Closing GAAPs
4 MIN
Koch needed something better than Generally Accepted Accounting Principles to make good economic decisions.
Being constrained by rigid rules is common in most professional disciplines, but it can severely limit progress and knowledge. By applying proven economic principles, we have developed ways to analyze and report business results that have led to much better decision making.
Ever since it was established in 1933, GAAP (Generally Accepted Accounting Principles) has provided standards for businesses to produce consistent and comparable financial statements. The adoption of Fair Value Accounting (FVA) beginning in the 1990s brought a seismic change. It was designed to more accurately reflect the current market value of an asset instead of its purchase price. Although well-intended, FVA produced unintended consequences.
Koch needed to follow GAAP to receive what’s called an “unqualified” audit opinion. This informs banks, rating agencies, lenders, insurance companies, stockholders and other partners of Koch’s financial health. However, for Koch to make good decisions for its businesses it also needs to understand economic reality. “GAAP rules sometimes obscure the financial realities of our businesses,” said CFO Richard Dinkel, who was Koch’s controller when FVA was introduced. “As rules became more detailed and prescriptive, and our transactions got bigger and more complex, GAAP reporting became disconnected from economic reality.”
“GAAP reporting became disconnected from economic reality.”
This tension came to a head in 2017. After five years as a minority owner (44.5%) of Guardian Industries, Koch decided to acquire all of Guardian. Because of improvements made since 2012 and the higher value of a controlling interest, the price of these shares had risen. Under GAAP rules, Koch had to revise the value of its initial investment to the same per share price paid for the remaining 55.5%. This created an enormous gain on paper, overvaluing the company.
A year later, the business experienced a downturn and slipped below book value. “We then had to write down what GAAP had made us write up,” said Dinkel. “These gyrations were leading to unnecessary volatility, distorting our decision making.” GAAP accounting was also unhelpful when evaluating contributions and bonuses for employees, because it did not reflect the true performance or value of the business.
The scenario threatened to repeat itself as Koch made a growing number of new investments and transactions. “GAAP reporting standards caused us to miss out on some acquisitions and created doubt about the value of existing investments,” said Dinkel. “If you only use GAAP to estimate the value of acquisitions and assets, it may lead to poor decisions.”
The accounting team was between a rock and a hard place. If they didn’t use GAAP, Koch’s ratings and the trust of our financial partners would drop. But if the team did nothing, Koch would continue to lack the measures necessary for sound economic decisions. “Charles Koch regularly reminded me of how destructive these rules were and urged us to find ways to satisfy GAAP but also report our results more in harmony with economic principles,” said Dinkel.
The team began challenging the paradigm that we need to rely only on GAAP accounting to make sound economic decisions. What if we maintained our accounting records in compliance with GAAP for regulatory and reporting purposes, but created an additional report that better reflected the company's true economic position?
In 2018, Dinkel and team began working on an “Economic Reporting Framework” to apply a different accounting perspective to specific transactions that would better reflect economic reality. “I remember preparing to go to Charles and our leadership for the first time with this idea. I worried they would think such an approach was ludicrous,” Dinkel admitted.
“I worried they would think such an approach was ludicrous.”
Fortunately, company leadership welcomed the new approach for its economic clarity and integrity. Both the GAAP and economic reports were shared with preferred partners. “We want to be completely transparent about our practices. Those with access can look at whichever reports they like,” said Dinkel. “For example, we are only required to show auditors our GAAP reports, but we always say, ‘Look at our economic framework too, and tell us if you think we're missing anything.’ To the extent that there any differences between the two, that is merely due to timing.”
When Koch was considering the acquisition of Infor prior to 2020, it had to sort through the valuations of Infor’s intangible assets, such as intellectual property and customer relationships. GAAP reporting required, among other things, that Koch immediately depreciate those assets, causing future earnings to appear much lower. “Without the clarity from Koch’s economic reporting framework, we may have been far less likely to acquire a technology company like Infor,” said Dinkel.
This unconventional approach also encourages Koch to make decisions regarding impairments or restructuring as they occur. “GAAP would have us carrying these values, or amortizing these costs, for years,” said Dinkel. “We would rather face reality now.” Recognizing these sunk costs earlier was particularly helpful for INVISTA and Koch Engineered Solutions when they needed to refocus their activities and pursue a narrower portfolio. They could concentrate on future strategies and not carry over-valued assets.
Since Koch’s investing businesses have become a much larger portion of Koch’s financials, accounting for their investments using GAAP can produce a lot of variability. “We keep our investment balances at cost, unless we are convinced the value to us has significantly and permanently changed,” said Dinkel. “As long-term investors, economic accounting enables us to earn better returns by making better decisions.”
Challenging conventional accounting norms has created mutual benefit. “Our auditors love it because we no longer have to debate why GAAP accounting doesn’t provide the right economic results. Our banks and creditors love it, because they get an unqualified opinion. And we love it because we get information that contributes to our long-term success,” said Dinkel.
Give it a Try
The power of these principles happens through application. There’s no substitute for learning as you apply.
- Identify a process you use regularly. Articulate its purpose and objectives then evaluate whether it's achieving those goals. Make changes if needed.
- What would be a bold new approach in your area of work? How could you test its effectiveness?
- When have you been afraid to raise an idea because you thought it was “ludicrous”? How would you act differently today?