Reporting to Shareholders: What
Accounting Do They Really Need?
Stephen Penman
Columbia University
(Formerly Kings College, New York)
THE INSCRIPTION
King's College
Founded in the Province of New York By Royal
Charter in the Reign of George II
Perpetuated as Columbia College by the People
of the State of New York When they became
Free and Independent
Maintained and Cherished from Generation to
Generation For the Advancement of the Public
Good and the Glory of Almighty God
What Accounting Do Shareholders
Need?
The simple answer: Report to me! I’m the owner!
• Accounting is utilitarian; it serves a customer
• Accounting cannot be designed without defining
the customer
• The quality of accounting is judged by how well it
serves the customer
This is a different approach to the thesaurus approach of appealing to
accounting concepts such as “assets”, “income,” “fair value”:
accountants referencing themselves
The Shareholders’ Needs
1. Valuation of my claim: How much is my
equity worth?
2. Evaluation of my agents: Are my managers
serving me well? Are they delivering Value?
Valuation is a Matter of Accounting
• When one values a firm, one effectively does
an accounting for value; accounting for the
future
• What do I want the accounting to look like for
valuation?
Accounting for Value: Do I Want Cash
Accounting?
Value = Present Value of Expected Free Cash Flows
Free cash flow = Cash flow from operations
- Cash investment
FCF3
FCF1 FCF2
Value0 


 ........
2
3
1  r (1  r )
(1  r )
Cash Accounting
(Wal-Mart, Home Depot, General Electric)
The Kings College (NY) Tradition of
Valuation: Fundamental Analysis
The Principles of Benjamin Graham
• Price is what you pay, value is what you get
• When calculating value, understand what you
know and don’t mix what you know with
speculation
• Anchor a valuation on what you know rather than
on speculation
• When calculating value to challenge price,
beware of using price in the calculation
Graham to the Accountant:
Tell me what you know and leave the
speculation to me, the analyst
Do not mix price with value
Accounting for Value
Value = Anchoring Accounting Value
+ Speculative Value
• Give me something to anchor my valuation to
• Give me something to guide and discipline my
speculation
Accounting for Value: Accrual
Accounting
Value = Book Value + Present Value of Expected
Excess Earnings
• Anchor on the balance sheet
• Add value for speculation about future
earnings
Value0  Book value0 
Earnings1  r.Book value0 Earnings2  r.Book value1

 ......
2
1 r
(1  r )
The Shareholders’ Request
• Give me a “hard” balance sheet to anchor on
- Minimize speculation in the balance sheet: No water
in the balance sheet!
- The balance sheet must not contain (or omit)
something that can come back and hit me later
• Give me an income statement that helps me to
speculate about future income
- The income must tell me what future income will be if
current conditions prevail
- We should not see income in the future different from
current income simply because of the accounting
The Hard Balance Sheet Request
• Respect the shareholders’ property rights
• No “soft” speculative assets in the balance
sheet
• No off-balance sheet liabilities
• Focus on transactions: what you know
• Fair value accounting is suspect
The Predictive Income Statement
Request
• Revenues must be “hard”
• Income must be sustainable income: no
reversals
- no write downs with bleed backs
- no “cookie jars”
• Resolve the tension between an informative
income statement and a conservative, hard
balance sheet: excessive conservatism
The Big Debate
A fundamental conceptual issue [facing accounting
standard setters] is the extent to which the standards
should move away from traditional cost based accounting
to marking assets and liabilities to market, euphemistically
referred to as ‘fair value’ accounting. There is without
doubt considerable momentum to move toward fair value
methodologies, but there are also significant questions
about the practical and useful application of that approach
to certain industries and firms.
-- Paul A. Volker, Chairman of the Trustees, International Accounting Standards Committee
Foundation in a statement before the Capital Markets, Insurance and Government Sponsored
Enterprises Subcommittee of the U.S. House of Representatives, Washington DC, June 7,
2001
The Momentum Continues
FASB Exposure Draft, May 26, 2010:
All financial instruments, including bank loans,
to be carried at fair value
Contrast with IFRS 9:
Most bank loans carried at amortized cost
The Momentum Moves to Core
Deposits
“Core deposit liabilities would be initially and
subsequently measured at the present value of the
average core deposit liability amount discounted at the
rate differential between the alternative funds rate and
the all-in-cost-to-service rate over the implied maturity
(the ‘remeasurement amount’). In calculating the
present value of the average core deposit liability
amount, entities should consider future core deposits.
This would result in an intangible asset being reflected
in the valuation.”
--FASB, Accounting for Financial Instruments: Summary of Decisions Reached to
Date, as of March 31, 2010, at www.fasb.org.
The Appeal of Fair Value Accounting
• Prices have information about future cash
flows: the efficient market hypothesis
• Fair values give timely information
• Historical costs are old costs, backward
looking; we need current values
The Problem with Fair value
Accounting
• Prices in the financial statements
• Speculation added to the balance sheet; the
hard anchor is lost
• The risky balance sheet is a less levered
balance sheet
• The income statement is rendered
uninformative
• Bonus and dividends paid out of fictitious
profits: A Ponzi scheme?
The Experience to Date
• The 1920s. Water in the balance sheet: asset
values from write-up to market subsequently
evaporated
• The 1990s. The tech bubble: asset values from
write-up of equity investments to market
evaporated
• Early 2000. The Enron fair-value scam: fair value
assets evaporated
• The 2000s. The real estate financing bubble:
mortgage values evaporated
The Mortgage Crisis: Going Up
• Loan securitization, encouraged by fair value
accounting and 1st-day profits
• Assets move far from information at originating banks
• Bubble real estate prices go into mortgage prices which
go into bank’s books
• Banks lend against bubble prices in their books,
perpetuating the bubble
• Dividends and bonuses paid out of fake profits,
increasing leverage
• Crash and Bang!
The Mortgage Crisis: Going Down
• Markets go out of existence, or just distressed
prices
• Level-3 world: price is a guess
• 1st-day losses
• Collateral demands against depressed prices
leads to further distress: cascades
A Solution for Loan Accounting
• Amortized historical cost for loans has problems: very much like
Level-3 fair value accounting
A Solution:
1. Record loan at historical amount
2. Record interest income at the risk-free rate until credit worthiness
has been established
3. Then book the credit premium, and amortize it to income over a
number of years
See American Accounting Association, Financial Accounting Standards Committee,
Accounting for Revenues: A Framework for Standard Setting, 2010
The Level-3 Fair Value Problem
• Fundamentalists dislike accounting based on
speculative prices
• Even more, fundamentalists dislike accounting
based on manager’s expectations
• We have always demanded that accounting be
independent of managers
• Earnings have to be earned...they are not just
changes in managements’ expectations
• Remember Enron
The Hedge Fund Model: Accounting
without Regulation
• Mark-to-market so that net asset value = price
NAV is the price at which investors trade in and
out of the fund
• But, when there is doubt about the value—lock
up or establish side pockets
Accounting under voluntary contracting is
instructive for accounting under regulation: don’t
book profit until uncertainty has been resolved
When is Fair Value Appropriate?
The one-to-one principle: fair value is appropriate when the
shareholders’ wealth varies one-to-one with market price
•
•
•
•
•
Holding a bond?
The pile of coal?
The warranty liability?
The mortgage loan?
The insurance contract?
Most business do not get value from “exit prices” but from
arbitraging market prices. Exit price is realized revenue.
The Misconception in Fair Value
Accounting
• The focus: we must get the balance sheet right to
indicate asset value
• Impossible: assets don’t have stand-alone value,
for value comes from using assets together
• There is also an income statement: value may be
missing in the balance sheet, but earnings from
assets is coming through the income statement.
Earnings is a summary number from using assets
together
Reporting to Shareholders
Shareholders need a hard balance sheet that
minimizes speculation but recognizes their
property rights and their obligations
The focus should be on the income statement:
tell me about the future in an unbiased way
The IASB and FASB: a balance sheet focus