A key characteristic of a thriving discipline is its willingness to put aside old tenets that no longer produce useful results. Likewise, a key characteristic of a dying discipline is its clinging to old tenets that obviously aren't working.This notion certainly applies to financial reporting as it's practiced today. In too many situations, practitioners keep applying old generally accepted accounting principles to current problems, and the result is ineffective accounting. For example, today's rules for treasury stock were published in the 1930s. Despite seven decades of ever-increasing sophistication in capital structures, accountants keep accounting for massive buy-back programs as if the company bought a few shares to hold for a while and then resell.
Another example is GAAP for convertible debt. Under APB Opinion 14, issued in 1969, convertible bonds are accounted for as if they are not convertible at all, and as if the nominal interest rate is the real deal. In today's world, companies create such sweet conversion ratios that some convertibles are sold at par, even though they have a zero or a near-zero face rate. Accountants blithely put them in the debt section at face value and recognize no interest expense. To repeat, what nonsense! In both cases, applying very old solutions to current problems produces bad financial statements.
HERTZ GLOBAL HOLDINGS
We recently encountered the 2006 10-K filed by Hertz Global Holdings Inc., the first since its public offering last fall. The company operates or franchises the ubiquitous car rental agencies found in every airport, and other places. Hertz has an unusual past, moving back and forth from public company to wholly owned subsidiary several times. Until late in 2005, it was owned by Ford; at that time, it was divested to a consortium of private equity interests that bought it to buff it up and sell a portion of its shares to the public.
Although Hertz has diversified by renting industrial equipment, its car rental business dwarfs that segment. In running this business, Hertz obviously must have a large fleet of vehicles. Further, to please its clientele and minimize its maintenance exposure, the company "buys" (wink, wink) new cars for its fleet primarily with repurchase agreements that require it to "sell" (wink, wink) them back to the manufacturer at a guaranteed price. Notably, the average service life is only 10 months.
THE HERTZ FLEET
Hertz's managers report the fleet on its balance sheet as a non-current asset called "revenue-earning equipment." We find fault with that treatment, because the fleet is a current asset due to the fact that its utility is consumed within a year. Further, we disagree with reporting the fleet at "cost" less accumulated depreciation, where "cost" is the full front-end "purchase" price in the repurchase agreements.
What we see is misleading accounting, because an old solution is being applied to a new problem. Reporting assets at cost less depreciation is an expedient that is supposed to provide an idea of the gross investment in productive capacity and how close the company is to having to replace its assets at the end of their service lives. Because accountants and auditors have a phobia against reporting actual values, they expediently assume a systematic decline in value, and recognize the annual reduction as depreciation.
Accordingly, we have serious reservations about the merits of reporting any long-term assets at depreciated cost. However, we think it's essentially a sham for Hertz to report its fleet in this outmoded conventional manner. Because Hertz hasn't really bought cars, it shouldn't report them as non-current assets. What it has acquired is the right to use the cars for a fixed short-term period for a fixed price. To provide useful information, the unexpired portion of this net amount needs to be reported among the current assets.
Instead, the management and the auditors are forcing this fleet into fixed-asset GAAP like a square peg into a round hole. In doing so, they send signals that the calculated book value is the residual of an allocation process that assumes that the assets' original cost will be consumed down to a small salvage value.
Hertz simply has no business applying this inferior expedient method of avoiding interim valuation. Why not? Because it knows in advance exactly what it will be "selling" the cars for within the next 10 months or so. Management absolutely doesn't have to go through the charade of acting like it has estimated this cost as if they don't know when they'll dispose of their assets or at what price. The old solution simply doesn't apply.
MORE BAD ACCOUNTING
What hit us squarely between the eyes is that for Hertz, depreciation is a cash expense. It's not an estimated allocation of an unknown cost over a predicted life. Rather, it is the known cash sacrifice incurred to use the vehicles over a known life. The fleet is no different from other prepaid expenses like rent and insurance.
Why does this matter? Because Hertz's management presents the so-called depreciation in the conventional antiquated manner on the cash-flow statement. Like a doctor applying a leech to a sick patient, instead of administering antibiotics, management adds depreciation back to net income to indirectly estimate operating cash flow. For 2006, $1.8 billion of depreciation expense is added back to $0.1 billion of net income on the way to producing a $2.6 billion measure of cash from operations.
But what if depreciation is really a cash expense? Then it should not be added back to the net income at all. In Hertz's case, treating depreciation as a cash expense would cause the reported operating cash flow to drop to a relatively anemic $0.9 billion, less than one third the inflated amount presented by applying the old expedient solution to a reporting problem where it doesn't work, as shown in the accompanying table (see box on page 15).
INVESTING CASH FLOWS
The muck gets deeper down in the investing section of the statement. By pretending that the vehicles are long-term assets, management reports their alleged purchase as an investing outflow and the proceeds from the repurchase agreements as an investing inflow.
For 2006, Hertz dutifully reports $11.4 billion as paid to acquire the fleet, and $9.6 billion as an investing inflow from disposing of the fleet. Note that the difference is $1.8 billion, essentially the same as the "non-cash" depreciation.
These bad policies make Hertz look like it is trying too hard to buff up its cash-flow results. Like a used-car huckster, the cash-flow statement unctuously proclaims that Hertz generated $2.6 billion through operations and had a net investing outflow of $2.3 billion. This pair of numbers makes the car rental business appear to be a cash cow, while implying that management consists of foresighted entrepreneurs preparing the company for its future by spending huge amounts of cash on the resource base.
NO, NOT EXACTLY
When we apply our new solution, we see an entirely different picture. By classifying Hertz's "depreciation" as a cash expense, the reported operating cash inflow is cut to a relatively skimpy $0.9 billion and the net investing outflow to a dismal $0.4 billion. This change shows that the company is barely scraping by, and that management is making only a minuscule investment in the future.
THE BIG PICTURE
We think that this case demonstrates once again the issue about the Financial Accounting Standards Board's proposal to do away with Rule 203 exceptions so that only published rules are followed, regardless of how old and inapplicable they are. With one eye closed and the other one squinting, it's possible that Hertz's accountants and auditors could pretend that the company is buying long-term assets and depreciating them over a predicted useful life, in which case GAAP requires the treatment they used.
But if their eyes were open, they would see that this terrible accounting for the assets produces outright misleading information. And if management understood what they were doing and did it anyway, we don't think it's a stretch to say that they might have knowingly presented false and misleading information.
Instead of shutting down any departures from GAAP by eliminating Rule 203 exceptions, we think FASB (and the Securities and Exchange Commission, for that matter) ought to be encouraging managers to approach financial reporting with their eyes open, finding ways to provide more complete and useful information.
Of course, some would see that as an opportunity to buff up their images, but it won't work any better for them than it will for Hertz, because the markets inevitably see what's beneath the bright, shiny exterior.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at email@example.com.
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