Many years ago, the bookkeeper in a small manufacturing firm accidentally dropped one of the company's two adding machines when moving it from one desk to another. The equipment was so severely damaged as to be unusable. With trepidation, the employee approached the controller's office, knocked timidly, and entered when beckoned. Upon confessing the accident, the bookkeeper was asked, "Which one was it? The newer one or the older one?" When the answer was, "The older one," the controller's face showed a glimmer of a smile as he said, "There, there. You don't need to be so glum. That machine was fully depreciated, so your little mishap has cost the company nothing. Now get back to work."
This fable was heard by one of us a long time ago, in an introductory accounting class far, far away. It was told then to make the point that an asset's GAAP book value means nothing, even nothing at all, yet some managers seem to think that it means something, even everything. One would hope that the passage of many decades would replace this foolishness with more rational thought.
Alas, such is not the case, and the consequences aren't without consequence. The March 16, 2009, issue of Fortune presented a series of short comments from business leaders describing how they're managing in the midst of difficulty. Alongside the chief executives of other "Most Admired Companies," including Southwest Airlines, Coca-Cola, Johnson & Johnson and McDonalds, was Fred Smith, the founder-chairman-president-chief executive of FedEx. Smith's legend includes turning a poorly received term paper into a multi-billion-dollar flagship company. According to an interview in Business Week from 2004, there isn't much substance to that story, but it cannot be denied that he is reputed to be a quintessential entrepreneur with a propensity for bold innovation.
Despite this reputation, he said several things in Fortune that merit close attention and skeptical analysis. Before we begin, we acknowledge that it's likely that his comments were severely edited. If his meaning was radically changed, thank goodness. If not, well, judge for yourself.
FLEXIBILITY
In describing how FedEx is being defensive, Smith first said, "We built FedEx with a lot of flexibility to meet cyclical financial situations." There's nothing wrong with that, as long as the flexibility is real and helpful. Let's see how he explained the FedEx brand of flexibility.
* Compensation. Smith's first example is: "Management compensation is heavily related to company performance." In other words, one would expect managers to feel the pain when things start to go bad.
But this knife cuts both ways, and may even be a dull blade. The pivotal point, of course, is the definition of "performance." Is it a share-based measure, such that compensation depends on the stock price? Or is it a bonus system tied to (heaven forbid) GAAP earnings? Maybe it could be tied to EVA, or "Economic Value Added," which would be especially useful in a company with such a huge investment in capital assets. (More on this point later.)
In either case, there can be a lot of static and disconnects in the linkage between company-wide performance and the compensation paid (or not paid). Just exactly what can managers do on any given day to drive a huge company's operations? Perhaps they can make a difference in the long run, but maybe not. And it's certainly true that stock price and profits can be affected by essentially random events that have nothing to do with management ability, effort or creativity.
To put it succinctly, we doubt that cutting management pay in a downturn is the driving force behind the arrangement. Rather, we suspect the real goal is participation on the upside. And we suspect there is plenty of cushioning on the downside. For any who doubt, re-read the financial headlines for the past several months. Managers at many companies seem to be doing far better than the rank and file they oversee. We'd be remiss if we didn't point out that FedEx has laid off more than a few workers. Not to worry - it's part of the company's flexibility, we're sure.
* Free assets. Consider this next point, and think of the controller in the opening fable: "And when it comes to our capital equipment, we purposely have a number of airplanes that are fully depreciated. They're sort of our reserve fleet. When times are good, you pull those planes out and fly them, and when times are bad, you park them in the desert. It's free spare capacity."
If one of FedEx's aircraft was lost through a maintenance accident, we're sure that Smith would first determine whether anyone was injured. But we're wondering if he would hope it was one of those fully depreciated planes. If so, would he blithely accept the loss of a valuable asset simply because it had outlived someone's assumed useful life from many years back? Of course not, and neither should he act as if that fleet of ghost ships in the desert is free.
What would concern us the most, perhaps, is the possibility that he really thinks that flying a plane with zero book value produces no real cost. That "free" notion is just the artifact of a bad accounting method created who knows when and that no one in authority has had the courage to seriously question, much less propose replacing.
In fact, the Accounting Principles Board addressed cost- based depreciation in Opinion 6 a mere 44 years ago, but concluded that it was fine for now. We find incredible irony in these words from APB member Professor Sid Davidson: "Mr. Davidson agrees with the statement that at the present time 'property, plant and equipment should not be written up' to reflect current costs, but only because he feels that current measurement techniques are inadequate for such restatement. When adequate measurement methods are developed, he believes that both the reporting of operations in the income statement and the valuation of plant in the balance sheet would be improved through the use of current, rather than acquisition, costs. In the meanwhile, strong efforts should be made to develop the techniques for measuring current costs."
How could the leaders of the accounting profession have looked at this situation with a blind eye then, and how can today's leaders keep doing it?
* Return on investment. In addition, Smith must think it's perfectly fine to leave the fleet grounded when it's not needed. After all, if the planes are fully depreciated, he might think that they have no value and that there is no opportunity cost in leaving them on the ground. We hope his thinking is nowhere in that territory, but it sure sounds like it is.
In contrast, the management at Southwest Airlines is often commended for its relentless pursuit of operating efficiency. We expect they understand that a motionless and empty aircraft (regardless of its book value) is a complete drag on performance because it's an investment that is earning no return. We have no evidence one way or another, but we're confident that Southwest's folks are not lulled into thinking it's OK to park a fully depreciated plane for months or even years at a time. (And, if someone wants to say a leased plane isn't really an asset, they should read the recent discussion paper from the Financial Accounting Standards Board and the International Accounting Standards Board that proposes capitalizing all leases.)
If FedEx managers were to apply a more complete analysis, they would attribute a capital cost to those assets and more fully understand the economic impact of mothballing them. Whatever analytical model they use, it should not include a zero cost because they're fully depreciated for financial reporting purposes.
THE REAL BLAME
It seems beyond argument that Smith's thinking has been shaped by GAAP. And it's clearly beyond argument that GAAP depreciation falls short of providing useful information for either management or external decision makers. And it's way beyond argument that the fault lies with accountants, standard-setters and regulators for not putting this issue on the front burner and then pushing it to resolution. The same blame can be laid on academic accountants who refuse to do normative theoretical thinking and just keep teaching the same old stuff over and over again.
More than anyone else, we blame a management corps that doesn't know any better or, if it does, has no compunction about publishing numbers that are patently false.
It's even worse in Smith's case if he's using those bogus GAAP numbers in internal analyses.
Say it ain't so, Fred.
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 paulandpaul
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