Investing

Why Companies’ Balance Sheets Can Be Misleading

(photo: Philippe Put)

Investors rely on accurate financial information to pick companies. But are you getting truly accurate information from a company’s balance sheet? Can you tell what a company is really worth based on a list of assets and liabilities?

No.

And that’s because both assets and liabilities can give you a misleading picture of a company’s true worth.

The Asset Side

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 their 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 have 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, or 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.

The Liability Side 

A disturbing reality about financial statements is that they are inherently inaccurate and incomplete. Fundamental investors are told to apply a series of popular balance sheet ratios to test working capital and financial strength. Observing trends in the current ratio and debt ratio, for example, reveal the status of rising, falling, or unchanging degrees of financial control. All of those tests are valuable. However, the balance sheet is not a complete report of a company’s assets, liabilities or net worth.

On the liability side, accounts are broken down into two major categories: First are the current liabilities, debts that have to be paid within 12 months. These include 12 months of debt service on longer-term notes as well as accounts and taxes payable. Second are long-term liabilities, the obligations of the company beyond the next 12 months. These accounts include long-term debts and bonds issued.

However, a lot of significant obligations are left off of the balance sheet. Even with a thorough audit, these important matters are found buried in the lengthy and complicated footnotes, and their real meaning may also be cloaked behind technical language that is difficult to decipher.

Two examples: contingent liabilities and contractual agreements are not shown on the list of liabilities.

A contingent liability is a possible debt that has not yet been realized but could come to pass in the future. So if a lawsuit has been filed against a company seeking $80 million in damages, it is not a liability. But if the case is won by the plaintiffs, it becomes a liability. This contingency is not included on the balance sheet, but is disclosed in the footnotes.

A contractual agreement may include leases on autos and trucks, or even very long-term leases on occupied buildings and warehouses. Even though these obligations can run into the millions, they do not show up under current or long-term liabilities. You have to search through the footnotes to find them. They are very real obligations, but under the accounting rules they are simply not listed on the balance sheet.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Why Companies’ Balance Sheets Can Be Misleading was provided by Minyanville.com.