October, 2000

Fruits of Thought

Loose Accounting

The recent collapse in the stock price of Priceline.com and the closing of its WebHouse.com affiliate – that’s the company slated to revolutionize grocery sales by applying the Priceline name-your-own-price formula to food items – makes it an appropriate moment to look carefully at the accounting practices of public companies.

I became interested in this area years ago when a public company in the produce business wanted to buy a grape ranch. The company had a peculiar requirement: It wanted to buy the ranch on the day before the crop was ready to be harvested. You see, the company intended to buy the ranch inclusive of the ready-to-harvest crop and list the entire purchase price as an asset on its books.

In effect the company would have been capitalizing all the costs of raising that year’s crop. This would have had the effect of making the company look exceptionally profitable that year. When I inquired about the dangers of making the following year’s earnings look bad by comparison, I was told the company hoped to buy two ranches the following year and do the same thing.

That incident illustrated how private and public companies really do differ. Most private companies look for legal ways to reduce their taxes, but many public companies generally want to show higher earnings in the hope of boosting the stock price.

In many cases, the way this is done is such that it is extremely difficult to understand what the financials of a company actually represent. Boston Chicken, for example, had a very complicated financial statement. What Boston Chicken did was find other companies to be “Master Franchisees” in whole states or multi-state territories. These companies actually operated the restaurants, and because Boston Chicken did not own these companies, their financials were not consolidated. These franchisees paid Boston Chicken franchise fees and royalties that Boston Chicken took in as revenue.

Here is the rub: the restaurants never made money and the franchisees didn’t have the capital to pay these fees, so Boston Market lent the franchisees money to pay to Boston Chicken.

All this machination did was to keep the money-losing restaurants off the P& L statement of Boston Chicken, but it couldn’t change the fact that all the money had to come from either profits from restaurants or investors in Boston Chicken. When the profits never came and new investors couldn’t be found, the whole thing collapsed.

The big high-tech companies are expert in playing these games. Priceline.com tries to make itself look bigger than it is by reporting as revenue all the sales prices on airplane tickets, although travel agencies traditionally only report their commission as revenue. Legally Priceline.com may be in the clear since its arrangements with the airlines allow it to hold a ticket in inventory for a nano-second before it resells it to its customers. But substantively, Priceline.com takes no inventory risk as it sells every ticket before it buys it from the airline.

Amazon.com took a page out of the Boston Chicken book. What Amazon does is find companies that want to market through Amazon.com’s web page. One of these companies, Living.com, sold furniture and has just closed up.

Amazon would invest money into companies like Living.com then the companies would pay Amazon.com a fee for the use of Amazon’s website. So Amazon would simultaneously gain an asset (the investment in the new company) while goosing its own earnings (the fee from the company). But it was all Amazon.com’s money to begin with, and there was no evidence that these other companies would have paid Amazon.com the same fee if Amazon didn’t invest. So the effect was to overstate earnings.

At least all these things are there if someone studies the financials closely enough. But some items require one to be as much a psychologist as investment analyst. For example, Priceline.com’s shares have been falling for a while – so much so that options Priceline.com had given the airlines for cooperating with it are under water. Then just recently, Priceline.com announced that sales of airplane tickets wouldn’t meet expectations. These two things are not unrelated.

Priceline.com depends on getting good prices from the airlines. If airlines hold in the money options, the airlines in effect own a piece of Priceline.com and have every reason to help Priceline.com. But when the options are so worthless as to be meaningless, the airlines lose that incentive. Thus they don’t provide Priceline.com with good deals; thus sales don’t meet plan.

Accounting for employee options is in general a disgrace. When a company gives an employee an option, it is giving him something of value, and the dilution of a company’s stock is a real cost to its owners. Yet most stock options are not considered an expense. Though currently legal, it is also bizarre and deceptive. While the stock market was booming, people ignored this problem, but now more attention is being paid.

Whether it is considering how to hand out credit or looking at the solidity of potential marketing partners or planning one’s personal investments, this much is clear: beware of loose accounting. The mindset revealed by fast and loose accounting tells a lot about the goals of the company and the people associated with it. It shows a preoccupation with market perception rather than business fundamentals. In the go-go times, maybe that is easy to overlook, but in the end, the truth will come out.  pb