In corporate finance, the means to accurately calculate and record the operating activities of a corporation is vital both as an internal measure of performance and as an external signal of profitability to investors. However, large corporations often invest in assets that are unrelated to the actual operations of the organization. The disposal of these assets can have important repercussions when valuing a firm’s worth.
Suppose that thirty years ago a corporation purchased a plot of land for $10,000. The price was a fair one at the time and the book value of the land was recorded at $10,000. Now suppose that today, thirty years later, that piece of land is appraised at $100,000. According to Generally Accepted Accounting Principles (GAAP), the land must still be valued on the company’s accounts at the original purchase price even though it is known that the land is worth much more. The company, in need of cash to finance operations, decides to sell the land and invest the money in some new equipment.
The sale of the land would constitute extraordinary income because it meets one very important qualification. Sustainability is the belief that an event is likely to occur again in the near future and will continue with regular intervals. The recognition of cash gained through operations is a sustainable event and is considered operating income. A non-sustainable event, such as the sale of land, generates income that is extraordinary because it is not expected to occur again in the near future and was not a result of normal business operations for the organization. Extraordinary income has two implications for investors.
Extraordinary income has the effect of increasing the value of company because something that was originally valued at the book price of $10,000 has suddenly ballooned to a realized value of $100,000. Although investors may be aware of the discrepancy between the book value and actual value of the land, the sudden increase in cash can raise stock prices.
In addition to the increase in the firm’s value, the sale of major assets such as land can send signals to the market that cash is needed for regular operations. This can be for two reasons: (1) the firm is in trouble and needs to cash in some assets to keep operations afloat, and (2) the firm is growing and the cash from extraordinary income is needed to finance the new increased operations. The truth behind the sale may be hard to grasp so investors are on the constant lookout for signals of why the extraordinary income is needed.
Of course, this is a simple example. Perhaps the extraordinary income will be used to invest in another asset offering a better return than holding on to the original asset is expected to provide. Either way, the principle of signaling is an important concept that both managers of a firm and investors take seriously. The firm must be careful to convey the right message to avoid unnecessary speculation as to the profitability of the organization.