Pontifications: Is the end in sight for program accounting?

By Scott Hamiltn

By Scott Hamilton

Oct. 26, 2015, © Leeham Co.: Is the end of program accounting, the staple of The Boeing Co. profit and loss reporting, on its way out?

It is in Europe, where it is called contract accounting, the end of its use is required by January 1, 2018. (LNC’s Bjorn Fehrm has talked about contract accounting in the past.) Companies have the option to eliminate it in 2017.

The fundamentals between contract and program accounting are similar: defer costs of the goods or services, and recognize profits sooner.

Europe’s International Financial Reporting Standards (IFRS) 15 says this has to stop.

Agency Partners of London, on a September 11 research note, focuses on Rolls-Royce and its linkage of engine sales with long-term service (LTS) contracts to report profits that otherwise would be elusive for engine sales only.

The analyst group estimates RR EBIT (Earnings Before Interest and Taxes) would be reduced by more than 20%. RR is currently delivering engines at about a 10% negative margin, and has the LTS contracts linked to make up the losses and future profits on the Maintenance, Repair and Overhaul (MRO) deals.

This approach has been common in commercial aviation for decades, and engine OEMs have increasingly sought to make service agreements a solid profit center.

Complying with IFRS 15 also means the RR (and other companies) will require restating prior year results.

For RR, which had been under financial pressure for many years, compliance will be a mixed bag. The balance sheet and profit-loss figures will take a hit, but, Agency Partners note, showing losses will enable management to better make the case to employees about wage cuts and give-backs.

“…[R]eported profits kept on rising, hence it was hard to make the case that RR had a problem that needed addressing. RR has said more recently that it welcomes the change, which converges reported profits with cash flow, as it better reflects economic reality,” Agency Partners writes.

A New York analyst told me last week he believes Boeing will have to comply with the new standard because it does business in Europe. Internet information indicates that this is true for any Boeing subsidiaries based in Europe, but it’s not clear to me (based on what I found) that The Boeing Co. will have to dump program accounting by January 1, 2018. According to a Q&A on IFRS, US companies don’t have to follow IFRS; the US accounting standard, GAAP, is more detailed.

Boeing has disclosed its Boeing Commercial Airplanes P&L for year under unit cost accounting rather than program accounting; it’s in the financial filings and it’s on the website.

29 Comments on “Pontifications: Is the end in sight for program accounting?

  1. So, a quick check shows that since 2010, Boeing reported 28 bUSD earning, where they only recieved 1.5 bUSD…

    Who finances the difference?
    that’s a 26.5 bUSD hole that needs filling by someone, doens’t it?

  2. “…[R]eported profits kept on rising, hence it was hard to make the case that RR had a problem that needed addressing. RR has said more recently that it welcomes the change, which converges reported profits with cash flow, as it better reflects economic reality,” Agency Partners writes.

    Which of course begs the question why they were using programme/contract accounting to begin with, seeing as it was never compulsory.
    We all know the answer of course.

    If, all of a sudden, wage cuts are necessary despite posted profits having steadily risen over the last few years, all of this means
    a) those profits were fake to begin with, which begs the question why programme/contract accounting was ever legal to begin with

    or

    b) the profits were (somewhat) real, but any excuse to cut wages and thus increase profits further is welcome

    or

    c) a combination of a) and b)

    It’s an odd world we live in.

    • Years back I was on the cutting edge of that logic.

      Company put out a personal satisfaction review of the company performance. .

      When we got the results it said that we hated the fact that if we really really did good (and they held you to the grindstone) you could get a 15% raise.

      Huh, now if there ever was a turn around of biblical proportion that was it, everyone listed the possibility of a good raise for performance as one of the big plusses.

      No one else did but I was grinding my nose off and was getting 10 to 12%. The really good ones got 6 or 8% (I was in a new area and doing very well at it so I had a great opportunity)

      So of course I would not want that, that’s simply insane, of course I don’t want any raises, that’s almost communism I mean.

      The final killer was that in order to get a raise you had to exceed your previous standards, not company standards.

      Of course when it came to attendance I had a perfect year, I finally told my boss I could maybe die and then come in and that would set a new benchmark.

      Sad state of affairs for sure and its gone downhill ever since.

      • ?!?
        Not sure I understand what you’re getting at.
        Nobody said anything about anybody having anything against raises, even personal performance-based ones?

        By the way – I have a contrarian story to yours to tell. My team in general and myself in particular were absolutely up the walls with work, and doing a great job of it, too, as everybody from our direct manager to the VP were saying. Except – raises were cancelled completely that year because profits didn’t *rise* quite as much as had been hoped for (the company still wasn’t anywhere near the red). So much for raises based on personal performance, then. Don’t think this was made up for when, the next two years, profit expectations were exceeded.

        • Erm, I think your stories are largely agreeing with each other.

          Basically executives will f_ over anyone to get a little bit more short term profit and hence bonus for themselves. Damn the employees and damn the long term sustainability of the company.

          • Erm, I think your stories are largely agreeing with each other.

            Ah – excellent. I blame it on lack of coffee in the morning 😀

  3. Lies, Damn Lies and Quarterly Reports…….

    Program Accounting and Unit Cost accounting are good ways for a company to understand how a program is contributing to, or taking away from, the company bottom line in a forward looking holistic manner.

    They are [edited as violation of reader comment rules] when used as a means to pump paper profits for short term stock market (and hence executive compensation) gain.

    These [edited], which materially benefit corporate executives, materially harm outside and unsophisticated investors. Certainly ethically they are fraud, however it is a kind of fraud endorsed by our government because their corporate overlords have paid them to write the laws to allow it.

    • “Program Accounting and Unit Cost accounting are good ways for a company to understand how a program is contributing to, or taking away from, the company bottom line in a forward looking holistic manner.

      They are [edited: violation of reader comment rules] when used as a means to pump paper profits for short term stock market (and hence executive compensation) gain.”

      Bilbo nails it in my opinion.

    • apologies for the violation of content rules. I shouldn’t have used a dirty word.

    • Bilbo – spot on. It practice rewards the current execs and boosts bonuses, but defers the real costs to a future management team.
      Kind of like a legal pyramid scheme. In a few years time, when the deferment ends, the company’s shares will be a lot less than it is now.
      What is alarming is the view that the 787 is being produced at around $31m loss per unit (Leeham figures). There are no future orders at the moment for 787’s that can be produced at a profit. I think I read that Boeing needs to find around 200 additional 787 orders (still loss making but diminishing) to fully overcome the programme costs. Thank goodness for the 737 cash cow. I could say the 777 output was healthy, but the lean years are coming.

  4. I wonder if program accounting is viewed by the corporations as fanning the system to justify R&D and long term investments in a regulatory and fiscal environment that focuses on short term profit.

    Boeing, for example, should not count standing up a new supply chain and some of the assembly infrastructure in SC as part of the 787 program…

  5. ‘Complying with IFRS 15 also means the RR (and other companies) will require restating prior year results’

    That should be interesting reading.

    So the upshot of all this if I have read it correctly is that Airbus will be required to revert to normal accounting very shortly after adopting Contract accounting for the early A350 aircraft. This seems ridiculous, didn’t the accounting chaps in Toulouse realise this was in the offing when adopting their new accounting policy?

    It will be interesting to see the sort of impact of such a change on the bottom line. It appears that these early plastic planes are considerably more expensive than they were expecting and this is putting accounting staff under considerable pressure to match these costs to future revenues.

    Will the change in accounting rules have an impact on the willingness for the OEMs to invest in these massive projects and does Boeing now have a clear competitive advantage in having the scope to do so?

    Program accounting for the B787 has allowed Boeing to avoid something like $31Bn in deferred costs in the past 5 years. It is rolled up into the future protecting the short-term bonuses of Boeing staff and allowing for such financial engineering as share buybacks to be perpetuated.

    • Airbus is only using contract accounting for the first several deliveries.

      • Using program accounting looks bad to many readers just because it is en essence dividing the cost of a product into many years as not to drag down profit in for the first few years the program is coming to fruition. Looking at it that way, is understandable to think of it like that, but this expenses will not just disappear into thin air. it is carry forward till is accounted for or written off as a loss. If for example Boeing had not used program account for the 787 from the time Jim Mcnerney became CEO of the Boeing company, he would be running a highly unprofitable company for many years of his reign, even though those charges most likely had nothing to do with decisions taken by him.
        Or looking at it another way, the new boss of Boeing would be running some pretty good years ahead of him for something he won’t have to do much for if those charges for the B787 were already sunk and not dragging future profits in the process. So, I do not see it as something as bad as it seems, if they keep it going as it is, they will either make a profit on the program and celebrate or just write off whatever it is they know it won’t be recovered for this program. I don’t know how this will give a company an advantage other than for stock prices in the short term. Does that make a company less or more competitive? Hey nobody is making you buy stock for any company if you don’t want to.

        • Well put Oscar.

          People after reading this column should read
          Bjorn’s excellent piece on accounting

          https://leehamnews.com/2015/09/11/bjorns-corner-production-costs/

          It’s very illuminating…

          “Program Accounting gives the external observer a good idea of the real production costs in the aircraft industry.”

          “As the practice leads to the company presenting the deferred costs each quarter combined with statements of how fast the cost breakeven point will be reached, Program Accounting enables an analysis of the production costs that normal accounting does not allow for.”

          As investors can already account for “sunk” costs” this is more valuable for predicting the future cost and profitability. There is nothing inherently wrong or dishonest with this method as some seem to believe.

          • Hi Geo

            I must disagree. The fundamental aspect of reporting is to consider the financial health and performance of the company as an entity and not as individual programmes. As such the critical issue of whether a company is generating return overall is of more importance than the understanding of different programmes and their contribution. If we look at Boeing we could argue they have two massive cash cows in 777 and 737 and one large user of funds in 787 (ignoring other bits and bobs). As a result it would be reasonable for Boeing’s cash generative products to cover the investments of the new products.

            The critical problem of program accounting is that it allows the company to decide when profits are generated and brings the potential to book profits forward.

            I would argue that companies should be allowed to account for program matching as a subsidiary report to provide the information that you want. At the same time they should not be allowed to mask the underlying financial performance of the company by smoke and mirrors.

          • Program accounting violates the first rule of an independent audit. Nobody who is independent can judge if the accounting block and expected learning curve is realistic. Probably anybody able to pass judgement on Boeing´s claims works for Airbus, and vice versa for the small program accounting used on the first few A350s.

        • Looking at it that way, is understandable to think of it like that, but this expenses will not just disappear into thin air. it is carry forward till is accounted for or written off as a loss.
          Nobody said the cost was going to disappear – but it’s effectively hidden. It allows shareholders today to profit from profits that haven’t actually been generated yet, while future shareholders may get hit with losses that were actually incurred today.

          If for example Boeing had not used program account for the 787 from the time Jim Mcnerney became CEO of the Boeing company, he would be running a highly unprofitable company for many years of his reign, even though those charges most likely had nothing to do with decisions taken by him.

          So? What would be the problem with that?
          Nobody would be stupid enough to blame somebody for their predecessor’s mistakes, and there’s no natural right for a CEO to post a profit just because “it wasn’t his fault”.

          Look at it the other way – assuming McNerney was to blame for the 787 disaster, programme accounting would still allow him to post a profit. If necessary, he could adjust the accounting block.
          Also, with programme accounting, costs incurred but spread out by one CEO could lead to a loss for his successor, or even the successor of the successor, if the forward-looking prognoses about cost and income for, say, the 787 don’t develop as expected.

          Imagine programme accounting had been used for the A380, for instance. It would basically mean that about now, Mr Enders would get hit with the deferred costs of that programme, which isn’t selling in the numbers anticipated and took much longer than anticipated to turn a profit per frame sold. Even though Mr Enders had no hand in launching the A380 to begin with.
          Instead, the additional cost got written off almost immediately, which led to a stock price plummet – and a pretty big shake-up in Airbus/EADS leadership. Which was a good and healthy thing.

          “Does that make a company less or more competitive? Hey nobody is making you buy stock for any company if you don’t want to.”

          Problem is that programme accounting can make the whole thing very, very intransparent. It basically hides a big chunk of cost from the casual stock market onlooker. Which seems to be the main purpose of that kind of accounting.

          • The numbers are put in the report for anybody to see them (unlike charging a big loss where the company does not even have to say what it was for, “just a loss”)( bjorns’ corner explained beautifly). So, is it better to bring the company down with a big loss in a single year and quit the bossiness rather that spreading the loss over multiple years and keep it moving along in a healthy way? I don’t get that really. Airbus is using some type of program accounting for some of the early A350 planes because is more coherent for them to present this charges spread out over time or products instead of one chunk. If the buyer doesn’t see that, perhaps he or she should get someone that can understand the business practice to handle the transaction.

          • The numbers are put in the report for anybody to see them (unlike charging a big loss where the company does not even have to say what it was for, “just a loss”)( bjorns’ corner explained beautifly).

            That’s fine, but at the cost of massive intransparency in another area, because (as has been pointed out) nobody outside Boeing is really in a position to judge whether the projected accounting block and other assumptions are realistic. So your argument is “it’s more transparent in one specific aspect”, but the counter-argument is that it’s much less transparent regarding the company as a whole and how much each programme *actually* contributed.
            You end up with different programmes at different stages of their programme accounting (if any), with individually different risks attached to them, and all of these forecast-based programme accounting numbers then get bunched together with current income to make up the company’s overall EBIT, operating margin, etc. So all those cummulative numbers don’t really represent the *current* state of affairs any more, and make it pretty tedious to figure out how
            It’s pretty tedious to find out how the company is actually doing today, as opposed to “at various virtual future points in time, taking today’s situation marginally into account where it suits”.
            Would a lower share price scare off investors? Probably. But a lot of people would also be scared off if they realised that profits posted today thanks to programme accounting are actually virtual profits.

            You expect buyers to be clever/interested enough to read into and understand the details of programme accounting.
            If people are clever/interested enough to do that, they’re surely intelligent enough to understand the basic development cycles and associated cost (read: temporary losses) of the commercial airliner market. There’s no need to hide those to begin with.

            I agree with Sowerbob above:
            I would argue that companies should be allowed to account for program matching as a subsidiary report to provide the information that you want. At the same time they should not be allowed to mask the underlying financial performance of the company by smoke and mirrors.

            As I said before, I think that spreading cost across a maximum of 24 months might make some sense, e.g. to buffer the effect of higher cost per frame during production ramp-up. That’s a somewhat manageable (and non-extendable) amount of time; you wouldn’t be projecting cost and income for a decade in advance. Overlooking 24 months, both Boeing and Airbus have a pretty good idea of how many planes of type X they’re going to build at what cost and at what income.
            But then, I don’t think that sort of “limited time programme accounting” is a must, either. Such special/out of the ordinary expenses are part of pretty much any business.

            So, is it better to bring the company down with a big loss in a single year and quit the bossiness rather that spreading the loss over multiple years and keep it moving along in a healthy way? I don’t get that really.

            See above. It’s about transparency/being realistic.
            Programme accounting amounts to posting income as hard profit today that a) has not been generated yet b) will not be generated for a few years to come c) may never be generated to begin with.
            I.e. you’re artificially inflating today’s balance sheet (and reducing tomorrow’s), which has the potential of creating a sort of “profit bubble”.
            As we’ve seen, the main thing that gets revised is the accounting block, i.e. the losses simply get spread out over more frames/time, instead of adjusting profits for the last few years, which were based on assumptions that you just had to throw out of the window. The alternative would be to simply face the fact that you’ll effectively be loss-making for longer than anticipated.

            Again – look at the A380 (where programme accounting wasn’t used, at least not for the whole programme) as a perfect example for why programme accounting is intransparent, misleading, and lacks accountability once the proverbial manure hits the fan.

      • If at are only using contract accounting in a specific situation, does it suggest that there is something messy to hide?

      • Hi Scott

        With respect I did mention ‘early production’, I am guessing this relates to tranche 2 aircraft. Judging from the relatively low ramp up and the queue of aircraft in final assembly it appears that rework is an issue for Airbus on the a350 to some extent similar to the b787. Is it the case that ‘fettling plastic’ is a difficult thing to do.

        Is there any story behind the couple of Qatar a350s that are waiting for delivery? They have been there for a few weeks waiting for someone to pick up the keys.

        Note that it seems totally inconsistent for Airbus to take a charge against development in 2013 on the a350 only to carry that charge in 2015 (I appreciate the semantic differences between development and production). Airbus should simply have bitten the bullet and taken a further charge against early production in my view.

  6. If today’s stockholders are cashing out on income due from a decade forward, where does a company get the next 20 B to launch a new jet, or who will be investing in the future when all of the equity has been bled dry?

  7. Program accounting is doomed. The USA were one of the main participants developing IFRS accounting rules.
    The USA has been delaying to move to IFRS, but I assume it will be only delayed and come eventually as more countries and regions accept new standard.
    It is not only program accounting, quite different from contract accounting in rules and especially scope, that will bite the dust, IFRS leads overall to lower reported profits, than GAAP allows.

  8. IFRS 15 was developed in a joint effort between the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB). I am a chartered accountant by profession, and all I could say at this point in time is that the standard is not that easy to follow let alone implement. If it is true that contract accounting (and by implication program(me) accounting will be eliminated by this standard, then Boeing will have no choice, but to abandon program accounting.

    As is always the case, there will be exceptions to the general rule, and exceptions to the exception as well as transitional arrangements to ease the burden of implementation on companies, but the FASB will adopt this standard and US SEC reporting corporation will be required to comply with it. It is only a matter of time.

  9. I think the problem with cost/program accounting isn’t so much when assessing the worth of a company the size and structure of Boeing as there are plenty of analysts who can dig in and understand fairly well what all the data translates to in the here and now, but with smaller, less thoroughly analysed companies. And it would be unfair to have one rule for the Boeings and another for the (relatively speaking) Mom & Pops.

    It is also a question of degrees. It is entirely possible to ‘move around’ profits/losses from one year to the next to an extent under ‘regular’ accounting methods in order to smooth things out or not, as desired. Which is important for investor confidence and so the long term success of the business. Program/cost accounting formalises these shifts into potentially very long time periods.

    That said, I do prefer to see clear financial accounting, not this financial/management accounting hybrid. Plus I would rather see an end to the quarterley filings focus in the USA in favour of something more long term.

  10. All of these tactics are nothing more than accounting exercises. Whether a company does or does not make money on a program is determined by whether a company wants to reconize a profit early, when it has more of a tax advantage or later, when the write off is used to cover the lower margin. All programs want to be consistent in their presentation of program returns. Getting started, costs more so, but the losses can be stored. Middle life the program is pumping cash, so you do nothing to mess with the margins, fixed costs are low, operational performance is under control. At the end when there is little interest in the program, you dump the losses and use them to keep the margins consistent.

    I still don’t get why anyone not working for the company really cares how and when profits are realized? As a corporate observer, the point is whether the company’s products are selling. If they are selling and the finance folks are doing their jobs, profits are in line with expectations. Yes corporate executives make money, and the underlings get screwed. If, on the other hand and there are no sales, how you recognize program costs is really not an issue anyone really wants to discuss. Right?

    In the case of Rolls and GE engines, both are after aftermarket business. Parts are sold at a mark up that is ungodly. But how else will you cover the costs of developing the program? Rolls and GE will give away an engine to get it on an airline’s wing for the MRO/aftermarket CUT. Look at Pratt, they went YEARS without a commercial engine but the flying inventory they had worldwide was worth MORE to them than Rolls/GE market annually for YEARS. Aftermarket MRO carried the day at Pratt. Long term, failing to do program development (cost) caused a major blow to their commercial program for many years, but corporate profitability was outstanding. The market was excitied about the Pratt business model, because program costs on all comercial programs were minimal, but profits from part sales were outstanding.

    You folks on here want Boeing to do the same thing? Stop developing new programs because the development costs are terrible for profitability? It is never going to be perfect, and being in aerospace is messy and the cost to bring programs to market are not cheap. Much in the space is done on hope that the sunk costs of development will be offset by both sales and offset of program startup costs so governments grant opportunities to offer offsets. If we didn’t have those options you posters would have nothing to complain about.

    Personally I often wondered how Airbus, Boeing, and McD ever made money when there was no way for them to play in the aftermarket. MRO work was done by shops not connected to the OEM, so after the sale there was little for the OEM to do. Well, Boeing certainly woke up with the 787 and has gotten in the aftermarket business in a BIG WAY. They have cut into the world of their suppliers in the aftermarket space, forcing agreements that were never done in the past for a piece of the aftermarket. SO, posters what do you have to say about the fact on the 787 Boeing has crafted a way to continue making money on the program after the final sales? On the 787, Boeing has established a new revenue stream that has not been seen on other Boeing programs. Much of the early discounts offered were done because the company saw that a flying plane was a way to get the money tree going. Which, is another reason why all this discussion about the program being a negative position is pointless because the sales model for the program is VERY different than past programs. I’ve not seen a single writer make mention of the GoldCare programs and how those strategies play in to program profitability. Service agreements between repair shops globally and Boeing, parts programs for fleets and Boeing, and service agreements are new value streams on the 787. So the 300+ frames flying today are now 40 year value streams not seen for the company before. No one has asked how those activities have been going, all I read about is this crap about program cost recognition. It’s as if ever writer, analysts, and posted wants to discuss the old days. Boeing internal break even models take that in to consideration, but the rest of you, “there’s no way the program can make money.” By the way Boeing is selling 787s, announcements keep happening. If the EK sale happens the program’s backlog will address the breakeven in the way most program address them. Through sales.

    By the way Keesje – who made that purchase of 777X with no customer indentifed? I thought you said that program was dead on the vine? Seems it, of the flapping wing, are finding customers willing to take the chance you said would never happen. ET, was a fluke too I guess. Maybe offsets for 787 delays?

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