Sometimes You Have to Look At Accounting

One of the things you should learn in business school is the differences between accounting and economic numbers.  You never make a long term business decision based on accounting numbers.  You have to look at costs and opportunity costs.

An aside, government people make this mistake all the time.  If there is a stream of cash, and they want more revenue they think if they increase the tax rate, or slap on a tax the change in the tax will equal the revenue imputed.  Hence, a lot of folks in Chicago think that if you slap a 9.5% personal income tax on people that you will get 5.05% higher tax revenue than you do today with our existing 4.95% tax.  Any logical person knows it doesn’t work that way and human behavior changes.

That’s why accounting numbers and economic numbers are very different.

At the end of the day though, accounting numbers make a difference.  It shows what happened.  Because there is room to wiggle inside the Financial Accounting Standard Board’s rules, and because there is a bit of wiggle room in generally accepted accounting principles (GAAP), companies are allowed to make certain judgements that affect how they show their performance.  If they use sleight of hand, it works until it doesn’t.  We are starting to see that in two major companies with very different lines of business.

Sears is finally going to declare bankruptcy.  Killed not only by Amazon, but by mismanagement a long time icon is going to finally go away.  They cannot pay their debt.  I don’t know what the lenders saw, but anyone with common sense and logic could see this coming from a mile away years ago.  Sears pursued the Monty Python Black Knight strategy to survive and it never works long term.

The other more interesting development is Tesla.  My friend at Streetwise Professor Craig Pirrong has written about their demise for a while.  A friend of mine passed this blog along to me and I found point four interesting.

Problem #4: Q32018 May be Tesla’s High Water Mark

Which brings us to the 3rd quarter results, which should be announced in just a few weeks.  Musk has been vociferously promising for months that Q3 and Q4 would be GAAP profitable and cash flow positive.  He went so far as calling out the Economist Magazine for having the temerity to suggest that this did not sound realistic.

Perhaps as a result of this very public commitment, Tesla has very clearly pulled out all the stops to really juice the third quarter.  For example:

• It carried over a lot of inventory from Q2 to be sold in Q3

• It has mined its order book to find all the folks who have ordered the most profitable cars.  It abandoned the promised first-come-first-served manufacture-to-demand approach to focus on batch producing cars for those who ordered the highest margin versions.

• It has mined two years of orders and sold them all in one quarter

• It has reportedly done a sale and leaseback of all its demonstration and loaner fleet

• It has reportedly taken full payment from multiple people for the same car, delivering it to one person and holding the money from the other for a 4Q delivery.

• It has stretched out the time it takes to repay deposits for cancelled orders to 45 days

• It has stretched its payment to vendors, resulting in a number of vendor complaints.  As a result its net working capital has gotten more and more negative.

• It has had special end-of-quarter sales of inventory

• It has used expensive promotions (e.g. free Supercharging for life) that it promised earlier not to use again in order to move inventory at the end of quarter

• It has switched to batch production from produce to order in the factory, presumably to cut costs and increase throughput but having the effect of creating inventory for which there is no current buyer.

• Once it was too late for manufactured cars to get sold in the quarter, it cut way back on production in the last days to conserve cash.

• Tesla has some undisclosed number of government ZEV credits it can sell, which would lead to a one-time increase in profits and cash flow.  Tesla takes advantage of a loophole in GAAP accounting to leave these off their balance sheet, presumably so they can act as Musk’s personal burn-the-shorts slush fund.

You can pass it off until you can’t. Tesla’s day of reckoning may be nigh.

Moral:  Don’t mess around with your financial statements.  Take the pain now. Much better than later.