Columbia University. Graduate School of Business. - Accounting for Value

Accounting for Value

Columbia University Press

Publishers Since 1893

New York Chichester, West Sussex

cup.columbia.edu

Copyright 2011 Columbia University Press

All rights reserved

E-ISBN 978-0-231-52185-7

Library of Congress Cataloging-in-Publication Data

Penman, Stephen H.

Accounting for value / Stephen Penman.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-231-15118-4 (cloth : alk. paper)ISBN 978-0-231-52185-7 (ebook)

1. Investment analysisAccounting. 2. Accounting. I. Title.

HG4529.P45 2010

332.63'221dc22

2010042335

A Columbia University Press E-book.
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Contents

IT IS PROBABLY WITH mixed feelings that you find yourself holding a book on accounting in your hands. Apprehensive: Isnt accounting complex? Deflated: Isnt accounting boring? Amused: Remember all those accounting jokes? Your interest may occasionally be piqued when accounting is called into question, usually during a crisisin the Enron collapse or the recent financial meltdownbut the discussions of revenue recognition, fair value accounting, variable interest entities, and so on that ensue quickly dissolve into technicalities beyond the common man. Or worse: Babel and confusion. Leave it to the nerds, it is not for me.

I hope to persuade you otherwise.

First understand that, while this book deals with accounting, it is primarily a book on valuation, written for investors and those to whom they trust their savings: investment advisors, analysts, and portfolio managers. The book explains how to employ accounting to estimate share value. It embraces the fundamental investing approach identified with Benjamin Graham, adapted to incorporate pertinent principles of modern finance. Fundamentalists distinguish price from valuethe two can be differentand it is accounting, executed independently of price, to which the investor refers to determine the difference. This book shows how the investor handles accounting to identify value and challenge stock prices.

In this book the investor will see that accounting and valuation are so intertwined that valuation is actually a matter of accounting; valuation involves performing an accounting on a firm, an accounting for value. Accordingly, a valuation is only as good as the accounting underlying it. There is thus a question for the accountant to answer: What is good accounting for valuation? Do generally accepted accounting principles (GAAP) fit the bill, or does the investor look for an alternative accounting for valuation? The book is a conversation with the investor about valuation, but a conversation that accountantsparticularly accounting regulators and standard settersare most welcome to sit in on. Like investment advisors, analysts, and portfolio managers, they also serve the investor. Just as poor valuation can harm an investors savings, so can poor accounting. And there is considerable room for improvement in todays accounting.

The Importance of Accounting

If you have ever purchased a stock, you understand the importance of valuation, but let me persuade you of the importance of accounting.

In most endeavors, whether a household, a club, a firm, or a government, one needs to keep track. Indeed we account all the time as a matter of instinctive behavior. In personal relationships, one keeps account of the pros and consassets and liabilities, debits and creditsof the relationship, often instinctively. We do so in more formal arrangements, but more formally. With corporate accounting, owners keep track of their investments and the stewards who manage them, and with government accounting citizens keep track of their politicians. Without accounting to tell us where we are, where are we?

To function well, market economies require defined property rights enforced by independent courts, along with minimal restrictions on contracting. But of equal importance are accounting systems of high integrity that track our rights and obligations to each other. For our common wealth, accounting is critical for directing capital to firms that will use it most productively, and for the efficient functioning of capital markets where those firms are valued and where our savings are at stake. It is no wonder that in almost every crashwhether it be the 1929 crash, the recent financial crisis, or corporate debacles like the Penn Central failure in the 1960s or Enron more recentlythe finger is pointed at the accounting (among other suspects). Accounting is boring when all is well, but critical when one needs it most. Accounting can be complexoften unnecessarily sobut accounting is no joke. (But, still, lets keep those accounting jokes in inventory.)

Accounting defines reality. It does so by bringing specificity to what would otherwise be speculative generalities. Economists work with concepts of revenue, cost, income, assets, and such; concepts that are very helpful for economic reasoning but have no manifestation until someone puts a number on them. The rubber hits the road with measurement and measurement falls to the accountant. Cost of production, in reality, is an accounting measure and that reality is determined by how one does the accounting. Economic profit is a useful concept, but no one has seen it until a number is put on it; consultants market economic profit measures but their products are simply accounting measures with economic profit a mere label (and a pretentious one at that). Accounting gives expression to profitability, financial position, growth, and so on. Indeed, as we will see, accounting gives expression to value. With-out accounting, these various concepts are simply in the mind of the beholder, open to speculation. Accounting forces concreteness, not just concrete numbers but also concrete thinking.

In the heyday of strong efficient market views, the accounting that fundament investors so rely on was dismissed: accounting does not matter, it was said, for the market can see through the accounting. What then, one might ask, does the market see? The standard answer is that the market sees through to the future cash flows. But one cannot, of course, see the future. The market must see something observable, something real, and that reality must be some form of information that forecasts future cash flows. We, of course, do see factories, employees, the movement of goods and delivery of services, but accounting produces a representation of these realities appropriate for valuation.

It is popular to dismiss accounting as unconnected to reality, an archaic system unrelated to cash flows. This is a gross misconception. One must always reserve criticism of any particular form of accountingGAAP, indeedbut this is not the way to look at accounting as a matter of first order. Accounting forces managers to face the numbers in reporting to shareholders rather than deliver platitudes about plans and prospects. It forces them to come to grips with reality. Sound government accounting forces politicians to be straightforward in reporting to taxpayersto view borrowing as debt rather than revenue, for example. It forces reality. And sound accounting for valuation forces investors to come to terms with reality rather than speculate. That opens the question: What is sound accounting for the purpose at hand?

Accounting expresses our reality for another reason. You and I dont need a behavioral scientist to tell us that our ability to process information is limited, but behavioral research has told us that people adapt to this limitation by developing heuristics that focus on a few pieces of summary information. Investors do so when they multiply just one number, earnings, by a multiplier (the P/E ratio), to estimate the value of a share. Economists do so when they appeal to one economywide earnings number, gross domestic product (GDP), to summarize the performance of an economy. Both know they are taking shortcuts and glossing over the imperfections in the two numbers (the P/E heuristic is particularly suspect, as we will see). One should always be skeptical of any accounting measure, but the demand for summary numbers from the limited information processors of the planet is strong. They have straightforward questions, such as What did I earn this year? and What did my firm earn? They seek accounting summary numbers, like earnings, to treat as real numbers, to be relied upon. But again, the question is: What is a good summary number for the purpose at hand?