Boeing (NYSE:BA) shares tumbled as the company is facing a SEC probe regarding its accounting method on the Boeing 787 and Boeing 747 programs. In this article I will have a look at why Boeing's program accounting for the Dreamliner program is different from accounting on other programs.
Figure 1: The Boeing 787 and Boeing 747, whose accounting methods will be investigated (Source: airlinereporter.com)
First of all, it is important to understand what program accounting is. Boeing utilized 2 accounting methods in the past. Until 2003 it used the unit accounting method, which means that the company attributes costs for producing a unit to that same unit. From 2003 and onwards Boeing used program accounting, which means that the company no longer attributes costs related to a unit to that unit but divides it over the entire accounting block. This way the company can push some of the costs into the future and this obviously sketches a rosy picture.
In essence this accounting method is not bad, keeping in mind that the first units are always costlier. Incurring the costs as they appear puts pressure on earnings in the first few years while the program runs over multiple years. If deferred costs keep rising the company might be forced to increase the accounting block and take a charge. Additionally, in the case of a bubble in the order book, which more and more investors seem to be afraid of, expected number of deliveries could fall short of the number in the accounting block.
So basically as long as the market looks bright and the deferred costs don't increase drastically, investors will be more than happy with the program accounting method.
Accounting on the Dreamliner program
What has to be noted is that program accounting is not new, although a lot investors seem to be treating it like it is was introduced on the Dreamliner program. What is 'new' is the scale on which Boeing has been using program accounting on the Dreamliner program.
On previous programs the accounting block had a standard size of 400 units, which later on was altered if needed. The first 100 units are critical as lot of progress in cutting costs can be made there, but these are also the units with the highest burn rate. For the Boeing 787 program Boeing used an initial accounting block of 1100 units. This block was later altered to 1300. As Boeing introduced the Boeing 787-10 it used the opportunity to increase the blocksize to account for the extra costs that would be incurred. On the other hand one can question whether the block size of 1100 units was sufficient as deferred costs, even without the Boeing 787-10, piled up. With this bigger accounting block Boeing basically claims it is able to estimate average costs and profit for 1300 deliveries (which is over 10 years of production). One of the things the SEC probe will be centered around is this accounting block to see how Boeing is able to 'estimate' average costs and earnings for a block of this size.
Not only the size of the accounting block differs from that on other Boeing programs, also the deferred costs differ in scale.
Whereas the Boeing 777 had deferred costs of $6bn or $3.7bn (inflation adjusted figure) and the Boeing 747 program now has deferred costs of $1.9bn, the Dreamliner deferred costs are pushing $30bn in total deferred costs. So the deferred costs for the Dreamliner program are 8 times higher than that of the Boeing 777, while the accounting block is not 8 times that big. This means that Boeing has a steep learning curve in mind. However, given the fact that Boeing kept adjusting their deferred costs guidance upwards over the past few years, it can be questioned whether the company is succeeding in cutting costs at a fast enough rate.
Combining the size of the block, the uncertainty the block size brings and about $30 bn in deferred costs it is not weird that the SEC will be investigating Boeing's accounting method.
The main thing the SEC will probably be looking at is whether Boeing at this point already could know whether they will be able to recover the $30bn in deferred costs within the current accounting block. If the company has knowledge that it will not be able to recoup the deferred costs within the accounting block it should notify shareholders about this as soon as possible.
- Program accounting on the Dreamliner differs in deferred costs, block size and time
- As the company altered its deferred costs guidance over the past few years, it can be questioned whether the company is reaching its internal targets on the program
Program accounting has always been a dubious trick to most investors, but as long as it returns strong results investors are accepting it. It is not until the accounting method is being investigated or a charge is being taken that investors send shares lower.
I, myself, think that it will be a major challenge for Boeing to recoup all of the deferred costs within the accounting block. On the other side I also think that the recent drop was overdone, especially since a lot of investors are not quite familiar with the accounting method other than calling it 'pulling non-existent profits forward in time'. In the end the program accounting method has to make sense at some point. Boeing management is aware of this and the company is also aware of the consequences untimely notification of any disruptions in recouping the costs might have.
Disclosure: I am/we are long BA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.