11.5 Accounting Costs vs. Economic Value

1
11.5 Accounting Costs vs. Economic Value

• Accounting numbers are very important management
  tools.
• But they can never account for all opportunity
  costs. Managers must see these within their own
  organization.
• Sometimes managers only focus on accounting
  numbers and, not understanding them, drive firms
  into bankruptcy.

2
Some Elementary Differences

• You start a new oil company in 2013.
• Accounting Expenses
• Land and oil equipment leases 100,000
• Wages and salaries 200,000
• Total expenses 300,000
• Total revenue 0
• You strike oil worth an estimated 10 million
  when well is developed. What is the accounting
  book value of the firm at the end of the year?
• The economic value?

3
Primary roles

• Accounting
• Following strict rules, it records and tracks
  receipt of and expenditure of money.
• Helps establish responsibility for assets and
  reduce theft.
• Help managers determine if operations are working
  as expected and are required by regulatory
  authorities.
• It is a system of controls based on rules.

4
Primary roles

• Economics
• Considers the value of assets determined by
  usefulness to owner compared to alternative means
  of producing same services and considers
  potential use (opportunity cost) to other
  possible owners of the assets.
• Both accounting cost and economic costs are
  important tools of analysis.

5
Economic Value

• The economic value of an asset requires an
  estimate of the net cash flow expected from the
  asset, discounted.
• Hence, valuation is continuous and subjective -
  an educated guess about expected cash flows. Past
  cash flows (accounting data) from assets can
  provide useful information to a manager in making
  valuation decision but may not be relevant as to
  future opportunities.

6
Need deep understanding of accounting number
meanings. U.S. banks in 2013 appeared more
profitable because they moved more cash into net
revenue. 18 of net revenue is cash set aside to
prepare for covering bad loans.
7
Practical Problem Intangible Assets

• A firm spends cash on research, development and
  marketing because managers believe the present
  value of the expenditures is positive. That is, a
  profitable venture by the company.
• But, accounting records expenditures as if no
  value was created.
• Similarly, costs of training personnelall
  expense in an accounting sense. There is no
  immediate offsetting revenue but should be an
  economically valuable activity.

8
Even True Numbers Can Mislead. P/E ratios
change in A YEAR for same time periodONE BASED
on Analysts Earnings Estimates the other on
later Real data
Data for SP 500
9
Other Practical Problems

• SEC and PCAOB want assets reported at market
  value annually. How much is your customer list
  worth? Better come up with a defensible number.
• Income and Expenses Accounting books do not
  reflect changes in assets due to changes in
  demand for output of changes in replacement cost
  of inventories of effects of new regulations. So
  accounting expenses may go over or below changes
  in real economic value. Lehman Brothers, as a
  firm, was worth tens of billions but vanished
  overnight.

10
Accounting Methods Matter

• Three firms. Each buys 100 units of inputs per
  month at 110 per unit in January. Price rises
  10/month, so in December cost is 220 per unit.
  Total accounting cost for year is therefore
  198,000.
• During the year, 800 units are sold for total
  revenue of 160,000.
• 400 units remain in inventory at the end of the
  year.
• What is the value of the inventory?
• What is the cost?
• What is the profit?

11
It Depends on the Accounting Method

• Inventory Ending Annual Cost Annual Gross
• Method Inventory of goods sold Profits/Sales
• FIFO 82,000 116,000 44,000
• LIFO 50,000 148,000 12,000
• AC 66,000 132,000 28,000
• Three firmssame number good in and out and money
  flow the same, but accounting methods differed.
  What is the economic value? Current opportunity
  costnone of the above. (Oil industry uses LIFO
  to help cut tax burden.)

12
Problems that Have No Solution

• If a firm produces different products, how do you
  assign labor costs? Lump sum? Per unit? Based on
  total wage cost or per hour estimate? You cannot
  figure that out from accounting (or any other)
  numbers.
• Any method may be useful to managers to
  understand labor costs, but same costs may look
  very different across identical firms.
• What about retirement benefits for workers? Is it
  overhead or labor cost? A liability or a cost?

13
Example GM

• For decades, worker pension costs not recognized.
  Not well funded nor explicitly calculated as
  liability. Company falsely profitable for
  decades.
• Does not know how much it costs to build a car.
  Part of problem traditionally came from internal
  pricing gaming (gradually being corrected).
  Divisions would sell parts to other divisions
  at inflated prices to make the division look
  good. The parts looked good the whole did not.

14
More Problems

• Warranty Accruals (set aside in reserve)some
  firms count call center costs as warranty cost
  others do not. Some put product recall under
  warranty cost others do not. Apples accruals
  doubled 11 over 10. Products worse? Caterpillar
  accruals dropped although sales rose. Products
  better?
• Firm adopts its own performance measure, such as
  paid memberships or other metric. These dont
  meet FASB rules, so SEC does not like themit
  wants all companies to report similar data.
  Apples to apples, but companies are apples and
  oranges.

15
What Is a Name Worth? Is the Apple brand worth
33.5 billion or 183 billion?
16
Measuring Depreciation

• Depreciation of assetsmultiple methods are used.
  All are legitimate, but same situation can look
  very different to an observer of the books.
• Assume an asset expected to provide net cash flow
  of 200,000 at end of year one. Cash flow
  expected to decrease 20,000/yr. over 6 year life
  when cash flow is 100,000 and asset expected to
  have scrap value of 18,000. At 10 discount
  rate, present value is 818,000. Assume that is
  also the purchase price of asset.

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Which Method Is Best? ( 000)

• Net Depreciation Expense Net Profit
• Year Cash SL SYD DDB SL SYD DDB
• 1 200 133 229 273 67 -29 -73
• 2 180 133 191 182 47 -11
  -2
• 3 160 133 152 121 27 8 39
• 4 140 133 114 81 7 26 59
• 5 120 133 76 54 -13 44
  66
• 6 100 133 38 36 -33
  62 64
• SL Straight Line Depreciation SYD Sum of
  Years Digits DDB Double Declining Balance.
  Cost is the same, but looks very different. None
  are related to real economic value, but
  consistency important for managers.

18
Impact of One Change in One Cost Rule

• FASB (U.S.) and IASB (Intl.) rules differed for
  long-term leases. Leases are now average cost
  over life (10-25 years) rather than annual
  obligation. Change to IASB mean about 1 trillion
  in new costs being recognized (front-loaded) on
  the books in the U.S.
• Example Whole Foods reported 639 million in
  long-term liabilities for 2006. New accounting
  rule Must include lease obligations on stores it
  does not own that expense rose to 4.8 billion,
  reducing return on assets from 7.2 to 3.7 and
  increasing debt/equity ratio from 38 to 169.

19
Shift from GAAP to IFRS can cause changes in
apparent profitability

• Daimler-Chrysler moved Chryslers books from GAAP
  to IFRS.
• Result Loss suffered by Chrysler dropped from
  1.5 billion to 682 million.
• Overall most firms, when shift to IFRS report
  higher earnings and higher increase in equity
  value of firm.
• Note Gradual merging of IFRS and FASB in rules
  employed.

20
Too Bad Manulife Financial Is Canadian

• Posted 1.28 billion loss in 2010 under Canadian
  (international) accounting rules.
• It would have posted a 2.2 billion profit under
  U.S. rules and shown 16 billion more in
  shareholder value.

21
Its Magic!

• 100 Largest Corporate Pension Plans had funding
  deficit of 390.7 billion at the end of Dec.
  2012. Six months later, the deficit was down to
  179.3 billion!
• Did firms put 210 billion into the funds?
• No, the rate on corporate bonds used to calculate
  the present value of payments to retirees rose
  0.80 thereby reducing the liability.

22
Keep It Straight

• Accounting numbers are very important managerial
  tools.
• Butdo not think they tell the full story of real
  value and real cost.
• Managers must know their firm and their market to
  know of opportunities that mean changing
  opportunities inside an organization and in the
  market.