Compound Errors

Over the past years, I’ve been intrigued by why airplanes crash. Yes, I suppose it’s a slightly morbid fascination, but I suspect it has to do with a general tendency of mine to learn from mistakes to prevent future catastrophes.

Years ago, one of my friends who is a pilot explained to me that planes rarely crash because of a single error. They’re almost always due to multiple consecutive errors that result in a tragedy.

In his book Outliers, author Malcolm Gladwell states that most plane crashes are due to a whopping seven consecutive errors.

One of the most common errors in airplanes is apparently a loss of situational awareness. A pilot must be aware of the location of the airplane in the sky. Is it climbing or is it descending? Is it turning right or is it turning left? Is it flying fast enough to achieve lift or too slow where a stall and subsequent crash is imminent?

When you misunderstand the problem, almost by definition any solution you take will be incorrect — and in an airplane that may be fatal.

Over the decades, I’ve seen public companies get into accounting scandals where they misstated (aka lied about) their earnings. These are not minor errors where a person rounded numbers up or down incorrectly. These are errors, technical deceptions, in the billions of dollars.

Sometimes these accounting scandals start with the desire to outright lie, cheat, and steal. However, I have a theory (for which I have no evidence) that these scandals start more innocuously.

To understand this theory, it’s important to realize how publicly owned companies work.

These companies must report their financial results to shareholders on a regular basis (quarterly here in the United States).

Profits are reported on both an aggregate basis (e.g., the company made $1 billion in profits this quarter) as well as on a per share basis (total profits/number of shares). The latter metric allows each shareholder to know how much profit each share of the company produced.

Wall Street analysts make predictions about how much profit a company will make for a particular quarter or year. When companies exceed Wall Street analyst estimates, the stock price goes up. When a company “misses” earnings forecasts, the stock price goes down.

This positively or negatively impacts shareholders and the executives who have stock option compensation plans.

In a public company, there is enormous pressure to “meet or exceed” earnings expectations.

Here’s the thing:

When you manage the finances of a corporation, there are some legitimate things you can do to “manage your earnings.” If you want to increase profits, you might intentionally delay some expenses into the next fiscal year.

Instead of spending $10 million on December 31, 2022, you could delay that expenditure by 24 hours, lowering expenses in 2022 and increasing them in 2023. This is fairly normal and legal financial management.

However, what happens a year later on December 31, 2023, when you exhaust the normal ways of managing profits? What happens then?

This is where one gets into the slippery slope that ends in an accounting scandal.

If you missed your financial targets, the right thing to do is just to admit it. You missed—it happens. Take the stock price hit. Go work on the fundamentals of your business—good products, happy customers, properly treated employees, etc.—and earn more next quarter.

However, some companies just refuse to admit that they underperformed. They start engaging in gray-area financial practices and end in outright fraud to just “meet earnings” for the quarter. The problem is that in the next quarter, you have double the problems. You’re missing earnings for this quarter as well as the earnings missed from last quarter that you’re covering up.

Eventually, the errors compound and you end up with billions in fabricated sales or earnings.

In every domain I can think of, the right thing to do is very simple.

Own your mistakes.

If you made a moderate error with an employer, a colleague, or a client, admit it. People are human, and we all make mistakes. It’s okay.

What is not okay is trying to cover up the error. Now, you have two problems — the original one and the fact that you lied about it. Sometimes there are multiple lies… lies upon lies… to cover up what you covered up with the original mistake.

It’s a road that takes you nowhere good.

The lesson learned is simple. If you screw up (and you and I definitely will sooner or later), admit it. Learn from it. Don’t make the same mistake twice. Move on.

Don’t make it worse than it needs to be.

Let me know your thoughts on this by commenting below.