Dangers of Book Value Accounting

Article excerpt

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. …