Balance-Sheet Battle

In the board rooms of some 1,000 big companies across the U.S., executives are eying an arcane but potentially far-reaching bookkeeping innovation that will affect the size and shape of what business calls "profits." The Securities and Exchange Commission is now requiring large corporations to adopt a procedure called "replacement-cost accounting." The move represents a long-overdue attempt to clear away the distorting effects of inflation on a company's bottom line. The rule involves some tinkering with numbers that, if integrated into the corporate accounts, could cause a sharp downward jag in an earnings report.

The SEC is requiring publicly held companies with inventory and fixed assets exceeding $100 million to include in their "10-K" financial reports to the commission for 1976 an estimate of the current cost of replacing their inventories, plant and equipment. (Many of these companies are expected to mention the new figures in their annual reports to stockholders.) U.S. companies carry their assets on their books at their original cost--the "historic" cost, in accountants' lingo--with no provision for the impact of inflation over the years. But the addition of replacement-cost figures, the SEC argues, will provide a more realistic measure of the true worth of a company in an era of persisting inflation.

Growing Value. Replacement-cost accounting, says one analyst who favors the system, "does not make a company's results poorer. It just shows how poor they were." Under the traditional accounting method called straight-line depreciation, a company that bought a $100,000 machine with a life expectancy of ten years could reduce the value of that machine on its balance sheet by $10,000 every year. Proponents of replacement-cost accounting argue that the machine should be carried on the books at the price of a new machine, which, after a decade of extremely high inflation, could jump to as much as $300,000. (The higher the dollar value of a company's plant and equipment, the greater the amount charged against its assets to provide for depreciation and thus the lower its reported profits.) In Britain, where double-digit inflation has prevailed since 1973, replacement-cost accounting will be required by 1978; by one estimate, conversion to the system will reduce the reported pretax profits of companies there by an average of 45%. In the U.S., where inflation in recent years has never exceeded 12% for any length of time, the effect on profits would be less pronounced. Yet it would still be sizable, especially for capital-intensive industries such as steel and oil, and electric utilities. Lee Seidler, an accounting professor at New York University who is a strong proponent of the new system, has calculated its impact on some firms in recent years. At Union Carbide, for example, the 1975 earnings of $746 million would have slipped to $655 million, a 12% slide.

The boardroom uneasiness about replacement-cost accounting starts with the expense of making the new calculations, a job that might cost as much as $1 million at some large firms. More fundamentally, executives worry about the impact of lower reported earnings on Wall Street's view of a corporation's stock.

These fears could be exaggerated. Some analysts suggest that Wall Street has been making its own calculations on the amount of pure inflation in company profits all along and that is why stock prices have failed to keep in step with higher posted earnings. Declared corporate profits climbed by about 40% from 1968 to 1976; yet "real" earnings, adjusted for inflation, have risen hardly at all.

Meaningless Numbers. Some of the earnings "loss" that companies stand to suffer with replacement-cost accounting could be made up by reduced corporate taxes. But many businessmen and economists still doubt the basic value of the system. They point out that estimating replacement costs is a highly subjective business. A machine might be obsolete and thus hard to price. Its replacement, because of unproved technology, could even cost less. "The numbers just don't mean anything," warns International Business Machines Economist David Grove. But John C. Burton, who pushed through the new rules as chief accountant at the SEC (he is now New York's deputy mayor for finance), disagrees: "It's time that financial types developed a greater tolerance for imprecision, because that's the way the world is."

Inflation accounting has been used successfully in Brazil, where inflation rates have been hovering around 40%. Holland's huge Philips Co. has been using replacement-cost accounting for more than 15 years. Shell Oil Co. offered its 1974 results in both "historical dollars" and "current dollars" adjusted for purchasing power, an approach similar to one advocated by the American accounting profession's own Financial Accounting Standards Board.

In the U.S. many economists now regard replacement-cost accounting as a simple matter of the bookkeepers' finally catching up with reality. Irwin Kellner of New York's Manufacturers Hanover Trust Co. cites the "salutary effects" of replacement-cost accounting. If it reduces high taxes on inflation-bloated corporate profits, it frees funds for badly needed capital investment. And in a time of high inflation, he adds, ordinary depreciation "is much too little to replace plants. It's like a camel trying to live off its hump--O.K. for a while, but eventually starvation."

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