What’s the Right Number?

To obtain a bank loan, you are often asked to produce a personal balance sheet and income statement. If you were told that if you made a mistake you could be fined $100,000 and go to jail, as corporate executives now face with the new legislation, would you be willing to submit the documents?

If you say “no problem,” then perhaps you should try the following exercise. (Don’t be afraid. It is not a math quiz, only an accounting concept quiz. Yet despite all of the blustering, even members of Congress cannot give definite answers to these questions.)

Many people assume that individuals and businesses should have no problems in producing financial statements. To do an income statement, you merely have to list revenues and deduct expenses to measure profit or income, right? To do a balance sheet, you merely list your assets and deduct liabilities to get net worth, right? Perhaps it is not so simple.

• Question: If you pay $5,000 for a computer that is useful for more than one year, you are supposed to “depreciate it” when you list it on your balance sheet (i.e., show its reduction in value as it is used). Assume that the computer will be technologically obsolete in three years, at which time you will replace it. Yet the Internal Revenue Service might say you need to depreciate it over five years according to the tax law, and the computer will physically work for 10 years. To be truthful, what value do you put on your balance sheet for a 2-year-old computer?

• Question: If you buy a small restaurant from a friend for $150,000, yet the value of the physical assets (e.g., chairs, table, stoves and refrigerators) is only $100,000, do you put the remaining $50,000 on your balance sheet as an asset? The answer is yes, under the heading “good will,” which is value created by the good reputation the restaurant had because of the work of the previous owner. But what happens if your business declines by 25 percent over the next year? Do you still list “good will” as $50,000? If not, what number do you use?

• Question: If, for $100,000, you bought 100 acres of timberland 20 years ago, and the tax assessor now claims it is worth $200,000, while your real estate agent tells you he thinks he can sell it for $400,000, what number do you put on your balance sheet?

• Question: You own a sailboat that originally cost you $100,000. You contract to sell it for $180,000. Your buyer agrees to pay you $140,000 this year, $40,000 next year plus 6 percent interest. You also think there is a 10 percent chance that the buyer will not pay you what he owes you next year. Did you make a profit of $80,000 or $40,000 this year? How much profit and in what year did you make the profit if the buyer does not pay you next year?

Very honest and knowledgeable people can come to different conclusions about what the answers are to the above and hundreds of other accounting treatment questions. Thus Congress should not get in the business of setting accounting standards because most members have insufficient knowledge and experience to do it wisely. For instance, many in Congress and others have said companies should list stock options as an expense.

There are many different types of stock options, but a common one would be to grant to an executive the right to buy 100,000 shares of his company’s stock for $15 per share at any time from two to five years in the future. If the present price of the stock is $12 per share and there are a million shares outstanding, what is the cost to the company? Assume the executive succeeds in causing the share price to rise to $25 per share in three years. At that point, he buys the 100,000 shares by paying the company $1.5 million, and then turns around and sells his shares for $2.5 million, making himself a million-dollar profit. What is the cost to the company? If you are having trouble coming up with an answer, it is because there is no clear or consensus answer.

You are president of a company that buys another company that once sold products containing asbestos. The courts make an unexpected ruling that not only producers but also sellers of products that contain asbestos can be subject to class-action lawsuits. This causes your stock price to fall because of the newly expected legal liability. What number do you put on your balance sheet as the contingent liability? (This is the precise situation that happened to Vice President Richard Cheney when, as president of Halliburton, he purchased Dresser Industries, which had an unexpected asbestos liability, and he is now being blamed for an event outside his control.)

Finally, you have to hold a stock for one year before obtaining the lower long-term capital-gains tax rate on whatever profit you make from the sale.

It used to be six months, why now 12? If Congress reduced the capital-gains holding period to six months, the stock market would immediately soar, and a year from now the Treasury would reap a huge increase in capital-gains tax receipts. Congress picked the wrong number — 6 is better than 12 when it comes to holding periods and zero is better yet. Let’s ask members of Congress to change the holding period to six months, rather than put them in jail, and if they go to zero we might even vote for their re-election.

The lesson is, Congress ought to be very careful in placing executives at risk for accounting and tax judgments that are not clear fraud. If you are going to fine or imprison business executives for honest miscalls, many will correctly demand that members of Congress and government executives be subject to the same standards. Given the deplorable state of the federal government’s books and congressional misstatements about the cost of government programs, we might find many Washingtonians in jail — hmmm.

Richard W. Rahn is a senior fellow of the Discovery Institute and an adjunct scholar at the Cato Institute.