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Getting full value on the balance sheet.

The value of an asset is its capacity to earn money. Unfortunately, that definition does not always apply to a corporation's real estate. Current accounting rules, as they apply to real estate, distort a firm's earning potential, since these assets are required to be reflected at cost (less accumulated depreciation) on the firm's financial statements.

This " gap" in reality particularly affects manufacturing and real estate companies with appreciated real estate that has been on the books a long time. Such assets may have a current market value significantly greater than the initial cost.

But there is a solution to the dilemma of getting financial statements to reflect the current values of a company's resources and obligations that will generate future cash flow. It is known as estimated current value (ECV).

Estimated current value

Estimated current value, or fair market value, is the amount at which an asset can be exchanged between a buyer and seller, each of whom is well informed and willing, and neither of whom is compelled to buy or sell. In 1982, the American Institute of Certified Public Accountants (AICPA) issued The Guide to Personal Financial Statements, the only meaningful, authoritative literature available at this time on the use of estimated current values in personal financial statements.

The guide asserts that, "Users of personal financial statements rely on ECVS in determining whether to grant credit, in assessing the financial activities of individuals, in assessing the financial affairs of public officials and candidates for public office, and for similar purposes". The relevance of estimated current value information also applies to business entities, especially those that invest in and develop real estate. Many real estate companies now use "dual column" financial statements showing both historic cost and estimated current value, and many CPAS issue estimated current value reports on such financial statements.

ECVs are currently required on personal loan applications for estate, gift, and income tax planning and defined benefit pension plans. They are also a prerequisite for assessing collateral for a lender. Consequently, many lenders and investors consider ECV information to be more relevant than historical cost information.

Determining estimated

current value

As described in Figure 1, there are a multitude of methods to use and factors to consider in determining ECVs. Some of the more common methods used for valuing real estate are capitalization of current or forecasted cash flows, present value of future cash flows, or comparative sales values. The first two of these methods are commonly referred to as "income approach methods of valuation"

The underlying premise of the income approach is that value is equal to the present worth of the future benefits of owning a property.

There are four main steps in calculating ECV on residential or commercial properties based on capitalization of cash flows: first, estimate the potential annual gross income based on all units being rented or leased at their market value. Next, determine the effective gross income by deducting an allowance for vacancies and other contingencies. Then, determine the annual net operating income by deducting the annual operating expenses. And finally, apply the appropriate capitalization rate to the annual net income.

ECV reporting for

financial statements

Figure 2 is an example of estimated current value reporting for financial statements. It is a summarized version of an actual corporation with extensive real estate assets. The estimated current value of the real estate assets is 61.5 percent higher than the historical cost, resulting in total assets being 40 percent higher when reflected at estimated current value. The differences between historical cost and ECV will affect how a potential investor or creditor evaluates the worth and earning power of this corporation.

For example, financial ratios are often used to weigh and evaluate the operating performance of a firm. But if the estimated current value of assets is not reflected, the resulting ratio could be misinterpreted. Potential creditors may want to measure the prudence of the debt management policies of the firm before deciding how much funding to provide, if any.

Using amounts in Figure 2 to compute a debt-to-equity ratio for ABC, Inc. would result in a 93.5 percent debt-to-equity figure based on historical cost and a 73.8 percent figure using estimated current value. A creditor would be unlikely to provide additional funding based on the historical cost figures, as it appears that ABC, Inc. has already used up its borrowing capacity. The estimated current value figure of 73.8 percent reveals a larger available asset base to borrow against.

These distortions between historical cost and estimated current value are even more evident when evaluating an entity's or individual's investment in a separate real estate enterprise. If an entity's investment in a real estate enterprise is reported on the balance sheet using the equity method of accounting, it can quite often display a negative (or zero) balance in the investment account. This is due to the fact that many real estate firms, especially developing ones, will exhibit paper losses during their first few years of operation, and possibly for many subsequent years.

Also, funding for operations and/or development is usually acquired through loans rather than owner contributions. The continual recording of losses at the holding company (or individual) level, with no corresponding increases in equity by contributions, would normally result in a negative investment balance. This will severely distort the appearance of the entity's financial reports ff they are prepared using historical cost values instead of estimated current values.

More guidance needed

Not only do ECV statements, especially for real estate enterprises, more realistically reflect the financial position and earning capacity of a company, but they consider the possible ultimate tax consequences of recognizing the incremental increase in equity.

Based on the probability that real estate values will continue to fluctuate in most areas, but stabilize well above cost for most companies with low-cost real estate, financial statements based on historical costs will continue to decline in usefulness. This will create a greater need for real estate assets to be presented at estimated current value in order to more closely reflect economic reality.

The Accounting Standard Executive Committee of the AICPA is currently addressing ECV reporting by real estate companies. At a meeting in December 1989, the committee generally agreed that the scope of its research and conclusions should be expanded to include real estate subsidiaries of reporting entities that are not real estate companies.

It also agreed that guidance should be provided for firms that are currently required to present estimated current value information in accordance with Financial Accounting Standards Board Statement 35, Accounting and Reporting by Defined Benefit Pension Plans.

In the future, there will be more literature and more guidance addressing the issue of estimated current value reporting.

Scott Farb, CPA, is director of entrepreneurial services at Kenneth Leventhal & Company. Headquartered in Los Angeles, but with offices throughout the United States, the firm is widely recognized for its expertise in real estate and related financial services. Kenneth Leventhal is affiliated internationally with Clark Kenneth Leventhal.
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Author:Farb, Scott
Publication:Journal of Property Management
Date:Mar 1, 1991
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