How To Get Rich Quick Using GAAP

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Mar 15, 1992 - wanted to be rich and famous, but weren't very good businessmen. ... B. Grow. The two men proceeded as follows. First Company A bought ...

March 15, 1992

How To Get Rich Quick Using GAAP

Abstract Wherein it is shown how to make your company as large as desired and as large a portion of capitalization weighted stock indices as desired without doing anything useful, and how to borrow huge sums of money from banks with virtually no collateral, all within the confines of GAAP.

Robert Ferguson AnswersToGo

Neal Hitzig Professor, Accounting Queens College Graduate School of Business

6815 Edgewater Drive, Apt 208 Coral Gables, FL 33133 786-897-4573 [email protected]

Flushing, NY 11367

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I. Introduction. Once upon a time there were two men, each of whom controlled a small firm. Both men wanted to be rich and famous, but weren't very good businessmen. Their businesses, although profitable and well thought of, remained small. Nothing they tried produced the growth they so badly desired. The men grew increasingly frustrated and unhappy as the years went by. They did not know what to do. Fortunately, both men had MBA degrees in Finance and Accounting from a top ranked business school. One day, after reading an article in a professional journal about the financial machinations of recent years, the men realized that wealth, status, and influence were theirs for the asking. All they had to do was forget about building a business and concentrate on building a financial structure. Their education was perfectly suited to this. In the space of a year, the market capitalization of each man's company had increased manyfold, to more than $1.0 billion. Naturally they had profited personally from this growth. The men were rich and famous. They were consulted about important issues of the day by a variety of government agencies and politicians. They were content. Here, in a nutshell, is how they did it. Note that no laws were broken, nothing unethical was done, and GAAP was scrupulously observed. II. The Basic Idea. A. Two Small Companies. The companies controlled by the two men were named A and B. They were identical. Each firm originally issued 200 shares of stock for a total of $200. Of the proceeds, $100 was invested in real assets and $100 remained in cash. In each case, 101 of the issued shares were retained by the founder and 99 were sold to the public. A liquid market developed for each firm's shares. As it turned out, the actual business operations, which utilized the real assets, had a market value of precisely $100. Consequently, the market value of each company was $200 and the price of each company's shares was $1.00. The firms' balance sheets are shown in Figure 1.

Figure 1 Company A Cash: 100 Real Assets: 100

Equity: 200

Shares Outstanding: 200. Book Value per Share: 1.00.

Company B Cash: 100 Real Assets: 100

Equity: 200

Shares Outstanding: 200. Book Value per Share: 1.00.

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B. Grow. The two men proceeded as follows. First Company A bought $100 of newly issued shares of Company B. Company B's book value was $200 just prior to the transaction. This consisted of $100 of cash with a market value of $100 and $100 of real assets, which were supporting a business with a market value of $100. Thus Company B's per share book and market values were $1.00 just prior to the transaction. It was therefore agreed that a suitable price for Company B's stock was $1.00 per share and 100 new shares were issued. Figure 2 shows how the balance sheets of the companies looked just after this transaction. Note that aggregate book value increased from $400 to $500. Aggregate market capitalization also increased from $400 to $500. The latter increase reflects the fact that Company A's market capitalization remained at $200. It holds real assets with a market value of $100 and an investment of 100 shares of Company B's stock which has a market value of $1.00 per share.

Figure 2 Company A Cash: 0 Real Assets: 100 Investments: 100

Company B Cash: 200 Real Assets: 100

Equity: 300

Equity: 200

Shares Outstanding: 200. Book Value per Share: 1.00.

Shares Outstanding: 300. Book Value per Share: 1.00.

Next, Company B bought $100 of newly issued shares of Company A. Company A's book value was $200 just prior to the transaction. This consisted of $100 of marketable investments with a market value of $100 and $100 of real assets which were supporting a business with a market value of $100. Thus Company A's per share book and market values were $1.00 just prior to the transaction. It was therefore agreed that a suitable price for Company A's stock was $1.00 per share and 100 new shares were issued. Figure 3 shows how the balance sheets of the companies looked just after this transaction. Once again, $100 was added to aggregate book value and market capitalization. Each company's equity was $300, $100 greater than before the two transactions. Book value per share remained at $1.00. Each company's market capitalization also had grown by $100 to $300. Both companies' shares continued to sell at $1.00.

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Figure 3 Company A Cash: 100 Real Assets: 100 Investments: 100

Equity: 300

Company B Cash: 100 Real Assets: 100 Investments: 100

Shares Outstanding: 300. Book Value per Share: 1.00.

Equity: 300

Shares Outstanding: 300. Book Value per Share: 1.00.

C. Without Limit. There was no reason why the same two transactions couldn't be repeated, with the same result.1 Both men realized this and followed through. Each pair of transactions increased each company's equity and market capitalization by $100. Book and market value per share remained at $1.00. Figure 4 shows how the balance sheets of the two companies looked after seventeen more cycles.

Figure 4 Company A Cash: 100 Real Assets: 100 Investments: 1800

Equity: 2000

Shares Outstanding: 2000. Book Value per Share: 1.00.

Company B Cash: 100 Real Assets: 100 Investments: 1800

Equity: 2000

Shares Outstanding: 2000. Book Value per Share: 1.00.

Needless to say, our two protagonists capitalized on this phenomenon in more ways than one and lived happily ever after.

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The astute reader will recognize that consolidation is required when one company owns more than 50% of another, thus eliminating the intercompany holdings. However, it is easy to avoid this problem, as shown later.

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III. Implications. The series of transactions described above can indeed be used to increase each company's equity to any desired level.2 Most of each company's assets eventually will consist of an investment in shares of the other company. These shares have a well defined book value and market price. Each company's market capitalization will reflect the value of its investments just as do shares of mutual funds. Thus each company's market capitalization also can be increased to any desired level. A consequence of the companies' increased market capitalization is that they become an arbitrarily large portion of capitalization weighted stock indices. A consequence of the increased value of each company's marketable investments is that they will be viewed as excellent collateral by lenders. Indefinitely large sums can be borrowed without any underlying real collateral. Clearly, aggregate balance sheet equity and market capitalization can be gross distortions of the aggregate value of underlying businesses. IV. Some Fine Points. A. Consistency With GAAP. The mechanism described above is not consistent with GAAP. The percentage of each firm owned by the other is too high. GAAP (APB Opinion 18) requires consolidation in such cases, thus eliminating the cross ownership effect.3 There is a simple way around this problem, however. Consider what happens if each of 100 companies like A and B buy 1 percent of each of the other 99 using a series of transactions of the type described above. The end result is that each company is 99 percent owned by the other companies, as a group, yet no company owns more than 1 percent of any other company. GAAP's safety precautions are bypassed. Figure 5 shows what the balance sheet of one of these companies looks like.

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The process of equity creation described here is similar to deposit creation in the banking system. Banks, however must maintain minimum reserves. This limits the amount of deposits banks can create. There is no corresponding limit when it comes to cross-ownership. Try visualizing Company A consolidating Company B at the same time that Company B is consolidating Company A. It has a nice pornographic touch, don't you think? It's surprising what sometimes lurks beneath the numerical veneer of an accountant.

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Figure 5 Company i Cash: 100 Real Assets: 100 Investments: 19800

Equity: 20000

Shares Outstanding: 20000. Book Value per Share: 1.00.

B. What Stops The Process. The process stops if firms invest the proceeds of their stock sales in real assets. In terms of Companies A and B, the series of transactions cannot proceed beyond Figure 2 because Company B uses the $100 it has just received from A to buy more real assets. Figure 2 has to be replaced with Figure 6. Note that while the process has stopped, there still is a distortion produced by the first transaction. In Figure 6, aggregate equity exceeds the aggregate of cash and real assets by $100.

Figure 6 Company A Cash: 0 Real Assets: 100 Investments: 100

Company B Cash: 100 Real Assets: 200

Equity: 300

Equity: 200

Shares Outstanding: 200. Book Value per Share: 1.00.

Shares Outstanding: 300. Book Value per Share: 1.00.

V. Finding The Aggregate Market Value Of Businesses. In the examples above, the aggregate market value of businesses is simply total capital less investments. This is because it was assumed that the market value of real assets is the same as their book value. Typically, this is not the case. The available data are market value and proportionate ownership, not the market value of underlying businesses. The latter can be found from the former.

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Denote the market value of the i 'th company's business by ViB , its total market capitalization by Vi , and its proportionate ownership of company j by pij . Then the following set of simultaneous equations characterize the situation. n

ViB   pijV j  Vi

, i  1,, n

j 1 j i

(1) Define pii as 0 for all i . Then equations (1) can be rewritten as follows. n

ViB   pijV j  Vi

, i  1,, n

j 1

(2) The solution to these equations is n

ViB  Vi   pijV j

, i  1,, n .

j 1

(3) As expected, The value of a company's business is the difference between its total market capitalization and the market value of its investments. Note that the ownership of one company by all others as a group cannot exceed 100%. Thus, n

p i 1

ij

1

, j  1,, n .

(4) To illustrate equation (3) assume that there are 100 companies and that they are identical. In particular, assume that each company owns 1% of each other company. In this case:

ViB  VB , Vi  V ,

(5) (6)

n

pV j 1

ij

     pij V j  .99V ,  j 1  n

j

VB  .01V .

(7)

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The distortion amounts to 10,000%. VI. Security Analysis And Cross-Ownership. A. Book Value. Security analysts will begin with stated book value and adjust it as they think necessary. The value of real assets will not be an issue. Neither will be the value of investments. Assuming that stated book value reflects pension assets less pension liabilities, there will be no apparent reason for making any adjustment whatsoever. Indeed, none is called for if the analysis focuses on a single company. Aggregate book value, as determined by security analysts, will be distorted as described above. This would not be true if each of the companies had bought their own stock. Such stock would no longer be "outstanding". Consequently, it would not be included in the computation of equity. B. Market Value. The security analyst's job is to determine a company's fair market value. The market value of each company's real assets will reflect the value of the business they are supporting. Analysts typically will determine each company's business value to be somewhat different than the accounting value of its real assets. On average, however, these two values will tend to be about the same. Thus, the entire analysis hinges on how the analyst treats the market value of each company's investments. A cursory survey of investment texts and actual analytical reports suggests that security analysts simply value marketable investments at their current market value (quoted price times shares held). A particularly thoughtful analyst may substitute "fair" value for these market values. Indeed, nothing else is called for if the analysis focuses on a single company. In either case, the cross-ownership distortions described above will be preserved. Aggregate market value, as determined by security analysts, will be distorted as described above. This would not be true if each of the companies had bought their own stock. Such stock would no longer be "outstanding". Consequently, it would not be included in the computation of market capitalization. C. Earnings. Knowing the business earnings of all of the companies and the various cross-ownership relationships permits the analyst to compute each company's total earnings by taking the sum of its business earnings and its proportionate interest in other companies' earnings as follows.

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In a manner analogous to the analysis of value, Denote the earnings of the i 'th company's business by EiB , its total earnings by Ei , and its proportionate ownership of company j by pij . Then the following set of simultaneous equations characterize the situation.4 n

Ei  EiB   pij E j

, i  1,, n

j 1

(9) Assume, for example, that each company's business and total earnings are identical and that all of the cross-ownership proportions are the same. If there are 4 companies and each owns 20% of each of the others, then equation (5) shows that each company's total earnings, as computed by the security analyst, are 2.5 times its business earnings. This represents a distortion of 150% in aggregated earnings as determined by security analysts. This would not be true if each of the companies had bought its own stock. Such stock would be treasury stock and no longer outstanding. Consequently, it would not be included in the computation of earnings. If there are 50 companies and each owns 1% of each of the others, then each company's total earnings are 1.96 times its business earnings. This represents a distortion of 96%. D. Price/Earnings Ratios. Assuming that security analysts compute market values and earnings as described above, then each company's price/earnings ratio will be independent of the degree of crossownership. VII. Japan. Maybe Japan isn't as big as we think. Japanese companies are famous for their crossownership. Average cross-ownership in Japan is reputed to be about 50%. If so, then the distortion may be about 100%. How can this be checked? A reasonable first test is to aggregate business assets such as plant and equipment, inventories, working capital, and so on. Ignoring investments in securities avoids multiple counting of business assets. A rough approximation to the market value of business assets can be obtained by subtracting investments in securities (less any associated liabilities) from total equity.5 VIII. Conclusion. This is a joke, right? Well, yes and no. The paper is amusing, yet the point is valid. GAAP has gaps. GAAP, with its emphasis on the financial statements of individual enterprises, cannot provide an effective device for preventing the kind of distortion described here. The equity method of accounting for an investment (when an investor's holdings exceed 20% 4 5

This characterizes equity method investment revenue. Pension investments are examples of investments with associated liabilities. Assuming the balance sheet reflects both pension assets and pension liabilities, then it is excess pension assets that will be subtracted from total equity according to this rule.

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of an investee's voting stock) results in precisely these kinds of distortions. The cost method, too, introduces these distortions. However, the impact is mitigated by the method's upper limit on the carrying amount of an investment, historical cost. Can GAAP be modified to provide adequate disclosure of cross-holdings? Probably not without the establishment of some form of clearing house which would maintain a database and matrix of investor-investee relationships. This seems unlikely. And no matter how the accounting profession deals with the cross-ownership problem, consider what security analysts, in focusing on the value of individual companies, will do. Wow, look at XYZ. It has an investment in ABC that is worth $55 per XYZ share, yet XYZ sells for only $65 per share. XYZ's business is being valued at only $10! What a buy! And strangely enough, they'll be right!