• Choose a category
• All
• Classic-Fiction

By Root 2805 0

Crossing would sell other communications companies the right to carry their traffic over its network of cables. In 1998 alone, Global Crossing spent more than $600 million to construct its optical web. That year, nearly a third of the construction budget was charged against revenues as an expense called “cost of capacity sold.” If not for that $178 million expense, Global Crossing—which reported a net loss of $96 million—could have reported a net profit of roughly $82 million.

The next year, says a bland footnote in the 1999 annual report, Global Crossing “initiated service contract accounting.” The company would no longer charge most construction costs as expenses against the immediate revenues it received from selling capacity on its network. Instead, a major chunk of those construction costs would now be treated not as an operating expense but as a capital expenditure—thereby increasing the company’s total assets, instead of decreasing its net income.4

Poof! In one wave of the wand, Global Crossing’s “property and equipment” assets rose by $575 million, while its cost of sales increased by a mere $350 million—even though the company was spending money like a drunken sailor.

Capital expenditures are an essential tool for managers to make a good business grow bigger and better. But malleable accounting rules permit managers to inflate reported profits by transforming normal operating expenses into capital assets. As the Global Crossing case shows, the intelligent investor should be sure to understand what, and why, a company capitalizes.

An Inventory Story

Like many makers of semiconductor chips, Micron Technology, Inc. suffered a drop in sales after 2000. In fact, Micron was hit so hard by the plunge in demand that it had to start writing down the value of its inventories—since customers clearly did not want them at the prices Micron had been asking. In the quarter ended May 2001, Micron slashed the recorded value of its inventories by $261 million. Most investors interpreted the write-down not as a normal or recurring cost of operations, but as an unusual event.

But look what happened after that:

FIGURE 12-1

A Block of the Old Chips

Source: Micron Technology’s financial reports.

Micron booked further inventory write-downs in every one of the next six fiscal quarters. Was the devaluation of Micron’s inventory a nonrecurring event, or had it become a chronic condition? Reasonable minds can differ on this particular case, but one thing is clear: The intelligent investor must always be on guard for “nonrecurring” costs that, like the Energizer bunny, just keep on going.5

The Pension Dimension

In 2001, SBC Communications, Inc., which owns interests in Cingular Wireless, PacTel, and Southern New England Telephone, earned $7.2 billion in net income—a stellar performance in a bad year for the overextended telecom industry. But that gain didn’t come only from SBC’s business. Fully $1.4 billion of it—13% of the company’s net income—came from SBC’s pension plan.

Because SBC had more money in the pension plan than it estimated was necessary to pay its employees’ future benefits, the company got to treat the difference as current income. One simple reason for that surplus: In 2001, SBC raised the rate of return it expected to earn on the pension plan’s investments from 8.5% to 9.5%—lowering the amount of money it needed to set aside today.

SBC explained its rosy new expectations by noting that “for each of the three years ended 2001, our actual 10-year return on investments exceeded 10%.” In other words, our past returns have been high, so let’s assume that our future returns will be too. But that not only flunked the most rudimentary tests of logic, it flew in the face of the fact that interest rates were falling to near-record lows, depressing the future returns on the bond portion of a pension portfolio.

The same year, in fact, Warren Buffett’s Berkshire Hathaway lowered the expected rate of return on its pension assets from 8.3% to 6.5%. Was SBC being realistic in assuming that its pension-fund managers could