More Estimates and Assumptions (Except for Cash)
Assets are what the company owns: cash and securities, machinery and equipment, buildings and land, whatever. Current assets, which usually come first on the balance sheet, include anything that can be turned into cash in less than a year. Long-term assets are those that have a useful life of more than a year.
Within those broad categories, of course, are many line items. We’ll list the most common ones—those that appear on nearly every company’s balance sheet.
Cash and cash equivalents are the hard stuff. Money in the bank. Money in money-market accounts. Also publicly traded stocks and bonds that are owned by the company—the kind you can turn into cash in a day or less if you need to. Another name for this category is liquid assets. This is one of the few line items that are not subject to accountants’ discretion. When Microsoft says it has $56 billion in cash and short-term investments, or whatever the latest number is, it means it really has that much in banks, money funds, and publicly traded securities. Of course, companies can lie. The giant Italian company Parmalat reported on its balance sheet that it had billions in an account with Bank of America. It didn’t.
Accounts receivable, or A/R, is the amount customers owe the company. Remember, revenue is a promise to pay, so accounts receivable includes all the promises that haven’t yet been collected. Why is this an asset? Because all or most of these commitments will convert to cash that soon will belong to the company. An account receivable is like a loan from the company to its customers—and the company owns the customers’ obligation. Accounts receivable is one line item that business owners need to watch closely, since it has a lot to do with the cash that will, or will not, come in. Creditors are likely to be watching it as well. We’ll say more on how to manage accounts receivable in part 7, on working capital.
Sometimes a balance sheet includes an item labeled “allowance for bad debt” that is subtracted from accounts receivable. This is the accountant’s estimate—usually based on past experience—of the dollars owed by customers who don’t pay their bills. In many companies, subtracting a bad-debt allowance provides a more accurate reflection of the value of those accounts receivable. But note well: estimates are already creeping in. In fact, many public companies use the bad-debt reserve as a tool to “smooth” their profit (remember, Wall Street is watching them). When they increase the bad-debt reserve on the balance sheet, they have to record an expense against profit on the income statement. That lowers their reported profit. When they decrease the bad debt reserve, similarly, the adjustment increases profit on the income statement. Since the bad-debt reserve is always an estimate, there is room here for subjectivity.
You might think that Wall Street would like a big spike in a public company’s profits—more money for shareholders, right? But if the spike is unforeseen and unexplained—and especially if it catches Wall Street by surprise—investors are likely to react negatively, taking it as a sign that management isn’t in control of the business. So companies like to “smooth” their earnings—that is, their profit—thus maintaining steady and predictable growth.
Service companies typically don’t have much in the way of inventory, but nearly every other company—manufacturers, wholesalers, retailers—does. One part of the inventory figure is the value of the products that are ready to be sold. That’s called finished-goods inventory. A second part, usually relevant only to manufacturers, is the value of products that are under construction. Accountants dub that work-in-process inventory, or just WIP (pronounced “whip”). Then, of course, there’s the inventory of raw materials that will be used to make products. That’s called—stand back—rawmaterials inventory.
Accountants can (and do!) spend days on end talking about ways of valuing inventory. We plan to spend no time at all on the subject. However, you should know that different methods of inventory valuation can often alter the assets side of a balance sheet significantly. If a company changes its method of valuing inventory during a given year, that fact should appear in a footnote to its balance sheet. Many companies detail how they accounted for their inventories in the footnotes, as Crocs, Inc. did in its 2007 Form 10-K:
Raw materials and supplies are valued at the lower of cost, replacement cost, or net realizable value. Work in process and finished goods are valued at the lower of cost and net realizable value. Cost is determined on the first in, first out basis. The cost of work in process and finished goods consists of the cost of raw materials and an applicable share of the cost of labor and manufacturing overhead.1
If you have questions about how your accountants are valuing your inventory, be sure to ask them. What you do need to remember as a business owner, however, is that all inventory costs money. It is created at the expense of cash. (Maybe you’ve heard the expression “All our cash is tied up in inventory,” though we hope it doesn’t apply to you.) In fact, this is one way companies can improve their cash position. Decrease your inventory, other things being equal, and you raise your company’s cash level. And if your company’s financial resources are tight (as they are for many entrepreneurial companies), watching and managing inventory is going to be important. A company always wants to carry as little inventory as possible, provided that it still has materials ready for its manufacturing processes and products ready when customers come calling. We’ll come back to this topic later in the book.
Another line on the balance sheet—property, plant, and equipment (PPE)—includes buildings, machinery, trucks, computers, and every other physical asset a company owns. The PPE figure is the total number of dollars it cost to buy all the facilities and equipment the company uses to operate the business. Note that the relevant cost here is the purchase price. Without constant appraisals, nobody really knows how much a company’s real estate or equipment might be worth on the open market. So accountants, governed by the principle of conservatism, say in effect, “Let’s use what we do know, which is the cost of acquiring those assets.”
Another reason for using the purchase price is to avoid more opportunities to bias the numbers. Suppose an asset—land, for example—has actually increased in value. If we wanted to mark it up on the balance sheet to its current value, we would have to record a profit on the income statement. But that profit would be based simply on someone’s opinion about what the land is worth today. This is not a good idea. Some companies—think Enron—go so far as to set up corporate shells, often owned by a company executive or other insider, and then sell assets to those shells. That allows them to record a profit, just the way they would if they were selling off assets. But it is not the kind of profit investors or lenders like to see.
The fact that companies must rely on purchase price to value their assets, of course, can create some striking anomalies. Say you started an entertainment company thirty years ago, and you bought land around Los Angeles for $500,000. The land could be worth $5 million today—but it will still be valued at $500,000 on the balance sheet. Sophisticated investors like to nose around in public companies’ balance sheets in hopes of finding such undervalued assets.
Land doesn’t wear out, so accountants don’t record any depreciation each year. But buildings and equipment do. The point of accounting depreciation, however, isn’t to estimate what the buildings and equipment are worth right now; the point is to allocate the investment in the asset over the time it is used to generate revenue and profits (remember the matching principle in chapter 3). The depreciation charge is a way of ensuring that the income statement accurately reflects the true cost of producing goods or delivering services. To calculate accumulated depreciation, accountants simply add up all the charges for depreciation they have taken since the day an asset was bought.
We showed you in a previous chapter how a company can magically go from unprofitable to profitable just by changing the way it depreciates its assets. That art-of-finance magic extends to the balance sheet as well. If a company decides its trucks can last six years rather than three, it will record a 50 percent smaller charge on its income statement year after year. That means less accumulated depreciation on the balance sheet, a higher figure for net PPE, and thus more assets. More assets, by the fundamental accounting equation, translate into more owners’ equity.
Goodwill is found on the balance sheets of companies that have acquired other companies. It’s the difference between the price paid for the acquired company and the net assets the acquirer actually got. (Net assets, again, refer to the fair market value of the acquiree’s assets minus the liabilities assumed by the acquirer.)
An acquisition occurs when one company buys another. Often you’ll see in the newspaper the words merger or consolidation. Don’t be fooled: one company still bought the other. A more neutral-sounding term may make the deal seem more palatable to the owners, employees, or customers of the acquired company, but it is still an acquisition.
The idea isn’t as complex as it sounds. Say you’re the CEO of a successful company that is on the acquisition trail. You spot a nice little warehousing business called MJQ Storage that fits your needs perfectly. You agree to buy MJQ for $5 million. By the rules of accounting, if you pay in cash, the asset labeled cash on your balance sheet will decrease by $5 million. That means other assets have to rise by $5 million. After all, the balance sheet still has to balance. And you haven’t done anything so far that would change liabilities or owners’ equity.
Now watch closely. Since you are buying a collection of physical assets (among other things), you will appraise those assets the way any buyer would. Maybe you decide that MJQ’s buildings, shelving, forklifts, and computers are worth $2 million, after deducting whatever liabilities you are assuming. That doesn’t mean you made a bad deal. You are buying a going concern with a name, a customer list, talented and knowledgeable employees, and so on, and these so-called intangibles can in some cases be much more valuable than the tangible assets. (How much would you pay for the brand name Coca-Cola? Or for Dell’s customer list?) In our example, you’re buying $3 million worth of intangibles. Accountants call that $3 million goodwill. The $3 million of goodwill and the $2 million of net physical assets add up to the $5 million you paid and the corresponding $5 million increase in assets on the balance sheet.
And now we want to tell a little story about goodwill that shows the art of finance at work.
In years past, goodwill was amortized. (Remember, amortization is the same idea as depreciation, except that it applies to intangible assets.) Other assets were typically depreciated over two to five years, but goodwill could be amortized over a maximum of forty years, or the estimated useful life of the acquired business.
Then the rule changed. The people who write those generally accepted accounting principles—the Financial Accounting Standards Board, or FASB (pronounced faz-bee)—decided that if goodwill consists of the reputation, the customer base, and so on of the company you are buying, then all those assets don’t lose value over time. They actually may become more valuable over time. In short, goodwill is more like land than it is like equipment. So not amortizing it helps accountants portray that accurate reflection of reality that they are always seeking.
But look at the effect. When you bought MJQ Storage, you wound up with $3 million worth of goodwill on your balance sheet, and let’s say you estimated the useful life of that goodwill at thirty years. Before the rule change, you would have amortized the goodwill over thirty years at $100,000 per year. In other words, you would have deducted $100,000 a year from revenues, thereby reducing the profitability of your company by the same amount. Meanwhile, you’re depreciating MJQ’s physical assets over, say, a four-year period at $500,000 per year. Again, that $500,000 would be subtracted from revenue to determine profit.
So what happens? Before the rule change, other things being equal, you wanted to have more goodwill and less in physical assets, simply because goodwill is amortized over a longer period of time, so the amount subtracted from revenue to determine profit is less (which keeps profits higher). You had an incentive to shop for companies where most of what you’d be buying was goodwill, and you had an incentive to undervalue the physical assets of the company you were buying. (Remember, it is your own people who are doing the appraisal of those assets!)
With the new rule, goodwill sits on the books and isn’t amortized. Nothing at all is subtracted from revenue, and profitability is correspondingly higher. You now have even more of an incentive to look for companies without much in the way of physical assets, and even more of an incentive to undervalue those assets. Tyco was one company that was accused of taking advantage of this rule. In the go-go years of 2000 and 2001, Tyco was buying companies at breakneck speed—more than six hundred in those two years alone. Many analysts thought that Tyco regularly undervalued the assets of these numerous companies. Doing so would increase the goodwill included in all those acquisitions and lower the depreciation Tyco had to take each year. That, in turn, would make profit higher and would drive up Tyco’s share price.
A company’s intangible assets include anything that has value but that you can’t touch or spend: employees, proprietary knowledge, patents, brand names, reputation, strategic strengths, and so on. Most of these assets are not found on the balance sheet unless an acquiring company pays for them and records them as goodwill. The exception is intellectual property, such as patents and copyrights, which can be shown on the balance sheet and amortized over its useful life.
But eventually, analysts and investors noticed that Tyco had so much goodwill on its books and so little (relatively speaking) in the way of physical assets, that if you took goodwill out of the balance sheet equation, the company’s liabilities were actually higher than its assets. This is not a situation investors like to see.
How do you account for the cost of creating a new software program that you expect to generate revenue for years? What about the cost of developing a new wonder drug, which is protected by a twenty-year patent (from the date of application)? Obviously, it makes no sense to record the whole cost as an expense on the income statement in any given period, any more than you would record the whole cost of buying a truck. Like a truck, the software and the patent will help generate revenue in future accounting periods. So these investments are considered intangible assets and should be amortized over the life of the revenue stream they generate. By the same token, however, R&D expenses that do not result in an asset likely to generate revenue should be recorded as an expense on the income statement.
You can see the potential for subjectivity here. GAAP says that R&D can be amortized if the product under development is technologically feasible. But who determines technological feasibility? Again, we are back in the realm of art. If a company decides that its R&D projects are technologically feasible, it can amortize those sums over time and make its profits look higher. Otherwise, it must expense R&D costs as they are incurred—a more conservative approach. Computer Associates is one company that got itself into trouble for amortizing R&D on products that had a questionable future. Like depreciation, amortization decisions can often have a sizable effect on profitability and owners’ equity.
To explain accruals and prepaid assets, let’s look at a hypothetical example. Say you start a high-end bicycle manufacturing company, and you rent manufacturing space for the entire year for $60,000. Since your company is a lousy credit risk—nobody likes to do business with a start-up for just this reason—the landlord insists on payment up front.
Now, we know from the matching principle that it doesn’t make sense to book the entire $60,000 in January as an expense on the income statement. It’s rent for the whole year. It has to be spread out over the year, so that the cost of the rent is matched to the revenue that it helped bring in. So in January you put $5,000 on the income statement for rent. But where does the other $55,000 go? You have to keep track of it somewhere. Well, prepaid rent is one example of a prepaid asset. You have bought something—you own the rights to that space for a year—so it is an asset. And you keep track of assets on the balance sheet.
Every month, of course, you’ll have to move $5,000 out of the prepaidasset line on the balance sheet and put it in the income statement as an expense for rent. That’s called an accrual, and the account on the balance sheet that records what has not yet been expensed is called an accrued asset account. Though the terms are confusing, note that the practice is still conservative: we’re keeping track of all our known expenses, and we’re also tracking what we paid for in advance.
But the art of finance can creep in here as well because there is room for judgment on what to accrue and what to charge in any given period. Say, for example, your company is developing a major advertising campaign. The work is all done in January, and it comes to $100,000. The accountants might decide that this campaign will benefit the company for two years, so they would book the $100,000 as a prepaid asset and charge one-twenty-fourth of the cost each month on the income statement. A company facing a tough month is likely to decide that this is the best course—after all, it’s better to deduct one-twenty-fourth of $100,000 from profits than the whole amount. But what if January is a great month? Then the company might decide to expense the entire campaign—charge it all against January’s revenue—because, well, the accountants can’t be sure that it will help generate revenue during the next two years. Now the company has an advertising campaign that’s all paid for, and profits in the months to come will be correspondingly higher. In a perfect world, our accounting friends would have a crystal ball to tell them exactly how long that advertising campaign will generate revenue. Since they don’t yet have such a device, they must rely on estimates.
So that’s it for assets. Add them all up, along with whatever extraneous items you might find, and you get the “total assets” line at the bottom of the left side of the balance sheet. Now it’s time to move on to the other side—liabilities and owners’ equity.