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Dangers of book value accounting.

Dangers of Book Value Accounting Publicly traded corporations, master limited partnerships, and other companies with diverse ownership are under constant scrutiny by stockholders, lenders, and corporate raiders. A big part of the attraction for these takeover artists is often the undervalued assets, including real estate, sitting, undetected on corporate balance sheets. These raiders see what companies without competent asset management may not have noticed--real estate presents tremendous opportunities for increased value.

Why this situation exists

In many cases, corporations may overlook the truevalue of the real estate and other assets they own because widely used accounting methods consistently undervalue these holdings.

In the interest of conservatism, GEnerally Accepted Accounting Principles (GAAP), prescribed by the governing boards of the accounting profession, are required for most companies. These rules require that all assets on a company's balance sheet be shown at book value (historical cost less appropriate depreciation).

Companies whose stock is traded on the nation's stock exchanges are required to use GAAP (book value) accounting for their financial reporting. Many financial institutions require audited financial statements based upon book value accounting for loan applications.

An additiona rule, designed to give the most conservative view of a company's balance sheet to the unsophisticated investor, requires that any assset having a current market value significantly less than stated book value must have its current book value reduced to relief that current market value. On the other hand, assets that have increased in value since acquisition must remain at book value (acquisition cost less any accumulated depreciation) on the financial statements.

Book value accounting has served an important purpose. By requiring consistent reporting, it allows comparison of the operating results of companies that use these rules. But in an appreciating market, book value accounting creates traps for those who are nor aware of the changing market values of their assets.

Computerized databases and published information have made financial information about most companies readily accessible to investors, speculators, and financiers. Quick analysis of this information makes it possible for almost anyone to search for "undervalued assets" in any publicly traded company.

Once these undervalued assets are identified, it is relatively simple to develop a current market value for indiviudal assets and to create a pro forma balance sheet for the company being analyzed using current asset market values. When the pro forma market value of a company's assets, less its liabilities, significantly exceeds the value of the company's stock, the company is susceptible to takeover or management reorganization.

Using the pro forma information, a potential buyer may be able to secure needed financing to purchase the company by using iuts assets as collateral based upon current value rather than the value shown by the company on its balance sheet. Although the current owner of the assets is ot allows to mark-up assets to reflect current market value on the balance sheet, a purchaser of those same assets will be able to allocate the costs of purchase to show that increased value. The same assets that must remain on a seller's balance sheet at historical cost are increased or decreased upon a sale to reflect the purchaser's cost of the acquisition.

An additional problem for the U.S. company using book value accounting is that the requirement for book value accounting is not the same throughout the world. For instance, companies in Great Britain are allowed to periodically revalue their assets to reflect current market value.

When a company is allowed to revalue real estate assets in a rapidly appreciating real estate market, that company may be able to acquire more assets and grow faster than a company required to use traditional book value accounting. On the other hand, the rapid increase in values shown on the company's balance sheet may lead to the false impression that the company with market value accounting is growing more quickly and earning more than the company required to use book value accounting.

A higher value on a company's balance sheet also makes it easier for it to borrow money. Because most lenders are willing to loan money, with assets as security, based upon a fixed percentage of the current market value of company assets, the company with current value accounting in an appreciating real estate market may be able to borrow more easily than a company required to use book value accounting.

Additional borrowing power can increase leverage and earnings as well as augment the rate of increase in earnings for a company in an appreciating market. This increased leverage will also speed the decline of a company's earnings in a declining market.

There is a discussion of accounting principles that may lead to market value accounting as a supplement to the classic book value accounting, but such a rule is not yet in place. Until the time that market value accounting is accepted, an astute asset manager must be aware of the pitfalls of book value accounting and take steps to be certain that all assets under management are properly valued and utilized.

The asset manager's responsibility

Real estate asset management entails a broader responsibility for management than that classically required of a property manager. In addition to ensuring that a property is properly operated, asset management extends the accountability for a property. An asset manager should analyze his or her company's (or client's) annual balance sheet to ensure that all real estate assets are properly identified, valued, and utilized. Failure to use a company's assets efficiently leads to missed opportunities and, possibly, to takeovers.

One of the easiest areas to revalue in a company's financial statements is the real estate asset portion of the balance sheet. A corporate raider could identify real estate assets, check recent sales prices for similar properties in the company's location(s), and determine a current market value for those assets, using very little more than readily accessible public databases. As a result, real estate asset managers must become sophisticated in financial and market analysis as well as in management techniques.

For instance, analysis of a company's assets may show that many of the company's facilities, buildings, and land are being underutilized when compared to the highest and best use of the property. Such an occurrence is most likely for companies in the industrial sector.

In the core of many cities, warehouse facilities, manufacturing plants, stockyards, and transportation facilities are abandoned or have not been redeveloped to reflect current market conditions. In cities like Chicago, New York, Detroit, and San Francisco, current redevelopment of older commercial and industrial areas may have significantly increased the value of company holdings without management realizing what has happened. The book value may reflect only the historical costs at the time the company was formed or was last acquired.

Some types of companies that have large real estate holdings shown at a very low book value on their balance sheets are railroads, public utilities, and manufacturing companies.

For example, the railroads acquired vast land holdings at little or no cost as they built their tracks across the United States. The book value of many of those assets is still shown on the company financial statements at the original cost, as required by book value accounting. Although some of these assets include only a right-of-way through barren land, others include extensive urban and suburban holdings that are unused or underutilized.

If an asset manager does not quickly recognize asset underutilization and keep company management informed of actual and impending redevelopment potential, action may be forced by outsiders. An example of such a forced restructure is that of the Santa Fe Railroad, a multibillion dollar holding company, recently renamed the Santa Fe Pacific. Although the Santa Fe Pacific has numerous assets, including real estate, timberlands, mineral holdings, and its entire rail system from Chicago to California, the stock market has classically valued the company based primarily upon its operating earnings.

When the Santa Fe Railroad merged with the Southern Pacific Railroad, additional real estate assets, including a large unused railyard near downtown San Francisco, were acquired. Although the Southern Pacific Railroad was eventually divested because of antitrust considerations, many of the real estate assets were retained by a successor corporation, the Santa Fe Pacific.

These assets did not go unnoticed. The Henley Group, a corporate raider and financier, and Olympia and York, a Canadian real estate and investment firm, bought large blocks of Santa Fe Pacific stock and forced a restructure. [1]

This restructure included a recapitalization of the company. A high percentage of the Santa Fe Pacific's value was borrowed, a large one-time dividend was paid to the stockholders, and management was changed. Although the company was left much more highly leveraged, the stock market still did not reflect what Henley and Olympia and York perceived to be the underlying asset value.

As a result, an additional restructure proposal was made. It divided the company into an operating company, which includes the Santa Fe Railroad, and a real estate company, owned by the current stockholders. The major stockholders include Olympia and York; Sam Zell, a Chicago real estate owner, financier, and takeover artist who bought Henley's Santa Fe Pacific stock; and a major California pension fund. [2] They believe that the resultant two companies, one of which now owns several valuable real estate parcels, will be valued more highly on Wall Street, even though the stock market has classically valued real estate assets at less than current market value.

The size of the Santa Fe Pacific graphically demonstrates that very few companies are immune from the trauma brought by outside recognition of poor asset management. In addition, to the large, older companies discussed above, the rapid appreciation of real estate in certain parts of the United States in recent years has left many relatively young companies susceptible to "hidden asset" value problems which can lead to raids or restructures. In areas like California, Florida, and the high-tech areas of the Northeast, this trend of value escalation has been most noticeable.

A good asset manager must periodically review all company or client holdings to ensure that current values are reflected in the balance sheet or properly described in financial statement footnotes. When an investor knows that a company is aware of "hidden assets," the stock price of that company is more likely to reflect the value of those assets.

Asset management strategies

For companies that must follow the book value accounting rules, there are several strategies that can accurately reflect appreciated asset values and their contributions to profits and company value.

* Sale of the asset. Sale of an underutilized asset has several potential benefits for the company. The value of the asset will be fully recognized by the sale, and liquidity of the corporation will be enhanced because the funds created by the sale will be available for new investment.

Assuming that the value of the asset that is sold was appreciating at a rate less than the rate of return earned by the newly available funds, the profitability of the corporation will be enhanced. The corporation's short-term earnings will grow in the year of the sale, and the company will be protected against downturns in the real estate market.

In most cases, the sale of the appreciated asset will trigger a gain for income tax purposes. If the corporation is not in a taxable position, the taxable gain on the sale may be totally of partially offset by operating losses or losses carried forward. If the company is profitable, any tax paid upon the sale must be reflected as reduction in actual gain on the sale of the asset.

Other negative of the sale are loss of asset control, asset use, and potential appreciation. The return on assets and return on equity will be reduced by the sale of the asset if the return earned on the newly acquired cash is less than the company's average rate of return. Because the asset base has been increased by the amount of the appreciation acknowledged by the sale of the asset, overall earnings must be higher to reflect the increased asset base.

If the asset must be replaced by a similar one purchased at today's market value, the only gain to the company may be the recognition of the true asset value. This negative may be partially offset by retaining an option to repurchase the asset at a later data.

However, if an option agreement is contemplated, sound legal and accounting advice should be sought to guarantee that the option agreement is written properly to achieve the desired results. If an option agreement is structured incorrectly, the Internal Revenue Service may tax the sale, and the company's auditors may not allow the benefits of the sale to be added on the company's balance sheet.

* Sale of the asset to an affiliated group or company in addition to the advantages of a sale to an independent third party, benefits of a sale to an affiliated group or company may include allowing the value of the asset to be realized while maintaining control of the asset. If the transaction is structured properly, with a seller and purchaser acceptable to the company's auditors as bona fide buyers and sellers of the asset, the full value of the asset can be shown on the new company's balance sheet.

This strategy is extremely difficult to execute successfully. Sound legal and accounting advice should be sought prior to initiating the transaction. When both the buyer and the seller have common or similar ownership, the company's auditors may take the position that no change in control has occurred and, consequently, may not allow the asset to be shown on the buyer's balance sheet at a higher value than it was originally shown on the seller's balance sheet. Furthermore, the Internal Revenue Service may take the position that a sale was consummated and assess income taxes on the sale even when the balance sheet effect was not allowed by the company's auditors.

Disadvantages of a sale to an affiliate inlcude a potential increase in ad valorem taxes to the buyer as a result of the sale. The return on assets and return on equity for the selling company will also be reduced by the sale of the asset if the return earned on the newly acquired cash is less than the average return on other asssets. Because the asset base has been increased by the amount of the appreciation acknowledged by the sale of the asset, absolute earnings must be higher to reflect the required return of the increased asset base.

* Sale and leaseback of the undervalued asset. A sale and leaseback of the asset may have advantages in addition to those attained by a sale. The company is able to retain the use of the asset that has been sold and may also be able to transfer some expense and liability exposure to the new owner, if the lease is properly structured.

And because the lease payments are expenses which probably exceed the previous depreciation and interest expense related to the appreciated asset, an increased income tax deduction may be available. If the company generates taxable income, the increase in expenses of the lease may be partially offset by the increased tax shelter available.

Disadvantages of a sale leaseback include a potential increace in ad valorem tax expense, which will probably be passed through to the lessee by the new owner. The lease cost is an additional, continuing operating cost that will reduce the company's operating income by the amount that the increased costs exceed the operating cost of the asset prior to sale. The increase in operating cost will act solely to decrease earnings.

At lease expiration, the company is also subject to escalation of its lease payments and increased operating costs. Care should be taken to structure a lease of sufficient term to meet the companyhs needs. If the opportunity is available, several options to renew the lease at favorable terms should be written into the original agreement.

* The asset may be refinanced. Many of the desirable results of an asset sale will be achieved by refinancing an asset. Ownership of the asset is maintained, and company lieuidity will increase. Although asset value will not increase on the balance sheet, the increase in the cash from the refinancing will produce a similar effect. The cash portion of the balance sheet will increase, as will the liability portion. The company will have the use of the increased cash without the increase in income tax liability that is generated by a sale of the asset.

Some disadvantages of a refinance are that the debt of the company will increase, as will interest expenses. However, this additional expense may be partially offset by any tax benefit created. As debt increases, so does risk.

Absolute operating earnings must also grow to offset the additional net expense, or cash flow will suffer from the refinancing. If the local tax assessor is astute, ad valorem taxes on the asset may increase.

* A supplemental financial statement can reflect market value. A supplement to the financial statements can be prepared and provided along with the book value financial statements. Care must be taken to ensure that guidelines for release of this additional information are followed. The GAAP financial statements should not be replaced with market value financial statements unless the companyhs financial reporting requirements allow the change.

Investors, lenders, and management will be more aware of the true asset value and can easily compare the asset book value to current market value when supplementary statements are reviewed. A supplemental statement also allows for easier comparisons between companies that follow GAAP and those that use market value accounting. Publishing a supplemental statement does not increase debt, does not permit loss of asset control, and does not increase risk related to increased debt.

A set of supplementary financial statements is relatively inexpensive to prepare. with the additional financial data, management will be able to determine the true return on equity using the appreciated value of the assets. This information itself may help management make the changes that are necessary to maximize asset value without undergoing the travail of a takeover or restructure.

Disadvantages of market vlue financial statements are that the stock market may value the company no differently even when given current valuation data. With the additional, market value information, it is easier for speculators and takeover artists to identify those "undervalued assets" on the companyhs balance sheet.

A similar disclosure to supplementary financial statements can be given by adding additional footnotes to book value accounting financial statements. The same advantages and disadvantages apply to footnote disclosure as to supplemental financial statement disclosure. due to the placement of footnotes at the back of financial statements and to the number of footnotes required in many company statements, footnote disclosure may not be as effective as preparing a complete set of supplementary financial statements.


Book value accounting takes a conservative approach to valuing a company. This method may protect an investor in a severe market downturn, but it can contribute to management complacency, thereby inviting greenmail, takeover, or restructure.

By continually valuing assets at current market value for internal reporting and by issuing a supplement to book value financial statements for investors, a clear picture of the actual asset value is given. The additional information allows a quicker and more concise view of operating results.

Undervalued real estate assets, coupled with the relative stability of the United States economy, may also make break-up, restructure, or takeover of a company tempting to foreign investors. Undervalued or underperforming assets of a competitor or synergistic company may lead domestic managers, speculators, and financiers to seek control of existing companies to force a break-up or restructure of their assets.

It is the responsibility of the individual asset manager to understand book value accounting and the nuances of allowed accounting disclosures which may affect a portfolio. Every asset manager should consider different operating scenarios and continually review the assets under management to ensure their most profitable and efficient use by the current. If the asset is underutilized and improvement is not feasible for the current owner, recommendation for disposal may be warranted.

Failure to recognize the possibilities for maximal utilization of an asset as well as failure to operate the asset in a prudent and profitable fashion will surely cost the asset manager his or her job. It may well cost the company its independence.

Bruce Meiklejohn is an independent consultant in banking and real estate based in Fairport, N.Y., and Boulder, Colorado. His activities include conducting feasibility studies, developing management plans for restructuring of loans and real estate investments, recommending improvements in management, and evaluating the advisability of extending loans and investments. MR. Meiklejohn holds an M.B.A degree and a B.S. degree in accounting and is a certified public accountant.


[1] "Santa Fe keeps throwing the raiders off track," Business Week, February 15, 1988, p. 28.

[2] "Is Santa Fe home free: Henley sells its stake--sort of," Business Week August 8, 1988, p. 25.
COPYRIGHT 1990 National Association of Realtors
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Author:Meiklejohn, Bruce
Publication:Journal of Property Management
Date:Mar 1, 1990
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