Accounting Basics, Part Three

An issue quite analogous to depreciation is depletion. For businesses that operate by extracting resources from the ground, surely one of their most important assets is the expected amount of oil, coal, diamonds, or whatever-it-might be that is still down there, yet to be extracted, on the land owned or leased by the company for this purpose. Over time, as oil [let us say] is removed, necessarily the remaining oil under there is depleted.

The issue has often been politically contentious. Indeed, references to the oil depletion allowance in various stages of its development run like a Wagnerian motif through the various volumes of Robert Caro’s work on the life and times of Lyndon Johnson, who as both Representative and Senator from the oil-rich state of Texas was a stalwart defender of a very generous allowance for the tax accounting books, one which does not have to be duplicated in the financial accounting books.

But let’s stick to the latter.  One way in which accountants might value the remaining oil, or the somewhat-used-up conveyor belt for that matter, (we’ll just consider this for now as a hypothetical possibility) is by repeatedly marking them to their market value – at the end of every year or quarter or what-have-you. As each new period ends, the accountants could ask themselves, “how much can we get on the market for a conveyor belt like this?”

That is called a mark-to-market rule, and it has its attractions. If a firm could regularly mark to market the value of the conveyer belt, and if it could do so in a transparent way (that is, a way that would allow any interested observer to confirm that valuation) then it would have set at ease the minds of many a counter-party. Insurance companies and bankers would welcome the information. Marking to market would facilitate the securitization of the conveyer belt itself: that is, it would help the firm if it chose to offer the belt as collateral.

Unfortunately, just as there is no crystal ball to tell us how long the belt will last, so there is no conveyer-belt blue book to tell us how much it would be worth if sold. Constant appraisals [by hypothetical conveyer-belt appraisers] would represent an expenditure of time and money that may easily exceed the benefits.

There may be another consideration: market vicissitudes. Perhaps the market for conveyer belts has seized up, due to some quite temporary emergency. If our firm had to sell the belt today, the price we would get for it would be a disastrously low one, a “fire sale price”.  Would it be fair then to expect us to mark it down to that fire sale price?

For such assets as this accountants have long since shrugged at such questions and accepted rules of thumb telling them how long a productive asset may be expected to last, and discounted its original value, as measured by that sales price, a period at a time accordingly.

But let’s vary the facts a bit. Suppose a large chain of widget retailers has created a division that makes its own conveyor belts, thus freeing itself from the vicissitudes of its former vendors.  Then a new boss comes in and decides to tighten up the focus of the organization by selling off non-core assets. He spins off the conveyor belt division into a new company, CBD Inc.   

The widget-selling parent company retains an equity interest in CBD Inc.  Suppose it retains 30 percent ownership and sells the other 70.

Now it must list its share in CBD Inc. on its balance sheet. How does it value that?

If CBD itself goes public, if that other 70 percent of its equity is bought and sold daily on the New York Stock Exchange, then the question answers itself. The value of the 70 percent of the stock that trades on the market will serve as a metric for the value of the 30 percent that the parent corporation holds as an asset.

Inventory  

Let’s return to the list of assets in our hypothetical balance sheets above, and look to the next line on the list, below equipment. That line is inventory, and this term accountants define as the stock of merchandise at hand that a company holds ready to sell. This is often an important item on the asset side of the balance sheet, and the valuation of inventory can become a matter of intense controversy, especially during periods of price inflation.

In particular, consider last-in first-out valuation on the one hand and first-in first-out on the other (LIFO and FIFO).  Those names describe the distinction: a retailer using LIFO will match the value of a just-purchased item at wholesale against the sales value of the most recently sold item of the same kind. A retailer using FIFO will match the supplier’s price of the oldest “widget” still in the storeroom against the sales price of the most recent one just sold to a customer.

We have, let us say, 50 widgets in stock. The oldest of these we purchased a year ago for just $2 from our wholesaler/supplier. But it has been quite an inflationary year in the world of widgets, and the newest on stock we bought just yesterday at $3.50. 

A customer just bought one at our present retail price of $4.20. We now have $4.20 more in the till than we used to. But we have a less valuable inventory. How much less valuable? Under LIFO, we have to mark down the value of our inventory by $3.50: under FIFO, by just $2.

This difference would be an even bigger deal if we were discussing income statements than when discussing balance sheet, because in the former case it would be a matter of determining how much profit we’re making per widget.