needed a tool to continue operations and that item cost $2,200, we would have to embarrassingly ask our supplier to increase the price to $2,500. This made it a capital expenditure instead of an expense on the income statement and we could now purchase the tool. Sure, it actually cost more, but the company got to pay it out over time as the tool depreciated on the accounting books. Let the next guy worry about it.

Impact on corporate integrity – smaller, but still ridiculous.

Conclusion

Lack of integrity in accounting can undermine credibility. It also wastes time and resources.

Privately held, self-funded companies do not play these games. They try to maximize profits, not pretend by adjusting accounting… because there is no one to fool. However, for private companies with outside investors, the temptation exists to play the same sort of games.

We should not manage the numbers. Let them fall where they fall and focus our team’s energy on managing and growing the business instead.

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FOOTNOTES:

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1. I don’t even know if contract law actually states this, but the point here is that he subscribed to this thesis.
2. I should say from the outset that I enjoyed my time at GE. At the time, it was one of the great, global companies and I learned a lot while there. The following examples are not meant to be vindictive, accusational nor condemning. These are just my (potentially fallible) observations and the subsequent lessons I have extrapolated from them. I should also note that these examples are all 20+ years old and are well-past the statute of limitations. In other words, please don’t sue me because I’m not an accountant and I’m probably incorrect on all these points. Probably.
3. Technically, accelerate revenue.
4. You might say it was a post-sale inventory holding tank to smooth revenue (and thus earnings). Holding inventory costs money and ties up capital. Holding some product inventory is a normal manufacturing procedure… but holding “sold” inventory for pure accounting reasons, simply increases cost for no benefit (except to smooth earnings).
5. I spoke too soon. After some research, I noticed that GE in fact also changed their mortality assumptions in 2014 compared to the mortality assumptions it used in previous years. Apparently, even mortality rates are up for debate.
6. I originally wrote this in 2014 and I didn’t want to take the time to update my research. The point still stands to illustrate this concept, regardless of the year it happened.
7. General Electric 2013 Annual Report. “Postretirement Benefit Plans”. Page 36.
8. UPDATE October 2019 – according to CNN Business “GE is freezing its pension plan for 20,000 US workers… As of the end of 2018, GE’s pension plans were underfunded by $22.4 billion.”
9. GE even said that we should bring paper and pencils from home if we needed them at work.