Understanding the Cash Conversion Cycle
Board: Berkshire Hathaway
Since cash basis accounting is not appropriate for sophisticated business enterprises, accounts are reported under accrual, not cash basis accounting. Accrual accounting aims to report transactions in the accounting period in which they occurred, not in the period in which the cash was received or paid. To accrual accounting, the matching principle is applied. The matching principle simply places the costs and revenues into the appropriate accounting periods. In other words, the cost of producing revenue needs to be recognized in the same period that the revenue is reported. Thus income and expenses on the income statement are often reported in a period different from which they are paid out or received in cash. This gap between when cash flows out or in and when the income or expense is recognized in the income statement is the well of opportunity for the intentional or unintentional misstatement of profit.
Any error, intentional or not, in the under or over stating of profit will be reflected in the balance sheet. The overstatement of profit will result in an asset being overstated, a liability being understated, or both. So, one way of looking for either overly aggressive accounting or even fraud is to analyze the balance sheet.
There are many ways to overstate assets. One way is to capitalize what are in reality period costs, such as regular maintenance and repairs. If you are a cable television company or a telephone company and operate a vast communication system, you incur regular maintenance costs, upgrade costs and expansion costs. Some transactions may be a combination of several of these at once. Some of these separate types of expenditures may be done with the same employees, equipment and supplies. So, to overstate profit, simply classify regular maintenance expenditures as expansion outlays - overstating assets by capitalizing and amortizing these costs over a period of years instead of charging them against the current period’s income.
The problem for both accountants and investors is that often determining what period a cost should be charged to is subjective. In the first quarter annual report for Berkshire, GEICO is changing its method for capitalizing and amortizing its policy acquisition costs, resulting in lower assets and faster recognition of period costs. GEICO was not doing anything wrong, just something different than what is now required.
An easy, yet eventually detectable, way of overstating assets is to simply create them from whole cloth. Just recognize a fake asset, such as cash or a receivable, along with fake revenue. It has been done.
Another easy way to overstate profit is to simply not record or to understate a liability. But, even honestly getting liabilities right is difficult. Management has just discovered that its employees at some remote location have been dumping toxic waste in a back lot. The entire cleanup costs should be recognized immediately, but what is the correct amount?
As you can see, it is difficult to impossible for the investor to uncover these misstatements. However, the investor can determine the likelihood for such misstatements by analyzing the cash conversion cycle. Two questions to ask: how quickly will assets and liabilities convert to cash, and how determinable are those amounts. The more quickly an asset is either converted to cash or recognized as a period cost, and the more quickly a liability is paid in cash, the less likelihood there will be for intentional or unintentional misstatement of the amount. And the more determinable the amount of the asset or liability the less likelihood for error as well.
Some liabilities are easily determinable. The bill for office supplies is for a fixed amount. But, if one of Berkshire’s insurance companies receives a claim for workman’s compensation, how do they determine the extent of the injury and estimate all future medical costs before the end of the next reporting period? So, it is application of period accounting principles to the cash conversion cycle that requires the accountants to create the estimates that are the most easy to manipulate or honestly get wrong.
We have a real life Berkshire example: the derivative book of General Re. When General Re sold a derivative, it booked a profit based upon its estimate of future events. ( Booked a loss on sale, are you kidding? ) The time it took for the derivative to convert to cash? Years? Many years? The determinability of the future cash to be paid or received? Well, we know how good a job General Re did in estimating future events by all the charges to income Berkshire took in unwinding its book. This was one of the worst kinds of long term, undeterminable cash conversion cycles you can imagine, so you see why Buffett discontinued it, even at considerable cost.
Accountants often get a bad rap, but their job is not an easy one.
Some more examples. I could not provide the amounts for a See’s Candies balance sheet, but I think I have a good idea of what it looks like. It will have some fixed assets: kitchens, office equipment and furniture, and store fixtures. It will have a small amount of raw ingredients and finished inventory. The amounts would be small because of See’s demand for freshness. They will have some accrued expenses, mostly salary related and some accounts payable, mostly raw materials. The difference between those will be equity.
How quick is See’s cash conversion cycle? Very. The revenue from the sale of products will be received in cash immediately or almost immediately. The payables and accruals will be paid in days or weeks, not months and certainly not years. And all of these amounts will be highly determinable. About the only long term conversion cycle will be in fixed assets which are depreciated. But, the amount of these assets is easily determinable and the period depreciation expense is subject to formulas. Piece of cake. Own companies like See’s.
Now, from the sublime to the ridiculous: insurance company financial statement. These nightmares, these spawns of demons are the financial statements from hell. Insurance accounting should only be discussed in hushed voices and in dark alleys. Little, and almost nothing important in their cash conversion cycle is quick or determinable. Premiums are paid in advance – try collecting the premium due on a lapsed policy for which the insured does not plan to file a claim or renew the policy. So, premiums collected in advance are recorded as deferred income and amortized over their life. This, however is not really a problem; still rather quick and determinable. The real parade of horribles is in the rest of the balance sheet.
With all due respects to accountants, nothing is as it seems. The most important liability, the accrual for unpaid policy claims, is a work in progress, subject to amendment and correction. I will not go into real life examples; it is easy to see why attempting to determine the amount to be paid for a claim that may require years to settle in currently unknowable amounts is from difficult to impossible. But, that is only the half of it. On the other side of the balance sheet we have investments. They are recorded at market value, but how well does such market value truly represent the net present value of all future free cash flows? We only need to look a few years back to see insurance companies with grossly understated liabilities and grossly overstated assets. Do not own the stock of insurance companies. ( Unless, of course, you have high confidence in the integrity of its managers. )
Looking at the cash conversion cycle is not an end-all by any means. However, it can help determine which companies have more complicated accounting: accounting that is the most subject to intentional manipulation or honest error.