Accounting relativism: the unstable relationship between income measurement and theories of the firm

The knowledge structures underlying accounting representations are rarely investigated and usually tend to be taken for granted. As a case of the problematic knowledge foundations of accounting, we concentrate on one of the most relevant conceptual underpinnings informing the construction of the accounts—the relationship between theories of the firm, accounting theories, and income measurement. In particular we analyse and compare the ways in which this relationship has been conceived and developed in two theoretical contexts, the Italian tradition of Economia Aziendale and the US entity vs proprietary debate. Various and contradictory approaches to the concept of the firm and income calculation in these two theoretical traditions emerge. Such a conceptual variety is what we refer to as ‘accounting relativism’. This is defined here as the co-existence of different accounting representations and measurements, both of which are not objectively rankable in any conceptual hierarchy, because of the incommensurability of their basic assumptions, i.e. of their knowledge bases. This intrinsically ‘unstable’ character of accounting at a conceptual level is likely to have relevant implications, representing a major source of theoretical variety, as well as a premise for making sense of power uses of accounting within organisational settings. ©     

What Do FAS 157 “Fair Values” Really Measure: Value Or Risk?

FAS 157, the U.S. accounting standard that prescribes how fair values of assets and liabilities are to be measured when other U.S. GAAP standards require fair valuation, stipulates that fair values be measured as the exit values of assets and liabilities—the proceeds for assets hypothetically sold on the date of the financial report, and, correspondingly, the amount required to settle liabilities on the date of the financial report. This conceptual article argues that exit values do not reflect the value of the net assets of the firm to shareholders, which is best reflected by discounted cash flows to maturity. Moreover, exit values—biasing fair values downward when markets are illiquid—have a pernicious, systemic risk effect; specifically, they give rise to write‐downs that in turn cause contagion: prices of equities and other financial instruments of peers react negatively, leading to further write‐downs by those peers. This may have aggravated the recent financial crisis. However, while exit values are not proper measures of value to shareholders, they are useful measures of downside risk when prospects turn sour for a firm. Thus, both exit values and discounted cash flows should be presented in financial statements.     

Resurrecting the Discounted Cash Equivalent Flow

Following the debate between Chambers and Peasnell, it is argued that the correct criterion for investment appraisal is the discounted net cash equivalent flow, that is CoCoA income net of interest on wealth.     

Chambers on Price and Price-Level Variations: Exiting Intellectual Grooves

From early in his enquiry, Chambers perceived the price variation problem in accounting to not be a separate phenomenon related to inflation or deflation, but to be the failure in conventional accounting to incorporate the full financial effects of the medium, money, in which its calculations were made and its output expressed. He absented himself from the inflation accounting focus early in the 1950s and set about an enquiry into the nature and meaning of monetary calculation and measurement, within a framework of accounting functioning to provide indications of the wealth and progress of firms. Accordingly, when the substantial literature on the topic and the report of governmental enquiry into accounting and inflation emerged during the early 1970s he addressed the various proposals by drawing upon his theory of Continuously Contemporary Accounting (CoCoA) with devastating effect.     

Cash Flows and Net Realizable Values: Further Evidence of the Intuitive Concepts

This paper reports the results of a survey of students with and without prior knowledge of accounting with a view to identifying any differences in their perception of the relevance of current prices of assets.
The combination of cash flows and net realizable values appears to have an intuitive appeal to students with no prior exposure to accounting concepts or practices. In the process of learning about accounting, it seems that students learn to abandon net realizable values in favour of historical costs.     

Consistency,Value Relevance and Sufficiency of Book for Market Values in Five Japanese Conglomerates Over the Period 1950–2004

Market and accounting data for five Japanese conglomerates, Toyota, Fuji, Sony, Itochu and Sumitomo, are analysed over the period 1950 to 2004. Annual market value is regressed on three accounting and six macroeconomic variables, using a general‐to‐specific approach to construct simple error correction models for each of the five firms. The results show that in four of the five firms there is evidence of a long‐run relationship between market value and the net book value of assets, which can be interpreted, with increasing degrees of strength, as book values being either consistent with, value relevant for, or sufficient for market value.     

Liability Valuation and Debt Defeasance: A Cash-Flow Exit-Price (CaFE) Approach

This paper reviews the arguments of Chambers with respect to liability measurement in his continuously contemporary accounting (CoCoA) system and the views of his critics are summarized and discussed. The paper then examines the issue of laibility valuation and in-substance debt defeasance in the context of historic-cost accounting. A specific illustration is provided showing how an in-substance debt-defeasance arrangement would be reported under a CaFE system. It is concluded that stating debt at its exit price would provide useful information and could reduce the incentives for firms to enter into in-substance debt-defeasance arrangements.     

Mergers and Acquisitions Accounting and the Diversification Discount

q‐based measures of the diversification discount are biased upward by mergers and acquisitions and its accounting implications. Under purchase accounting, acquired assets are reported at their transaction value, which typically exceeds the target's pre‐merger book value. Thus, measured q tends to be lower for the merged firm than for the portfolio of pre‐merger entities. Because conglomerates are more acquisitive than focused firms, their q tends to be lower. To mitigate this bias, I subtract goodwill from the book value of assets and a substantial part of the diversification discount is eliminated. Market‐to‐sales‐based measures do not have this bias.     

FMA Roundtable on New Developments in European Corporate Governance

In this discussion that took place in Helsinki last June, three European financial economists and a leading authority on U.S. corporate governance consider the relative strengths and weaknesses of the world's two main corporate financing and governance systems: the Anglo‐American market‐based system, with its dispersed share ownership, lots of takeovers, and an otherwise vigorous market for corporate control; and the relationship‐based, or “main bank,” system associated with Japan, Germany, and continental Europe generally. The distinguishing features of the relationship‐based system are large controlling shareholders, including the main banks themselves, and few takeovers or other signs of a well‐functioning corporate control market. Given the steady increase in the globalization of business and international diversification by large institutional investors, the panelists were asked to address the question: can we expect one of these two systems to prevail over time, or will both systems continue to coexist, while seeking to adopt some of the most valuable aspects of the other? The consensus was that, in Germany as well as continental Europe, corporate financing and governance practices have already begun to look much like those in the U.S. and U.K., with much less reliance on bank loans and greater use of bonds and public equity. And these financing changes have resulted in major changes in ownership structures that have seen local main banks largely supplanted by foreign institutional investors—some of whom have demanded a greater voice in how companies are run. Moreover, Finnish economist Tom Berglund may well have provided a blueprint for the dominant European governance system of the future in describing the “Nordic model” as

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R. J. Chambers on Securities and Obscurities: Making a Case for the Reform of the Law of Company Accounts in the 1970s

This study examines the contribution of Raymond J. Chambers to the British inflation accounting debate in the early‐to‐mid 1970s, from the perspective of the reception of his book, Securities and Obscurities: A Case for Reform of the Law of Company Accounts, published in 1973. To structure the empirical narrative, drawing on previously unpublished documents from the R. J. Chambers Archives, we employ Czarniawska and Joerges’ ( 1996 ) notion of the ‘travel of ideas’, and Mumford’s ( 1979 ) observation of the existence of ‘inflation accounting debate cycles’. The result is a narrative that traces the environmental and material circumstances that led to Chambers’ book having a lesser impact on the British inflation debate than one would expect based on the international exposure of his ideas, his influence at the time, and the empirical rigour of his proposal. The purpose of this exercise is to assess how contextual factors, such as the choice of publisher, use of promotional material, and distribution methods, can be as (or more) important than the substance of the proposed ideas, arguments, and solutions.     

Financial Intermediaries and the Cross‐Section of Asset Returns

Financial intermediaries trade frequently in many markets using sophisticated models. Their marginal value of wealth should therefore provide a more informative stochastic discount factor (SDF) than that of a representative consumer. Guided by theory, we use shocks to the leverage of securities broker‐dealers to construct an intermediary SDF. Intuitively, deteriorating funding conditions are associated with deleveraging and high marginal value of wealth. Our single‐factor model prices size, book‐to‐market, momentum, and bond portfolios with an R² of 77% and an average annual pricing error of 1%—performing as well as standard multifactor benchmarks designed to price these assets.     

A note on value relevance of mark-to-market values of energy contracts under EITF Issue No. 98-10

This paper examines whether marked-to-market values of energy trading assets and liabilities of companies that enter into energy contracts are related to market value of equity. The Emerging Issues Task Force of the Financial Accounting Standards Board ruled in November 2002 to ban the use of mark-to-market accounting for energy contracts out of concern that fair values can be easily inflated. We find that the excess of fair value over original value of energy trading assets and energy trading liabilities is not relevant for valuation. It may be inferred that fair values which are subject to management estimates and not verifiable are poor signals of worth and performance (Watts, R., 2003. Conservatism in accounting Part I: Explanations and implications. Accounting Horizons 17, 207–221).     

Multi‐period Asset Lifetimes and Accounting‐based Equity Valuation: Take Care with Constant‐growth Terminal Value Models!

The merits of accruals in forecasting cash flows or mitigating the volatility of financials shortly after the valuation date are indisputable. However, the usefulness of accounting in equity valuation is very limited if we step beyond a certain forecasting horizon. In this paper, this limitation is emphasized by shedding new light on the accounting‐based value driver model (VDM), a widely used constant‐growth terminal value tool that uses accounting variables as input. The paper shows that, if the lifetime of a firm's assets is, on average, longer than one period, the VDM works accurately only in an idealized academic environment with an even historical corporate investment activity, a single depreciation method for all assets, and no historical inflation volatility. Artificially adjusting real‐world figures to this steady state is possible in principle, but bloats the valuation model and requires exactly the same information that is used in our cash flow‐driven benchmark model (where no adjustment phase is necessary). Beyond these theoretical shortcomings, the VDM is also prone to being misused in valuation practice due to its reliance on book (rather than economic) rates of return, and to its shortcomings in dealing adequately with the assets with an ex ante indefinite lifetime.     

Brealey,Myers, and Allen on Real Options

Real options are valuable sources of flexibility that are either inherent in, or can be built into, corporate assets. The value of such options are generally not captured by the standard discounted cash flow (DCF) approach, but can be estimated using a variant of financial option pricing techniques. This article provides an overview of the basics of real option valuation by examining four important kinds of real options:

• 1 The option to make follow‐on investments. Companies often cite “strategic” value when taking on negative‐NPV projects. A close look at the payoffs from such projects reveals call options on follow‐on projects in addition to the immediate cash flows from the projects. Today's investments can generate tomorrow's opportunities.
• 2 The option to wait (and learn) before investing. This is equivalent to owning a call option on the investment project. The call is exercised when the firm commits to the project. But often it's better to defer a positive‐NPV project in order to keep the call alive. Deferral is most attractive when uncertainty is great and immediate project cash flows—which are lost or postponed by waiting—are small.
• 3 The option to abandon. The option to abandon a project provides partial insurance against failure. This is a put option; the put's exercise price is the value of the project's assets if sold or shifted to a more valuable use.
• 4 The option to vary the firm's output or its production methods. Companies often build flexibility into their production facilities so that they can use the cheapest raw materials or produce the most valuable set of outputs. In this case they effectively acquire the option to exchange one asset for another.

The authors also make the point that, in most applications, real‐option valuation methods are a complement to, not a substitute for, the DCF method. Indeed DCF, which is best suited to and usually sufficient for safe investments and “cash cow” assets, is typically the starting point for real‐option analyses. In such cases, DCF is used to generate the values of the “underlying assets”—that is, the projects when viewed without their options or sources of flexibility.     

IS NOISE TRADER RISK PRICED?

We examine the hypothesis that closed‐end fund shareholders garner greater returns than holders of the underlying assets as compensation for bearing “noise trader risk.” We demonstrate that the returns on fund shares are more volatile and exhibit greater mean reversion than the returns on the underlying assets, consistent with the hypothesis that noise traders play a more active role in closed‐end fund shares than do the underlying assets. Inconsistent with the De Long et al. (1990) noise trader model, however, we find that after accounting for fund expenses, fund shareholders do not earn returns greater than holders of the underlying assets. JEL classification: G12     

The value relevance and reliability of reported goodwill and identifiable intangible assets

We examine the value relevance and reliability of reported goodwill and identifiable intangible assets under Australian GAAP from 1994 to 2003; a period characterised by relatively restrictive accounting treatment for goodwill and relatively flexible accounting treatment for identifiable intangible assets. Our findings, using an adaptation of Feltham and Ohlson (1995), suggest that for the average Australian company the information presented with respect to both goodwill and identifiable intangible assets is value relevant but not reliable. In particular, goodwill tends to be reported conservatively while identifiable intangible assets are reported aggressively.     

On the conceptual foundations of financial reporting

Standard setters advocate a balance sheet approach to financial reporting, which views assets and liabilities as primary, and income as just the derivative change in net assets. This paper argues that income is conceptually and practically better described as ‘adjusted net cash flows,’ where the adjustments are the accounting accruals. One proof of that is seen in the existence of whole accounting systems like tax accounting and national income accounting, which emphasize the determination of income but have no balance sheets. The paper also argues that an income-based approach to financial reporting is by nature better suited to reflect the success of advancing cash to earn more cash, which defines what for-profit entities do. There are two main features of the income-based approach. One is attention on the cash flows as the natural foundation for financial reporting because they are precisely determined, and provide a clear link to firm valuation. The other is attention on the accounting accruals, which serve to adjust the raw cash flows to better show the current success of investing cash to ultimately earn more cash. Specifically, the paper argues for revenue recognition which is close to current practice, and for expense recognition which is aligned with the matching principle.     

Population age structure and household portfolio choices in Italy

Based on the exceptional ageing of the Italian population, this paper aims to contribute to the current debate on population ageing and financial markets. To this end, we use the data taken by the Bank of Italy Survey of Household Income and Wealth over the period 1995–2006, and we analyse the average household portfolios in relation to age and net wealth (NW). Our analysis rests on a clustering of assets according to risk, which is different from the one used in Guiso and Jappelli (Guiso, L., and T. Jappelli. 2002. The portfolio of Italian households. In Household portfolios, eds. L. Guiso, M. Haliassos, and T. Jappelli. Cambridge: MIT Press). We find that age has affected financial choices of Italian households over the whole decade, but the portfolio age profile has significantly evolved over time with important differences across wealth quartiles. Overall, our analysis highlights a tendency towards a hump-shaped age profile of the allocation in risky assets for the most NW levels.     

Axiomatization of residual income and generation of financial securities

This paper presents an axiomatization of residual income, also known as excess profit, and illustrates how it can univocally give rise to fixed-income or variable-income assets. In the first part it is shown that, depending on the relations between excess profit and the investor's excess wealth, a well-specified theory of residual income is generated: one is the standard theory, which historically traces back to Hamilton and Marshall and is a deep-rooted notion in economic theory, finance, and accounting. Another is the systemic value added or lost-capital paradigm: first introduced by Magni, the theory is enfolded in Keynes's notion of user cost and is naturally generated by an arbitrage-theory perspective. In the second part, the paper inverts the usual analysis: instead of computing residual incomes from a pattern of cash flows, residual incomes are fixed first to derive vectors of cash flows. It is shown that variable- or fixed-income assets may be constructed on the basis of either theory starting from pre-determined growth rates for residual income. In particular, zero-coupon bonds and coupon bonds traded in a capital market are shown to be deduced as equilibrium vectors of residual-income-based assets.