© 2000 John Petroff
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© 2000 John Petroff |
B- Distortions in fixed assets amounts on the balance sheet
Second only to the distortion in inventory caused by LIFO, discussed earlier, the distortion in the fixed assets is almost as serious. The distortion in fixed assets numbers comes from accounting principles in both GAAP and international accounting systems (as well as in other Western and Russian accounting systems), and not from management deliberate actions. Although the distortions can be sizeable, corrections suggested in the following paragraph are only done when an analyst needs to evaluate the company in the context of merger, acquisition, restructuring or bankruptcy proceedings.
1)- Plant and equipment:
Accounting rules require that the plant and equipment be recorded on the balance sheet, at cost. In periods of inflation, the historic cost of plant and equipment purchased only a few years ago grossly understates the replacement value of the same plant and equipment. Moreover, when comparing this item over several years, it is not possible to tell from the balance sheet amount what portion of the equipment was retired and/or modernized in any given year because the number shown on the balance sheet is a aggregatyed number of all plant and equipment. Nor is it possible to obtain this information from the depreciation allowance, neither for the current year, nor for the accumulated depreciation of prior years. The reason is the same: there is no breakdown by item or type. Equipment lasting 3 years is lumped with equipment with useful lives of 5, 10 years or more.
At best, the notes to the financial statements may state the depreciation method used (straight-line, accelerated, or sum-of-years-digit) and the average life of different categories of equipment. Reconciliation is practically impossible for an outsider (i.e. unless given all the necessary information by the company). The statement of cash flows is also of little use. When inflation is mild, the plant and equipment amount on the balance sheet is only moderately understating a replacement value. But when inflation is high, this item can become virtually meaningless. In some countries with high inflation rates, the government usually mandates a reevaluation of assets and depreciation using official indexes. But using the same index for a variety of assets that experience totally different increases in price, remedies the distortion only partly.
For an outsider, it is also usually futile to try to find realistic replacement values. The only thing that can be done is to find an index of inflation that is relevant to the company assets, and to use an index to deflate current numbers or inflate prior year data. Failing that (especially if no index is available), the only solution is to use the numbers as they are, knowing that the distortions are there, and hoping that distortions of comparable magnitude are present in plant and equipment of prior years and other companies, and therefore the distortions would cancel each other out. Unfortunately, there is obviously no assurance of this is actually the case.
Could the amounts shown for fixed assets in the balance sheet be overstated rather than understated? Yes, of course, if real physical depreciation of the equipment, technological obsolescence or excess capacity render the equipment worth less than the amount reported. If the financial statements have been audited, the financial analyst can rely on the auditor's opinion most of the time for accuracy of data in financial statements, but not for the physical assets they represent. One of the major reasons for an analyst's visit to the premises of a company is to verify the existence and working state of each major plant. It goes without saying that if the statements have not been audited, the physical inspection is all the more important. The danger is twofold. First, if the company failed to write off or depreciate fixed assets timely (i.e. when the asset is loosing its value), this overstates prior years profitability and therefore retained earnings, aw well as the assets themselves. Second and more importantly, inflated assets defeat the purpose of financial planning: this may prevent a firm from seeking more productive assets, and may jeopardize the achievement of sales objectives.
See review questions Q-10B1.1 through Q-10B1.10.
2)- Equity investment:
As indicated earlier, this item is part of fixed assets and represents shares of stock of affiliated companies that have not been consolidated with the parent company. The equity method of accounting requires that the shares of an affiliate be first recorded at their purchase price, then the initial purchase price be increased or decreased by the parent company's portion of the affiliated company's profit (net of any dividends) or loss. Since this amount is never adjusted for the change in market price, after several years the disparity between the equity investment amount on the balance sheet and the market value can be substantial, especially if the affiliate is in a growth industry.
But, here, again, it is not of crucial importance. Even if the shares have been owned for several years, the amount will significantly understate market prices, but the distortion has little bearing on sales and production of the company itself; and therefore, the distortion has little import in long range decisions and correction for it is not necessary. If an affiliate has experienced difficulties, the market price may be lower than the amount shown in the balance sheet; however, adjustment is still not necessary, unless the analyst needs to arrive at a liquidating value for the assets.
See review questions Q-10B2.1 and Q-10B2.2.
3)- Intangibles:
Goodwill (i.e. the excess paid to acquire an affiliate over the book value of its assets), appears only if a company has acquired another company. Accounting rules recommend that goodwill be amortized as quickly as possible or at least faster than 50 years. Some goodwill dating back to before (i.e. 1970's) the new rule was adopted in the United States has never been amortized. This item is likely to be overstated.
Patents, copyrights, trademarks, and other forms of industrial property appear in a GAAP balance sheet only if they have been acquired. Contrary to practices in some European countries and in international accounting, in the United States, expenses for research and development are not capitalized, as long as they have been incurred internally. (GAAP rules have recently changed with respect to development of software that can now be capitalized and amortized over three years). Thus, this item is grossly understated on the balance sheets of American companies. Naturally, this industrial know-how is an extremely valuable asset of the company. Yet, it does not appear as an asset in American balance sheets. It is all the more important, therefore, to scrutenize the annual report and its income statement in order, for instance, to derive the size of research and development expense, to conduct as much investigation on it as possible, and to determine its potential commercial value (as was suggested in the previous chapter).
See review questions Q-10B3.1 through Q-10B3.6.
4)- Other fixed assets:
Among the other fixed assets, one may find prepaid expenses and fixed portion of inventory. Even if large in size, most prepaid expenses are not great significance. They may pertain to some expenses incurred when the company was formed. Such capitalized organizational expenses are generally amortized over many years. A deferred tax asset may be present but it, too, is not a real asset as explained in Chapter 13. The fixed portion of inventory may be more noteworthy because it is a recognition by management that there is an inventory in excess of current needs. If the holding of such inventory was not planned (and is not made of some raw material precious to the company), then some serious difficulties must have been encountered. And that deserves an analyst's attention. There may also be some excess capacity plant and equipment or real estate that can be shown separately from other fixed assets, or indicated in notes to financial statements. An investigation is clearly warranted to determine why funds are tied up in non-productive assets, and whether plans exist either to put them to use in the future or to dispose of them. Indecision can be costly to a company.
See review questions Q-10B4.1 and Q-10B4.2.
5)- Tangible assets and tangible net worth:
It is customary to calculate a tangible net worth when assessing the value of a firm for merger or acquisition purposes. Tangible net worth is calculated as tangible assets less all liabilities. To obtain the tangible assets, all forms of unproductive and unsalable assets must be deducted from total assets. All these items have been pointed out above and in Chapter 8. They include prepaid expenses, goodwill, excess value of physical and financial assets over market value, excess inventory and industrial property whose salvage value is undeterminable.
See review questions Q-10B5.1 and Q-10B5.2.
See research assignments R-10B.1 through R-10B.3.
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