accounting for value why the accountancy bodies are losing their way in the standard setting process

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Accounting for Value: Why the Accountancy Bodies AreLosing Their Way in the Standard-Setting Processby Stephen Penman

Introduction

Stephen H. Penman is the George O. May professor in the Graduate School of Business, ColumbiaUniversity. Prior to this he was the L. H. Penney professor in the Walter A. Haas School of Business at theUniversity of California at Berkeley, and has served as a visiting professor at London Business School andStockholm School of Economics. He has a first-class honors degree in commerce from the University ofQueensland, Australia, and MBA and PhD degrees from the University of Chicago. His research is on equityvaluation and the role of accounting information in security analysis. He is managing editor of the Review ofAccounting Studiesand is on the editorial board of the Schmalenbach Business Review, and in 2002 he wasawarded the Wildman Medal for his book, Financial Statement Analysis and Security Valuation.

In your recent book, Accounting for Value, you take the accountingstandards-setting bodies to task for bringing speculative values into theaccounts. Where do you see them going wrong?

I approach accountancy by asking what it measures that is of use to an investor. Basically, I am looking foraccountancy to be a set of tools for measuring valuethe real value of a business. My book was first andforemost a book on valuation, aimed at investors and those to whom they entrust their savings. This lastgroup includes investment advisors, analysts, and portfolio managers. Beyond them, of course, I hope that itwill also be useful to businesses that have an interest in ensuring that investors and their advisors are able tograsp the value of a company and its operations.

With this as my starting-point, I distinguish between accounting techniques for measuring value and modelsthat are aimed at predicting, say, exit values on assets that the business is not actually exiting. I want touse known value as my anchor and then add to that a speculative component about future performancewhere value is derived from the best information available to me. In investing you are always taking a viewof future performance, so a speculative dimension is inevitable. However, this should come only after youhave anchored yourself on actual valuation. If your starting-point in appraising a particular company is alsospeculative, where are you?

With this approach it is clear that historic cost accounting is very useful to investors who like to basethemselves on fundamental values, since it grounds itself in prices actually paid. My problem with theaccountancy bodies begins at the point where they start to move away from historic cost accounting towardwhat they define as balance sheet accounting. With balance sheet accounting they are trying to put apresent value on all the assets on the balance sheet, including assets such as stock, which the business has

no intention of selling, but which, rather, is designated for production purposes. As such, external prices forthat stock are completely irrelevant until and unless the company is in the process of winding upat whichpoint you would be highly unlikely to want to invest in it anyway.

There are very few companies where balance sheet accounting is actually useful for a potential investor.With a pure investment company that holds a large equity portfolio, for example, knowing the present valueof that portfolio is excellent information. The companys worth really does go up and down with the market,so you need to know where it stands. A banks portfolio of mortgage loans, on the other hand, is not, I wouldargue, something to which you need to apply a moment-by-moment fair value.

That mortgage portfolio is what drives revenue for the bank, and it is, by its nature, going to be held totermination. Where the bank conducts a securitization of its mortgage book and sells that part of the book,of course you have a present value for the securitized bundle, but that is a special case where the bank isliterally turning part of the book into cash and there is nothing speculative about that cash value.
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What you would want to know about the banks mortgage portfolio is not its fluctuating present value, butrather that there has been appropriate due diligence in the granting of the loans that comprise the portfolio.You want to know, in other words, that the banks business processes are sound and under control. Ifyou conclude that its processes are hugely flawed, then the present value of the banks book is largelyirrelevant since you can assume that the bank is highly likely to experience a much higher rate of default

than its competitorsin other words, that the value of its book is likely to be considerably impaired over time,irrespective of what its present value might beand you would be a fool to invest. This point, clearly, has todo with the importance of information and nothing to do with fair value, or the supposed present value of thebanks mortgage portfolio.

You contend then that taking a fair-value view of the assets on the balancesheet does not generate much useful information for investors?

In my view this is a crucial point to make. Fair-value accounting, which is what the accounting standardsbodies are now nailing their colors to, by definition sees value as being communicated through the balancesheet. The US Financial Accounting Standards Board (FASB) and the International Accounting Standards

Board (IASB), in developing their conceptual framework for accountingwhich is designed to harmonizethe standards-setting process between the two bodiesappear to be committed to this balance sheet focus.

In their view, if you measure value in the balance sheet, then earnings will fall out as simply the changein balance sheet measurement. My contention is that, for anyone interested in a companys value and itsactual and potential earnings capability with a view to investing in that companys shares, this approach ismisguided. Accounting for value looks not to the balance sheet but to the companys income statement foran assessment of value, and then adds to this to the information in the balance sheet.

It should be clear from what I have said that fair-value accounting is not the same thing as accounting forvalue except in the case of the example just given of an investment company. An accountant cannot hope tocapture value by listing assets and liabilities at their fair value, defined as their present price in the market.

The role of the accountant, then, is to avoid all speculation? Is this possible?

As I say in the book, accounting defines reality by bringing specificity to what would otherwise be speculativegeneralities. It takes concepts in common use by economists, such as revenue, cost, income, andassets, and applies measurement to them. Cost of production is, fundamentally, an accounting measure,and the figure that emerges depends on how one does the accounting. Economic profit is just a phrase,a pretentious label, until accounting gives it content. There is much in accounting that is an art rather thana science, and that relies on professional judgment. How profit is determined, for example, depends verymuch on the accounting conventions that are used, but there is a solid, agreed body of best practice hereas far as historic cost accounting is concerned and investors, by and large, are comfortable with this bestpractice.

Without accounting, concepts such as profitability, financial position, and growth are just speculativeideas in the mind of the beholder. Accounting forces concretenessnot simply concrete numbers, which areimportant, but also concrete thinking. It gives investors the chance to ground their analysis of an organizationon something solid. In the heyday of efficient market theory, accounting was held not to matter. It was saidthat the market sees through the accounting to the future cash flows of the company concerned. Whenwe analyze this idea, however, it turns out that what the market is seeing is some form of informationthat allows it to forecast future cash flows, and ultimately the information that the market is seeing flowsfrom accounting. We can, of course, see factories, employees, the movement of goods, and the delivery ofservices, but accounting produces a representation of these realities that is appropriate for valuation.

Proponents of the efficient market have a tendency to dismiss accounting as unconnected to reality,an archaic system that is unrelated to cash flows. This is a gross misconception. Accounting forcesmanagement to face the numbers when reporting to shareholders, rather than simply delivering platitudesabout plans and prospects. Similarly, sound government accounting forces politicians to be straightforwardin reporting to taxpayersto view borrowing as a debt, for example, rather than as a miraculous revenuestream.
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while buying insurance against risk factors to which they do not wish to be exposed. But fundamentalistshave reservations. They see arbitrage opportunities, so no-arbitrage engineering goes against the grain.If you are buying a business rather than a share, then you recognize that businesses are fundamentallyabout arbitrage. They trade in input markets (assets, labor) and in output markets (customers) on the basisthat they sell high (to customers) and buy low (from suppliers). That is arbitrage. When you buy a share of

a business, you are essentially expressing your confidence in its ability to operate the arbitrage principle!The no-arbitrage principle comes in one level above this, as it were, and for the fundamental investor whatit states is that information about that businesss ability to operate the arbitrage principle is available to themarket and therefore determines that businesss value to investors. It is that value which the principle isstating cannot be arbitraged. Put like this, the principle is seen as no more than a probability statement aboutthe likelihood of investors all reaching a similar conclusion on value based on identical access to information.Differences between price and value have to do with which kinds of information a market is mainly payingattention to. If fear is driving the markets, then value information often has little traction and whole sectorsare marked down. This misalignment of price and value creates opportunities for value investors. What isbeing arbitraged here is not price, but the misalignment of price and value.

Looking again at the information content, what is clear is that a value investor needs an accounting modelthat accounts for how the shareholders value is increased (or diminished) by the businesss ability to

arbitrage inputs and outputs. This brings us to the negative use of financial engineering. It is clear that fora given accounting system, say US GAAP (Generally Agreed Accounting Principles), financial engineeringwill be used to structure transactions to get around the requirements of accounting. Lease transactionscan be arranged to take leasing contracts off the balance sheet. Assets and liabilities can be moved intospecial-purpose vehicles (SPVs), and borrowing can be restructured to look like an option on stock.Fundamental investors look for ways to finesse these masking activities by bringing that information backinto the accounting model. The energies and expertise of the accounting standards bodies would be muchbetter employed focusing on undoing these negative impacts of financial engineering, rather than continuingwith their current enthusiasm for balance sheet accounting.

More Info

Book:

Penman, Stephen. Accounting for Value. New York: Columbia University Press, 2011.

Articles:

Black, Fischer, and Myron Scholes. The pricing of options and corporate liabilities. Journal of PoliticalEconomy81:3 (MayJune 1973): 637654. Online at: www.jstor.org/stable/1831029

Merton, Robert C. Theory of rational option pricing. Bell Journal of Economics and ManagementScience4:1 (Spring 1973): 141183. Online at: www.jstor.org/stable/3003143

See Also

Best Practice

Origins and Rationale for IFRS Convergence The Rationale of International Financial Reporting Standards and Their Acceptance by Major Countries

Viewpoints

The Comply or Explain Approach to Improving Standards of Corporate GovernanceChecklists

International Financial Reporting Standards (IFRS): The Basics Key Accounting Standards and Organizations

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