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Boeing's 787 accounting block a big break from its history (Update1)

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On the same day as All Nippon Airways will fly its maiden commercial service aboard the 787, Boeing will report its third quarter earnings. The October 26 call with analysts and media will provide the first concrete details about the company's expectations on the 787's long-term financial health and will see the disclosure of the initial accounting quantity, widely expected to spread its investment over as many as 1,000 deliveries to maintain a position of profitability.

UPDATE 10/21: Boeing emphasizes its selection of its initial accounting quantity is not determined in an effort to "maintain a position of profitability", but rather is determined through a "multi-diciplinary process"..."independently of the profitability calculation in accordance with GAAP and rigorous, externally audited procedures." The company says the figure, which will be disclosed on Wednesday, "is our estimate of the quantity of airplanes that will be produced for delivery under existing and anticipated contracts. It is bounded by our ability to make reasonably dependable estimates of both revenue and cost."

Large aerospace projects use an accounting method known as program accounting, which allows Boeing to take the total sum of its upfront investment and spread it across a block of deliveries. As Boeing explained in its 1998 Annual Report (PDF):
Commercial aircraft programs are planned, committed and facilitized based on long-term delivery forecasts, normally for quantities in excess of contractually firm orders. Cost of sales for the 737, 747, 757, 767 and 777 commercial aircraft programs is determined under the program method of accounting based on estimated average total cost and revenue for the current program quantity.

The program method of accounting effectively amortizes or averages tooling and special equipment costs, as well as unit production costs, over the program quantity. Because of the higher unit production costs experienced at the beginning of a new program and the substantial investment required for initial tooling and special equipment, new commercial jet aircraft programs normally have lower operating profit margins than established programs.
While the final figure will not be known until next week, Boeing CFO James Bell said on the company's second quarter earnings call on July 27: "Given the tremendous success of this product in the marketplace with over 820 airplanes in backlog. The initial accounting quantity will be substantially higher than previous new program initial quantities."

This represents a significant shift in Boeing's historical accounting behavior, according to that same 1998 report:
"The initial program quantities for the 777 program and the 737-600/700/800/900 (Next-Generation 737) programs had been established at 400 units, the same initial program quantity as used for the 747, 757 and 767 programs."
Bell's justification for raising the initial accounting quantity due to the 787's "the tremendous success of this product in the marketplace" - whose orders now stand at 797 - only further illustrates the break with the company's past accounting practices. The Next Generation 737 had accumulated around 700 orders at the time of the 737-700's first delivery to Southwest in December 1997, breaking 800 in March 1998, 900 in May and 1,000 by August. At the time, it was the fastest selling aircraft in commercial aviation history.

Despite the unprecedented sales success, after its late 1997 production debacle that significantly slowed the company's production ramp up, Boeing declared it wouldn't make a penny on any of its first 400 Next Generation 737 deliveries, and in fact, it would lose $1.05 billion across all 400.

Boeing CEO Jim McNerney said at the 787's first delivery he expected the program to breakeven before the end of the decade. The "breakeven" was not on its entire investment, but rather on a recurring basis, meaning that by sometime before 2020 each 787 that is delivered will sell for a price higher than it cost to build the aircraft.

Conversely, McNerney's statement indicates that each 787 delivery between now and 2015 - at the earliest - will lose money, before revenue can even begin to pay off the initial investment, let alone the lost cash on each of the deliveries that preceded. Boeing holds $16.2 billion in inventory on 787s spread across some 40-plus aircraft as of June 30, averaging $300 to $400 million per aircraft.

On a program basis, UBS, JP Morgan and Bernstein Research all estimate it will take at least 1,000 deliveries to break even, while Air Lease CEO Steven Udvar-Hazy estimated the number to be as high as 1,500.

Though McNerney - referring to the company's method of program accounting - assured reporters: "In the way these planes are accounted for, we will be profitable from day one."  

With three and a half years of delays and billions in cost overruns and supplier acquisitions, Boeing is facing a precarious accounting question for how it manages its astronomical investment, especially in the face of hundreds of poorly priced orders that are weighing on its backlog. The disclosure that takes place next week may shape Boeing's fortunes for decades to come.

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