The Accounting Problem
Let's start with the nature of an accountant's role in any business. It is to simply to keep the financial part of the firm in order, and make its state of affairs understandable to those who must make budgetary decisions.
My favorite accounting professor, David Boyd, who was also one of the very best teachers of any subject I have ever encountered, likened the accountant's extended duties to such things as bringing a bit of joy and warmth into the workplace, as personified in the Charles Dickens character Bob Cratchit, and as captured in this illustration by Arthur C. Michael for a 1911 edition of A Christmas Carol.
Dave also liked to compare the accountant's role to that of the military hero, marshalling his files and columns, making sure that everything is in order, so as to be ready for the hard work that lies ahead, and whose job it is to set an example so that all may understand what is expected. In many ways, General George S. Patton set the kind of example Dave was describing, if one looks past some of Patton's rough edges.
Accounting is a noble profession when viewed through these lenses. But, like any human endeavor, the trust and expectations of the public can be betrayed. The tools of the accountant, which have been developed over generations of practitioners, are there to more accurately portray the financial results and conditions of an enterprise. But these tools can also be used by the unscrupulous to obfuscate and mislead. An accountant who uses his or her skills in an effort to deliberately conceal and mislead is not only breaking that trust, but is also engaged in something that is illegal. Unfortunately, intent is often difficult, if not impossible to prove; so such crimes by accountants are seldom punished in the courts even when it is clear what happened.
As an auditor, I was trained to think a bit like Agatha Christie's Miss Marple. As Christie described "Aunt Jane" in her autobiography: “There was no unkindness in Miss Marple, she just did not trust people. Though she expected the worst, she often accepted people kindly in spite of what they were.” I particularly enjoy the portrayals of Miss Marple by Joan Hickson, pictured here.
Boeing's post-merger top leadership was composed of a bunch of people trained by Jack Welch, of General Electric infamy. Welch's basic philosophy, based on what he said and wrote, was that the earnings the stockholders received, especially from the valuation growth of their stocks, as opposed to any dividends being paid, was of paramount importance. Yield was not enough. Most people believe, myself included, that Welch was a very smart guy.
Based on that belief and his behavior, one might fairly conclude that he was not actually interested in the long term value of his company's stock, but rather in what a short term focus on that would enable him to grab for himself. This suggestion that his real goal of taking as money out of GE for himself as enabled by his hand-picked board of directors is not contradicted by what actually happened. As for Welch and his minions, you can draw your own conclusion. I've drawn mine. Let's look at the accounting issue.
Toward the end of the very first chapter in any introductory accounting textbook is a discussion of the limitations of accounting. There are several ways to parse the limitations, so such lists vary a little bit. They usually have between nine and twelve items, but a close read will show them all to cover the exact same things. A good summary of these limitations can be found here.
A simple way to think about the limitations of accounting is in how one draws the boundaries of a firm or entity that is being described by the financial statements. What are the things not covered by the statements, but which are none-the-less critically important to the accounting entity?
Many people in business tend to think of the things that are not reflected in the financial statements as being intangibles. Whether or not something is tangible is beside the point. What matters is whether or not the assets beyond those described in the work product of the accounts include an ownership interest in them by the stockholders. One could argue that such things as trade secrets might be subject to ownership claims, especially if there are some obligations associated with those secrets on the part of the employees as stipulated in either written employment agreements or common law. But things that are beyond those bounds, such as the skills and professional knowledge base of the employees as individuals, and of the firm's so-called "tribal knowledge" when talking about them collectively, well those things are definitely not owned by the stockholders nor subject to liens on the part of the creditors. There are two problems for accountants when it comes to such things. One is identification and the other is valuation.
Accountants have a variety of estimating techniques which can be used to assign valuations to many things. But for those tools to be used, a simple condition must be met. Two independent accounting teams must reasonably be expected to choose the same estimating methodologies given similar circumstances. And, using those methods, they should be able to come up with reasonably similar results. If those two conditions cannot be satisfied, then the items in question cannot be included within the scope of the financial statements.
Again, the boundaries of accounting, and the boundaries of an accounting entity are two very different things. It is even quite common for most of the value that it is believed that a firm has to not be disclosed in the financial statements. For example, as I write this, The Boeing Company has been bankrupt for over three years. Again, you can see this for yourself here. Just expand the section titled "Liabilities & Stockholders' Equity." Despite this fact, during this entire time the stock has been trading in a range between $95 and $440 per share, and has not paid a dividend since February 2020. Clearly, investors who are willing to pay those prices believe that there is some value there someplace that is not reflected in the audited financials of the company. In fact, this is to be expected.
It used to be that accountants were taught that the starting point when placing a valuation on a firm for purposes of a potential merger or acquisition, was to project an expected five years worth of earnings, discount those to their present value, and then adjust for any off-the-books assets or liabilities. Of course, placing a valuation on those is total guesswork, and not something that is subject to audit nor to our two requirements for making an accounting estimate. But that said, virtually no stock that is listed on a public stock exchange ever trades below a price earnings (P/E) ratio of 5:1 unless there is a serious known risk of the company being liquidated to satisfy some liabilities that are being litigated. Historically, the average P/E ratio of the S&P 500 ranges between 13:1 and 15:1. That's one heck of a lot of benefit that the investors are expecting from things which they do not own. And yet, in a healthy economy that is growing at a reasonable rate, such valuations will indeed most likely be justified by the next five years of actual earnings. So how did Jack Welch manage to consistently "beat the street?"
The answer is simple. He figured out how to monetize in the near term those things that were not on the books. All that he required was a portfolio of products that had very long lifecycles, and then pull the plug on R&D spending. He even stretched things out a bit by having his accountants do something illegal with the way they used generally accepted estimating techniques.
Another one of my accounting professors was Dr. John Burke, who as founding chair of the department, had actually built it into a great part of the Haworth School of Business at Western Michigan University, starting from almost nothing. Dr. Burke liked to tell a story to explain what was ethical and what was not in accounting. I'll paraphrase as best as I can. On most days, I feel like I can remember him telling the story as though I was sitting in his class just yesterday.
He said to imagine that the controller of a company is asked into the president's office at the end of the quarter, and asked: "How did we do? What do the numbers say?" The controller then closes the door and walks over and draws the blinds, before turning to the president and asks: "What do you want them to say?"
The process of making an accounting estimate starts with an evaluation of the situation. Then an estimating method is chosen that fits the circumstances. That's estimating, and it is perfectly ok. Most of the numbers in a set of financial statements contain at least some estimates. What is not ok, is to first choose the answer you want, review all possible estimating methods that might exist, and then a pick a method that comes close to the answer that you want. That is not estimating. It is fraud. It may be difficult if not impossible to prove this particular kind of an accounting fraud unless the accountant admits to having done it, but it is fraud none-the-less. This estimating fraud trick is just one example of the kinds of things accountants can do to misrepresent what has gone on in a business. The auditors are supposed to catch it, but it can be very hard, if not impossible to detect such things until a whole bunch of such funny numbers have made it into the financials over several years.
And the thing about such a fraud, is that once you have done it with regular accounting data that has been generated by the ongoing activities of the business, it becomes easier to take the next step, and start making business decisions that are bad for the long term health of the company, but which feed raw material to the accountants to inappropriately value using their estimating fraud trick. Numbers may not lie, but it is certainly possible to tell lies using numbers.
One can read about several of the accounting frauds that were perpetrated at General Electric under the leadership of Welch in the 2020 book by Thomas Gryta and Tedd Mann titled "Lights Out: Pride, Delusion, and the Fall of General Electric."
This is the kind of thinking and leadership that Harry Stonecipher and Jim McNerney brought to Boeing. And, they swapped out the old Boeing board of directors for a team that would go along with this chicanery as fast as they possibly could.
When the auditors review the financial condition of a firm, they write a report called an opinion. The goal of any company is to get a clean opinion, that is, one that doesn't say that their financial statements are not giving a fair picture of what is going on. The point is, that accountants believe that one can tell a part of the story, that is, the part that is the subject of their trade, and if you add any needed supplemental footnotes or explanations, that the finished report can indeed be fair.
At the end of an audit there is frequently a big debate between the auditors and a company's executives as to what sort of footnotes and supplemental information is required in the report in order to paint a fair picture. Sometimes this works, and sometimes it doesn't. Jack Welch basically invented a way to fool the auditors, con the investment community into believing that he was getting fantastic results, while at the same time, bleeding the GE company into collapse. The key to Welch's discovery or invention, was products which have very long life cycles, large sales prices, large after market support requirements, and no near term competitive threats.
By bleeding GE of its non-accounting assets, and arguably, fabricating some of the valuations for others, he was able to appear to be leading the company to such unusual performance, that no one would care that he was being paid an absurdly high salary and being provided him with perks one might normally associate with middle eastern royalty. He was worth it because his stock was doing so well. All he needed, was a company whose product life cycles were long enough to provide him cover for his tenure as CEO and then well into retirement. It worked, and he trained a large cadre of followers in his methods.
The Boeing Company has products with some of the longest lifecycles there are, and like the locomotives and power plant turbine generators that GE once made so profitably, with the jet airplanes and the other defense products that were in Boeing's product portfolio prior to the merger, it was super easy to bleed these Boeing's businesses dry while making the company look profitable long enough for McNerney to make it into retirement. Some might argue in McNerney's defense that these are just coincidences, and that he tired hard and things just didn't work out as hoped. I personally think he is a very smart guy who knew exactly what he was doing, and that he trained with the best and repeated his mentor's performance, but if you someone wants to argue that he wasn't very smart and is all just sort of went south due to no fault on his part, well then I would like to talk to that person about some Florida real estate opportunities.
Now, let's cover one specific example of how the Jack Welch company bleeding methodology was applied in Boeing on the 787 Program.
As described in the section on this site about the 20xx Program, in order to achieve that audacious goal of remaking the entire American aerospace industry so as to make the "1 in 10 airplane" possible, the suppliers needed to become more independent. They needed to shift into a mode of continuous evolution of each of their pieces, and Boeing needed to work very closely with them to evolve the highly standardized interfaces on our planes that would make that possible.
On previous airplane programs, the Supplier Management organization would typically have at least fifty engineers embedded with the suppliers. But to pull of the transformation required by the goals of the 20xx Program, we were going to need several times that many on airplane #1, which was the 787. So how many did Stonecipher and McNerney allow? Exactly two. The third one was not hired until 2011. That was enough to sabotage the whole program and guarantee that it would be late, even without the goals of the 20xx Program, or the culture that consistently produced watermelon stop light charts.
Now, you might ask how I know this part of the story. Well, the third engineer hired into the 787 Supplier Management organization just happened to be the niece of my college roommate. And after Samantha moved to Seattle to take her new job on the program, she lived in our house for a few months. Like I said, I really was everywhere, when it came to pulling together the pieces of this story. McNerney, Stonecipher, and Bair can run, but they can't hide this stuff any more. It's all coming out.
I could go on for several more pages about the mismanagement and flawed accounting practices of Boeing under the leadership of the Jack Welch trained people that took over the company, but that is enough to provide an insight into the accounting part of what went wrong on the 787 program.
Another accounting issue that was not specific to the 787 program, but which goes into yet another problem with the Jack Welch and GE approach to business non-leadership will be covered in a separate section. That is the complete farce that Deborah Chase Hopkins' brought to Boeing with her schtick about RONA, or "return on net assets," which at best, was a poor attempt at a kind of magician's sleight of hand or redirection.
The final accounting issue that is worth discussing here relates to how to think about the cost of talent as an asset, and how to apply that to the aerospace business, part of which really is rocket science, and all of which is all about seriously complicated systems integration challenges involving cutting edge technologies. A really fine book by Reed Hastings, the CEO of Netflix that he coauthored with Erin Meyer titled No Rules Rules: Netflix and the Culture of Reinvention provides some great insights into this issue. This is another one of those things which Jim McNerney got completely wrong. Harry also missed the subtleties of the "team versus family" part of this story, which Hastings and Meyer get almost right. I should hedge that a bit, as they were thinking about a company filled with artistic and creative talent, which was also not yet major percentage of the local economies in the communities where they have a physical presence. So some of the issues that loom large in aerospace do not apply to them, at least not yet. But other than that one caution, their discussion is fantastic, and is covered on another page linked below.