Everyone knows that economists tend to be people who are good with numbers but don’t have enough personality to make good accountants.
Knowing my limitations, I avoid accounting issues as much as possible. But when a friend asked, “Is it true that Xcel Energy really has its regulated businesses completely isolated from its non-regulated subsidiaries such as NRG?” I could not resist responding.
I don’t know about Xcel’s finances or its accounting procedures. But like Will Rogers, I do read the newspapers, and like many other people I enjoy reading history. Both repeatedly show how firms have used what economists call “transfer pricing” to perform various kinds of financial sleights of hand.
I just finished an excellent history of U.S.-Iran relations. It described how, in the early 1900s, the Anglo-Persian Oil Co. (now part of BP) got exclusive rights to extract oil in Iran. The Iranian government was not paid any lump sum or any fixed amount per barrel. It settled instead for 16 percent of the profits of the company’s Iranian operations.
But the company manipulated its accounts so that almost all of the profits accrued from operations outside of Iran, thus virtually no profits would have to be shared with that country. The company accountants assigned a low value to oil leaving Iran and high values to engineering and financial services charged to the Iranian operations. Economists call this cost-accounting practice “transfer pricing.”
Transfer pricing is a common subject in the study of international economics and economic development of poor countries. It can occur within a company, as in the case of the Iranian oil, or in the course of import and export business.
Say a country in Latin America has capital controls that limit its citizens’ ability to send money to banks abroad. Any exporter from that country who can find a cooperative buyer abroad can issue two invoices for a sale. The first invoice — for some credible fraction of the shipment — is the “official” one that is presented to customs officials and the Central Bank. Money paid to settle this invoice returns to the country and is declared for tax and capital control purposes.
But the exporter also issues a “supplementary” invoice for the balance of the true agreed-upon cost of the shipment. Funds in payment of this second invoice are paid into an account in New York, Miami, London or Switzerland. With a few such “under-invoiced” transactions, the exporters can shift significant quantities of cash to foreign investments.
“Over-invoicing” can move money the other way. Auto companies produce many components in Brazil for shipment back to assembly plants in Germany or the United States. If Brazil has lower corporate tax rates than these other countries, the automaker can overvalue the castings or gears shipped back home. This lowers profits in Wolfsburg or Detroit and increases them in Sao Paulo.
Such accounting legerdemain is not limited to obscuring cross-border financial flows. Two decades ago, U.S. citizens were shocked to find that defense manufacturers were charging $200 for hammers and $600 for replacement toilet seat assemblies. Members of Congress tut-tutted about waste and abuse. But in most cases, the firms were following cost-accounting rules established by the Pentagon and Congress.
Most of the cost of any modern weapons system is in research and development. These fixed costs have to be spread over the number of units actually built. High per-unit costs are politically embarrassing to the contractor, to U.S. Department of Defense procurement bureaucrats and to Congress.
Per-unit costs can be lowered by requiring that a portion of research and development costs are allocated to tools, accessories and spare parts for the system. Such rules reduce the price tag on the tank or airplane itself, but result in $200 hammers.
Want more examples? Accountants can list any number of discretionary choices that can move money from one part of a company to another, including above- or below-market rent for facilities or charges for internal business services, “lending” of personnel, or “sharing” of design or marketing information and services.
Is Xcel allocating any of its nonregulated business costs to the regulated side of the business? I have no reason to suspect that they are. Could they do so if they wanted? History says they could.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.