BALANCE SHEET

The balance sheet is a remarkable invention, yet it has two fundamental shortcomings. First, although it is in theory useful to have a summary of the values of all the assets owned by an enterprise, these values frequently prove elusive in practice. Second, many kinds of things have value and could be construed, at least by the layperson, as assets. Not all of them can be assigned a specific value and recorded on a balance sheet, however. For example, proprietors of service businesses are fond of saying, “Our assets go down the elevator every night.” Everybody acknowledges the value of a company’s “human capital”—the skills and creativity of its employees—but no one has devised a means of valuing it precisely enough to reflect it on the balance sheet. Accountants do not go to the opposite extreme of banishing all intangible assets from the balance sheet, but the dividing line between the permitted and the prohibited is inevitably an arbitrary one.

During the late 1990s, doctrinal disputes over accounting for assets intensified as intellectual capital came to represent growing proportions of many major corporations’ perceived value. A study conducted on behalf of Big Five accounting firm Arthur Andersen showed that between 1978 and 1999, book value fell from 95% to 71% of the stock market value of public companies in the United States.2 Increasingly, investors were willing to pay for things other than the traditional assets that GAAP (generally accepted accounting principles) had grown up around, including buildings, machinery, inventories, receivables, and a limited range of capitalized expenditures.

At the extreme, start-up Internet companies with negligible physical assets attained gigantic market capitalizations. Their valuations derived from “business models” purporting to promise vast profits far in the future. Building up subscriber bases through heavy consumer advertising was an expensive proposition, but one day, investors believed, a large, loyal following would translate into rich revenue streams.

Much of the dot-coms’ stock market value disappeared during the “tech wreck” of 2000, but the perceived mismatch between the information intensive New Economy and traditional notions of assets persisted. Prominent accounting theorists argued that financial reporting practices rooted in an era more dominated by heavy manufacturing grossly understated the value created by research and development outlays, which GAAP was resistant to capitalizing. They observed further that traditional accounting generally permitted assets to rise in value only if they were sold. “Transactions are no longer the basis for much of the value created and destroyed in today’s economy, and therefore traditional accounting systems are at a loss to capture much of what goes on,” argued Baruch Lev of New York University. As examples, he cited the rise in value resulting from a drug passing a key clinical test and from a computer software program being successfully beta-tested. “There’s no accounting event because no money changes hands,” Lev noted.

THE VALUE PROBLEM

The problems of value that accountants wrestle with have also historically plagued philosophers, economists, tax assessors, and the judiciary. Moral philosophers over the centuries grappled with the notion of a “fair” price for merchants to charge. Early economists attempted to derive a product’s intrinsic value by calculating the units of labor embodied in it. Several distinct approaches have evolved for assessing real property. These include capitalization of rentals, inferring a value based on sales of comparable properties, and estimating the value a property would have if put to its “highest and best” use. Similar theories are involved when the courts seek to value the assets of bankrupt companies, although vigorous negotiations among the different classes of creditors play an essential role in the final determination.

With commendable clarity of vision, the accounting profession has cut through the thicket of valuation theories by establishing historical cost as the basis of its system. The cost of acquiring or constructing an asset has the great advantage of being an objective and verifiable figure. As a benchmark for value, it is, therefore, compatible with accountants’ traditional principle of conservatism.

Whatever its strengths, however, the historical cost system also has disadvantages that are apparent even to the beginning student of accounting.

As noted, basing valuation on transactions means that no asset can be reflected on the balance sheet unless it has been involved in a transaction. The most familiar difficulty that results from this convention involves goodwill.

Company A has value above and beyond its tangible assets, in the form of well-regarded brand names and close relationships with merchants built up over many years. None of this intangible value appears on Company A’s balance sheet, however, for it has never figured in a transaction. When Company B acquires Company A at a premium to book value, though, the intangibles are suddenly recognized. To the benefit of users of financial statements, Company A’s assets are now more fully reflected. On the negative side, Company A’s balance sheet now says it is more valuable than Company C, which has equivalent tangible and intangible assets but has never been acquired.

Liabilities, too, can become distorted under historical cost accounting.

Long-term debt obligations floated at rates of 5% or lower during the 1950s and 1960s remained outstanding during the late 1970s and early 1980s, when rates on new corporate bonds soared to 15% and higher. The economic value of the low-coupon bonds, as evidenced by market quotations, plunged to as little as 40 cents on the dollar. At that point, corporations that had had the foresight (or simply the luck) to lock in low rates for 30 years or more enjoyed a significant cost advantage over their competitors.

A company in this position could argue with some validity that its lowcost debt constituted an asset rather than a liability. On its books, however, the company continued to show a $1,000 liability for each $1,000 face amount of bonds. Consequently, its balance sheet did not reflect the value that an acquirer, for example, might capture by locking in a cheap cost of capital for an extended period.

ISSUES OF COMPARABILITY

Although some would regard the prohibition of adjusting debt figures to the market as artificial, they might at least find it tolerable if it applied in every instance. Consider what happens, however, in an acquisition. Statement of Financial Accounting Standards (SFAS) 141 (“Business Combinations”) makes it mandatory to revalue the acquired company’s debt to current market if its value differs significantly from face value as a consequence of a shift in interest rates since the debt was issued. Here again, as in the case of first-time recognition of goodwill, the historical cost principle makes comparable companies appear quite dissimilar. The equally large “hidden asset value” of another company with low-cost debt will not be reflected on its balance sheet, simply because it has never been acquired.

The lack of comparability arising from the revaluation of the liability persists long after the acquisition is consummated. By contrast, the footnote detailing the adjustment eventually disappears from the acquired firm’s annual report. In later years, readers receive no hint that the company’s debts have been reduced—not in fact, but through one of accounting’s convenient fictions.

Critics of historical-cost accounting deplore the quirks that give rise to such distortions, arguing that corporations should be made to report the true economic value of their assets. Such criticisms assume, however, that there is a true value. If so, determining it is a job better left to metaphysicians than to accountants. In the business world, it proves remarkably difficult to establish values with which all the interested parties concur.

The difficulties a person may encounter in the quest for true value are numerous. Consider, for example, a piece of specialized machinery, acquired for $50,000. On the day the equipment is put into service, even before any controversies surrounding depreciation rates arise, value is already a matter of opinion. The company that made the purchase would presumably not have paid $50,000 if it perceived the machine to be worth a lesser amount. A secured lender, however, is likely to take a more conservative view. For one thing, the lender will find it difficult in the future to monitor the value of the collateral through “comparables,” since only a few similar machines (perhaps none, if the piece is customized) are produced each year.

Furthermore, if the lender is ultimately forced to foreclose, there may be no ready purchaser of the machinery for $50,000, since its specialized nature makes it useful to only a small number of manufacturers. All of the potential purchasers, moreover, may be located hundreds of miles away, so that the machinery’s value in a liquidation would be further reduced by the costs of transporting and reinstalling it.

The problems encountered in evaluating one-of-a-kind industrial equipment might appear to be eliminated when dealing with actively traded commodities such as crude oil reserves. Even this type of asset, however, resists precise, easily agreed on valuation. Since oil companies frequently buy and sell reserves “in the ground,” current transaction prices are readily available.

These transactions, however, are based on estimates of eventual production from unique geologic formations, for there is no means of directly measuring oil reserves. Even when petroleum engineers employ the most advanced technology, their estimates rely heavily on judgment and inference.

It is not unheard of, moreover, for a well to begin to produce at the rate predicted by the best scientific methods, only to peter out a short time later, ultimately yielding just a fraction of its estimated reserves. With this degree of uncertainty, recording the true value of oil reserves is not a realistic objective for accountants. Users of financial statements can, at best, hope for informed guesses, and there is considerable room for honest people (not to mention rogues with vested interests) to disagree.

“INSTANTANEOUS” WIPEOUT OF VALUE

Because the value of many assets is so subjective, balance sheets are prone to sudden, arbitrary revisions. To cite one dramatic example, on July 27, 2001, JDS Uniphase, a manufacturer of components for telecommunications networks, reduced the value of its goodwill by $44.8 billion. It was the largest write-off in corporate history up to that time.

This drastic decline in economic value did not occur in one day. Several months earlier, JDS had warned investors to expect a big write-off arising from declining prospects at businesses that the company had acquired during the telecommunications euphoria of the late 1990s.4 If investors had relied entirely on JDS’s balance sheet, however, they would have perceived the loss of value as a sudden event.

Shortly before JDS Uniphase’s action, Nortel Networks took a $12.3 billion goodwill write-off and several major companies in such areas as Internet software and optical fiber quickly followed suit. High-tech companies had no monopoly on “instantaneous” evaporation of book value, however.

In the fourth quarter of 2000, Sherwin-Williams recognized an impairment charge of $352.0 million ($293.6 million after taxes). Most of the write-off represented a reduction of goodwill that the manufacturer of paint and related products had created through a string of acquisitions. Even after the huge hit, goodwill represented 18.8% of Sherwin-Williams’s assets and accounted for 47.9% of shareholders’ equity.

Both Old Economy and New Economy companies, in short, are vulnerable to a sudden loss of stated asset value. Therefore, users of financial statements should not assume that balance sheet figures invariably correspond to the current economic worth of the assets they represent. A more reasonable expectation is that the numbers have been calculated in accordance with GAAP. The trick is to understand the relationship between these accounting conventions and reality.

If this seems a daunting task, the reader may take encouragement from the success of the bond rating agencies in sifting through the financial reporting folderol to get to the economic substance. The multibillion- dollar goodwill write-offs in 2001 did not, as one might have expected, set off a massive wave of rating downgrades. As in many previous instances of companies writing down assets, Moody’s and Standard & Poor’s did not equate changes in accounting values with reduced protection for lenders. To be sure, if a company wrote off a billion dollars worth of goodwill, its ratio of assets to liabilities declined. Its ratio of tangible assets to liabilities did not change, however. The rating agencies monitored both ratios, but had customarily attached greater significance to the version that ignored intangible assets such as goodwill.

HOW GOOD IS GOODWILL?

By maintaining a skeptical attitude to the value of intangible assets throughout the New Economy excitement of the late Nineties, Moody’s and Standard & Poor’s were bucking the trend. The more stylish view was that balance sheets constructed according to GAAP seriously understated the value of corporations in dynamic industries as computer software and ecommerce.

Their earning power, so the story went, derived from inspired ideas and improved methods of doing business, not from the bricks and mortar for which conventional accounting was designed. To adapt to the economy’s changing profile, proclaimed the heralds of the New Paradigm, the accounting rule makers had to allow all sorts of items traditionally expensed to be capitalized onto the asset side of the balance sheet. Against that backdrop, analysts who questioned the value represented by goodwill, an item long deemed legitimate under GAAP, look conservative indeed.

In reality, the stock market euphoria that preceded Uniphase’s mindboggling write-off illustrated in classic fashion the reasons for rating agency skepticism toward goodwill. Through stock-for-stock acquisitions, the sharp rise in equity prices during the late 1990s was transformed into increased balance sheet values, despite the usual assumption that fluctuations in a company’s stock price do not alter its stated net worth. It was a form of financial alchemy as remarkable as the transmutation of proceeds from stock sales into revenues described.

The link between rising stock prices and escalating goodwill is illustrated by the fictitious example. In Scenario I, the shares of Associated Amalgamator Corporation (“Amalgamator”) and United Consolidator Inc. (“Consolidator”) are both trading at multiples of 1.0 times book value per share. Shareholders’ equity is $200 million at Amalgamator and $60 million at Consolidator, equivalent to the companies’ respective market capitalizations. Amalgamator uses stock held in its treasury to acquire Consolidator for $80 million. The purchase price represents a premium of 331⁄3% above the prevailing market price.

Let us now examine a key indicator of credit quality. Prior to the acquisition, Amalgamator’s ratio of total assets to total liabilities is 1.25 times whereas the comparable figure for Consolidator is 1.18 times.

The stock-for-stock acquisition introduces no new hard assets (e.g., cash, inventories or factories). Neither does the transaction eliminate any existing liabilities. Logically, then, Consolidator’s 1.18 times ratio should drag down Amalgamator’s 1.25 times ratio, resulting in a figure somewhere in between for the combined companies.

In fact, though, the total-assets-to-total-liabilities ratio after the deal is 1.25 times. By paying a premium to Consolidator’s tangible asset value, Amalgamator creates $20 million of goodwill. This intangible asset represents just 1.4% of the combined companies’ total assets, but that suffices to enable Amalgamator to acquire a company with a weaker debt-quality ratio without showing any deterioration on that measure.

If this outcome seems perverse, consider Scenario II. As the scene opens, an explosive stock market rally has driven up both companies’ shares to 150% of book value. The ratio of total assets to total liabilities, however, remains at 1.25 times for Amalgamator and 1.18 times for Consolidator. Conservative bond buyers take comfort from the fact that the assets remain on the books at historical cost less depreciation, unaffected by euphoria on the stock exchange that may dissipate at any time without notice. As in Scenario I, Amalgamator pays a premium of 331⁄3% above the prevailing market price to acquire Consolidator. The premium is calculated on a higher market capitalization, however. Consequently, the purchase price rises from $80 million to $120 million. Instead of creating $20 million of goodwill, the acquisition gives rise to a $60 million intangible asset.

When the conservative bond investors calculate the combined companies’ ratio of total assets to total liabilities, they make a startling discovery.

Somehow, putting together a company boasting a 1.25 times ratio with another sporting a 1.18 times ratio has produced an entity with a ratio of 1.28 times. Moreover, a minute of experimentation with the numbers will show that the ratio would be higher still if Amalgamator had bought Consolidator at a higher price. Seemingly, the simplest way for a company to improve its credit quality is to make stock-for-stock acquisitions at grossly excessive prices.

Naturally, this absurd conclusion embodies a fallacy. In reality, the receivables, inventories, and machinery available to be sold to satisfy creditors’ claims are no greater in Scenario II than in Scenario I. Given that the total-assets-to-total-liabilities ratio is lower at Consolidator than at Amalgamator, the combined companies’ ratio logically must be lower than at Amalgamator. Common sense further states that Amalgamator cannot truly have better credit quality if it overpays for Consolidator than if it acquires the company at a fair price.

As it happens, there is a simple way out of the logical conundrum. Let us exclude goodwill in calculating the ratio of assets to liabilities. As shown in the exhibit, Amalgamator’s ratio of tangible assets to total liabilities following its acquisition of Consolidator is 1.23 times in both Scenario I and Scenario II. This is the outcome that best reflects economic reality. To ensure that they reach this commonsense conclusion, credit analysts must follow the rating agencies’ practice of calculating balance sheet ratios both with and without goodwill and other intangible assets, giving greater emphasis to the latter version.

Calculating ratios on a tangibles-only basis is not equivalent to saying that the intangibles have no value. Amalgamator will likely recoup all or most of the $60 million accounted for as goodwill if it turns around and sells Consolidator tomorrow. Such a transaction is hardly likely, however. A sale several years hence, after stock prices have fallen from today’s lofty levels, is a more plausible scenario. Under such conditions, the full $60 million probably will not be recoverable.

Even leaving aside the possibility of a plunge in stock prices, it makes eminent sense to eliminate or sharply downplay the value of goodwill in a balance-sheet-based analysis of credit quality. Unlike inventories or accounts receivable, goodwill is not an asset that can be readily sold or factored to raise cash. Neither can a company enter into a sale-leaseback of its goodwill, as it can with its plant and equipment. In short, goodwill is not a separable asset that management can either convert into cash or use to raise cash to extricate itself from a financial tight spot. Therefore, the relevance of goodwill to an analysis of asset protection is questionable.

On the whole, the rating agencies appear to have shown sound judgment during the 1990s by resisting the New Economy’s siren song. While enthusiasm mounted for all sorts of intangible assets, they continued to gear their analysis to tangible-assets-only versions of key balance sheet ratios. By and large, therefore, companies did not alter the way they were perceived by Moody’s and Standard & Poor’s when they suddenly took an axe to their intangible assets.

More generally, asset write-offs do not cause ratings to fall. Occasionally, to be sure, the announcement of a write-off coincides with the disclosure of a previously unrevealed impairment of value, ordinarily arising from operating problems. That sort of development may trigger a downgrade.

In addition, a write-off sometimes coincides with a decision to close down certain operations. The associated severance costs (payments to terminated employees) may represent a substantial cash outlay that does weaken the company’s financial position. Finally, a write-off can put a company in violation of a debt covenant. Nervous lenders may exploit the technical default by canceling the company’s credit lines, precipitating a liquidity crisis. In and of itself, however, adjusting the balance sheet to economic reality does not represent a reduction in credit protection measures.

LOSING VALUE THE OLD-FASHIONED WAY

Goodwill write-offs by technology companies such as Uniphase make splashy headlines in the financial news, but they by no means represent the only way in which balance sheet assets suddenly and sharply decline in value. In the “Old Economy,” where countless manufacturers earn slender margins on low-tech industrial goods, companies are vulnerable to long-run erosion in profitability. Common pitfalls include fierce price competition and a failure, because of near-term pressures to conserve cash, to invest adequately in modernization of plants and equipment. As the rate of return on their fixed assets declines, producers of basic commodities such as paper, chemicals, and steel must eventually face up to the permanent impairment of their reported asset values.

In the case of a chronically low rate-of-return company, it is not feasible to predict precisely the magnitude of a future reduction in accounting values.

Indeed, there is no guarantee that a company will fully come to grips with its overstated net worth, especially on the first round. To estimate the expected order of magnitude of future write-offs, however, an analyst can adjust the shareholders’ value shown on the balance sheet to the rate of return typically being earned by comparable corporations.

To illustrate, suppose Company Z’s average net income over the past five years has been $24 million. With most of the company’s modest earnings being paid out in dividends, shareholders’ equity has been stagnant at around $300 million. Assume further that during the same period, the average return of companies in the Standard & Poor’s 400 index of industrial corporations has been 14%.

Does the figure $300 million accurately represent Company Z’s equity value? If so, the implication is that investors are willing to own the company’s shares and accept a return of only 8% ($24 million divided by $300 million), even though a 14% return is available on other stocks. There is no obvious reason why investors would voluntarily make such a sacrifice, however.

Therefore, Company Z’s book value is almost certainly overstated.

A reasonable estimate of the low-profit company’s true equity value would be the amount that produces a return on equity equivalent to the going rate:

Although useful as a general guideline, this method of adjusting the shareholders’ equity of underperforming companies neglects important subtleties.

For one thing, Company Z may be considered riskier than the average company. In that case, shareholders would demand a return higher than 14% to hold its shares. Furthermore, cash flow may be a better indicator of the company’s economic performance than net income.

This would imply that the adjustment ought to be made to the ratio of cash flow to market capitalization, rather than return on equity. Furthermore, investors’ rate-of-return requirements reflect expected future earnings, rather than past results. Depending on the outlook for its business, it might be reasonable to assume that Company Z will either realize higher profits in the next five years than in the past five or see its profits plunge further. By the same token, securities analysts may expect the peer group of stocks that represent alternative investments to produce a return higher or lower than 14% in coming years. The further the analyst travels in search of true value, it seems, the murkier the notion becomes.

TRUE EQUITY IS ELUSIVE

What financial analysts are actually seeking, but are unable to find in the financial statements, is equity as economists define it. In scholarly studies, the term equity generally refers not to accounting book value, but to the present value of future cash flows accruing to the firm’s owners. Consider a firm that is deriving huge earnings from a trademark that has no accounting value because it was developed internally rather than acquired. The present value of the profits derived from the trademark would be included in the economist’s definition of equity, but not in the accountant’s, potentially creating a gap of billions of dollars between the two.

The contrast between the economist’s and the accountant’s notion of equity is dramatized by the phenomenon of negative equity. In the economist’s terms, equity of less than zero is synonymous with bankruptcy. The reasoning is that when a company’s liabilities exceed the present value of all future income, it is not rational for the owners to continue paying off the liabilities.

They will stop making payments currently due to lenders and trade creditors, which will in turn prompt the holders of the liabilities to try to recover their claims by forcing the company into bankruptcy. Suppose on the other hand, that the present value of a highly successful company’s future income exceeds the value of its liabilities by a substantial margin. If the company runs into a patch of bad luck, recording net losses for several years running and writing off selected operations, the book value of its assets may fall below the value of its liabilities. In accounting terms, the result is negative shareholders’ equity. The economic value of the assets, however, may still exceed the stated value of the liabilities. Under such circumstances, the company has no reason to consider either suspending payments to creditors or filing for bankruptcy.

Negative shareholders’ equity can also arise from a leveraged recapitalization, a type of transaction that gained a considerable vogue in the 1980s. The analytical relevance of leveraged recaps does not arise solely from the insight they provide into the differences between economic and accounting-based equity. One day, they may be of more than historical interest.

If stock prices ever become as depressed as they were in the early 1980s, the massive stock repurchases with borrowed funds may easily make a comeback.

A leveraged recap is ostensibly designed to remedy a corporation’s low stock market valuation. Another, unadvertised purpose may be to fend off a hostile takeover. Suppose that several large shareholders, who are sympathetic (or even identical to) the corporation’s incumbent management, retain their stock as the total number of outstanding shares declines sharply. The small group of shareholders will materially increase its proportional ownership.

If all goes well, the leveraged recap will kill two birds with one stone, solidifying the insiders’ control of the company while boosting the share price to appease shareholders who were disposed to support the hostile bid.

In the fictitious example shown in Exhibit 2.2, Sluggard Corporation’s stock is languishing at a modest 9.3 times earnings, or $25 a share. Restive shareholders are urging management to improve Sluggard’s operating performance, explore the possibility of selling the company at a premium to its present stock price, or step aside in favor of others who can do a better job of enhancing shareholder value. A dissident group has even nominated its own slate of directors, who are committed to divesting unprofitable operations and replacing the current chief executive officer.

Management counters by asserting that the real problem is with the stock market. Fickle, short-term-oriented investors are not attributing appropriate value to Sluggard’s excellent long-term business prospects. Under current market conditions, says the CEO, shareholders cannot realize full value on their investment by engineering the sale of Sluggard to a bigger company.

To satisfy shareholders’ legitimate desire for better stock performance, while preserving Sluggard’s ability to capitalize on its outstanding opportunities as an independent company, management and the board announce a bold financial transaction. The company will tender for 32 million of its 45 million outstanding shares at a 25% premium to the current market price, or $30 a share. To pay for the $960 million stock repurchase, Sluggard has arranged an interim credit line, which it plans to refinance through a longterm bond offering. The greatly increased debt load that will result will raise interest expense from $68 million to $183 million annually, on a pro forma basis. After-tax income will consequently drop from $121 million to $46 million. That decline will be more than offset, however, by the reduction in shares outstanding. Earnings per share, management concludes, will rise from $2.69 to $3.54.

To be sure, the market may lower Sluggard’s price-earnings ratio to reflect the increase in financial risk indicated by a sharply higher ratio of long-term debt to capital and a significantly reduced pretax interest coverage ratio. Under reasonable assumptions, however, thecompany’s stock should continue to trade at the tender price of $30 a share

after the tender offer is completed. Accordingly, the currently disgruntled stockholders will get a chance to sell some of their shares at a big premium to the current market and also enjoy a longer-run boost to the share price.

Furthermore, for the next few years, Sluggard plans to devote the cash generated from its operations to debt repayment. That should take care of the biggest concern raised by management’s plan, namely, the heightened risk of financial strain posed by sharply increased interest costs.

Based on the bankruptcies of many prominent companies that underwent leveraged buyouts or leveraged recapitalizations in the 1980s, investors’ worries about Sluggard’s expanded debt load are by no means unfounded. In the period of the leveraged recaps’ greatest popularity, in fact, many veteran financial analysts perceived the leveraged recaps to be bankrupt from inception.

The only instances in which they had previously observed negative shareholders’ equity, comparable to the −$60 million figure shown in Exhibit 2.2, involved moribund companies that had wiped out their retained earnings through repeated losses. Typically, those companies were approaching negative equity in the economic, as well as the accounting sense.

The leveraged recaps presented a very different case, however. Their negative shareholders’ equity figures arose from the conventions of doubleentry- bookkeeping. Unlike other kinds of asset purchases, a company’s purchase of its own stock does not simply result in one type of asset (cash) being replaced by another (such as inventory or plant and equipment) on the balance sheet. Instead, the entry that offsets the reduction in cash is a reduction in shareholders’ equity. In the illustration, Sluggard pays a premium over book value, with the consequence that a buyback of less than 100% of the shares costs more than the stated shareholders’ equity.

Despite the resulting negative shareholders’ equity that arises, Sluggard is by no means faced with an immediate prospect of bankruptcy. The company’s pretax earnings continue to cover expense, albeit by a slimmer margin than formerly. Moreover, Sluggard is continuing to earn a profit, which the stock market is capitalizing at $30 a share times 13 million shares, or $390 million. This is a plain demonstration that in economists’ terms, the company continues to have a substantially positive equity, whatever the financial statements show.