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The Outmoded Balance Sheet

Investors rely on accurate financial information to pick companies. But are you getting truly accurate information from the balance sheet? Can you tell what a company is really worth based on a list of assets and liabilities? No.

On the asset side alone, assets are potentially valued far below their true value. The accounting rules require that capital assets (buildings, machinery, autos and trucks) is listed at its purchase price, minus depreciation. The resulting "net" asset is the value carried on the balance sheet no matter what true market value is at the time.

For example, a company may own a building it purchased 30 years ago for $2 million, including $500,000 for the land and $1.5 million for the building itself. Today, the property is worth $30 million. However, the value of the building has been depreciated from $1.5 million down to zero (the value of land stays on the books at $500,000 and is not depreciated). So in this case, a property with market value of $30 million is carried at only $500,000, or 1/60th of its true value.

This can work in the other direction as well. Companies might pay for assets that have become obsolete or lost value, but this is never adjusted on the balance sheet. The original cost, minus depreciation, is the basis for all capital assets, no matter how their actual value has moved.

In the case of other assets, reserves are set up in an attempt to accurately report value. For example, the accounts receivable balance (simply the value of what customers owe the company) is reduced by a reserve for bad debts. Then when future bad debts are recognized, the reserve is adjusted to even out the timing of the write-off. In this case, bad debts are written off each year rather than all at once, improving accuracy.

The valuation of assets on a company's balance sheet is archaic, and may lead to very inaccurate book value for stock, either positively or negatively. With this in mind, astute investors need to investigate beyond what the numbers reveal. A study of the footnotes in the annual report should disclose the differences between net book value and true market value of capital assets; it should also explain how other assets may be valued either above or below true market value. Unfortunately, footnotes often run over 100 pages in the annual report and are not easy to understand. Even so, if you are concerned about the equity value of a company, big adjustments to asset valuation has to be taken into consideration as part of the analysis.

The greatest part of the problem is with the outdated accounting standards. The Generally Accepted Accounting Principles (GAAP) are overly conservative when it comes to accurate asset valuation. Unless you can find an analyst's detailed report that explains the real equity value, relying on the balance sheet is not enough. A planned merger between GAAP and IFRS might fix many of these inaccuracies; but that merger has been scheduled and postponed many times, so whether it will ever happen is questionable.

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