Pontifications: Boeing sued over program accounting

Hamilton KING5_2

By Scott Hamilton

Feb. 29, 2016, (c) Leeham Co.: It was inevitable: a class action lawsuit was filed last week against The Boeing Co., its top officers and directors over the investigation by the US Securities and Exchange Commission of the company’s program accounting.

The lawsuit was filed last Wednesday.

The lawsuit alleges “among other things, that defendants issued materially false and misleading statements and/or failed to disclose that: (i) Boeing’s use of program accounting for its 787 Dreamliner and/or 747 jumbo aircrafts relied on inflated sales forecasts; (ii) Boeing’s use of program accounting for its 787 Dreamliner and/or 747 jumbo aircrafts relied on understated estimates of production costs; and (iii) as a result of the foregoing, Boeing’s public statements were materially false and misleading….”

I’m no fan of program accounting and never have been. I think it artificially inflates profits, or in extreme cases, reverses losses into profits. It misleads all but the most sophisticated of shareholders and analysts following the company go along with this smoke-and-mirrors.

But the Financial Accounting Standards Board (FASB) approves and so do the independent accountants.

Boeing has been using program accounting “forever,” and it’s never made any secret about this. In recent years it also has disclosed what the financial results would be without program accounting.

With respect to the specific allegations above, as one who has followed Boeing closely for decades and who is hardly known as being soft on the company, I think the allegations are without much merit–if any at all.

787 program

I don’t think Boeing had the slightest inkling what a disaster the 787 program would be, nor the knock-on effect to the 747-8 program. If executives did, then there would be merit to a lawsuit. But what executive in his right mind would approve a program that would rack up $30bn in cost overruns?

The 787 program was a series of bad, bad and stupid management decisions and executions. There is just no getting around this.

Did the management miscalculate? This is clearly the case. But they did first set the program accounting block at 1,100–far higher than any previously. Later, this was increased to 1,300. I hear it will likely go to 1,600. There have been 1,143 orders to date. The airplane went into service in late 2011. We’re five years into what is likely to be at least a 25 year life (if not longer), leaving 20 years for more sales.

Will Boeing sell 457 more 787s to hit 1,600, a figure that should recover all ~$30bn of deferred production? I don’t see why not, and then some. That’s only an average of 23 787 sales per year. Going to 1,600 in the accounting block should avoid any forward loss charges.

The 747-8

When Boeing launched the 748, I thought this was a good move. Airbus was then in the morass of the A380 wiring debacle that delayed the jet for about two years. I thought Boeing had a window of opportunity to make some inroads into sales. But because of the 787 mess, the 748 suffered as engineers that were supposed to be released from the 787 to the 748 program were retained by the former. Engineers were diverted from the 748 to the 787 and some key engineering work was outsourced, with sorry results.

What was supposed to be a straight-forward re-engining of the iconic airplane evolved into a new wing, some new systems and what former Boeing Co. CFO James Bell ultimately described as an 80% new airplane.

Flutter and other issues emerged. The airplane ran 18 months late and missed its window to steal orders from the A380.

Optimistic forecasts? Boeing has always been far more conservative about the 20 year market for the Very Large Aircraft than has Airbus. Today the forecast is less than half of Airbus’. A large part of the forecast, when the 748 was launched, revolved around cargo demand. But the global air freight demand plunged and never has recovered. Boeing today stubbornly still sees a demand for the 748 and 748F (at least publicly), but changing market conditions make even this lowered forecast unlikely. Still, when the 748 was launched, I didn’t see anything out of kilter.

Forward Losses

Another aspect of these two airplanes, the forecasts and financial liabilities related to them, is this: for many years, Boeing has included in its 10Q and 10K SEC filings warnings that “material” forward losses for each program could emerge based on a number of risk factors, including lower than expected demand. Former CEO Jim McNerney was clearly loath to declare forward losses, but he did on the 748. So has his successor, Dennis Muilenburg. I think Muilenburg should as well on the 787, to clean up the books.

Boeing may be guilty of wishful thinking, but I don’t think it’s guilty of the allegations set forth above.

 

32 Comments on “Pontifications: Boeing sued over program accounting

  1. The failure of the B747-8I in the market place cannot be reasoned with failed schedule alone. The performance wasn’t as expected, it didn’t beat the B777-300ER with substantial margin.
    It was known from the beginning that the wing was entirely new, just fitting into the B747 Classic’s planform. Maybe that was a reason for severe cost overruns, it was originally intended as cost control measure.
    When designing a new wing there should be as few boundary conditions as possible. The A340-600 also got its back broken by having a highly compromised wing.

    • They chose to use a smaller team than usual for the pre development work before launch, and changed quite lot of their previous idea on what they could do. ie “going from a minimal change to major change in L/D for the wing in only 6 months”
      Thickening the wing box depth slightly helped stiffness and fuel volume but had to be faired in next to the fuselage to maintain the wing centre box dimensions.
      Then there was the fuselage length, with the passenger version shorter than the cargo version to give 8000nm range , but the airlines ( except Emirates) wanted more passengers, so the two versions ended up the same length. But the forward fuselage stretch for both versions was done in different places- one just in front of the wing box the other in the constant fuselage section of the upper deck.
      Development of the 747-8, Boeing Company paper ICAS 2008
      http://www.icas.org/ICAS_ARCHIVE/ICAS2008/PAPERS/073.PDF

      Running a lean headcount to start meant they were constrained when the extra people they needed were keep on the 787 program. So it could factor in the lawsuit when Boeing knew the staff weren’t going over to the 787-8 and when they told the markets some years later?

  2. I always wondered if the communication during the roll-out of the 787 were legal. I’m not sure how this works out from a legal standpoint, but at the time the fact that no mention was made that terrible delays lay ahead, whilst there was all the reason to assume this for management, did not seem all too honest.

    • As far as I trust my memory, at the time of the famous roll out , the only explanation for delay published was a lack of fasteners !!! … not a big problem ??

  3. I concur with you Scott, at the outset the initial announcements were reflective of the company aims. Further when all the nonsense of accounting is forgotten the b787 programme will be seen as a triumph in terms of the base product. The programme itself is another matter but it brought Boeing into a new and highly competitive position in the WB market that they were losing to the a330. It introduced new architecture, systems and materials that Boeing will leverage off for decades.

    Interestingly it looks like it will break even and more on the programme (time value ignored) which I never thought was possible and has put Boeing in a strong position in one market that allows it to focus on the NB market with some of the technologies as a knowledge base.

    What is Boeing guilty of? Possibly being too positive when things were definitely going poorly, trouble is that once they had dug their hole getting out was difficult. The investors are using hindsight to batter the corporation when they could relatively easily see for themselves that there was something not quite right. Whether senior management were guilty of deception is almost impossible to pin down. It is not the fault of program accounting but maybe they were guilty of error by omission, but how much Do they have to say about an ongoing development programme?

    The 748 is dead and should be written off, whether the 787 deferred cost should also be partially written down is a moot point. You either believe it will recoup the cost or not. It is after all merely accounting semantics and any investor will be far more focused on the FCF today and going forward.

    If the the analysts are so clever let’s see what they could bring to market. The engineering prowess of Boeing has been dented but based on the MAX programme it looks like they are on a roll again. Long may it continue

    • merely accounting semantics

      Not completely. Dividends, and perhaps more tellingly directors’ bonuses, depend on profits. When you book your losses and pay dividends is material. Doing the latter will impact future cash flow and the ability to fund future programs.

      • @FF

        I was specifically relating to the charges and in that context the accounting treatment is relatively minor in relation to all the other transaction and window dressing going on

        Take your point re bonuses though

        SB

    • ” You either believe it will recoup the cost or not”

      “Believe” is either used to express the doubt and the certainty … I believe in God and I believe rain is coming …

  4. In terms of production costs it appears that the a350 programme is not immune to severe cost issues. Not to the same degree as the 787 but then again it was in many ways an evolution of the a380 in terms of systems at least. Making aircraft to a cost is the difficult bit and by my calculations the a350 will not be breaking even per unit until 2018/9. Hence the need for a bit of contract accounting!! Does anyone have a clearer understanding of the a350 program, Airbus are very good at keeping their cards close to their chest and say the bare minimum. Maybe that is the difference, Boeing senior management talk too much!

    • The A350 will only break even by 2019. This is an official statement of Airbus.

  5. Boeing’s accounting practices were no secret. If “investors” failed to do due diligence, then tough poop.

  6. What Boeing may be conveniently ignoring is the cost of capital (i.e. interest and return to shareholders) when it does program costing – the value of a few million dollars per aircraft on a sale 20 years from now is materially less than those same millions on a sale today.

  7. I hope / believe Boeing are too well informed / experienced to be off this much on market projections. We have discussed this a lot over the years. Sometimes I was surprised by the things McNerney, Fancher and Tinseth said / presented in the media.

    In some cases I was amazed to conclude they actually believed what they said. E.g. this one, 4 week before the AA 737MAX order, by arguably one of their best people; surreal.
    https://www.youtube.com/watch?v=rJzRsodeYes

    At this moment they state the bread and butter 737 is going to be valid until 2030, and will then be replaced.
    -> Are they believing what they hope, is it short term MAX promotion or are they burying their heads in the sand / misinforming the bigger public?

    • And within that is the crux of the questions.

      When does a spin become illegal?

      Clearly Boeing knew how hosed up the 787 program was on the empty rollout, you would have to go back and see who said what and then prosecute.

      That said, the general train wreck as laid out by Scott is valid. I sure would not want those people working on something I valued.

  8. Boeing can be accused shooting from the hip when it comes to utterances from it’s executive. Shareholders surely cannot accuse the company of suddenly changing it’s accounting approach.

    What is a bigger issue for Boeing shareholders is the period 2018 to 2020 when the 777 lines stop and before the 777x lines starts up. I see two very lean years ahead as the 777 orders have dried up. Boeing may go down to 3 777’s a month, with a full labour force.
    Will Boeing rearrange the plan and start delivering the 777x early 2019? Is that even possible?

  9. Agree Boeing need to take a write down on the 787 program, right now while they have good cash flow. It will put them in a stronger position in 5 years time when 777X deferred costs peak and MOM/NSA development costs are biting. Still having say 10 billion in deferred on the books then would just be hurting themselves.

    Add in increasing advanced payments and share buybacks will in the end cost them the dividend. As more and more shareholders retire and are using the dividends to live off, either via funds or direct shareholdings, the dividend has become holy and is looked upon more like debt to be paid immediately. Long term ownership isn’t something recipients of Boeing dividends are thinking too much about, a lot of them need there regular checks to live off.

    Write it off now, while it’s easy!

    • 2014 the Boeing ‘free cash flow’ came to $6.6 bill, while share buy backs came to $6 bill and dividends were more than $2 bill
      in 2015 share buy backs were $6.75 bill and its expected that 2 years 2016-2017 buybacks will total up to $11 bill.
      The idea that dividends are the major payouts these days is a a quaint idea from the before the 80s.

  10. Filing a legal action like this is the opening shot. The shareholder suit in 1997 showed a huge difference between what executives knew about production problems and what they told investors. That’s the key point in the legal theory of a shareholder law suit.

    From 2004 to first delivery, plenty of people on the 787 program were worried, if not scared to death about the new business model. It will be interesting to see what turns up in discovery.

  11. I suspect the law suit is linked into the SEC’s alleged investigation into Boeing accounting practices. A case of getting their suit in first.

    I’m no fan of program accounting and never have been. …But the Financial Accounting Standards Board (FASB) approves and so do the independent accountants.

    The problem with program accounting is that it is subjective when auditing is in theory an objective process. It’s am issue of how close your subjectivity is to the objectivity, not that program accounting is dishonest per se.

    • In Europe we had a similar cases with “independent accountants”. It turned out they were advisers, consultants and stake holders too, creating win-win’s for companies, their accountants and board members. Legislation was passed to (try) correct the situation.

      • Well I see the European commission is looking into Arianne 6.

        That will be interesting

  12. Well this lawsuit on Boeings accounting methods and communication provides a good opportunity for those who fanatically defended it over the years. Would they defend such practises from a Korean car manufacterer too?

    • Keeje: A lot of those who have defended Boeing in the past defended a generally honorable American company. Not that as a corporation they did not have issues and failures, but not what the last management did to gut it.

      Frankly I don’t care how the accounting is done, I do care about things like US tax laws that the profits go to foreign countries and not into the US coffers.

      This is one of those cases in which we need to change the law.

  13. All that said what I really would like to see is the MC-21 report come out from behind the firewall.

    That is a most interesting technical subject as well as an interesting program.

    I think it will flop but only because of Russian issues, not because its not a good aircraft (no way to assess that from this end, just going on past Russian behavior and lack of success)

  14. Note: Boeing’s Corp Com in Chicago emailed to clarify that this reader does not speak for Boeing, the Company.

    “I’m no fan of program accounting and never have been. I think it artificially inflates profits, or in extreme cases, reverses losses into profits. It misleads all but the most sophisticated of shareholders and analysts following the company go along with this smoke-and-mirrors.”

    These seem like a very self serving statements to frame an article a certain way. Program Accounting is simply averaging with estimates, something accounts do all the time. It is centered around the core of the matching principle. It really isn’t that complicated, its just not used very often due to the nature of the industry.

    Unit Cost with Loss Making Contracts that Airbus uses seems to be much more difficult to understand and provides significant opportunities to manipulate earnings. Say you think you might not hit margin targets – well lets try to shift some of the planes being delivered from a company that got a huge price concession with one that didn’t get as much so we can offer some margin relief in the current year? Lets redefine the deal later to change the “loss” amount on part of the deal and influence yearly returns, and so on

    This is simply a nuisance lawsuit that will likely be able to survive an initial dismissal action because estimates are part of the accounting and there was a loss (possible question of fact). These suits are filed all the time when stocks fall or regulatory issues are in the news – it is never going to be litigated, the law firm is looking for a settlement and would be in no position to take it to trial.

    • @Boeing

      All large corporations would be able to manipulate their profits. What is of particular issue with program accounting is that it accekerates substantial profit flow from future years into current years. It is also a long-term process, if Boeing takes a 1600 unit block for the b787 this represents 14/15 years of production. And finally it introduces a degree of arbitrariness to the block size that can be used.

      Although I am sure that Airbus take a view on certain accounting issues (everyone does) the implications are nothing like as far reaching on the year in which profits are generated. Aggressive use of program accounting is taking the matching concept to extreme but ignoring the fundamental issue of prudence. Has the profit really been earned in early years of a programme? I think noy

      • As we have heard recently Trump was Drumpf, while Boeing was originally Böing

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