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 personnelall
  expense in an accounting senseno 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 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.

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 liabilitya 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 companyhow should those costs be
  assigned?
• Research and Developmentwhere should that cost
  be assigned?

14
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.

15
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.

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.
• 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.