Budget capping invites accounting scandals

In January, I said that budget capping is a bad idea because it would turn Formula 1 into a competition to see who could hide their expenses the best. I still think this is the case, and in light of today's report that the FIA has proposed a 175 million Euro cap for 2009, I will try to go deeper into how the top Formula 1 teams can get around this.

First, let's try to understand the proposal given the little public information we have. The cap "would not cover expenditure on engines, KERS systems, marketing costs or driver and team principal salaries," according to Autosport. With engines and KERS systems, the rationale for unlimited spending seems to be, 1) engines are supposedly frozen for several years, and 2) KERS systems is a pet project of Max Mosley's and is not seen as a significant performance-enhancing item. The lack of a limit to marketing costs is probably to help teams get the 175 million Euros to fund the rest of the operation; once teams hit that amount, there's no point in spending more on marketing. Regarding the driver and team principal salaries, this is probably 1) to avoid a revolt from the Formula 1 stars, who generate lots of revenue for the sport, and 2) to appease the team principals, who seem to be contemplating the removal of Max Mosley from office.

Now, here are some hypothetical ways for all the teams to "make the most of" the budget capping:

• Consideration given in exchange for wind-tunnel services can be classified as "marketing costs." For example, say McLaren-Mercedes has a deal with ABC Aerodynamics Corp., whereby ABC will provide a 50% discount on their F1 wind-tunnel work, if they get 1) free trips to all the races and unlimited access to the McLaren motorhome, 2) free Mercedes-Benz cars, 3) free demonstration rides in the McLaren MP4-23, and 4) advertising on the race cars and uniforms. Obviously, only a wealthy team like McLaren would be able to take advantage of a deal like this. Furthermore, aerodynamics expense would be on their books below the normal market value. Under certain accounting rules, an arrangement like this might even be taken as a reduction to advertising revenue instead of an expense, making it a total pain for the auditors to find out what's going on.
  
• Better yet, ABC may agree to a further discount if Daimler agrees to hire ABC for work related to a new Mercedes sports car. Perhaps ABC would agree to do the F1 work for free, thus eliminating the expense from the F1 books altogether. Any serious auditor would have to learn about race car design and engineering, and have access to the Daimler books, to even suspect anything like this had occurred.
  
• Over the next few years, BMW spends billions of dollars developing the next generation F1-spec V8 engine for a Le Mans race car. When the engine freeze is lifted, BMW Sauber copies the blueprints onto their server, and simply needs to pay for the manufacturing of additional units of the engines.
• In order to reduce costs, Renault outsources all of its R&D to India. Whereas before they were paying each engineer $100 per hour, now they can get away with paying $30 per hour. Many jobs are lost in France.
  
• There are thousands of engineering students who would love to work in Formula 1. Williams offers an apprenticeship program to give students the valuable opportunity to assist with the research and development of a real Formula 1 car. No benefits, low salaries. Special events include an all-night wind-tunnel staffing party, with free pizza.
• Ross Brawn, team principal at Honda, receives a $100 million salary (remember, team principal salaries are unrestricted). He uses $90 million to buy a state-of-the-art CAD system, which he gives as a birthday present to an American friend, who ships it to his cousin in Brazil, who ships it back to Japan as a generous anonymous donation to Honda.
• McLaren expands its "Young Driver Program" to include all employees of its organization. During the off-season, each McLaren employee, from software engineer to janitor, is taken through an intense karting program and a few laps aboard a Formula 1 car. They are, then, hired as drivers, so their salaries do not go towards the salary cap.
  
• For $1 billion, Honda produces the next generation Honda NSX, which miraculously conforms to F1-specs. The Honda F1 team acquires one example of this car, takes it apart, and quickly "designs" a car based on what they've learned.
• Toyota exits Formula 1 at the end of 2008. During 2009, they spend billions to develop a Formula 1 car, running the wind tunnel constantly and conducting on-track tests every week. At the end of 2009, they re-enter Formula 1, and then dominate the 2010 season.
• Employees at Red Bull F1 are paid a small salary, but are granted bonuses based on performance. These bonuses are not paid out until the next year, and the financial statements fail to accrue for the bonus at year-end. Additionally, Adrian Newey is persuaded that he has enough money, and agrees to work for free.
• New components are secretly tested at historical race events, which classify as "marketing events." For example, a tribute to Gilles Villeneuve at the Goodwood Festival of Speed, featuring Michael Schumacher driving a Ferrari 412T4, is actually a test of a new braking system for the Ferrari F2009.
  
• Force India and Toro Rosso agree to join forces and chip in $20 million each to an independent designer and manufacturer of gearboxes. Both of them get an identical, $40 million super gearbox that shifts much faster and is more reliable than ones developed by the better teams. The manufacturer also agrees not to provide any other Formula 1 team with the gearbox.
• Ferrari pays their employees in stock options, i.e. no cash is paid. They can get away with this easier, if the 175 million Euros is referring to actual cash payments rather than expenses under an accrual-based accounting system.
  
• Toyota hires an "R&D specialist" whose researching methods include purchasing and taking apart old Formula 1 cars from the back pages of Motorsport magazine.
• Honda builds an army of ASIMO robots, who are happy to work for free at Honda F1.
  
• Keep a set of books for management, and another set of books for the auditors.

Okay, some of these ideas are crazier than others. But the general idea is that, if the FIA imposes a budget cap, then we should expect to see some very ugly accounting scandals that threaten to put the sport into further disrepute. The last thing the public wants to hear about Formula 1 is how a team is improperly depreciating its fixed assets. As I have said before, the best way to cut costs is to make less money.