There are two basic types of accounting. What you’re probably most familiar with is called Cash Basis. In Cash Basis accounting, the amount of money left over at the end of the accounting period is the “profit,” or possibly “loss” if it’s negative. This is most likely how you do your personal finance. You may not think of it as accounting per se, but it’s keeping track of where your money goes over time, hopefully so you can make good choices with it, same as a business wants to do. Your bills most likely occur each month, so it makes sense to plan around how much you’ll make that month (your personal “revenue” line), then deduct out bills (“expenses”) and choose what to do with the rest – save, spend, invest, etc. There are only so many fundamental things you can do with money, and your list – spend, save, give, invest – is the same as a business.
Cash Basis is used in the business world, but it’s exceedingly rare, perhaps absent, among publicly traded companies. Instead, they Accrual Basis. With Accrual Basis, revenues are counted as they areearned and expenses counted as they are used. Why? Companies almost always have big investments that need to be made that would distort the trending performance of their business. The simplest example is a building. If a company buys a 100 million dollar building, it’s going to destroy the quarter they did that in, because it’s a huge one-time expense. But then, as they use the building, it seems to be free – until they have to do maintenance, or expand their property, or anything else. Cash basis would result in huge spikes and dips in profitability, and wouldn’t really represent the ongoing nature of business. Instead, Accrual Basis would depreciate their owned assets as they’re used, smoothing out the cost of a building, or expensive equipment, over the course of its useful lifetime. That lets us compare the cost of the stuff against the revenue that it helps us generate over time. This is actual, useful, relevant data.
There’s no question that Accrual Basis is superior for most businesses of reasonable size. There’s also no question that it leads to some interesting complexities that can confuse people without an accounting education… like, you know, most of the employees of most businesses. In today’s lesson, I want to talk about just a few of these concepts that seem to “distort time.” Hopefully after this, you won’t have to ask yourself, “With all these deferrals and catch-ups and depreciations, what actually happened this quarter?” It really does make sense, but you can’t be blamed for thinking it’s not clear. Let’s work on closing that gap, using a few common time-distorting concepts to illustrate.
Deferred Revenue
Another named for Deferred Revenue is “Unearned Revenue.” All this means is that somebody paid us in advance for work that we have yet to do. We don’t want to account for it in our profits and cash flows just yet, because it would make the quarter we were paid in look really good, but then as we do all the work over a number of quarters, it will drag all of those quarters down. This is a good reason to generate an “Adjusted” figure to better represent the trend, rather than all the ups and downs that are more random. See the example below:
Here, we’re paid $192M up front for work that we have yet to do. Sure, we’re heavy by $192M in cash, but if we account for it all now, we’ll be appearing to do work “for free” over the next several quarters. We chose a slightly annoying time distortion by using deferred revenue over a performance wrecking cash-basis method where we would have a big quarter now, but be $50M worse off for each of the next 4 quarters.
Just to even things out (like in all math, your equations have to balance), we will add $192M worth of liabilities to offset the advanced payment cash. Liabilities are most often thought of as debts; all debts are liabilities, but not all liabilities are debts. Some liabilities are services that we have to provide, as in this case. See below (read right to left for chronological order):
You’ll notice that the difference isn’t exactly $192M, since this is the growth in deferred revenue over a whole year (Dec 2014 to Dec 2015), but that $192M is in there prominently. Since that revenue is considered a “liability,” we can claim it as a benefit whenever we feel appropriate by reducing the deferred balance to equalize whatever gain we want. We’ll use this to claim profits as we actually produce the products we owe the customer, resulting in a more accurate depiction of our performance on each unit.
Deferred Inventory
Alright, deferred revenue was the slow pitch to start. Another major type of deferral that we hear about often is Deferred Inventory. This one is a bit more complicated… I’m gonna have to use a shoddily hand-drawn graph, so buckle up.
Deferred inventory is a feature of large-scale manufacturing. In the earnings calls, you’ll hear a lot about “accounting blocks” and “learnings curves.” This is because the first time you make a massive, high-tech product like an airplane, well, you kinda suck at it. We do our best to estimate how many units need to be produced before we start sucking a little less, then a little less, and so on, until we really hit our stride. Each of these ranges of less-suck-ness may become an “accounting block.” As in, we really suck on units 1-20, suck a little less on 21-40, and after 100 or so we’ve actually gotten pretty reliable and good. This is because we’re progressing down the learning curve over the entire course of production – across and within accounting blocks, we hope to be getting better at what we do.
When we take on a major project, we’d ideally like to estimate the overall profitability of the entire program. From beginning of design to last unit off the press, how much money will our company make? Those estimates exist, and deferred inventory, along with forward losses and catch-ups, is how we adjust those estimates to reality. Let’s dig deeper.
So what is deferred inventory? Time for the first shoddy drawing:
In a sentence, deferred inventory is the difference between how we really performed and how we expected to perform. Our estimate for line unit (S/N is for serial number above) 12, say, is based on some assumed learning curve. If unit 12 costs more than we expected it to, that overrun is unit 12’s deferred inventory. It’s added to the deferred inventory balance for the program.
Deferred inventory will metaphorically sit there and rot (unlike physical inventory, deferred is “just a number”) until we make a unit that costs less than estimated. If we do better than expected, it reduces the deferred inventory balance.
Now the trickier parts. If we believe we will never, over the entire course of the program, make gains that will deplete some of the deferred inventory, we have to write it off as profit we won’t ever earn. This is what’s known, affectionately, as a “negative cumulative catch-up,” or “forward loss.” The counter to this is the positive cum. catch, in which we beat estimates by more than we ever thought we would, and we can write additional profit.
Hopefully, that helps clarify what’s really going on when the analysts and executives talk about growth in deferred inventory, or deferred cost per unit. They’re talking at the absolute highest levels of any program. The deferred inventory balance is a measure of our overall performance on a per-unit, or at least per accounting block (several unit) basis. And the forward losses/catch-ups are adjusted profitability for the lifetimes of whole programs. So it’s quite a big deal.
Again, if it seems confusing, or manipulative of the numbers… well, it is. But it’s the best way to resolve some of the complexities of accrual basis accounting applied to large-scale manufacturing, and accrual basis really is the superior method of accounting for large businesses. It’s not complexity for complexity’s sake; it’s complexity that exists to represent reality as best as possible in a very complex situation with many moving parts.
Depreciation
Okay, so the heavy stuff is over. Let’s look at one more quick example and call it a day. One of the big three financial statements is the Statement of Cash Flows. It can be a little weird the first time you encounter it, because it works backwards from net income, adding back in expenses until you get to cash flow from operations. In other words, you’re adding money you spent; ordinarily you expect to subtract it.
Whatever. There are two basic kinds of costs in business: variable and fixed. Variable costs are those that depend on how many units are being built. Simplest example? Hamburger patties are a variable cost. You need to buy one patty for each burger you sell. Fixed costs are the “barrier to entry” items. The grill you cook a burger on is a fixed cost. You need it to get in the game.
Each type of cost has its advantages. Variables costs are nice because they’re flexible. You can get exactly as many burger patties as you need. On the downside, you don’t ever escape those costs. The variable cost of burger #1 is the same as burger #1,000,000. Fixed costs kinda stink because they’re often costly up front, but they benefit massively from repeated use. A grill makes burger #1 very expensive to make (cost of a patty plus an entire grill), but by burger #1,000,000, the fixed cost component gets divided out over a million units and is basically free.
When businesses have to make big, expensive, up-front purchases like buildings, machinery, tooling, equipment, etc., it can absolutely wreck their financials for the period in which they bought it. So, while the cash hit happens whenever cash changes hands, the profit can be smoothed out using depreciation.
There are many different methods and approaches to calculating depreciation, but it doesn’t really matter for illustrating the point: by “distorting time” with depreciation methods, the overall trend of profitability can be shown instead of a huge loss up front followed by gains. If the restaurant estimates that their grill will last 5 years, they can assume reasonably well that by depreciating the grill’s cost over that time frame, they’ll get a pretty accurate measure of profit as they move along. Depreciation prevents burger #1 from showing up on the profit and loss statement as costing $600, and instead makes each burger, from #1-#1,000,000, cost about the same.
While accrual basis accounting can have some funky features like those listed above, you can pretty easily build a case for its superiority for larger businesses. If something doesn’t make sense, look for how it affects the timeline and the trendline of the business. And if you can’t quite figure it out, well, you can always defer the topic to another day.