Thursday, 13 March 2008

Industry Practice – Accounting Fundamentals – Growing Pressures to Massage the Books?

For some time (years infact) the automotive sector within ‘old world’ markets has gone through efficiency drive after efficiency drive so as to maintain control over escalating fixed and variable costs.

Whilst certain headwinds such as labour pricing and legacy costs have been battled and won, the never-ending pressure of energy fixed costs and raw-material variable costs constantly mount, the local US and European region ‘margins squeeze’ countered with on-going supplier re-negotiation and sales re-alignment away from fleet and rental. But in truth, private sale vehicle discounting still carries on to ‘shift metal’ and so improve turnover volume – especially in C & C/D segments - ultimately undermining the hard-fought wins achieved by the procurement negotiators. The pressure set to grow more intense as recession hits the US and Europeans take a firmer grip on their wallets, the only upside (if it could be called one) a consumer shift into small B sized cars. Some fortunates, like GME have claimed ‘success’ of their small and more affordable offerings as with the Chevrolet brand, which have admittedly kept European divisions in the black, but that’s only really relative to far poorer performing US cousins.

Though this is a general trend in the west, thankfully lacklustre sales have been offset by rapidly growing BRIC+ markets, even as Eastern Europe starts to slow. So whilst the likes of VW appears to shine – as with its latest record results – others like PSA and even BMW highlight cause for concern in a dropping, or at best flat, 2008 market.

This means that the HQs of European-centric automakers and foreign MNC’s European arms will once again look to see what fat can be cut out of their operations, but after what has been severe operational cost-cutting – also buoying local results – many like ourselves are concerned that there is little to extract from what are ostensibly lean profit centres. Indeed it has been a prior willingness to ‘right-size’ and ‘cost-down’ that has provided the positive margins to date.

Under such commercial conditions it is natural to ask the question “just how will the European arms keep constricting?”

As we’ve seen with GME many will seek to continue to out-source, not just standard back-office GA work, but also what were deemed as core activities such as portions of R&D and platform development work to both their supplier-base (offloading responsibility), to development project out-source specialists such as MSX International and of course ‘in-source’ to cheaper corporate engineering centres, primarily in Asia.

This takes care of the trimming of what were previously core ops, but once that has been done – possibly close to that point now – it may be a case that pressure is so high of legitimately (or otherwise) massaging the accounting methods and figures. As ever, creative accounting that can blur pure operational clarity tends to focus on:

1. Costs – ‘Capitalising’ and ‘Reserves’
2. Stocks – ‘Work in Progress’, ‘Inflationary Effect’ via FIFO to LIFO, ‘Altered Timing’, ‘Playing with Discounts’ & ‘Double Counting’
3. Off Balance Sheet Financing – the use of ‘Associate Company’ status
4. Depreciation – Loopholes closing

1. Costs -
Given that costs are such a large predetermination of margins, they will always be the arena that is open to a change in definitional interpretation and figure-work juggling across the Balance Sheet and of course impact upon the Profit and Loss Statement.

Even with the aforementioned out/in-sourcing of development work, the ‘capitalising’ of retained project costs – added to the Balance Sheet as an effective ‘Asset’ - may still be open to legitimate application and so removed from the P&L. The past saw abuses by the likes of British Leyland and Rolls-Royce Aero-Engines in the 1970s, so strictures were set and have been ever since through GAAP and IFRS, but being a legal process, it’s still open to plausible use.

A proper instrument open to management use for valid use, but can be abused in the allocation of costs. It spans aspects such as:

A. Loss-making contract(s) - often for specialist clients demanding greatly altered specification vehicles such as the military, where engineering development and final vehicle pricing don’t reflect actual costs
B. Bad debt provision - where a client may have gone bankrupt, into Chapter 11 or simply argue and refuse to accept and pay for work undertaken
C. FX losses - essentially hedges against foreign exchange currency movements.

2. Stocks –
‘Work in Progress’
Given that stock(s) are a prime indicator of profits, and are the singular direct inter-relate between the Balance Sheet and P&L, this area is open to re-interpretation of accounting methods, which inevitably allows it to be used as a reservoir against which additional costs can be drawn-off or pumped back.
As ever stocks of parts or complete cars can be counted not as pure stock items, but with a little re-invention, counted as work in progress and so discounted from stock quantities. Typically the auto-industry will create 2 separate, dedicated areas for ‘Work in Progress’ which stores:

1. Part-built assemblies - therefore extracting from parts stock
2. Unfinished Vehicles – therefore inhibiting from being included in vehicle inventory.

Item 2, often sees a build up of vehicles kept in Quality Assurance quarantine bays that are identified as requiring re-work. The quarantine bay has been known to reach the sizeable proportions relative to the automaker type (VM vs niche).

‘FIFO to LIFO’ -
In times of inflationary effect – as is definitely happening today [esp raw materials and parts] – the need to re-valuate stock worth (and so WiP costs and product price) is of course vital. So at such times there is often an accounting methodology switch-over from FIFO (First In First Out) to LIFO (Last In First Out), so that real (inflated) costs can be calculated and ideally passed-on to maintain margin. Under such conditions it greatly assists if a company can be a ‘Price Maker’ and not a ‘Price Taker’. Unfortunately for Tier 1 & 2s, they have historically been the latter, and may well continue to be as we see VMs such as GM assist the likes of Delphi in re-structuring.

‘Altered Timing’ –
Pushing costs forward into next year’s/quarter’s P&L can be done by taking the costs attributable to part-completed goods out of the P&L, and instead regard them as part of the value of stocks, not ordinary WiP. This obviously puts a greater pressure on next year’s (or quarter’s results).

‘Playing with Discounts’ -
As the name states, it is the ability to raise ‘sales’ by abusing high stock conditions through use of exceptional discounting. This can deplete stocks quickly and give the impression of impressive turnover, but does leave the inherent danger of saturating market demand for a set forward period and, if un-coordinated, see a massive cash-flow burn via rapid and unnecessary re-stocking, which will see liquidity effectively trapped and sat idle in the form of unmoving stock.

‘Double Counting’ –
Once again, as the name suggests, an unintended (though sometimes unquestionably intended) double-count of stock. In autos it relates more to finished vehicles sat in a manufacturer’s lot awaiting distribution and where company owned cars/trucks are not properly differentiated from customer paid/ordered vehicles awaiting delivery. This then leaves the door open to abuses of double counting and there have been stories where auditing accountants have been shown (with rapid reshuffling) the same vehicles time and time again!

3. Off Balance Sheet Financing –
Less of a problem for conventional automakers that simply assemble, and more open to abuse by high technology firms/makers who are able to take minority shares in ‘green-shoots’ R&D ventures that are yet to prove themselves. There have been cases of funds being transferred into such start-ups and incubatory small companies, whilst there is no legal requirement for them to be listed as a Group’s subsidiary, the minority stake giving them ‘associate’ standing. They may become only visible if/when they start providing dividends to the shareholding ‘parent’.

4. Depreciation –
Whilst people are under the impression that ‘Depreciation Charges’ can be abused carte-blanche, ever since the tightening up of regulatory loopholes through the 1980s and 90s Depreciation abuse (for want of a better term) has been limited, especially so in listed European companies that are far more closely watched and evaluated by “sell-side” and “buy-side” analysts.

Thus we see that the Costs and Stock aspects of the Balance Sheet and P&L are, as ever with legal regard, instruments by which analysts and investors can be proportionately misled.

We don’t of course state that western automakers will deploy illicit tactics, the likes of which we’ve seen in the past; but simply that come Q1,Q2,Q3,Q4 and EoY results, that equities and fixed income analysts may well be probing deeper into how the figures were legitimately calculated. As times get tougher, so historically we’ve seen, automotive companies have needed to be slightly more complex in their accounting methods. And as the € : $ FX rate maintains record levels and possibly widens, raw material costs rocket and inventories of cars look to swell, each and every automaker will be ‘sweating’ their accounting resource assets.