Accounting Costs vs. Economic Value

1. 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 drive the firm into bankruptcy.

2. Some Elementary Differences You start a new oil company in 2008. 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 value of the firm? The economic value?

3. Primary roles Accounting: record and track receipt of and expenditure of money. Helps establish responsibility for assets and reduce theft. The records help managers determine if operations are working as expected and are required by tax and regulatory authorities. It is a system of controls. Economics: considers the value of assets determined by usefulness to current owner compared with alternative means of producing same services and considers potential use (opportunity cost) to other possible owners of the assets.

4. Economic Value of Assets Economic value of an asset requires an estimate of the net cash flow expected from the asset (discounted). Hence, valuation is continuous and is subjective: an educated guess about expected cash flows. Past cash flows (accounting data) from an asset are generally irrelevant but can provide useful information to a manager in making valuation decisions.

5. Consider New Asset Purchase price is accounting value of asset. Economic value? Must be higher than accounting value or would not buy. Expected value in use of asset must be more valuable than purchase price. New machine purchased for $35,000 (asset value). Estimate machine life of five years with revenue of $10,000/yr. (discounted 10%/yr.) for net present value of $37,910. Profit of $2,910 not recorded.

6. Changes in Asset Value We acquired the machine for $35,000 (accounting asset recorded value) that had an economic present value (PV) of $37,910. Suppose costs rise and cash flow falls to $9,000/yr. from $10,0000/yr. Then PV falls to $34,120. Or demand increases and allows us to extend the life to six years for PV of $43,550. Or discount rate (alternative investment return) changes to 12%; then PV falls to $36,050. None of these changes in economic value cause accounting value to change. It continues to show initial value ($35,000) depreciated over 5 year expected life.

7. Non-recording of Assets Many activities or events produce assets that have no recorded accounting value. Example: Lockheed signs contract with Air Force to build $20 billion worth of new jets. A profitable deal. What shows up on the books? Nothing until cash realized. [Real value known by firm managers and to stock holders if public firm.]

8. 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, accountants only record expenditures as if no value was created. Similarly, costs of training personnel—all expense in an accounting sense—no immediate offsetting revenue. But economically valuable activity.

9. Other Unrecorded Changes Price level changes: as rate of inflation changes the economic meaning of the original cost of assets change, but accounting values generally do not change. So if inflation rises or falls. Book values deviate more and more from economic value (same for exchange rate changes). Income and Expenses: Accounting books do not record 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.

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.

12. Problems that Have No Solution In the production of complex products, how do you assign labor costs? Lump sum? Per unit? Based on total wage cost or per hour estimate? Any method may be useful to managers to understand labor costs, but same costs may look very different across identical firms. What about fringe benefits for workers, such as health benefits? Is it overhead or labor cost? What about retirement benefits? A liability or a cost?

13. More Problems Firm acquired land years ago; carried on books at original cost. Current value may be very high. Environmental liability—a firm will have to clean up a mess. Real cost to be incurred but not carried on books. Joint cost problem: Beef and hides. A chemical firm makes dozens of products in one building. How are costs assigned? Sales reps, overhead staff of company—how should those costs be assigned? Research and Development—where should that cost be assigned?

14. 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.

15. 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.

16. The Impact of One Change in One Accounting Cost Rule FASB (U.S.) and International Accounting Standards Board changed the rule for long-term leases. It meant about $1 trillion in “new” costs being recognized on the books in one year in U.S. Long-term leases were “hidden.” 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%.

17. 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.