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Home > Accountancy Viewpoints > Accounting for Value: Why the Accountancy Bodies Are Losing Their Way in the Standard-Setting Process

Accountancy Viewpoints

Accounting for Value: Why the Accountancy Bodies Are Losing Their Way in the Standard-Setting Process

by Stephen Penman

In your recent book, Accounting for Value, you take the accounting standards-setting bodies to task for bringing speculative values into the accounts. 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 for accountancy to be a set of tools for measuring value—the real value of a business. My book was first and foremost a book on valuation, aimed at investors and those to whom they entrust their savings. This last group includes investment advisors, analysts, and portfolio managers. Beyond them, of course, I hope that it will also be useful to businesses that have an interest in ensuring that investors and their advisors are able to grasp the value of a company and its operations.

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

With this approach it is clear that historic cost accounting is very useful to investors who like to base themselves on fundamental values, since it grounds itself in prices actually paid. My problem with the accountancy bodies begins at the point where they start to move away from historic cost accounting toward what they define as balance sheet accounting. With balance sheet accounting they are trying to put a present 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 for that stock are completely irrelevant until and unless the company is in the process of winding up—at which point 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 value of that portfolio is excellent information. The company’s worth really does go up and down with the market, so you need to know where it stands. A bank’s portfolio of mortgage loans, on the other hand, is not, I would argue, 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 to termination. 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 is literally turning part of the book into cash and there is nothing speculative about that cash value.

What you would want to know about the bank’s mortgage portfolio is not its fluctuating present value, but rather 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 bank’s business processes are sound and under control. If you conclude that its processes are hugely flawed, then the present value of the bank’s book is largely irrelevant since you can assume that the bank is highly likely to experience a much higher rate of default than its competitors—in other words, that the value of its book is likely to be considerably impaired over time, irrespective of what its present value might be—and you would be a fool to invest. This point, clearly, has to do with the importance of information and nothing to do with fair value, or the supposed present value of the bank’s mortgage portfolio.

You contend then that taking a “fair-value” view of the assets on the balance sheet 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 standards bodies are now nailing their colors to, by definition sees value as being communicated through the balance sheet. The US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), in developing their “conceptual framework” for accounting—which is designed to harmonize the standards-setting process between the two bodies—appear 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 change in balance sheet measurement. My contention is that, for anyone interested in a company’s value and its actual and potential earnings capability with a view to investing in that company’s shares, this approach is misguided. Accounting for value looks not to the balance sheet but to the company’s income statement for an 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 for value except in the case of the example just given of an investment company. An accountant cannot hope to capture value by listing assets and liabilities at their fair value, defined as their present price in the market.

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Further reading

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 Political Economy 81:3 (May–June 1973): 637–654. Online at: www.jstor.org/stable/1831029
  • Merton, Robert C. “Theory of rational option pricing.” Bell Journal of Economics and Management Science 4:1 (Spring 1973): 141–183. Online at: www.jstor.org/stable/3003143

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