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 firms into bankruptcy.

Some Elementary Differences

You start a new oil company in 2011.

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 formal accounting value of the firm? The economic value?

Primary roles

Accounting:

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.

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.

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 an asset are generally irrelevant but can provide useful information to a manager in making valuation decision.

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, 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.

Other Practical Problems

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.

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?

It Depends on the Accounting Method

Inventory Ending Annual Cost Annual Gross

Method Inventory of goods sold Profits/Sales1. FIFO $82,000 $116,000 $44,0002. LIFO $50,000 $148,000 $12,0003. 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.)

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?

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?

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.

How are costs assigned? Sales reps & overhead staff of company—how should those costs be assigned with respect to products sold? That is, how do you link costs and revenue?

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.

Which Method Is Best? ($ 000)

Net Depreciation Expense Net ProfitYear 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 64SL= 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.

Impact of One Change in One Cost Rule

FASB (U.S.) and IASB (Intl.) rules differ for long-term leases. Leases are now average cost over life (10-25 years); details often “hidden.” Change to IASB would 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%.

Other retailers get nailed: CVS, Walgreens, Wal-Mart

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: Multinationals must use IFRS by 2014; others follow in 2015 and 2016.

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.