The Formula 1 Accounting World Championships (#326)
/The topic of this episode comes from Christian Horner, who is not a listener, and it is the Formula 1 accounting world championships. He stated recently that the new budget caps that have been imposed on the Formula 1 teams are so complicated that they might actually decide who wins the championship. And in cases where the points total is close, he might have a point.
But first, for some background. Yes, I am a Formula 1 nutcase, and check on the latest Formula 1 news every single day. I also just got back from watching the Canadian Grand Prix, which is held every year at a race track outside of Montreal. Very cool. Also very, very expensive. And as a side benefit, I caught COVID while I was there. Already recovered, no worries.
So, who is Christian Horner? He runs Red Bull Racing, which is currently leading both the team championship and the individual championship. And they’ll probably win the whole thing this year.
The Formula 1 Cost Cap
And what is he so concerned about? How on earth does accounting enter into the Formula 1 championship? Well. The main problem with Formula 1 is that there are 10 teams, but only three of them usually have enough money build a car that’s good enough to actually win the championship. Those teams are Red Bull, Ferrari, and Mercedes. The other seven just don’t have the cash. So, to make things more competitive, Formula 1 imposed a cost cap on the teams that starts in 2022. Under the new rules, you can’t spend more than $140 million dollars for the entire season for 21 races. If an extra race is added, then the cost cap goes up by $1.2 million, which tells you how much money a team spends to move to a new venue and operate its cars there for four days.
Also, the cost cap goes down even more for the 2023 race season, with a cap of $135 million.
This creates some issues. One is that freight costs have gone up astronomically this year, so that transferring the cars and everything else from one race to the next costs three times more than they expected. And that’s a lot when you’re shipping by air freight. Horner guessed that costs have gone up so much this year that a majority of the teams might not even be able to compete by the end of the year, because they hit the cost cap.
So there’s one issue, which is a loss of competition due to the new cost cap rules – which is the exact opposite of what the cap was intended to do. But there’s more.
Cost Cap Rules
So. The $140 million cap does not include any financing or marketing or human resources costs, or the amounts paid to the drivers, or the travel costs of those drivers. And there are lots of other exclusions, like entertainment expenses and foreign exchange gain and losses. Which means that there’s lots of room for interpretation.
There are also pages and pages of rules about how to account for inter-team transactions. For example, Ferrari sells its engines to the Alfa Romeo and Haas teams, while Mercedes sells its engines to the McLaren, Aston Martin, and Williams teams. If you dig into Formula 1 at all, you’ll find that it’s quite incestuous. All of the seven other teams are interrelated with the Red Bull, Ferrari, or Mercedes teams in some way. Which also means that there’s room for some interpretation of where costs were charged.
There’s also an issue with redundant inventory, which most people would call obsolete inventory. The cost of redundant inventory goes against the current year cost cap, so of course there will be arguments about whether something is redundant.
And believe me, I’m only mentioning a sliver of the total costing rules.
Cost Cap Administration
There’s a group within Formula 1 called the Cost Cap Administration that issues guidance on how to interpret all of the cost cap rules. Sounds an awful lot like the Financial Accounting Standards Board, except that it only applies to Formula 1. The Cost Cap Administration reviews the reporting documentation that has to be submitted by each team, and can bring in an outside audit firm to conduct investigations.
And here’s a key item. The Cost Cap Administration can investigate a reporting year at any time within the following five years. So lets talk about some of the implications.
If the adjudication panel of the Cost Cap Administration finds that a team has made a procedural breach of the rules – like making a late report submission – then it can impose a financial penalty. Not a big deal.
Cost Cap Penalties
If a team goes over the cost cap by no more than five percent, that’s considered a minor breach. Which will result in a financial penalty and maybe also something called a minor sporting penalty. Despite the name, that minor sporting penalty can be a big deal, since it can include a deduction from the championship points total, and maybe exclusion from a race.
And if a team goes over the cost cap by more than five percent, then it’s committed a material overspend breach, in which case a championship points deduction is required – not optional – along with a financial penalty. And a team might even be kicked out of the championship entirely.
So let’s get back to that five year limitation on auditing the books. The Cost Cap Administration could hear from an insider that a reporting breach occurred a couple of years prior. Its investigation concludes that there was either a minor sporting penalty or a material overspend breach. If so, the resulting point deduction could strip a team of a championship that was awarded a couple of years ago.
If you’ve ever watched the Netflix series Drive to Survive, you’ll know that the top teams in particular are always filing complaints against each other for all sorts of perceived infractions. After all, these races can be decided by very small amounts, so anything that gives a team an advantage seems to be worth pursuing.
Will this now include arguments over the cost cap? Very likely. And it sounds like the squabbles could continue for years after a racing season has supposedly been decided. The only thing that’s certain is that Formula 1 teams will be hiring cost accountants.