Where did the phrase “creative accounting” originate?
It’s a tongue-in-cheek expression that refers to accountants who find “creative” ways to manipulate the books and make companies appear to be healthy when they are actually near ruin. The phrase was originally used in the Mel Brooks film The Producers when accountant Leo Bloom explained to Broadway impresario Max Bialystock that he could optimize his profits by intentionally producing a “flop” of a show. He could then close the show, pay the outstanding bills, and keep the significant remaining balance of his shareholders’ investment proceeds.
Although Brooks was primarily a comedian and not a financier, he had actually devised a strategy that has subsequently been applied in the real world. Some small-market professional sports teams, for instance, have been accused by their wealthier and more successful rivals of pocketing their share of league-wide revenues and then optimizing profits by refusing to sign talented (and costly) players.
Earlier this month, in another display of creative accounting, the internet coupon distributor Groupon astonished the financial markets while filing a plan to “go public” soon. Their filing plan itself didn’t generate any astonishment; rather, it was the valuation that advisors placed on the firm, and the manner in which they quantified that valuation.
Profits vs. Losses
Financial analysts have traditionally multiplied a firm’s accounting profits by a risk-adjusted multiple to estimate its value. A low-risk, low-growth firm with $1 million in profits, for instance, might be assigned a multiple of 2.0 and valued at $2 million. A high-risk, high growth firm with the same $1 million in profits, however, might be assigned a multiple of 10.0 and valued at $10 million.
The higher valuation of the second firm is attributable to its greater growth potential, a condition that inevitably attracts Wall Street investors. Those same investors, though, would take note that the second firm’s price-to-earnings ratio is 10:1 instead of 2:1; they would thus be forewarned that an investment in the second firm might carry a higher risk of failure.
What if a firm “goes public” while it is earning no profits at all? What if it is actually losing money and yet needs to value itself? Traditionally, investors would expect such a firm to develop detailed strategic plans to turn its losses into profits in the relatively near future, and thus would utilize that future profit forecast as a basis for valuing the firm.
Groupon, though, is using a novel approach to support its valuation methodology. Although it is currently incurring losses in a traditional accounting sense, it has creatively invented a new accounting term called ACSOI to restate those losses as profits.
Introducing … Adjusted CSOI!
Groupon acknowledges that it is losing money when profits and losses are measured in accordance with Generally Accepted Accounting Principles (GAAP). The firm claims, however, that its profits and losses are more meaningfully measured by a metric they call Adjusted Consolidated Segment Operating Income (ACSOI).
How does this number differ from profits and losses that are measured in accordance with GAAP? ACSOI apparently includes all of the revenues, but only some of the expenses, that are recognized by GAAP. By excluding certain significant expenses, Groupon manages to convert its losses into profits.
The expenses that are excluded from ACSOI encompass some of the most common expense items found in GAAP reports. Marketing expenses, for instance, are ignored by the ACSOI formula. So are acquisition-related expenses, stock compensation costs, and interest and taxation expenses. Groupon claims that these expenses are all unrelated to its current business of serving its core customers, but prospective investors may wish to think twice before embracing this creative accounting metric.
More Aggressive Than EBITDA
In all fairness, Groupon is certainly not the only firm that utilizes a profit measurement that is different than the traditional GAAP metric. Many analysts, for instance, utilize a measurement known as EBITDA, which refers to Earnings Before Interest, Taxation, Depreciation and Amortization Expenses. As is the case with ACSOI, EBITDA includes all revenues recognized by GAAP but excludes certain expenses, ensuring that it will usually produce a larger profit number than GAAP.
ACSOI is particularly aggressive, though, because it excludes marketing expenses. Groupon claims that its marketing activities are targeted primarily at attracting new clients and are not designed to retain current clients, and thus should be excluded from any profit measurement that is focused on current operating activity. Nevertheless, analysts have noted that Groupon’s “customer acquisition” marketing expenses are extremely high; such costs are completely ignored when excluded from metrics like ACSOI.
Ultimately, each investor must decide for himself whether Groupon actually deserves the mammoth $30 billion valuation estimate that has been calculated by analysts on the basis of its ACSOI metric. Whether you agree or disagree with that particular valuation number, you would be hard-pressed not to admire the creativity of the ACSOI metric, as well as (as Max Bialystock might say) Groupon’s sheer chutzpah in promoting it.