CFA Institute

How to Get Rich Quick Using GAAP

Author(s): Robert Ferguson and Neal B. Hitzig
Source: Financial Analysts Journal, Vol. 49, No. 3 (May - Jun., 1993), pp. 30-34
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4479646 .
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 How to Get Rich Quick Using GAAP
Robert Ferguson and Fortunately,both men had MBA
Neal B. Hitzig degrees in finance and account-
ing from a top-rankedbusiness
school. One day,afterreadingan
Withoutsteppingbeyond article in a professionaljournal
the bounds of generally about the financialmachinations
of recent years,the men realized
acceptedaccounting princi- that wealth, statusand influence
ples, a company can were theirsfor the asking.Allthey
"grow"equity,increasing had to do was forgetaboutbuild-
in size virtuallywithout ing a businessandconcentrateon
building a financial structure.
limit and withoutincreas- Their education
was perfectly
ing investmentsin any real suited to this.
assets!Thesecretlies in
cross-ownership--aform of In the space of a year,the market
corporatereproductionthat capitalizationof each man'scom-
"creates"equity.Theresults pany had increasedmanyfold,to
have implicationsfor inves- more than $1.0 billion. Theyhad
naturallyprofitedpersonallyfrom
tors in theJapanese and this growth.The men were rich
other marketscharacterized andfamous.Theywere consulted
by significantcross-hold- aboutimportantissues of the day
ings,for lendersthat may by a varietyof governmentagen- Table II shows how the balance
wish to avoid extending cies and politicians.They were sheets of the companies looked
content.
creditin the absence of any
collateral,and for usersof Here, in a nutshell, is how they
stock marketindexes. Their did it. Note that no laws were
primaryimportand most broken, nothing unethical was
done, and GAAP was scrupu-
general, however,isfor all
financial statementusers, lously observed.
who must recognize the The Basic Idea
limitationsof currentfi- The companiescontrolledby the
nancial reportingmecha- two men were named A and B.
nisms. They were identical. Each firm
z originally issued 200 shares of
stock for a total of $200. Of the
proceeds, $100 was invested in
Once upon a time, there were real assets and $100 remainedin
z two men, each of whom con- cash. In each case, 101 of the
z trolled a small firm. Both men issued shares were retained by
wanted to be rich and famous, but the founder and 99 were sold to
F-
neither was a very good business- the public.A liquidmarketdevel-
man. Their businesses, although oped for each firm'sshares.As it
-J profitable and well thought of, turned out, the actual business
remained small. Nothing they operations, which utilized the
U tried produced the growth they real assets,had a marketvalue of
z so badly desired. The men grew precisely$100.Consequently,the
Z increasingly frustrated and un- market value of each company
happy as the years went by. They was $200 and the price of each
30 did not know what to do. company'sshares was $1.00. Ta-
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ble I shows the firms' balance
sheets.
Growth
The two men proceeded as fol-
lows. 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 busi-
ness 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.
just after this transaction. Note
that aggregate book value in-
creased from $400 to $500. Aggre-
gate market capitalizationalso in-
creased from $400 to $500. The
latter increase reflects the fact that
Company A's market capitaliza-
tion 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.
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 market-
able 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 trans-
action. It was therefore agreed
that a suitable price for Company
Table I Original Balance Sheets percentage of each firm owned
by the other is too high. GAAP
Company A Company B (via APB Opinion 18) requires
Cash: 100 Cash: 100 consolidation in such cases,
Real Assets: 100 Equity:200 Real Assets: 100 Equity:200 which would eliminatethe cross-
Shares Outstanding:200. Shares Outstanding:200. ownershipeffect.3Thereis a sim-
Book Value per Share: 1.00. Book Value per Share: 1.00. ple way around this problem,
however.
Considerwhathappensif each of
A'sstockwas $1.00per share,and to increase each company'seq- 100 companieslike A and B buys
100 new shareswere issued. uity to any desired level.2 1%of each of the other 99, using
a series of transactionsof the type
Table III shows how the balance Most of each company's assets described above. The end result
sheets of the companies looked will eventuallyconsist of an in- is that each company is 99%
just after this transaction.Once vestment in shares of the other owned by the other companies,
again, $100 was added to aggre- company. These shares have a as a group,yet no companyowns
gate book value and marketcapi- well-definedbook valueandmar- more than 1% of any other com-
talization.Eachcompany'sequity ket price.Eachcompany'smarket pany. GAAP'ssafety precautions
was $300, $100 greater than be- capitalization will reflect the are bypassed.TableV showswhat
fore the two transactions.Book valueof its investments,justas the the balancesheet of one of these
value per share remained at shares of mutualfunds do. Thus companieslooks like.
$1.00. Each company's market eachcompany'smarketcapitaliza-
capitalizationhad also grown by tion can also be increasedto any The process stops if firms invest
$100 to $300. Both companies' desired level. the proceeds of their stock sales
sharescontinuedto sell at $1.00. in real assets.In termsof Compa-
A consequenceof the companies' nies A and B, the series of trans-
Without Limit increased market capitalizations actions cannot proceed beyond
There was no reason why the is thatthey become an arbitrarily TableII becauseCompanyB uses
sametwo transactionscouldn'tbe large portion of capitalization- the $100 it has justreceivedfrom
repeated,with the same result.' weighted stock indexes. A to buy more realassets.TableII
Both men realized this and fol- has to be replacedwith TableVI.
lowed through.Eachpairof trans- A consequence of the increased Note that,while the process has
actionsincreasedeach company's value of each company'smarket- stopped,there is still a distortion
equity and marketcapitalization able investmentsis thatthey will producedby the firsttransaction.
by $100. Book and marketvalue be viewed as excellent collateral In TableVI, aggregateequity ex-
per share remainedat $1.00. by lenders. Indefinitely large ceeds the aggregateof cash and
sums can be borrowed without real assetsby $100.
Table IV shows how the balance any underlyingreal collateral.
sheets of the two companies Finding the Aggregate
looked after 17 more cycles. Clearly,aggregatebalance sheet Market Value Of
Needless to say,our two protago- equity and marketcapitalization Businesses
nists capitalizedon this phenom- can be gross distortions of the In the examplesabove,the aggre-
enon in more waysthanone and aggregate value of underlying gate marketvalueof businessesis
lived happilyever after. businesses. simply total capital less invest-
ments. This is because it was as- z
Implications Some Fine Points sumed that the marketvalue of
The series of transactions de- The mechanismdescribedabove real assets is the same as their
scribedabovecanindeed be used is not consistent with GAAP.The book value. Typically,this is not
the case.
0
Table II Balance Sheets when Company A Buys $100 of Company The availabledataconstitutemar-
B's Stock ket value and proportionateown- Hr
ership, not the marketvalue of -J:

Company A Company B
underlyingbusinesses.The latter
can be found from the former. z
Cash: 0 Cash:200
Real Assets: 100 Real Assets: 100 Equity:300 Denote the marketvalue of the
Investments: 100 Equity:200
Shares Outstanding:200. Shares Outstanding:300. ith company'sbusinessby VXB,its
Book Value per Share: 1.00. Book Value per Share: 1.00. total marketcapitalizationby Vi,
and its proportionateownership 31

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 Table III BalanceSheetswith $200 in Cross-Holdings Glossary

Company A Company B *APB Opinion 18:

Cash: 100 Cash: 100 Opinion 18 sets forth the
Real Assets: 100 Real Assets: 100 views of the APB on the equity
Investments: 100 Equity:300 Investments: 100 Equity:300 method of accounting for in-
Shares Outstanding:300. Shares Outstanding:300. vestments in common stock by
Book Value per Share: 1.00. Book Value per Share: 1.00. enterprises.These are summa-
rized briefly below. Under the
equity method, which is ap-
of company j by pi.. Then the Note that the ownership of one plied when an investor holds at
following set of simultaneous companyby all others as a group least 20% of the voting stock of
an investee, the investor initially
equationscharacterizesthe situa- cannotexceed 100%.Thus: records the purchase of in-
tion. vestee stock at cost. The inves-
Eq. 4 tor recognizes investee income
Eq. 1 (or loss) as an increase (or de-
n crease) in the investor'scarry-
n ing amount regardlessof
Pij 1;. whether dividends are received.
ViB + pijvj = Vi; i= 1 Dividends received from the
j?1 investee decrease the investor's
To illustrateEquation(3), assume carryingamount.When an in-
i= 1,. . .,n. there are 100 companiesand that vestor owns less than 20% of
they are identical.In particular, the voting stock of an investee,
Define pii as 0 for all i. Then assume thateach companyowns the cost method is applied. The
Equation(1) can be rewrittenas 1%of eachothercompany.In this investmentis recorded at cost.
follows: case: Dividends are recognized when
distributedto the investor. Cost
Eq. 2 Eq. 5 remains the carryingamount of
the investmentunless dividends
in excess of investee income
n
ViB= VB, are received.
ViB + PijVj= Vi;
j=1 Eq. 6 *GAAP:
i= 1,. . .,n. The term refers to "generally
accepted accounting princi-
Vi = V,
The solution to these equations ples." GAAPincorporatesthe
is: consensus at a particulartime
Eq. 7 as to which economic re-
Eq. 3 sources should be recorded as
n n assets or liabilitiesby financial
n accounting,which changes
I Piivi= Pij Vj=0.99V, should be recorded, how the
ViB = Vi- E PijV; =
j>1 = assets and liabilities and
m
a)
j 1 changes in them should be
an i= 1,. . .,n. Eq. 8 measured, what information
z should be disclosed and how it
D
As expected, the value of a com- should be disclosed and which
0) pany'sbusiness is the difference VB = 0.01V. financialstatementsshould be
between its total marketcapitali- prepared.Put somewhat more
z zationand the marketvalue of its The distortion amounts to narrowly,generally accepted
investments. 10,000%! accountingprinciples are the
DIJ
-J
H
statementsand interpretations
of the FinancialAccounting
Table IV Balance Sheets with $3600 in Cross-Holdings StandardsBoard (FASB),the
z opinions and interpretationsof
Company A Company B the AccountingPrinciplesBoard
U
Cash: 100 Cash: 100 (APB)and the accounting re-
z Real Assets: 100 Real Assets: 100 search bulletins of the Commit-
z Investments: 1800 Equity:2000 Investments: 1800 Equity:2000 tee on AccountingProcedure
Shares Outstanding:2000. Shares Outstanding:2000. (vCAP).
Book Value per Share: 1.00. Book Value per Share: 1.00.
32

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Table V Balance Sheet of A ing value of its real assets. On ing set of simultaneousequations
Company 99% average,however, these two val- characterizesthe situation:4
Owned by 99 Other ues will tend to be about the
Companiesand Own- same. Thus the entire analysis Eq. 9
ing 1% of Each of 99 hinges on how the analysttreats
Other Companies the market value of each com- n
pany'sinvestments. Ei = EiB+ pijEj;
Company i
j= 1
Cash: 100 A cursory survey of investment
Real Assets: 100 texts and actualanalyticalreports =1=,..
n.< .,n.

Investments: 19800 Equity:20000 suggests that security analysts

Shares Outstanding:20000. Assume, for example, that each
Book Value per Share: 1.00.
simply value marketableinvest- company's business and total
ments at their current market earningsare identicaland thatall
value (quoted price times shares of the cross-ownershippropor-
held). A particularlythoughtful tions are the same. If there are
Security Analysis And analystmaysubstitute"fair"value four companies and each owns
Cross-Ownership for these marketvalues. Indeed, 20% of each of the others, then
Securityanalystswill begin with nothing else is called for if the Equation (9) shows that each
statedbook value and adjustit as analysisfocuses on a single com- company'stotalearnings,as com-
theythinknecessary.Thevalueof pany. In either case, the cross- puted by the securityanalyst,are
real assets will not be an issue. ownership distortionsdescribed 2.5 times its business earnings.
Neither will the value of invest- above will be preserved. This represents a distortion of
ments.Assumingthatstatedbook 150%in aggregatedearnings as
value reflectspension assets less Aggregatemarketvalue,as deter- determined by security analysts.
pension liabilities,there will be minedby securityanalysts,will be Thiswould not be true if each of
no apparentreason for making distortedas describedabove.This the companies had bought its
any adjustmentwhatsoever. In- would not be true if each of the own stock. Such stock would be
deed, none is called for if the companies had bought its own treasurystockand no longer out-
analysisfocuses on a single com- stock. Such stock would no standing.Consequently,it would
pany. longer be "outstanding." Conse- not be included in the computa-
quently,it would not be included tion of earnings.
Aggregatebook value, as deter- in the computationof marketcap-
minedby securityanalysts,will be italization. If there are 50 companies and
distortedas describedabove.This each owns 1% of each of the
would not be true if each of the Earnings others,then each company'stotal
companies had bought its own Knowing the business earnings of earningsare 1.96 times its busi-
stock. Such stock would no all the companiesand the various ness earnings.This representsa
longer be "outstanding." Conse- cross-ownership relationships distortionof 96%.
quently,it would not be included permits the analystto compute
in the computationof equity. each company'stotalearningsby Assuming that security analysts
taking the sum of its business computemarketvaluesand earn-
Market Value earningsand its proportionatein- ings as described above, then
The security analyst'sjob is to terest in other companies'earn- each company's price/earnings
determinea company'sfair mar- ings. ratio will be independentof the
ket value. The market value of degree of cross-ownership.
each company'sreal assets will In a manner analogous to the z
Lu

reflect the value of the business analysisof value,denote the earn- Japan
they are supporting.Analystswill ings of the ith company'sbusiness MaybeJapanisn't as big as we
typically determine each com- by EiB,its totalearningsby Ei,and think.Japanesecompaniesare fa- :rI
pany'sbusinessvalueto be some- its proportionateownership of mous for their cross-ownership. z0 -J
what differentfrom the account- companyj by pil.Thenthe follow- Averagecross-ownershipin Japan
is reputedto be about50%.If so,
then the distortionmaybe about cr
Table VI When B Buys More Real Assets 100%. D -J
z
Company A Company B How can this be checked?A rea-
Cash: 0 Cash: 100 sonable first test is to aggregate z
Real Assets: 100 Real Assets: 200 Equity:300 businessassets such as plantand
Investments: 100 Equity:200 equipment,inventories,working -3
Shares Outstanding:200. Shares Outstanding:300.
Book Value per Share: 1.00. Book Value per Share: 1.00. capitalandso on. Ignoringinvest-
ments in securitiesavoids multi- 33

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 ple counting of business assets. A
rough approximation to the mar-
ket value of business assets can be
obtained by subtracting invest-
ments in securities (less any asso-
ciated liabilities) from total equi-
ty.5
Conclusion
This is a joke, right?Well, yes and
no. The argument is amusing, yet
the point is valid. GAAPhas gaps.
GAAP,with its emphasis on the
financial statements of individual
enterprises, cannot provide an ef-
fective device for preventing the
kind of distortion described here.
The equity method of accounting
for an investment (when an inves-
tor's holdings exceed 20% of an
investee's voting stock) results in
precisely these kinds of distor-
tions. The cost method, too, intro-
duces these distortions. The im-
pact is mitigated, however, by the
method's upper limit on the car-
rying amount of an investment,
historical cost.
Can GAAPbe modified to provide another, thus eliminating the inter-
adequate disclosure of cross- company holdings. However, it is
holdings? Probably not, without easy to avoid thisproblem, as shown
the establishment of some form later.
of clearinghouse that would 2. Theprocess of equity creation de-
scribed here is similar to deposit cre-
maintain a database and matrix of
ation in the banking system. Banks,
investor-investee relationships.
however, must maintain minimum
This seems unlikely. reserves. Thislimits the amount of
deposits banks can create. There is
And no matter how the account- no corresponding limit when it
ing profession deals with the comes to cross-ownership.
cross-ownership problem, con- 3. Try visualizing Company A consoli-
sider what security analysts, in dating Company B at the same time
focusing on the value of individ- that Company B is consolidating
ual companies, will do. Wow, Company A. It has a nice porno-
look at XYZ.It has an investment graphic touch, don't you think? It's
in ABCthat is worth $55 per XYZ surprising what sometimes lurks be-
share, yet XYZsells for only $65 neath the numerical veneer of an
per share. XYZ'sbusiness is being accountant.
valued at only $10! What a buy! 4. Thischaracterizes equity method in-
And, strangely enough, they'll be vestment revenue.
right! 5. Pension investments are examples of
investments with associated liabilities.
Assuming the balance sheet reflects
Footnotes both pension assets and pension lia-
1. Theastutereaderwill recognizethat bilities, then it is excess pension assets
consolidationis requiredwhenone that will be subtractedfrom total
companyowns more than50% of equity according to this rule.

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