When Accountants Attack Profits

The Enron debacle has cast a shadow on the credibility of corporate America. Companies are turning over every stone to make sure that financial reports are both accurate and presented in a way to convey credibility.

One would think that in this environment, my company, Cypress Semiconductor, would be reporting exclusively with the “seal of approval” of the Generally Accepted Accounting Principles (GAAP). But we do not. We publish two sets of financial numbers: one in the GAAP standard, and the other in the “pro forma” standard, which we have turned to as the basis of our communication to our investors over the last few years.

Why would we issue two sets of financial numbers, when a simple, single report would have served better in the current environment? Simply stated, the GAAP accounting rules, as mandated by the Financial Accounting Standards Board (FASB), no longer conform to reality. Our GAAP-based report misrepresents the finances of our company to our investors, necessitating the second, pro forma report.

The root cause of the problem is that the Financial Accounting Standards Board, the organization that sets accounting standards, has prioritized some dubious accounting theories over clarity of reporting, accuracy of reporting and even common sense, as I will demonstrate. One problem relates to accounting for acquisitions. Another potentially more important problem (at least for Silicon Valley) will be created if FASB demands the expensing of stock options.

What company would risk deviating from GAAP accounting standards in the post-Enron era? The answer: Intel, Advanced Micro Devices, Conexant, Fairchild, LSI Logic, Motorola, STMicroelectronics, Texas Instruments, Cypress and many others. Indeed, a PriceWaterhouse- Coopers survey found that 74% of semiconductor companies issue pro forma earnings statements in addition to legally mandated GAAP statements. I will focus today only on the semiconductor industry, but the GAAP exodus is happening in other high-technology industries, as well.

The event that caused most semiconductor companies to break ranks with GAAP-only accounting was the gradual elimination of the pooling accounting method for mergers and acquisitions starting in 1998. A final ban on pooling accounting came in 2001. When FASB forced companies to begin accounting for acquisitions using the alternative method of “purchase accounting,” the earnings of the acquiring companies were suddenly decimated—with charges that did not reflect the reality of their acquisitions. After that change, investors, and the analysts that interpret results for them, had to subtract out the phantom purchase-accounting losses, known as “goodwill charges,” before comparing current earnings to prior results. This correction of the GAAP financial statements became a basis for the exodus from GAAP to pro forma accounting.

Figure 1 (below) shows why the elimination of pooling accounting for acquisitions distorts profit and loss (P&L) statements, necessitating the alternative pro forma reporting method.

Consider two hypothetical companies, ACO and BCO, that each share 50% of a U.S. market, with ACO dominating in the West and BCO dominating in the East. Suppose further that each company has identical finances, and that the president of BCO is retiring, causing BCO to accept an acquisition offer from ACO, a one-for-one stock swap, to form ABCO.

Under pooling accounting rules, the revenue and profit of ACO and BCO are added to create ABCO, a company twice as big as ACO or BCO. To pay for the acquisition, ACO issues 100 million new shares to the shareholders of BCO, making the combined share count of ABCO 200 million shares.

ACO BCO ABCO (Pooling) Revenue (mil.) $1,000 $1,000 $2,000
Pre-tax Profit (mil.) $200 $200 $400
Shares Outstanding (mil.) 100 100 200
Profit Per Share $2.00 $2.00 $2.00
Share Price $40.00 $40.00 $40.00
Market Cap. (mil.) $4,000 $4,000 $8,000

Since both the earnings and the share count double, the earnings per share remains constant. And, assuming that the shareholders value ABCO with the same price-to-earnings (P-E) ratio as they did both ACO and BCO, ABCO’s share price remains constant at $40. With twice as much revenue and profit, and twice as many shares outstanding, the market capitalization value of ABCO is simply the sum of the market capitalization of the two companies. This accounting treatment is simple, transparent, straightforward—and forbidden.

In contrast, ... the purchase accounting treatment of the same transaction creates a complicated and misleading result— due to the FASB mandate to create a fictitious “goodwill” balance sheet entry. BCO’s “goodwill” is defined to be the difference between the market capitalization of BCO and the value of BCO’s assets; that is, goodwill is the market capitalization of BCO that cannot be accounted for by physical assets. The purchase accounting treatment of the ABCO merger is given below.

In this case, the $2 billion goodwill value of BCO, a quantity which jumps up and down with share price and is nowhere reported in the GAAP financial statements of BCO, is forced onto the balance sheet of ABCO as an asset, despite the fact that the asset is a fiction and has no cash backing whatsoever. Furthermore, that asset is required to be amortized over a period of years, as if it were a piece of equipment. Assuming that the $2 billion goodwill value of BCO is amortized over a typical period of five years, ABCO’s earnings will be decimated with a charge of $400 million per year over that period.

Thus, purchase accounting requires that companies place a fictional asset on their books. The amortization of that asset over an arbitrarily determined period, or the revaluation of that asset, produces a fictional loss on ABCO’s profit and loss statement, which, in this example, completely wipes out ABCO’s very-real profits.

Under purchase accounting, ABCO is a $4 billion company which has no earnings. Under pooling accounting, ABCO is a $4 billion company that earns $400 million a year pretax—the combined amount that ACO and BCO made before the acquisition. Of course, pooling accounting reflects reality, since neither of the companies became less profitable due to paper shuffling.

FASB accounting theorists provide convoluted explana- tions of why a company making $400 million per year of profit doesn’t really make $400 million a year of profit. When common sense fails, the FASB high priests always fall back on the unassailable religion of “accounting principles.” (Unassailable principles, I might add, that were the opposite—and unassailably so—just years before.)

[snip] In this new environment, technology companies must either make strategic acquisitions, or fall behind their competitors. For example, Cypress made only one acqui- sition during its first decade of operation, but has made 13 acquisitions in the last three years.

The fuel driving our surge of acquisitions is the downturn of 2001, during which many good companies had trouble getting a second or third round of venture financing. For Cypress, these companies represent an incredible opportunity to assimilate talent and technology. Unfortunately, young companies typically have almost no hard assets. Under purchase accounting rules, we are therefore forced to write off almost the entire acquisition price as an expense. It is quite possible that an acquiring company taking advantage of a few acquisition opportunities in today’s market could not report a GAAP profit over the next five years, even if it were really making an actual 20% cash profit on a pro forma basis.

[snip] When Cypress was founded, Jerry Sanders, then president of Advanced Micro Devices, the company that I left to form Cypress, declared that there was no room for new startups and that the semiconductor industry was already consolidating toward a “Big Three,” like the car industry. Cypress had to fight through that real barrier to entry: the attack of established companies publicly discrediting us. Our first big customer, Digital Equipment Corporation, would not even talk to us during our first year, until AMD itself shut down one of their computer assembly lines by losing the manufacturing recipe for a product we also made, a Static Random Access Memory, or SRAM. Cypress did not lose its SRAM recipe and we recorded our first significant revenue in 1984.

Just as our business took off, Japan began battering the American semiconductor industry. Semiconductor industry leaders whined, claiming unfair play, but the reality, as I testified five times before congressional and senate committees, was that the Japanese were simply better than we were at that time. Typical Japanese product quality in 1982 was approximately 50 defective parts per million shipped, while American quality was in the range of 1,000 or more defective parts per million. Just as American consumers kicked out General Motors in the 1970s to embrace Toyota because of quality, so did American engineers kick out American semiconductor companies in the 1980s to embrace Nippon Electric Corporation (NEC), Toshiba and Hitachi. The president of NEC also said in an interview that he did not think a new company like Cypress Semiconductor could make it.

We fought our way through the Japanese quality wars. Despite four college degrees, I had never been taught the concepts and mathematics of quality control. My tenure at two American semiconductor companies did not add much quality-control education either. When the Japanese quality attack threatened our company, we hired experts, put together crash quality-education courses for the executive team, and, when we had mastered the subject, passed on that knowledge to the rest of the corporation. Cypress’s quality level is now 25 parts per million. And last year, Cypress surpassed NEC in revenues from our primary memory business, SRAMs. Indeed, we passed by all Japanese semiconductor companies in SRAMs, to become No. 2 in the world behind Korea’s Samsung.

Today we are facing our latest challenge: The communi- cations revolution. The semiconductor industry is moving abruptly away from its decades-long focus on the computer industry toward the datacom industry and its arcane technologies. As in the case of the quality revolution, we are again facing a knowledge gap. In the last year, Cypress executive staff has attended many lengthy seminars on how data is “framed” on the synchronous optical network (SONET); how data moves from a fiber on the SONET network through a photodiode, transim- pedance amplifier, limiting amplifier, serializer-deserializer, and demulti- plexer; and how your digitized and compressed voice is encoded in code- division multiple access (CDMA) cellular phone systems. It’s been a long, tough, challenging—and exciting—year.

One very challenging characteristic of the semiconductor industry is that we make the bricks and mortar of every electronic system. So, when an electronics era changes, we either fail or move on to become experts in the new field. I learn as much every year now as I did when I was in graduate school.

To summarize, my job is to raise shareholder value by increasing our profits through revenue growth. So far, Cypress has delivered those profits, despite the best efforts of established companies to thwart the Cypress startup, despite the withering attack of the Japanese semiconductor industry in the 1980s, and despite having to get the equivalent of a new Ph.D. every four or five years just to be able to understand the language of our customers.

I’ll be damned if I’ll let accountants take Cypress’s real and hard-earned profits away from our financial report card with phony losses.

I remember a meeting in 1998 in which we were discussing whether or not to acquire a small startup company with good people and great technology. At the time, the SEC had begun to restrict the use of pooling accounting. We could not find a way to structure this acquisition without triggering a punitive purchase accounting treatment. Get this: We nearly opted not to make an acquisition that was highly favorable to our shareholders because of punitive accounting, all in the name of “more transparent” financial reporting.

Our investment bankers said that we could break through the dilemma by using “synthetic pooling.” I’d never heard that term before. To use synthetic pooling meant to make the acquisition using purchase accounting, but with a new strategy. The strategy of synthetic pooling was not to optimize the purchase accounting treatment—that is, to minimize the impact of goodwill losses on the P&L statement—but to use purchase accounting at its punitive best, to deliberately create an ugly, large, goodwill hole in reported profits. The purpose was to highlight, not to hide, the inaccuracies of purchase accounting. The investment bankers claimed that institutional investors, the pros who hold 65% of our shares, would ignore the phony goodwill losses and give us credit for our real earnings and for making the right move for our shareholders. We did a case study of several companies that had employed synthetic pooling, which greatly reduced, or even eliminated, their profits, at least on paper. Their investors ignored the goodwill charges. The companies maintained normal P-E ratios based on their pro forma profits, which eliminated goodwill losses. The analysts who followed those companies also converted to pro forma earnings estimates to provide accurate analysis.

Given our modest size and stature at the time, we were not willing to blaze the “synthetic pooling” trail with the pioneers. We acquired the company and have suffered a goodwill charge to GAAP earnings ever since, despite the fact that it is now a profitable part of Cypress. A few years later, we noted that many semiconductor companies—and the analysts following them—were eliminating goodwill charges from their reports and earnings estimates. We finally joined the crowd when over half of the semiconductor industry had begun reporting pro forma earnings.

Business is good in Silicon Valley, even during hard times. I think we have set some high standards for creating value and treating our employees well. At Cypress—and we are just a typical Silicon Valley example—our average San Jose employee, including our manufacturing workers, earns $107,000 a year in cash and benefits. Capital gains on stock options add to that figure. Silicon Valley workers do not find it necessary to join unions, because they are treated well and they are all shareholders. Contrary to the current political rhetoric on “fat cat” stock options, approximately 82% of the options granted by Cypress every year are given to rank and file employees. The other 18% go to our board of directors, our executive staff and me. Three of the 10 most affluent towns in the Unites States are Silicon Valley bedroom communities. San Jose’s per capita income is double that of the United States, at large. We invent the future and spread the created wealth throughout the organization. It works well. Why would anyone want to change it?

Again we return to accounting principles and the belief that they should somehow cause us to change the way we run our businesses toward perfection, as viewed from the double-entry ledger. In 1994, FASB tried to force the expensing of stock options; that is, forcing companies to report a fictional loss when they grant options to their employees. FASB came to Silicon Valley for a so-called hearing on the topic, but they made it very clear their minds were already made up prior to the meeting. That was a big mistake. San Jose, a place that cares a lot more about electrons than elections, got mad and held some rallies. The politicians shut FASB down quickly.

Unfortunately, the accountants are supported by a few politicians in a current attack on stock options. Sen. Carl Levin (D., Mich.) has openly attacked companies and stock options throughout his career. Perhaps his animosity toward the auto industry has something to do with his views. But why should Silicon Valley suffer collateral damage in Levin’s battle of the big auto union versus the big auto company? Levin’s co- author, Sen. John McCain (R., Ariz.) is simpler to figure out: He has an unbridled ambition to become president of the United States. McCain scored in popularity polls during the last election for his position on campaign- reform. He is looking for another populist campaign issue. I met with McCain in his office, in an effort to convince him that corporate welfare should be eliminated. He dismissed my presentation (calling billions in corporate welfare “peanuts”) and then poked his index finger toward my chest, and said, “But we are going to do one thing you really won’t like; we are going to take away your big, fat stock options.” McCain believes attacking the “fat cat’s” paychecks will help get him elected. So, for reasons that have nothing to do with the reality of running a business right, for the sake of some accounting theories which don’t make sense, and for the sake of politicians who have unrelated axes to grind, stock options are again under attack.

Using the Enron episode as an excuse, the Senators scrambled to relaunch a word-for-word copy of Levin’s failed 1997 anti-stock-option legislation. It’s virtually impossible to have a rational, reality-based discussion with these politicians on why leaving the success of Silicon Valley alone is a good idea, because what they’re trying to “fix” is unrelated to improving our businesses.

When a company raises money, it faces a choice between using debt or equity methods. If it chooses the debt method, it borrows money, and its earnings per share go down because it must pay interest on that debt. If it chooses the equity method, it sells stock, and its earnings per share go down because of the greater number of outstanding shares; that is, because of dilution. As you might imagine, in a free market, the coupling between debt and equity financing is very tight. Often, the decision on which funding method to use boils down to a fraction of a percentage point in the cost of money. But, here is the main point: Companies either pay for raising money in the form of losses incurred by paying interest on a debt or they pay for raising money by the dilution incurred from issuing shares; they never pay both ways.

The Levin- McCain proposal (which is a very close cousin of the 1994 FASB proposal) would force us to treat stock options as both an expense and a dilution. In other words, the use of employee stock options would not only trigger a loss on the P&L statement, but it would further reduce earnings per share due to increased share count. Accounting theorists babble for hours on why this “double taxation” of stock options makes sense, but it simply does not.

Even in a technical accounting sense, the Levin-McCain proposal is inconsistent with current accounting methods for related financial instruments. For example, our company raises money— about $1 billion over the last 10 years—by selling a widely used security called a convertible debenture. A convertible debenture offering is a hybrid between a stock or equity offering and a debt offering. The value proposition behind a convertible debenture offering is that companies sell stock options to shareholders at prices above the current market price. Until the company actually delivers the higher share price, it is obliged to treat the offering as a debt, paying interest to the convertible debenture holders. Once the offering or “strike price” is reached, the company then pays off the debt permanently by issuing shares, as it would in an ordinary stock offering. The SEC rules for the accounting of convertible debentures require two calculations. In one calculation, the convertible debenture is not counted as debt (that is, the interest payments are ignored), but the shares underlying the convertible debenture are counted in the shares outstanding, diluting earnings per share. In the second calculation, the shares underlying the convertible debenture are ignored (that is, there is no dilution), but the interest payments on the debt are taken as a loss. The SEC rule is that a company with an outstanding convertible debenture must then report the lower of the two results. So, in a directly comparable case, the SEC itself requires that the stock options inherent in a convertible debenture are treated either as a charge to earnings or as dilution, but not both. McCain, Levin and FASB seem to be going out of their way to create a new punitive rule for stock options. Is their purpose to make Silicon Valley more like Detroit?

Consequently, if accountants require us to expense stock options it will represent another unrealistic charge against earnings that I predict both companies and analysts will ignore. If successful, FASB and McCain-Levin will have driven GAAP another step away from being a useful accounting method that investors can use to measure companies accurately.

The word “theology” relates to a set of beliefs that are supported by faith and not required to be supported by reality.

I have used the word in analogy to describe beliefs unsupported by reality in accounting and politics. In many professions, certainly accounting, law and even engineering, the self- consistent logic of the profession sometimes causes its practitioners to float in a theoretical space above reality. But business has a way of forcing people to deal with the reality of issues. Reality is where I live. If we do not produce what our customers want, we will be ignored and our competitors will prevail. Our employees expect their checks every other Thursday. Analysts and investors expect us to achieve our earnings estimates and that our share price will appreciate. Everybody expects that we will be ethical and obey the laws—just ask the ex-CEO of Enron to explain the penalties for violating that rule. Many of us regard the founding of Hewlett-Packard as the genesis of Silicon Valley. It is instructive to actually read the postulates of the HP Way. The first cited objective is to make a profit. Yes, in the HP Way, which is generally considered to be one of the most humanistic forms of management, the first order of business is to make a profit. Of course, making a profit the HP Way involves innovation and treating people right, the hallmarks for which HP is more well known.

Contrary to a popular saying, I submit to you that profit— money—is the root of all good. It is profit that enables Silicon Valley companies to pay their employees well— and that enables those employees to support their families and communities well. It is that environment which provides Silicon Valley workers with exciting jobs —not just paychecks—and that inspires them to engage in further invention. That invention, in turn, creates more wealth—wealth that is mostly reinvested to stimulate further invention. What I have just described is one cycle of the economic engine that drives Silicon Valley. Yet, we are asked to tinker with that incredible engine of prosperity, not because of any real issue, but because of the theologies of politicians and accountants. There are many examples of how theology creates systems inferior to those that are reality-based. An obvious example: One group of theologians may declare it is “right” for women to be veiled, uneducated and not allowed to appear on the street alone. The realists would say that any society that denigrated and ignored 50% of its brain power was destined to be—and stay—poor. That’s an easy example.

The Japanese economy is a more subtle example of economic reality versus economic theology. Many reasonably consider Japan to be a high-technology, capitalist economy. But why has their economy been in a decade-long recession, even when times were good here and elsewhere? The simple answer is that the Japanese government does not truly believe in free market capitalism, which they tout when they’re selling cars or TVs to us but ignore at home.

The economic theology of Japan is that a ruling group of men—the right men, from the right schools, working for the right companies, which are members of the right company groups, or keiretsus—have the unquestioned right to control the assets of the country.

Who controls the assets of America? You do. And I might add that you are rather brutal about it. You save money and invest it in the stock market, either directly, or through your 401K plan, or through the bank where you save it. When, for example, your 401K underperforms, you check off a box on your computer form to fire your 401K account manager with no warning and no mercy. When the investment firm you fired loses your funds, they immedi- ately have to dump some of the stocks that they hold. That’s Cypress stock, sometimes. I’ve been fired like that. My net worth was cut in half in 30 days in 2001. I accept your sometimes brutal decisiveness. Why should the college accounts of your children suffer to make me wealthier?

You invest in the stock market to get a better return than the 4% interest you can earn at a bank. Do you know where typical Japanese citizens invest their money and what interest rate they get? They invest in the Japanese Post Office at 0.25% interest. Unlike you, they are not allowed the free-market response of firing an underperforming 401K manager. Their government “protects” them from the complicated money market that you deal with—and they pay dearly for it. Who gets the nearly free money in Japan? The right men from the right companies enjoy financing at interest rates 10 times lower than ours. And the right men can under- perform all they want, because no one is able to check that box on the computer form to fire them.

Unfortunately for the American semiconductor industry, the anti-capitalist flaws in the Japanese economic system took more than a decade to smack the Japanese semiconductor industry into the stone wall of economic reality. At first, that nearly free money made Japanese companies very competitive. In our industry, 70% of the cost of a silicon chip is due to depreciation, the cost of the money we have invested in the factory that built the wafers. With the Japanese cost of money 10 times lower than ours, their chips automatically cost less than half of ours. That financial fact—combined with our industry’s quality problems—took its toll on the American chip industry in the late 1980s, when Japan surpassed the U.S. to dominate the world semiconductor market. But the American pay-as-you-go system has prevailed in the long term.

The Japanese economy fell ill as Japan’s economic belief system came into conflict with economic reality. Here’s a vignette of how it happened. The keiretsu bank lent the hypothetical Japanese Semiconductor Company, JSEM, $1 billion to build its first wafer fabrication plant, which I will call Fab 1. That plant was optimized to give up capital productivity in return for better quality and higher human productivity. Why not? The capital was cheap, quality was an effective competitive weapon, and people were expensive. The enhanced financial competitiveness of Fab 1 was not used to make extra profit, but to lower prices to drive competitors out of the market. And it worked; Japan took over the No. 1 market share position from the U.S. in 1986.

When it came time for JSEM to build Fab 2 two years later, because of its low-price strategy, JSEM had no retained earnings from Fab 1 to fund Fab 2, so it borrowed $1.5 billion more from the keiretsu bank to build a second capital-inefficient plant. JSEM then owed its keiretsu bank $2.5 billion, but continued to seek market share rather than profits.

JSEM’s Fab 3 was planned to be built two years after Fab 2 at a projected cost of $2 billion. But JSEM’s meager profits would not support the interest on $4.5 billion of debt. Furthermore, since JSEM built its original Fab 1, the American semiconductor industry had caught up in quality. The American semiconductor plants—built with much less capital because of the high price of money in the American markets—had also become more cost- competitive than JSEM’s plants. There were even bigger problems: JSEM’s keiretsu bank had lent too much money to too many companies that didn’t pay it back. The keiretsu bank ran out of money and even the national bank of Japan had a liquidity crisis, which endures today. There were no more “free money” loans to be had. And, since 1993, the American semiconductor industry is back solidly in first place, with 51% market share in 2001, nearly double Japan’s 28%.

In a capitalist free market, investors cold- heartedly select only the best investments. CEOs must be productive with your capital or be fired with a check mark on your 401K computer card. Japan is often described as a capitalist country, but it is certainly not. Under Japan’s economic theocracy ordinary citizens have little control over their money—the ruling class makes the “right” decisions about how money is spent. Do you see the politburo with capitalist camouflage here? The only difference is that the ruling class in Japan is selected on a merit basis. Unfortunately, when America engages in “government-industry partnerships,” a.k.a., subsidies, corporate welfare, tariffs, and the like, we engage in the same destructive practices that devas- tated Japan’s economy and put the Soviet Union out of business.

The tactical nature of the reality-theology conflict for us in Silicon Valley is that we broadly ignore the theologians in Washington for most of our careers. What we care about is uninfluenced by the latest, rehashed conservative- liberal debate, or by the blundering statements or sexual peccadilloes of the latest president. We are 100% consumed by increasing our knowledge of the technologies whose frontiers we are pushing back. A conflict with Washington ignites only when our companies are forced either to go along with the latest, dumb—and destructive—idea from Washington (or Sacramento or Norwalk, Connecticut, FASB’s hometown), or to fight it. That fight is why I don’t have much time to fight ordinary pork barrel politics anymore. Senator Snoot can build a parking garage named after himself in the name of homeland security at my expense—as long as his other laws don’t threaten my Silicon Valley homeland.

[There is more and you are invited to go tothe Cypress web site to locate the entire article]

A very long read, but incredibly valuable to understand the debate about stock options, GAAP and the political shenanigans of some of the most venal politicos in Washington. T.J Rogers is the most outspoken proponent of freedom and capitalism in the corporate world. And CY is a great buy.

I like catching T.J. Rogers on Fox. He's a pretty refreshing change to the PC/make-no-waves cookie cutter CEO. Good post. I loved the line on Mr. Populist himself(mccain). I also didn't realize that we had already beaten back the Japanese and taken back dominant market share...

He's a pretty refreshing change to the PC/make-no-waves cookie cutter CEO.

Probably because he's an engineer not an MBA or lawyer.

”I also didn't realize that we had already beaten back the Japanese and taken back dominant market share...”

I had not either. What I found most interesting was the explanation of how Japan was able to under cut us for a while and why they have been in a decade long depression. Three cheers for the “creative destruction” of capitalism.

Thanks. If you go to the whole article, there's a lot more on freedom vs. statism.

Yes. I went to the site and read the whole thing. T.J. is an egotistical jerk, but he's brilliant.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.