It may sometimes be desired to base an issue of bonds on real estate—land and buildings—which is being carried at an old cost figure as of many years ago but which has a greatly appreciated and available market value at the present time. Prudent financial considerations would require an independent appraisal to determine the amount of the bond issue. Upon the assumption that the issue is for a larger amount than the original cost of the security, a peculiar situation arises. In showing the transaction on the books and balance sheet, not only would no margin of security appear, but even an insufficiency of security so long as the original value of the security is carried. Here it would undoubtedly be wise to bring the appraised value of the security on the books, offsetting the appreciation in value by a suitably named surplus or reserve account, such as “Reserve for Land Value Increment” or “Appreciated Land Value Surplus.” Another method and perhaps a better one where possible of application is to reorganize the concern by a sale of the old to a new company and so capitalize the increment in value of the old company’s assets.
Another financial consideration in connection with appreciated real estate values concerns the advisability of the sale of the old and the erection of a new plant on less valuable land. Usually, the appreciation of land values is not reflected in increased profits; it may even result in lessened profits due to higher rates of taxation and other expenses. If there are equally favorable locations for the particular kind of business, it may be the part of business sagacity to use the old location for rental purposes so that the benefit of the appreciation may be secured, or to sell and move to a less expensive site. In the one case the status of the land has been changed from that of an operating fixed asset to an investment, perhaps best considered permanent. In the other case, the increased value is through sale realized in a lump sum and, as a surplus item, is available for any purpose to which surplus may legitimately be applied. Of course, the amount of such surplus is the difference between the sum realized by sale and the cost of an equally efficient plant on the new site. It will usually happen that a better plant is erected, thus consuming some of the surplus arising from the sale.
Depreciation in Land Values
In a great many instances land depreciates. Decrease in value due to use will be considered under the discussion of wasting assets, page 311. When land suffers depreciation it is usually because of obsolescence or inadequacy. Due to certain natural facilities giving out, or to the removal, dismantling, or decay of artificial facilities, a site may depreciate so much as to become untenable. Business and residence property in a mining town may be of mushroom growth and have practically no value when the market, which is dependent on mining operations, declines. Ventures of this sort are recognized as highly speculative from the beginning and should be handled as such in the accounts. Wherever depreciation due to these causes can be foreseen, suitable provision should be made; otherwise the burden will fall entirely on the period when the plant has to be abandoned and this stage is usually preceded by periods of lessened profits. Depreciation of land is therefore always a local question.
Valuation of Land Investments
Business considerations oftentimes make advisable the purchase of adjoining or otherwise located tracts of land, with an eye to the future when enlarged facilities will be required. These should be carefully differentiated and segregated in the accounts from the land in use for business purposes. Some points in their valuation, in addition to those treated under the discussion of investments in land on page 278, need to be considered. Such tracts of land may usually without prejudice be valued at cost.
If later developments should turn out as originally expected, there can be no objection to loading the carrying costs of these lands, including taxes and interest on any borrowed purchase money, on their value year by year. The only reason for their purchase at the present time is because it is expected that the transaction can be more advantageously made now than later. If such should not be the case, the cost of the land proves to be higher than if purchased later. Only by loading these carrying charges can this information be developed. If the land is finally put to its intended use, no serious objection is seen in carrying it at the figure of full cost to the date of use. Because of the speculative nature of the transaction, it is usually advisable to set up a reserve of the same amount as the accumulating carrying charges. This reserve becomes free when the land is put to its intended use.
Because of the ease of inflation of values in transactions of this kind, due largely to an overoptimism as to the future and even sometimes to fraud, all such transactions must be scrutinized very carefully and ample provision against an unfavorable outcome should be insisted upon. It is interesting to note in this connection that in the case of valuations for rate-making purposes, as a usual thing carrying costs on land of this kind are not allowed as expenses to be covered by the rate of the service rendered. But when these lands come into use such expenses become a part of the cost of the service.
Mortgages on Land
Mortgages on land require consideration as affecting the manner of showing the land value. Freehold land, i.e., land held in fee simple, if afterwards mortgaged should be shown on the balance sheet at full face value with the mortgage listed among the liabilities. The liability is usually a note or other bond which in case of the deficiency of the security would be a general claim against the free assets of the concern. It is therefore best, theoretically, not to show such a mortgage as an offset to its security. In the case of the purchase of land subject to mortgage without the assumption of the mortgage as a direct liability, theoretically the mortgage may be shown as a deduction from the full land value and only the equity value of land be extended as a significant asset. This differentiation is almost entirely an academic one and is seldom seen in practice. The land is usually listed among the assets and the mortgage as a liability.