NEW YORK (AFX) - In accounting circles, it is known as the 'big bath' when companies try to wash away as much bad news as possible with the hope that charges taken all at once will make their finances look better in the quarters to come.
That's something the nation's homebuilders could be up to lately. With their profits plunging due to a sharp drop in sales of new homes, many are taking big writedowns in their land values and other assets because they are worth less than they paid for them.
Since they have much discretion over the size and timing of such charges, the builders could be calculating that taking big hits now while investors already know times are tough is smart.
Conditions in the housing market having deteriorated over the last year. Homebuilders have seen a significant pullback in demand, surging cancellations, gains in inventories and serious pricing pressures that have led to massive discounting and incentives to get deals done.
That's quite a change from the not-so-distant past, when homebuilders -- along with mortgage brokers, real estate agents and anyone else with ties to the housing industry -- were enjoying the fruits of a five-year housing-market boom.
The turn in the market has left most homebuilders with assets -- including everything from already built homes to the land they bought to potentially build on -- that aren't going to generate the kind of cash-flow that had previously been expected.
When that happens, they have to test for impairments, meaning that they have to see whether the expected returns from a project are sufficient to cover their fixed costs. Should there be a deficiency, accounting rules dictate they must take a writedown on the assets.
KB Home announced Dec. 8 that it expects to take non-cash charges in its fiscal fourth quarter of between $235 million and $285 million to write down the value of its land holdings and an additional $90 million related to its abandonment of certain land-option contracts.
The Los Angeles-based homebuilder said the expected charges reflect 'an increasingly challenging environment, which includes an oversupply of inventory, a decline in new home orders and sales prices and an increase in sales incentives to generate new orders,' according to a securities filing.
Dallas-based D.R. Horton Inc. took a pre-tax charge of $199 million to write down the value of land, options to purchase additional land, and pre-acquisition costs. Luxury homebuilder Toll Brothers Inc. took a pre-tax writedown of $115 million, a big jump from the $1.4 million charge the Horsham, Pa.-based company took in the same quarter last year.
Investors seem to be taking the big writedowns in stride. They've been buying up homebuilding stocks in recent months. The Standard & Poor's 500 Homebuilding index has risen nearly 21 percent since late July, a turnaround from the 33 percent decline during the first seven months of the year.
That blind-eye approach has put some Wall Street analysts on edge, and they are warning investors that the homebuilders might be taking them for a bit of a ride with their massive writedowns.
'We are getting a bit more concerned with investors' passiveness toward these equity-destroying exercises,' Stephen East, an analyst at Susquehanna Financial, said in a note to clients.
As accounting experts explain it, companies have discretion over some inputs used to calculate the writedowns. The subjective variables include the future selling price, the rate which properties are expected to be sold and current rate for similar assets. They also have flexibility in deciding what discount rate to use when deducing potential future cash flows.
The homebuilders might see this as the right time for large writedowns. While market conditions are tough, they still have profits to show this year. Their earnings are likely to deteriorate more in 2007.
'Some companies see it as good for them to take a 'big bath' by taking a bigger writeoff sooner,' said Robert Dyson, managing director at the accounting firm RSM McGladrey. 'Then they get to show a profit improvement in the next year.'
But, as Dyson notes, writing down an asset now for recognizing more profit in a later period also could be construed as fraud. 'Companies doing so need to be careful to avoid allegations of 'cooked books.''
In the end, whether the homebuilders write off more now or later won't have any impact on earnings in the long run. But investors may prefer it done sooner, rather than later.
The key, as noted by Credit Suisse analyst Ivy Zelman, is whether those taking the big charges then can generate higher margins going forward. If they can't, investors could turn on a dime.
Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org
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