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 personnel—all 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 period—ONE BASED on Analysts’ Earnings Estimates; the other on later Real data Data for S&P 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 firms—same number good in and out and money flow the same, but accounting methods differed. What is the economic value? Current opportunity cost—none 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. Apple’s 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 don’t meet FASB rules, so SEC does not like them—it 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 assets—multiple 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.

17. Which Method Is Best? ($ 000) Net Depreciation ExpenseNet Profit YearCashSL SYD DDBSL 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 Year’s 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 Chrysler’s 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. It’s 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. But—do 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.