encyclopedia of accounting (colin clubb)

Similar to DDM, Easton 2004 shows that it is possible to simplify the general model PEGM into a closed form valuation model expressed in terms of information observable at time t, by ass

T H E B L A C K W E L L E N C Y C L O P E D I A O F M A N A G E M E N T

A C C O U N T I N G

THE BLACKWELL ENCYCLOPEDIA OF MANAGEMENT

SECOND EDITION

Encyclopedia Editor: Cary L Cooper

Advisory Editors: Chris Argyris and William H Starbuck

Volume I: Accounting

Edited by Colin Clubb (and A Rashad Abdel-Khalik)

Volume II: Business Ethics

Edited by Patricia H Werhane and R Edward Freeman

Volume III: Entrepreneurship

Edited by Michael A Hitt and R Duane Ireland

Volume IV: Finance

Edited by Ian Garrett (and Dean Paxson and Douglas Wood)

Volume V: Human Resource Management

Edited by Susan Cartwright (and Lawrence H Peters, Charles R Greer, and Stuart A.Youngblood)

Volume VI: International Management

Edited by Jeanne McNett, Henry W Lane, Martha L Maznevski, Mark E Mendenhall,and John O’Connell

Volume VII: Management Information Systems

Edited by Gordon B Davis

Volume VIII: Managerial Economics

Edited by Robert E McAuliffe

Volume IX: Marketing

Edited by Dale Littler

Volume X: Operations Management

Edited by Nigel Slack and Michael Lewis

Volume XI: Organizational Behavior

Edited by Nigel Nicholson, Pino G Audia, and Madan M Pillutla

Volume XII: Strategic Management

Edited by John McGee (and Derek F Channon)

Index

# 1997, 1999, 2005 by Blackwell Publishing Ltd except for editorial material and organization # 2005 by Colin Clubb

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Accounting practice encompasses a wide variety of organizational activities which include therecording of financial transactions and events in the firm’s books, the use of financial informationfor management decision-making and control purposes, and the preparation and audit of financialstatements prepared for external users such as investors, customers, and employees There are manytextbooks available which provide introductory, intermediate, and advanced treatments of the tech-nical and managerial issues raised by such accounting activities The current volume cannot possiblyaim to provide in depth coverage of the vast range of activities which comprise modern accountingpractice Instead, it aims to provide a way in to the expanding accounting research literature which inrecent years has come to provide a variety of perspectives on the big issues confronting accountingpractice I briefly consider some of these perspectives here

Some of the contributions to the volume focus on particular financial reporting, auditing, ormanagement accounting topics and outline alternative possible approaches or treatments within(and perhaps beyond) existing conventions or rules The information contained in the main financialstatements (the balance sheet, the profit and loss account, and the cash flow statement) is discussed;important aspects of financial reporting such as the treatment of employee stock options, pensionsaccounting, and the treatment of taxation are analyzed; comparative analysis of the use of statistical andjudgmental methods in auditing is provided: and the nature of costing systems required to generateproduct cost information in modern production environments are described While these contribu-tions to the volume throw important light on important technical developments in the broad account-ing arena, they also draw attention to the choices that must be made by accounting regulators, auditors,and managers in determining what is an appropriate treatment of a particular item in a company’sfinancial statements, an effective audit procedure or the ‘‘optimal’’ approach to product costing Thefact that these choices can have profound effects on management decision-making and on the fortunes(and decisions) of important corporate stakeholders or constituencies indicates the fundamentalmanagerial, economic, and social importance of developing understandings of the broader implications

of accounting practice

The need to understand the implications of accounting practices for the decisions taken by managersand investors, and the implications of these decisions for broader economic and social well-being,provides important motivation for accounting research with economic, organizational, social, andhistorical focus Several of the volume contributions consider the usefulness of accounting from aneconomic perspective, for example, by reviewing the large literature on the relationship between shareprice performance and financial statement information such as reported profit, dividends, cash flow,and R&D spending Much of the empirical work in this area draws on valuation theory, providinginteresting evidence on the extent to which accounting provides (or at least reflects) fundamentalinformation used by the capital markets to value corporate securities In addition to valuation theory,economic perspectives based on agency theory and information economics have been used to provideinsights into the problems of designing performance evaluation systems which encourage ‘‘optimal’’managerial decision-making and the problems of structuring of audit contracts to provide a high level

of audit quality from an investor viewpoint The volume provides a range of contributions that

demonstrate the importance and practical relevance of insights from applying economic analysis to theanalysis of accounting issues.

While the financial focus of much of what is usually regarded as accounting practice leads naturally

to the application of economic perspectives in the analysis of such practice, there has been a growingappreciation in the research literature that accounting is implicated in organizational and socialprocesses which affect the distribution of resources between stakeholders in the organization andwhich affect the impact of an organization on society A number of entries therefore focus on theproblems of implementing profit driven decision tools, such as discounted cash flow, in the context oforganizational and environmental uncertainty and the issues raised by the design of internal perform-ance evaluation systems to facilitate managerial decisions consistent with broader stakeholder object-ives in private and public sector organizations The ability of auditors to act impartially as guardians ofthe investor interest in companies and the relationship of financial reporting and auditing to the law iscritically examined The relative importance of profitability and alternative organizational objectiveshas been an important theme in much recent research and this is reflected in articles which consider thecurrent and historical status of social and environmental reporting as a managerial practice Theorganizational and social roles of accounting is a theme reflected in many entries, emphasizing theimportance of a more explicit recognition by managers and stakeholders of the interaction betweenaccounting practice and organizational decision-making Diversity of theoretical perspective andemphasis among researchers, however, can make comparisons of research in this area a difficult issue

To conclude, this volume aims to provide the reader with a range of articles that highlightimportant issues in accounting practice and the contributions that research can make to the under-standing and development of practice These articles can only provide a general indication of thevariety of perspectives and analyses conducted in the various areas and it is therefore hoped that theywill encourage (and guide) further enquiry by the reader By leading to a greater appreciation of theconceptual foundations of different accounting practices and the sometimes ambiguous economic,organizational, and social implications of these practices, it is hoped that this volume will help thereader to develop a deeper view of the usefulness of accounting as a mechanism for achieving economicand social goals

Colin Clubb

About the Editors

Editor in Chief

author of over 80 books, is past editor of the Journal of Organizational Behavior and FoundingPresident of the British Academy of Management

Advisory Editors

Harvard Business School

School of Business, New York University

Volume Editor

of the Journal of Business Finance and Accounting and has published research articles in a wide range ofmajor accounting and finance journals

University of New South WalesSasson Bar Yosef

The Hebrew University, JerusalemVivien Beattie

University of GlasgowMartin BenisNew York UniversityAlnoor BhimaniLondon School of Economicsand Political Science

Andrew P BlackConsultantJane BozewiczBabson CollegeNiamh BrennanUniversity College DublinGae´tan Breton

UQAM, CanadaJane BroadbentRoyal Holloway, University of LondonPeter Brownell

The University of Melbourne

Queen’s University BelfastPascal Frantz

London School of EconomicsThomas J Frecka

University of Notre DameSonja GallhoferUniversity of Aberdeen

University of ValenciaJames GodfreyJames Madison UniversityJayne M GodfreyMonash UniversityDavid GwilliamLondon School of EconomicsSusan Haka

Michigan State UniversityJim Haslem

University of DundeeJoanna L HoUniversity of California, IrvineJohn Holland

University of GlasgowShahed ImamJudge Institute of Management, University ofCambridge

Christopher D IttnerThe Wharton School, University ofPennsylvania

Cynthia JeffreyIowa State UniversitySteven J KachelmeierMcCombs School of Business, University ofTexas at Austin

Nanyang Business School, Nanyang

Technological University, Singapore

Margarita Maria Lenk

Colorado State University

Management School, Lancaster UniversityKen Peasnell

Management School, Lancaster UniversityStephen H Penman

Columbia Business School, Columbia UniversityPeter F Pope

Lancaster UniversityBrenda A PorterVictoria University of WellingtonBill Rees

University of AmsterdamDiane H RobertsUniversity of San FranciscoJoshua Ronen

Stern School of Business, New York UniversityWilliam Ruland

Baruch College, City University of New YorkOded Sarig

Arison School of Business (Israel) and TheWharton School, University of Pennsylvania(US)

R W SchattkeUniversity of ColoradoHerbert P SchochMacquarie University, New South WalesPrem Sikka

University of Essex

Nanyang Business School, Nanyang

Technological University, Singapore

Teoh Hai Yap

Nanyang Technological University, Singapore

Alison ThomasPricewaterhouseCoopersTony Tinker

City University of New York, Baruch CollegeSteven Toms

University of YorkKen T TrotmanUniversity of New South WalesWim A Van der StedeUniversity of Southern CaliforniaJulie Walker

University of QueenslandMartin Walker

University of ManchesterEamonn WalshUniversity College DublinPeter Walton

Open University Business SchoolTrevor A Wilkins

National University of SingaporeMarleen Willekens

Katholieke Universiteit LeuvenYong Li

Warwick Business SchoolTeri L Yohn

McDonough School of Business, GeorgetownUniversity

Steven YoungLancaster University Management School,Lancaster University

Ian ZimmerUniversity of Queensland

accounting and capitalism

Steven Toms

The ‘‘Enron stage of capitalism’’ (Prashad, 2002)

illustrates how an accounting scandal, with

ser-ious implications for financial reporting and

regulation, may also be an exemplar of the

polit-ical and economic processes governing the

evo-lution of global capitalism Accounting is, as the

debates reviewed below illustrate,

fundamen-tally implicated in the development of capitalism

through all its stages of development,

notwith-standing how these are labeled and defined

Ac-counting history is therefore more than simply

recording the evolution of a set of technical

procedures beginning with Paccioli’s Summa de

Arithmetica, Geometria, Proportioni et

Proportio-nalita in 1494 and ending with the latest

Standards Board Instead, accounting is

impli-cated in transformations in ownership, with war

and social upheaval, as well as with more stable

phases of capitalist development As these

rela-tionships have been increasingly acknowledged,

historical perspectives have begun to occupy a

significant position within the discipline of

ac-counting itself, set within a broader

interdiscip-linary social science research agenda, employing

the full range of methodological perspectives

This entry provides an overview of the

alterna-tive approaches employed and the debates that

have arisen It ends with a summary of their

contribution to our understanding of financial

reporting within its social and historical context

Accounting history, like all history, might be

said to have historical explanation as its objective

therefore be employed to trace the first use of

accounting techniques, perhaps the earliest

example being the household economy and

pri-vate estates of ancient Egypt, dating back to theMiddle Kingdom, thereby providing context fortheir present-day use (Ezzamel, 2002)

An early and important example of accountingbeing used to define the key features of a specif-ically capitalist enterprise dates back to Sombart

in 1915, who argued that double entry keeping (DEB) allowed the essential ideas ofthe capitalistic economic system to be fully de-veloped: the creation of economic wealth andeconomic rationality as applied to business cal-culations (Most, 1979) Sharing the ‘‘whig’’ in-terpretation prevalent in the wider discipline ofhistory, early accounting historians believedthere was a progressive development of account-ing techniques from their DEB origins (e.g.,Littleton, 1933)

book-The chief characteristics of ‘‘traditional’’ counting history – economic rationality, history

ac-as progress, and an excessive focus on DEB –form the basis of subsequent critiques and inturn a reference point for subsequent develop-ments in accounting history Yamey (1964)questioned the ‘‘Sombart thesis,’’ arguing thatthere was no substantial evidence for the utility

of DEB from the perspective of capitalistic nomic decision-making Pollard (1965), with ref-erence to a large number of empirical studies,confirmed that many entrepreneurs in the in-dustrial revolution had neither the ability northe access to sufficient expertise to set up ac-counting systems that would have provided thebasis for rational calculations

eco-While maintaining the central assumption ofeconomic rationality, Watts and Zimmerman in

a series of studies developed the positivist proach to consider aspects of financial reportingbeyond mere DEB For example, they recog-nized that principal–agent theory and efficientmarket theory, which became central to the

ap-mainstream accounting research agenda in the

1970s, also had important historical contexts

With reference to accounting practice in the

unregulated nineteenth century and before,

they showed that accounting functioned in

con-junction with contracting arrangements to align

agents’ incentives with shareholders and was

sufficient to explain the major aspects of modern

financial reporting practice, but in the absence

of modern regulatory requirements (Watts

and Zimmerman, 1979) Positivism has been

extended by other researchers to examine how

changes in accounting regulation have affected

wealth distribution between managerial and

ownership groups, for example to examine the

impact of the Securities Acts of 1933 and 1934

(Chow, 1983)

Such research has obvious utility, since

pre-sent day regulators do not have the ability to test

the impact of legislative changes on a ‘‘what if’’

basis Hypotheses such as what happens to

ac-counting disclosure if each shareholder is given

one vote regardless of the size of the holding, are

only tested through recourse to history (Toms,

1998) However, this justification for positivism

is at the same time its major weakness, since such

historical research proves that voluntary

ac-counting disclosure is socially contingent and

does not emerge merely as the result of market

incentives The major claims of the positivists,

that efficient capital markets are a substitute for

accounting regulation or that accounting

regula-tion may prevent the efficient operaregula-tion of

cap-ital markets, are therefore open to question when

examined against the historical evidence

Consequently, whereas the positivist

ap-proach has successfully extended the research

agenda away from merely DEB, its axioms have

been the focus of much of the critique from the

so-called ‘‘new accounting history.’’ For these

new accounting historians, accounting is to be

understood in the context in which it operates

Accounting is therefore no longer a neutral set of

techniques to assist decision-makers, rational or

otherwise, nor explained purely as a mediating

device between competing economic interests,

but is instead a means of control, historically

rooted in the context of power relations Such

applications of context to accounting history are

derivative of the work of the French

philoso-pher, Michel Foucault Napier (1989) reviews

the principal components of the application ofFoucault’s approach to contextual accountinghistory These are first the shift from sovereignpower to disciplinary power, the former based

on physical control and the latter on lance The shift occurred around 1800, andcreated a new social role for accounting

surveil-A second component is Foucault’s notion ofarcheology, or the emergence of forms of dis-course, including accounting and the institu-tional and legal norms that make them possible.The third element is genealogy, or the complex

of dispersed historical events and subsequenttransitions that give significance to accountingpractice Accounting and accountability aretherefore the extension of the utilitarian ‘‘panop-ticon,’’ assisting the task of social surveillanceand therefore the exercise of power, while ac-counting transitions are unintended outcomesproduced by the strategic actions of a number

of different participants The Foucauldian proach has obvious applications for managementaccounting, which has attracted the majority ofsubsequent accounting research, but is equallyimportant in attempts to interpret accountabilityrelationships and institutional processes (Burch-ell, Clubb, and Hopwood, 1985) and the histor-ical development of DEB as a rhetorical devicefor legitimating capitalist practices (Miller andNapier, 1993)

ap-A similar approach, which focuses on tions of power but does not necessarily rejectthe economic, or the rationality, elements ofthe traditional approach is the political economy

rela-of accounting (PEA) perspective According tothe PEA view, accounting is located in the socialrelations of production and, accordingly, mustreflect the location of power within society andthe conflict that exists in society (Cooper andSherer, 1984) At certain important stages in thedevelopment of capitalism, therefore, includingcases such as Enron, powerful managerial groupshave used accounting to further their own ends

at the expense of outside investors Typically,such purposes have been served by deliberaterestrictions on disclosure or manipulation ofthe figures that do appear Prior to the WallStreet Crash and the creation of the Securitiesand Exchange Commission, economic concen-tration and the rise of the trusts led to aconcentration of power in the hands of a small

group of men, so that accounts became relatively

useless from the investors’ perspective (Merino

and Neimark, 1982) As Britain industrialized,

similar concentrations of power, in railways, coal

and iron, and later in banking and shipping,

created opportunities for entrepreneurial and

managerial groups to mislead outside investors

using accounting reports (Edwards, 1989)

In a series of studies, Tinker (e.g., Tinker,

manipulation to offer a distinct and radical

per-spective to show how accounting is a social

adju-dicator and tool in the hands of the powerful and

is used to impose their agenda on weaker social

groups Since long before the Enron scandal,

Tinker has been examining how accounting is

implicated in the downsizing of state functions

and consequent wealth redistributions Tinker’s

approach is radical and Marxist, illustrating how

accounting is deeply implicated in capitalist

relations

The rise of the capital market underpins one

further important aspect of the PEA approach

Again from a radical and Marxist perspective,

although differing from Tinker, Bryer offers an

alternative political economy hypothesis of

powerful shareholders and investor groups as

the social instigators of modern accounting

According to this view, the collective interests

of capital dominate managers who assume

the role of mere ‘‘functionaries’’ as capital

becomes ‘‘socialized’’ (Bryer, 1993)

Conse-quently, modern accounting appears as a

re-sponse to the interests of collective capital

This relationship is only one aspect of Bryer’s

approach and of all contributors, he goes

fur-thest in arguing that accounting history and

accounting theory are central to any project

aimed at understanding the workings of

capital-ism and its social and economic history In a

series of papers, Bryer questions and

reinter-prets all the major perspectives referred to

above DEB is therefore not merely a rational

set of techniques nor merely a rhetorical device,

but originates as a calculative mentality designed

continuously to calculate the return of capital

employed, using consistent rules to identify

ob-jective asset values, mirroring the circuits of

capital set out by Marx In this formulation

Bryer goes beyond both the economic rationality

of the traditionalists and the social

constructiv-ism of the Foucauldians, arguing that accounting

is socially rational, and is explained by reference

to the social relations of production, that is thedegree to which labor has an independent means

of subsistence and capitalists have pooled theircapital (Bryer, 2004)

Unsurprisingly, Bryer’s perspective is versial and has generated considerable debateand criticism from traditionalists and conven-tional accounting theorists, Foucauldians, andother Marxists From the conventional stand-point, if the objectives of financial reportingare derived from the social relations of produc-tion, then accounting is essentially performing

contro-a stewcontro-ardship function contro-and is contro-at vcontro-aricontro-ance withthe proclaimed objective of the FASB, which is

to assist economic decision-making (Samuelson,1999) For the new accounting historians, thefocus of criticism is Bryer’s quest for objectiveaccounting rooted in the classical economic trad-ition that does little to expose intricacies ofthe complex power relations that exist in societyand the large organizations that new methods

of accounting give rise to (Macve, 1999) Finally,

for example Tinker, the assumed objective ofaccounting ‘‘to hold management accountable

to total social capital,’’ that is, to the capitalmarkets in Bryer’s framework, has been dis-missed as an ‘‘enigmatic assertion’’ (Tinker,1999: 644)

Although these debates are unlikely to be solved soon, their extent and intensity is perhapstestimony in itself to the importance of the topic

re-It is perhaps the best possible illustration of howcomplex a topic accounting becomes as soon as it

is defined as more than simply a set of niques Whichever of the above views is be-lieved, it is clear that accounting lies at theheart of capitalism as an economic system Tounderstand capitalism one must understandaccounting and to understand accounting onemust understand capitalism As the above dis-cussion suggests, debates framed in a historicalcontext address major areas of concern about thefundamentals of financial reporting that are ofgreat interest to regulators and practicingaccountants today If the research agenda foraccounting is as wide as the agenda for researchinto the origins, development, and workings ofcapitalism itself, the perspectives introduced

here will continue to be an important reference

point as accounting matures as a profession and

as an academic discipline

Bibliography

Bryer, R A (1993) The late nineteenth-century

revolu-tion in financial reporting: Accounting for the rise of

investor or managerial capitalism Accounting

Organ-izations and Society, 18, 649–90.

Bryer, R A (2004) A Marxist accounting history of the

British industrial revolution: A review of evidence and

suggestions for research Accounting, Organizations and

Society.

Burchell, S., Clubb, C., and Hopwood, A (1985).

Accounting in its social context: Towards a history of

value added in the United Kingdom Accounting,

Organizations and Society, 10, 5–27.

Chow, C W (1983) The impact of accounting regulation

on bondholder and shareholder wealth: The case of the

securities acts Accounting Review, 58, 485–520.

Cooper, D., and Sherer M (1984) The value of

account-ing reports: Arguments for a political economy of

accounting Accounting, Organizations and Society, 9,

207–32.

Edwards, J R (1989) A History of Financial Accounting.

New York: Routledge.

Ezzamel, M (2002) Accounting for private estates and

the household in the twentieth-century b c Middle

Kingdom, Ancient Egypt Abacus, 38, 235–62.

Keenan, M (1998) A defense of ‘‘traditional’’ accounting

history research methodology Critical Perspectives in

Accounting, 9, 641–66

Littleton, A C (1988) Accounting Evolution to 1900, 2nd

edn New York: Garland.

Merino, B D., and Neimark, M D (1982) Disclosure

regulation and public policy: A sociohistorical

re-appraisal Journal of Accounting and Public Policy, fall,

33–57.

Miller, P., and Napier, C J (1993) Genealogies of

calcu-lation Accounting, Organizations and Society, 18,

631–47.

Napier, C J (1989) Research directions in accounting

history British Accounting Review, 21, 237–54.

Macve, R (1999) Capital and financial accounting:

A commentary on Bryer’s ‘‘A Marxist critique of the

FASB’s conceptual framework.’’ Critical Perpectives on

Accounting, 10, 591–613.

Most, K (1979) Sombart on accounting history.

Working Paper No 35, Academy of Accounting

His-torians.

Pollard, S (1965) The Genesis of Modern Management:

A Study of the Industrial Revolution in Great Britain.

London: Edward Arnold.

Prashad, V (2002) Fat Cats and Running Dogs: The Enron

Stage of Capitalism London: Zed Books.

Samuelson, R A (1999) The subjectivity of the FASB’s conceptual framework: A commentary on Bryer Crit- ical Perspectives on Accounting, 10, 631–41.

Tinker, T (1985) Paper Prophets New York: Praeger Tinker, T (1999) Mickey Marxism rides again Critical Perspectives on Accounting, 10, 643–70.

Toms J S (1998) The supply of and demand for counting information in an unregulated market: Examples from the Lancashire cotton mills Accounting, Organizations and Society, 23, 217–38.

ac-Watts, R L., and Zimmerman J (1979) The demand for and supply of accounting theories: The market for excuses Accounting Review, 54, 273–305.

Yamey, B S (1964) Accounting and the rise of ism: Further notes on a theme by Sombart Journal of Accounting Research, 2, 117–36.

capital-accounting-based equity valuation

Peter F Pope

Dividend-Based ValuationBasic finance theory provides a well-establishedframework for valuing a firm’s equities (orshares) The value of a firm’s equity is equal tothe present value of the dividends expected to bepaid to equity holders over the lifetime of thefirm (including any terminal dividend paid inliquidation or takeover), discounted at the re-quired risk-adjusted rate of return on equity.Assuming the firm is never liquidated, the divi-dend discount model expresses the value of ashare as:

t¼t

de-notes expectations at time t, and r is the requiredrate of return on the firm’s equity The theoret-ical models described here assume either riskneutrality, in which case discounting is at therisk-free rate of interest, or that risk adjustmentcan be accomplished satisfactorily by using arisk-adjusted cost of equity However, Felthamand Ohlson (1999) build on risk-adjusted valu-ation techniques in the finance literature toargue that the theoretically correct approach todealing with risk in accounting-based valuation

is to adjust numerator terms for risk by taking

expectations using risk-neutral probabilities

(i.e., using certainty equivalents)

The Dividend Discount Model (DDM) can

be adapted for practical use in various ways For

example, to side-step difficulties in forecasting

dividends over very long horizons, a finite

fore-casting horizon can be established and the value

of all dividends beyond the horizon summarized

in a single estimate of the share price at the

horizon date Thus, for example, assuming a

four year forecasting horizon the value of the

firm’s equity can be written as:

be assumed to grow at a constant rate g < r, in

which case the closed-form Gordon growth

model of firm valuation can be obtained:

To the extent that dividends are predictable

and stable, DDM can be a reliable valuation

framework However, dividends are

distribu-tions of wealth by a firm to shareholders

Divi-dend policy is subject to managerial discretion

and can vary considerably over time

Conse-quently, valuation errors can arise because

divi-dends are difficult to forecast, especially over

relatively long forecast horizons, and estimation

of terminal values is especially problematic

However, despite practical implementation

dif-ficulties associated with DDM, it is nevertheless

an important theoretical construct As we will

see, it forms the basis for recent developments in

accounting-based valuation methodology It is

used as a fundamental assumption in ‘‘rational’’

valuation models because it reflects the

funda-mental no-arbitrage condition,

Alternative approaches to equity valuation

em-phasize wealth creation attributes rather than

models focusing on wealth creation naturallyuse accounting numbers as inputs

Earnings-Based Valuation

A widely used practical valuation technique is toestimate firm value as a multiple of current (orprospective) earnings Formally, this valuationapproach treats accounting earnings as if they are

‘‘permanent.’’ Kothari (1992), Kothari andSloan (1992), and others show that if earningsfollow a random walk and are fully distributed asdividends, value can be written as:

r

earnings valuation multiple is one over the quired rate of return on equity

re-The permanent earnings model underliesmuch of the market-based accounting researchliterature From a practical valuation perspec-tive, the main attraction of PEM is its relativesimplicity However, its limitations are primarilyrelated to the strong and unrealistic assumptionsthat must be made concerning earnings dynam-ics and dividend policy Specifically, earningsare known to contain transitory elements; andearnings are expected to grow depending oneconomic factors, accounting conservatism anddividend (or retention) policy

Practitioners inclined towards the use ofearnings multiples are known to take account

of earnings growth In particular, the price–earnings–growth (PEG) ratio, equal to theprice–earnings ratio divided by the short-termearnings growth rate, is a commonly used heur-istic for stock recommendations Easton (2004)provides formal analysis of the relation betweenequity values, earnings, and earnings growthrates, based on Ohlson and Juettner-Nauroth(2001) Starting from DDM, Easton shows thatthe value of a share can be restated in terms ofearnings as follows:

the abnormal growth in earnings in period

two main differences First, expected earnings in

capital-ized earnings term – the value of the equity is

‘‘anchored’’ to capitalized earnings Second, that

the share value also includes a component

re-lated to the expected abnormal growth in

Abnormal growth in earnings is defined relative

to a benchmark of normal accounting earnings

that would be expected given earnings in the

previous period, and after adjusting for

distribu-tions of earnings through dividends

Similar to DDM, Easton (2004) shows that it

is possible to simplify the general model PEGM

into a closed form valuation model expressed in

terms of information observable at time t, by

assuming a constant long run rate of change in

the abnormal growth rate for earnings, Dagr, as

Whether or not it is realistic to make such an

assumption will depend on the economic

cir-cumstances of a firm and the accounting

recog-nition rules it employs

The PEGM model takes account of potential

growth (or decline) in future earnings due to

economic factors, including retention/dividend

policy, and accounting recognition rules

Residual Income-Based Valuation

Preinreich (1938), Edwards and Bell (1961),

Peasnell (1982), Ohlson (1989, 1995), and

Fel-tham and Ohlson (1995, 1996) have

demon-strated how DDM can be recast in terms of

accounting numbers by exploiting the stylized

clean surplus relation This states that the

change in book equity value is equal to clean

surplus earnings (i.e., comprehensive income)

less dividends:

by the firm (i.e total dividends paid less any new

equity capital contributions) Note that while

earnings based valuation models in the previous

section tend to focus on per share valuation,

residual income valuation focuses on valuingthe total equity value of the firm (i.e the totalvalue of all its equity shares) Throughout thissection, all variables therefore refer to total(rather than per share) amounts

The DDM for the firm as a whole (where totalequity value is expressed as the present value ofexpected net dividends) can be rewritten usingCSR to give the well-known residual incomevaluation model:

income) at time t, defined as earnings less a

Under RIV the value of the firm is ‘‘anchored’’

to the firm’s book value and the target for casting becomes abnormal earnings

fore-An interesting feature of RIV (and other ation models that subsume RIV such as theOhlson (1995) linear information model dis-cussed below) is that although firm value is afunction of variables based on the accountingsystem, it works for any form of accounting aslong as clean surplus accounting holds It wouldwork, for example, if an accounting systemreports earnings equal to cash flow (i.e., accrualsare zero) RIV is also consistent with mark-to-market accounting because if assets arerecorded at fair value then expected abnormal

DDM and RIV all rely on the same arbitrage assumption and are equivalent giventhe additional clean surplus accounting assump-tions Both models should be equally reliable invaluing a firm’s equity, if applied using consist-ent assumptions and forecasts (Lundholm andO’Keefe, 2001a, 2001b; Penman, 1998, 2001).However, as in the case of DDM, fundamentalvaluation models are also subject to a forecastinghorizon problem requiring truncation of fore-casts at some arbitrary horizon and necessitatingestimation of a projected terminal value Bernard(1995) and Penman and Sougiannis (1998) pre-sent evidence consistent with RIV being moreaccurate in finite horizon practical applicationsbecause intrinsic value estimates are anchored

no-to book value The sensitivity of intrinsicvalue estimates to errors in the terminal value

calculation appears to be lower for RIV because

terminal value equals the discounted value of

abnormal earnings beyond the forecast horizon

in this case, and abnormal earnings are likely to

mean revert towards zero in a competitive

econ-omy (For further tests of the empirical

perform-ance of these models, see Francis, Olsson, and

Oswald, 2000; Lee, Myers, and Swaminathan,

1999.)

Linear Information Models

valu-ation to book value, RIV points to the

import-ance of forecasts in valuation and suggests

a further forecasting role for financial statement

numbers Abnormal earnings forecasts can

be derived using traditional financial statement

analysis techniques to forecast earnings and book

value Alternatively, statistical models can

be built that exploit persistence in abnormal

earnings and predictability by other accounting

numbers If accounting items are informative

as forecasting instruments, they will be relevant

and priced in valuation Garman and Ohlson

(1980) and Ohlson (1989, 1995) were the

first papers to demonstrate the possibility of

deriving closed form valuation linear models in

accounting fundamentals known at the valuation

date

The best-known linear information model

(LIM) is that of Ohlson (1995), who assumes

that the forecasting target in RIV, abnormal

earnings, follows the linear abnormal following

earnings dynamic process:

tþ vtþ e1tþ1

market value at time t which is reflected

in accounting numbers in future periods, ! is a

parameter capturing the persistence of abnormal

earnings, g is a parameter capturing the

zero expectation disturbance terms Ohlson

(1995) shows that assuming DDM, CSR, and

LIM1 leads to the following closed form linear

valuation function:

persistence of abnormal earnings increases,the valuation multiple on abnormal earnings in-creases

Equivalently, Ohlson (1995) also shows thatthe value of the equity can be written as aweighted average of a stock measure of value,book equity, and a flow measure of value, capit-alized earnings, adjusted for dividends, asfollows:

increases, the valuation multiple on earningsincreases and that on book value decreases.Ohlson (1995) demonstrates that his modeldisplays three noteworthy properties First, adollar of dividends reduces next period earnings

by r dollars Second, a dollar dividend reducesthe value of the firm by one dollar Thus, themodel is consistent with the Miller and Modi-gliani (1961) dividend irrelevance proposition.Third, the accounting system implied by themodel is unbiased, in the sense that any differ-ences between market value and book value areexpected to asymptote to zero in the long run.This final property stems from the fact thatabnormal earnings mean revert to zero in thelong run under O95–LIM

The Ohlson (1995) model implies no directrole for financial statement items beyond

‘‘bottom line’’ earnings and book value numbers.Yet financial statements contain many line itemdisclosures In a related paper, Ohlson (1999)shows how the valuation expressions O95–VAL1 and O95–VAL2 change when earningscontain a transitory component that is irrelevant

in forecasting abnormal earnings, is able, and is irrelevant in valuation Effectively,valuation expressions are identical in form toO95–VAL1 and O95–VAL2, with core (abnor-mal) earnings, excluding the irrelevant earningscomponent, replacing (abnormal) earnings andthe irrelevant component being netted offagainst dividends in O95–VAL2 Subsequently,Pope and Wang (2004) have shown that similarvaluation expressions involving the use of coreearnings as the relevant earnings construct for

valuation are applicable even when the irrelevant

non-core earnings component is predictable (see

also Stark, 1997)

model does not reflect the possibility that

ac-counting recognition rules are influenced by

application of the conservative (or prudence)

principle Balance sheet conservatism (or

uncon-ditional conservatism) leads to/involves

under-statement of (abnormal) earnings when a firm is

growing Accounting-based valuation must take

account of the conservatism attribute of

account-ing, if biased valuation estimates are to be

avoided

Feltham and Ohlson (1995) present a

valu-ation model allowing for conservatism in the

accounting for operating assets, based on

modi-fied linear information dynamics where expected

abnormal earnings depend on operating assets at

the beginning of the period as well as terms

similar to the first equation in O95–LIM:

persistence parameter on abnormal operating

other information variables relating to future

abnormal earnings and future net operating

assets respectively, with persistence parameters

disturbance terms Feltham and Ohlson show

that given FO95–LIM, the value of the firm’s

equity can be written as follows:

O95–VAL1, but with additional terms involvinginformation on operating assets Feltham andOhlson (1995) also derive a weighted averagevaluation expression similar to O95–VAL2 con-taining a conservatism adjustment depending onoperating assets:

where k is defined as in Ohlson (1995) Equityvalue depends on abnormal earnings and theirpersistence, as in Ohlson (1995), but also in-cludes a conservatism adjustment related to op-erating assets which increases with accountingconservatism and the expected rate of growth ofoperating assets The dividend irrelevance prop-erty of the Ohlson (1995) model is reflected inthe valuation coefficient on dividends beingequal to the valuation coefficient book valueminus one The assumptions relating to the sep-aration of financial assets and operating assetsmean that such dependence between valuationweights is not present in the Feltham and Ohl-son (1995) model The Pope and Wang (2004)model does not distinguish between financialassets and operating assets and derives abnormalearnings dynamics consistent with conservativeaccounting and dividend irrelevance

Feltham and Ohlson (1996) adopt a differentapproach to modeling accounting conservatismwithin a LIM framework They focus on thedynamics of cash flow fundamentals: operatingcash flow and cash investments Their cash flowdynamics LIM is as follows:

investments, g captures the persistence of cashreceipts, k captures the impact of cash invest-ments on future cash receipts, ! reflectsgrowth in cash investments, and all other vari-ables are defined similarly as above In thismodel the present value of future cash flowsgenerated from $1 of cash investment is thepresent value of a declining perpetuity and

charac-terize accounting accruals in terms of a

ation charge based on opening book value of

where d is the depreciation policy parameter

Assuming no financial assets or liabilities, clean

show that the following valuation expression

This valuation expression is similar to FO95–

VAL1 in that the value of the firm depends on

operating assets and abnormal operating

earn-ings, but there are two differences First, the

third term representing an adjustment for

accounting conservatism is based on lagged

operating assets If accounting depreciation

equals economic depreciation then g > d and

presence of the final term This reflects the net

present value of cash investments in operating

assets

Feltham and Ohlson (1996) also show that an

equivalent weighted average form of valuation

expression applies:

They further show that the model can be

modified to include other non-accounting

infor-mation about future cash receipts and cash

in-vestments; and to include the possibility that

depreciation policy may depend on other

infor-mation events Resulting valuation expressions

include additional terms based on other

infor-mation variables, but are generally similar to

FO96–VAL1 and FO96–VAL2

A significant amount of recent empirical

re-search has focused on the forecasting ability of

linear information models for abnormal earnings

and the properties of intrinsic value estimatesbased on linear information models in relation

to current and future market values – see, forexample, Ahmed et al (2000), Bar-Yosef et al.(1996), Begley and Feltham (2002), Callen andMorel (2001), Choi et al (2004), Dechow et al.(1999), Morel (1999, 2003), Myers (1999) Fur-ther discussion is beyond the scope of this chap-ter See also Richardson and Tinaiker (2004) for

a recent review of these and other related ical studies

empir-ConclusionsWhen one considers recent developments inpricing models for other securities (e.g., deriva-tives), it is remarkable that progress in the de-velopment of accounting-based equity valuationmodels has been so slow While the residualincome valuation model has been known to re-searchers for many years, a rigorous frameworkfor understanding how current period account-ing fundamentals might be linked to equity valuehas only started to emerge as a result of theseminal papers based on linear informationmodels of Ohlson (1989, 1995) and Felthamand Ohlson (1995, 1996) Anecdotal evidencesuggests that residual income-based valuationapproaches are now being adopted and adapted

by practicing analysts However, I believe that

remains to be done before a comprehensive counting-based valuation framework can beclaimed

ac-The residual income-based valuation proach underlying several models describedhere has important limitations First, it is highlystylized, having only two accounting inputs –earnings and book value It is silent on the po-tential roles in the valuation process for thenumerous line items contained in financial state-ments and accompanying footnotes Second, asOhlson (2000) points out, residual income-basedvaluation is unlikely to be valid on a per sharebasis because the clean surplus assumption willnot hold at this level if issuance of new dilutiveshares is expected Further, residual income-based valuation will only work at the total firmlevel if changes in equity capital are accountedfor at fair value This requirement would not besatisfied under current accounting rules forequity transactions such as pooling of interests

acquisitions and executive stock options Thus,

practical application of the residual income

valu-ation framework will require care At the same

time, the residual income framework can

pro-vide an insightful framework within which to

analyze accounting policy issues For example,

Landsman et al (2004) analyze accounting for

executive stock options accounting through a

residual income valuation lens and produce

results suggesting that all current policy

pre-scriptions fail to produce accounting numbers

that are directly useful for valuing current equity

claims

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acounting-based estimates of

the expected rate of return on equity capital

Peter Easton

The reintroduction of the residual income

valu-ation model by Ohlson (1995) and the

develop-ment of the abnormal growth in earnings model

by Ohlson and Juettner-Nauroth (2001) after, OJ, 2001) has been the impetus for a bur-

engineers these models to infer markets’ ations of the rate of return on equity capital Theobvious advantage of this reverse engineeringapproach is that the estimates of the expectedrate of return are based on forecasts rather thanextrapolation from historical data Prior to thedevelopment of these approaches, researchersand valuation practitioners relied on estimatesbased on historical data (estimated via themarket model, the empirical analogue of theSharpe–Lintner capital asset pricing model,

expect-or variants of the Fama and French (1992)three-factor model)

The practical appeal of these based valuation models (particularly the abnor-mal growth in earnings model) is that they focus

accounting-on the two attributes that are most commaccounting-only atthe heart of valuation analyses carried out bypracticing equity analysts: forecasts of earningsand forecasts of earnings growth The followingdiscussion (which relies heavily on Easton, 2004)provides an intuitive development of the abnor-mal growth in earnings valuation model that hasmany of the essential elements of the OJ (2001)model Gode and Mohanram (2003) and Easton(2004) rely on the essential elements of the OJ(2001) model to develop methods for estimatingthe expected rate of return on equity capital that

is implied by market prices and forecasts ofearnings and earnings growth

The Abnormal Growth in EarningsModel

The key elements of the abnormal growth inearnings valuation model are: (1) forecasts ofnext period’s accounting earnings, (2) forecasts

of short-run growth in accounting earnings fromthis base, and (3) expected growth in accountingearnings beyond the short forecast horizon Thedifference between accounting earnings and eco-nomic earnings characterizes the role of account-ing earnings in valuation

The derivation of the abnormal growth inearnings valuation model begins with the noarbitrage assumption:

where P0is current, date t¼ 0, price per share,

expected dividends per share, at date t¼ 1, r is

expected rate of return, and r > 0 is a fixed

constant Although equation (1) may be viewed

as a succinct statement of the no arbitrage

as-sumption, it may also be viewed as a definition of

expected return (r) even in a world where

arbi-trage opportunities exist Even under this

alter-nate view the analysis that follows calculates the

internal rate of return based on prevailing prices

and expectations of expected pay-offs

The central valuation role of forecasts of next

period’s accounting earnings is introduced by

adding (and subtracting) capitalized expected

focusing on the term that remains when

capital-ized accounting earnings is separately identified

Adding and subtracting capitalized accounting

earnings yields:

economic earnings (which may be defined as

to zero – in other words, next period’s expected

earnings are sufficient for valuation However, if

based on accounting earnings requires forecasts

beyond the next period

The role of two period ahead forecasts of

accounting earnings, may be seen by rewriting

earnings insofar as it is expected (period 2)

would be expected given earnings of period

earnings reflects the effects of generally acceptedaccounting practices that lead to a divergence ofaccounting earnings from economic earnings

and the ratio of expected earnings-to-pricewould be equal to the expected rate of return

An ExampleConsider Diageo plc (the company that manu-factures Guinness and other well-known bever-ages), which was trading at a price per share of

£7.40 at the end of its fiscal year (June 30) 2003

If Diageo’s expected rate of return was 10 cent, its expected economic earnings for 2004and 2005 would have been 74p and 81.4p, re-

were equal to economic earnings in these years,

0.1) Yet analysts were forecasting accountingearnings for 2004 and 2005 of 51p and 55p.The forecast of dividends for 2004 was 27p sothat cum-dividend accounting earnings for

words, the difference between expected dividend accounting earnings and expected eco-nomic earnings in 2004 and 2005 implies ac-counting earnings growth of 1.6p more thanthe expected rate of return on equity capital

cum-I will return to this example

The HorizonThe valuation role of expected accounting earn-ings beyond the two-year forecast horizon may

t¼1

That is, equation (6) shows that the present

differ-ence between price and capitalized expectedaccounting earnings

Equation (6) may be modified to date a finite forecast horizon by defining a

perpetual rate of change in abnormal growth in

earnings (Dagr) beyond the forecast horizon

In particular, if earnings forecasts are available

for two periods, equation (6) may be rewritten

as:

where

In equation (7), Dagr is the unique perpetual rate

of change in abnormal growth in earnings,

which, if known, would permit the estimation

of the internal rate of return implied by the

the expected rate of return is equal to the ratio of

be non-zero and Dagr captures the future

long-run change in abnormal growth in accounting

earnings to adjust for this difference between

accounting and economic earnings

Returning to the Diageo example, the

esti-mate of Dagr that equates the price of £7.40

and the forecasts of accounting earnings is 3

percent (This estimate is obtained by

recogniz-ing that, for this Diageo example, the only

un-known term in equation (7) is Dagr.) In other

words, 3 percent is the geometric average rate at

which the abnormal growth in earnings of 1.6p

will increase as accounting earnings eventually

‘‘correct’’ for the short-run difference between

accounting and economic earnings in the two

year forecast horizon The difference between

short-run forecasts of accounting earnings (51p

and 55p) and expected economic earnings (74p

and 81.4p) determines the abnormal growth in

earnings will change from this base at a

geomet-ric average rate (Dagr) of 3 percent in the future

and Dagr, suppose that the forecast of earnings

The forecast of earnings if this non-recurring

item had been removed would be 55.7p instead

of 55p This higher earnings forecast implies a

(zero) That is, accounting earnings growth of

2.3p greater than the expected rate of return onequity capital in perpetuity is sufficient to ex-plain the price of £7.40 In other words, thisperpetual growth in accounting earnings is suf-ficient for accounting earnings to eventually cor-rect for the difference between short-runforecasts of accounting earnings (51p and 55p)and expected economic earnings (74p and81.4p)

Special Cases: Reverse EngineeringThe PEG ratio, which is equal to the PE ratio

of growth in earnings expressed as a percentage

of this model (the PEG ratio is a common means

of comparing stocks in analysts’ reports) Thiscase, and a closely related special case, has beenused to obtain estimates of r Details follow

expected abnormal growth in earnings provides

an unbiased estimate of all subsequent periods’abnormal growth in earnings From equation (7)

it can be seen that this special case may bewritten:

equation (11) has two real roots, one of which

is positive Of course, the negative root is ingless

square root of the inverse of one hundred

r¼ ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi

p

(12)For the Diageo example,

p

¼ 7:4 percent:

expression of the expected rate of return on

equity capital as the inverse of the PE ratio,

implies an expected rate of return of 6.9 percent

As the proponents of the PEG ratio point out,

the estimates based on the PEG ratio (equation

12) are closer to the true expected rate of return

(10 percent)

(7) in order to invert the model to obtain an

estimate of the expected rate of return on equity

capital, Gode and Mohanram (2003) assume

Dagr is a cross-sectional constant equal to the

risk free rate of interest minus 3 percent Easton

(2004) circumvents the need for an assumption

about Dagr by simultaneously estimating r and

Dagr for portfolios of stocks

The Residual Income Valuation Model

The key elements of the abnormal growth in

earnings model (equation 7) are very similar to

the key elements of the residual income

valu-ation model that has been used to obtain

esti-mates of the expected rate of return in a number

of recent studies in the accounting and finance

literature The three elements of the abnormal

growth in earnings model – (1) forecasts of next

period’s accounting earnings, (2) forecasts of

short-run growth in accounting earnings from

this base, and (3) expected growth in abnormal

growth in earnings beyond the short forecast

horizon – have direct analogues in the

imple-mentation of the residual income valuation

model: (1) if book value is equal to market

value, book value (that is, the bottom line of

the balance sheet) is sufficient for valuation; (2)

if short-run forecasts of accounting earnings are

such that market value is equal to book value at

the end of the short forecast horizon, book value

and these forecasts are sufficient for valuation;

and (3) if short-run forecasts of accounting

earn-ings are not such that market value is equal to

book value at the end of the short forecast

hori-zon, a forecast of the rate of growth in residualincome beyond the forecast horizon is sufficientfor valuation

The finite horizon version of the residualincome valuation model may be written as

is the unique perpetual rate of growth in residualincome which, if known, would permit the esti-mation of the internal rate of return implied bythe current price, current book value, and fore-casts of earnings This residual income valuationmodel may be derived from equation (6) byassuming that the clean surplus relation holds

rearranging (The abnormal growth in earningsmodel is more general than the residual incomemodel inasmuch as the residual income modelmay be derived from the abnormal growth inearnings model but not vice-versa.)

Reverse Engineering the ResidualIncome Valuation Model

As with the abnormal growth in earnings model,analysts’ forecasts of earnings and current bookvalues may be used to determine an impliedexpected rate of return from this model Allattempts to reverse engineer this model require

an estimate of growth Claus and Thomas (2001)assume that earnings grow at the analysts’ con-

They assume earnings after year 5 grow at therate of inflation, which is set equal to the risk freerate less 3 percent Gebhardt, Lee, and Swami-nathan (2001) use actual earnings forecasts todevelop estimates of return on equity for years

1 and 2 They assume that accounting return onequity fades linearly to the historical industrymedian between years 3 and 12, and residualincome remains constant thereafter O’Hanlonand Steele (2000) and Easton et al (2002) cir-cumvent the need for an assumption aboutgrowth by simultaneously estimating r andgrowth for portfolios of stocks

Ohlson (2001) has pointed out that a possible

limitation of these studies is that many of them

rely on the clean-surplus assumption in the

fore-cast of future book values and this assumption

rarely holds as a practical matter Although the

residual income valuation model is becoming

more widely used by analysts, their reports still

pervasively focus on forecasts of earnings and

earnings growth rather than book value and the

forecasts of book value growth that are implicit

in the residual income valuation model In other

words, analysts’ reports have an earnings (or

income statement) focus rather than a book

value (or balance sheet) focus

Accuracy of the Estimates of the

Expected Rate of Return

Easton and Monahan (2004) examine variants of

most of the estimates of the expected rate of

return described in this discussion They show

that the extent of measurement error in

firm-specific estimates may be very large and they

suggest two reasons: (1) errors in analysts’

fore-casts of earnings, and (2) the assumptions about

growth beyond the forecast horizon may not be

reasonable In view of the usefulness of estimates

of the expected rate of return on equity capital,

the challenge is to refine the methods in such a

way as to deal with measurement error issues

Although the results in Easton and Monahan

(2004) suggest that caution must be exercised

when using firm-specific estimates of the

expected rate of return, their results do not

sug-gest that the average estimates for

groups/port-folios of observations are biased Nor do their

analyses assess the accuracy of estimates of the

expected rate of return that are obtained from

methods (such as Easton et al., 2002, and

O’Hanlon and Steele, 2000) that are specifically

designed for large portfolios of observations

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O’Hanlon, J., and Steele, A (2000) Estimating the equity risk premium using accounting fundamentals Journal

of Business Finance and Accounting, 1051–84.

Ohlson, J (1995) Earnings, book values, and dividends in equity valuation Contemporary Accounting Research,

11, 661–87.

Ohlson, J (2001) Residual income valuation: The lems Unpublished paper, New York University Ohlson, J., and Juettner-Nauroth, B (2001) Expected EPS and EPS growth as determinants of value Un- published paper, New York University and Johannes Gutenberg University.

prob-accounting for derivatives

Pearl Tan and Peter Lee

Financial derivatives are secondary financial struments that are derived from underlyingassets such as shares, bonds, commodities, andforeign currencies Financial derivatives can beclassified into generic types that include options,futures, swaps, and forward rate agreements(FRAs) Although the generic classifications are

few, the variations within each classification and

combinations of attributes across classifications

are overwhelming Through a process of

com-bination, repackaging, and variation of the

rights, obligations, and parameters inherent in

each derivative, new instruments are spawned at

a phenomenal pace (Lee, 1995)

Deregulation in the financial and commodity

markets brings about increased volatility that

leads to a demand for instruments that enable

firms to manage or even exploit those risks The

combined value of the turnover of

exchange-traded interest rate, stock index, and currency

contracts monitored by the Bank of International

Settlements (BIS) during the third quarter alone

was US$223 trillion and the notional amount of

outstanding over-the-counter (OTC) derivatives

at the end of the first half of 2003 was almost

US$170 trillion (BIS, 2003) Turnover of

ex-change-traded financial derivatives has almost

doubled over the period 2000–3

Regulators are concerned that the

unre-strained use of derivatives may lead to runaway

volatility and performance failures in financial

markets In July 1994 a key international panel of

banking regulators issued guidelines on

man-aging risk in derivatives The Basel Committee

on Banking Supervision puts the burden on

institutions to tighten internal controls on

de-rivatives and urges dealers and investors to

ob-serve basic principles of good risk management

that include supervision by boards of directors

and management, continuous monitoring of risk,

and comprehensive internal controls and audit

procedures

Why Do Companies Enter Into

Derivative Contracts?

A derivative is a two-edged sword On the one

hand, companies can use derivatives to protect

themselves from price and interest-rate

fluctu-ations by taking on an equal and opposite

pos-ition to that of an underlying exposure In

hedging through derivatives, exposed companies

effectively transfer their risk to their

counter-parties to protect their earnings and cash flows

from excessive volatility Alternatively,

com-panies can trade in derivatives In such

existing exposures but instead create new

expos-ures for the companies concerned

In the face of market imperfections, corporaterisk management (which includes the use ofderivatives for hedging purposes) may addvalue to a firm through lowering costs of finan-cial distress (Myers, 1977; Smith and Stulz,1985), mitigating managerial risk aversion(Stulz, 1984; Smith and Stulz, 1985), and redu-cing dependence on costly external debt marketsand under-investment problems by managingvolatility of internal cash flows (Froot, Scharf-stein, and Stein, 1993)

In their paper, ‘‘Why firms use currency rivatives,’’ Geczy, Minton, and Schrand (1997)found support for the notion that non-financialfirms with high growth opportunities and tightfinancial constraints used derivatives to reducevariation in cash flows or earnings to mitigate theproblems of under-investment and costly finan-cing Interestingly, they found that on average,their sample firms were not speculating withcurrency derivative instruments

de-Guay and Kothari (2003) examined the nitude of risk of non-financial corporationshedged through the use of derivatives Theirresults showed that most firms held derivativepositions that were small in relation to entity-level risks Hence, they concluded that firmsused derivatives in a limited way to ‘‘fine-tune’’

mag-a risk-mmag-anmag-agement progrmag-am thmag-at would includeother more ‘‘economically efficient hedgingstrategies’’ (e.g., operational hedges such as di-versification) One possible reason for thelimited use of derivatives as hedging instruments

by non-financial corporations is that standardderivative instruments deal with market risksand not operating risks to which these firms aremore heavily exposed

The above empirical studies show that tive use by their sample of non-financial firms ismainly for hedging purposes However, whenfirms engage in rampant speculative activity,the losses are potentially staggering, as evi-denced by a number of highly publicized deriva-tive-related corporate failures An example is theloss from the Nikkei Index futures trading thatcaused the collapse of Barings in 1995 A number

deriva-of unauthorized trades resulted in the building

up of a long position in Nikkei futures which wascontrary to general market sentiment followingthe Kobe earthquake in January 1995 The even-tual and expected fall of the Nikkei led to losses

that resulted in the demise of the Barings group

(Board of Banking Supervision, 1995)

Another example is found in the case relating

to Enron The company entered into derivative

contracts to purportedly hedge the volatility of

its ‘‘marked to market’’ investments (or what

Enron termed as ‘‘merchant investments’’)

The put option contracts were entered into

be-tween Enron and an Enron-controlled special

purpose entity (SPE) The intention of the

ar-rangement was to transfer losses to the SPE,

through the exercise of a put option, should the

stock price of a profitable ‘‘merchant

invest-ment’’ decline However, the SPE was financed

primarily with Enron stocks When Enron’s

stock price fell in value in late 2000 and early

2001, the SPE faced a liquidity crisis and could

not honor its obligations under the put option

(Powers, Troubh, and Winokur, 2002) Given

the relationship that Enron had with the SPE,

the ‘‘hedge’’ appears to be more in the nature of a

‘‘self-hedge,’’ which hardly qualifies as an

‘‘ef-fective hedge’’ under normal accounting

prin-ciples

Professional Accounting Standards

The two leading bodies that have undertaken the

task of regulating the accounting for derivatives

are the Financial Accounting Standards Board

(FASB) in the United States and the

(IASC) and its successor body, the International

Accounting Standards Board (IASB) The

FASB chose a more cautious approach by

carry-ing out its Financial Instruments project by

phases It commenced work on the project in

1986, with the first phase focused on improving

disclosure of information on financial

instru-ments Statement of Financial Accounting

Standard No 105, or SFAS No 105 (FASB,

1990) requires disclosure of financial

instru-ments with off-balance sheet risk and credit

risk SFAS No 107 (FASB, 1991) followed by

requiring firms to disclose market values of all

financial instruments, regardless of whether

these instruments are on-balance sheet or

off-balance sheet items These were followed by two

further standards, SFAS 115 (FASB, 1993) and

SFAS 119 (FASB, 1994)

However, the piecemeal approach drew many

criticisms because they were not consistent and

in many cases did not meet the objective oftimely recognition of the impact of using deriva-tives For example, Stewart (1989) points outthat the rules in accounting for futures are notsimilar in all respects with those of accountingfor foreign currency forward contracts In re-sponse to these criticisms, the FASB issuedSFAS 133, ‘‘Accounting for derivative instru-ments and hedging activities’’ (FASB, 1998), todeal with these issues on a comprehensive basis.Unlike the FASB, the IASC took a longertime to expose their proposed standards on fi-nancial instruments They tackled the FinancialInstruments project in a two-phase project Therelatively less contentious requirements relating

to financial instruments were included in IAS 32(IASC, 1995) The more thorny recognition andmeasurement aspects of financial instrumentswere included in IAS 39 (IASC, 1998) IA3 39was among the last ‘‘core’’ accounting standardsthat were completed to comply with the condi-tion set by International Organization of Secur-ities Commissions (IOSCO) for the latter’sendorsement of IASs for use in cross-borderlistings on securities exchanges in all majorcountries The adoption of IAS 32 and IAS 39

by national standard setting bodies is likely to be

a long process, particularly in the EuropeanUnion where existing national standards gener-ally do not require recognition of the fair values

of derivatives The European Union has warned

of a possible delay in taking up the full mendations of IAS 32 and IAS 39 Europeanfinancial institutions are apparently reluctant torecognize the fair values of derivatives on theirbalance sheets and there is serious objection tothe implementation of these standards

recom-Classification of FinancialInstruments

IAS 32 and IAS 39 classify financial instrumentsinto two broad categories: financial assets andfinancial liabilities, with each category being fur-ther subdivided All financial instruments arerecorded at cost at the time of initial recognition.However, the subsequent measurement basesdepend on the category of financial assets orliabilities Table 1 summarizes the measurement

the inevitable outcome of the increasing

import-ance being placed on information relevimport-ance and

the progress made in finance in the valuation of

financial instruments Furthermore, fair value

accounting facilitates assessment of the returns

from financial assets and prevents firms from

hiding losses and gains from changes in fair

value Derivatives such as forward contracts,

option contracts, future contracts, and swap

con-tracts are deemed as financial assets and financial

liabilities under IAS 39 although these contracts

are executory in nature The common

percep-tion of derivatives as being ‘‘off-balance sheet’’

instruments is therefore not supported by IAS

39

Hedging and the Treatment of Gains/

Losses from Derivative Instruments

In the absence of a hedging relationship,

deriva-tives are deemed as trading instruments in IAS

39 When derivatives are part of a hedging

rela-tionship, the matching of the gains/losses with

the underlying exposure is critical For example,

in a cash flow hedge, the gains/losses relating to

a derivative hedge instrument are deferred to a

future period and are not recognized in the

Income Statement in the period of the gains or

losses Difficulties in determining whether a

de-rivative is a hedging instrument are discussed in

Lee and Tan (1994) Complications include the

level at which hedge effectiveness is determined

(i.e., enterprise, divisional, or transaction level)and the special situations involving partial androllover hedges and the hedge of anticipatedtransactions

ac-counting is conditional upon hedge effectiveness

to be established at inception of the contract andthroughout the life of the hedge Techniques todetermine hedge effectiveness include criticalterm analysis, statistical analysis, and frequencyanalysis (Trombley, 2003) To assess effective-ness, a hedge or delta ratio can be worked out asfollows:

flows of the hedged item

Change in the fair value or cash flows of the hedging

being highly effective if the hedge ratio is withinthe range of 80–125 percent

Types of Hedges and Hedge AccountingIAS 39 has three broad classifications of hedges:cash flow hedge, fair value hedge, or hedge of anet investment

A cash flow hedge is a hedge of the exposure tovariability in cash flows that arises from a fore-casted transaction A fair value hedge, on theother hand, is the hedge of an exposure to changes

in the fair value of a recognized asset or liability, a

Financial assets

(a) Instruments held to maturity or for the

long-term

(b) Loans or receivables originated by the

enterprise

Amortized cost If there is a fixed maturity, effective interest rate method is to be used to recognize interest income Otherwise they are

to be measured at cost less provision for impairment loss.

To income statement

(c) At fair value through profit and loss

(e.g., trading securities)

Financial liabilities

firm commitment, or an identified portion of such

an asset or liability, that will affect reported net

income A hedge of a net investment is the hedge

of an exposure to changes in the carrying amount

of a foreign entity as a result of changes in foreign

exchange rates

The accounting for cash flow hedges and fair

value hedges differs because, as pointed out

pre-viously, in a cash flow hedge, the gains/losses

relating to a derivative hedge instrument are

deferred to a future period when the hedged

transaction occurs In the case of a fair value

hedge, gains and losses from measuring changes

in the fair value of the hedging instrument (and

the hedged item) are recognized in the profit and

loss account

Conclusion

Much progress has been achieved since the

mid-1990s The FASB has consolidated its various

standards under one umbrella standard The

IASC has also issued two critical standards after

a long exposure period While the United States

had a head-start with the implementation of

SFAS 133, the successor body of the IASC, the

IASB, has to work hard on the global acceptance

of IAS 32 and IAS 39 by national standard setting

bodies Further, while both the US and IAS

standards subscribe to the same underlying

prin-ciples pertaining to the accounting of derivatives,

further harmonization efforts are required to deal

with the specific differences that currently exist

Bibliography

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markets BIS Quarterly Review, December, 39–50.

Board of Banking Supervision (1995) Inquiry into the

Circumstances of the Collapse of Barings July 18.

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‘‘Disclosure of information about financial instruments

with off-balance sheet risk and financial instruments

with concentrations of credit risk.’’ Norwalk, CT:

FASB.

Financial Accounting Standards Board (1991) Statement

of Financial Accounting Standards (SFAS) No 107:

‘‘Disclosures about fair value of financial instruments.’’

Norwalk, CT: FASB.

Financial Accounting Standards Board (1993) Statement

of Financial Accounting Standards (SFAS) No 115:

‘‘Accounting for certain investments in debt and equity

securities.’’ Norwalk, CT: FASB.

Financial Accounting Standards Board (1994) Statement

of Financial Accounting Standards (SFAS) No 119:

‘‘Disclosure about derivative financial instruments and fair value of financial instruments.’’ Norwalk, CT: FASB.

Financial Accounting Standards Board (1998) Statement

of Financial Accounting Standards (SFAS) No 133:

‘‘Accounting for derivative instruments and hedging activities.’’ Norwalk, CT: FASB.

Froot, K., Scharftstein, D., and Stein, J (1993) Risk management: Coordinating corporate investment and financing policies Journal of Finance, 48, 1629–48 Guay, W., and Kothari, S P (2003) How much do firms hedge with derivatives? Journal of Financial Economics,

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evalu-48 Accounting and Business Review, 1 (2), 357–90 Myers, S (1977) The determinants of corporate borrowing Journal of Financial Economics, 5, 147–75 Powers W C., Troubh, R S., and Winokur, H S., Jr (2002) Report of Investigation by the Special Investiga- tive Committee of the Board of Directors of Enron Corp (February 1).

Smith, C., and Stulz, R (1985) The determinants of firms’ hedging policies Journal of Financial and Quan- titative Analysis, 20, 391–405.

Stewart, J E (1989) The challenges of hedge accounting Journal of Accountancy, 168 (6), 42–6.

Stulz, R (1984) Optimal hedging policies Journal of Financial and Quantitative Analysis, 19, 127–40 Trombley, M A (2003) Accounting for Derivatives and Hedging New York: McGraw-Hill.

Wall Street Journal (2004) Moving the market: Major economies at loggerheads over global accounting rules February 9.

accounting for human capital

Gilad Livne

The Conceptual ProblemFollowing major advances in information tech-nology and telecommunications, as well as in

applied sciences, researchers in accounting have

directed increasing attention to the valuation of

intangible assets (i.e., assets with no physical

presence) The motivation for this is that the

‘‘old’’ accounting model is inadequate to handle

reporting by ‘‘New Economy’’ firms whose main

assets are intangible Consequently, researchers

have tried to advance alternative reporting

frameworks to address the new challenges

posed by the New Economy But even prior to

the emergence on the New Economy,

account-ing researchers struggled with how to account

for human skill and talent, which is perhaps the

most important source of intangibles This could

be explained by the conceptual complexity of the

issue For example, ownership of human capital

cannot be enforced because employees are free to

leave at will, giving rise to the argument that,

unlike other assets, employees are not controlled

by companies and therefore cannot be

recog-nized in the balance sheet Complicating matters

even further, such expenditures are hard to

measure because they often do not involve

third party transactions (i.e., they are internally

incurred) Perhaps the most challenging

prob-lem is that investment in human capital involves

a great degree of uncertainty about the financial

and operational success of those activities Since

investments in highly risky projects cannot be

capitalized (i.e., reported on the balance sheet),

the traditional treatment of expenditures on

de-velopment of human capital (e.g., training,

ap-prenticeship, and incentive bonus) has therefore

been to expense them in the year in which they

are incurred However, this treatment has not

been universally accepted

The Labor Economics Literature

The main assumption made (explicitly or

impli-citly) by proponents of recognition of human

capital assets is that the firm is able to extract

some economic rent to investment in human

capital and that this rent recovers the original

investment The theoretical literature in labor

economics has identified a number of settings

where this may be the case The most widely

recognized example is given by Becker (1964)

He argues that only firm specific, as opposed to

general, investment in training will generate

rents to the investing firm This is because

such a skill can be used only by the investing

firm and not by other firms This, in turn, plies that the trained employee cannot extractthe rent because the skill is not transferable toother potential employers In the case of generaltraining, the argument goes, trained employeescan change employers to benefit from a pay rise.They will therefore be able to extract the rent tothe investment in training if their salary remainslow following training The training firm willanticipate this and therefore the cost of generaltraining will be deducted from employees’ salarywhile being trained and raised afterwards to thecompetitive level However, subsequent andmuch more recent research suggests that fric-tions in the labor market, such as search costsand restrictions on labor mobility, may give rise

im-to rent extraction by the investing firm, even forgeneral training (e.g., Acemoglu, 1997, and Ace-moglu and Pischke, 1999) This research there-fore suggests that, in principle, expenditures ongeneral training may also be capitalized.Early Theoretical Research inAccounting

The origin of the modern debate on humancapital accounting can be found in the literature

in the 1970s, which was stimulated by earlierwork of labor economists such as Becker.Then, a number of authors argued that lack ofrecognition of human capital is unsatisfactory.The early literature explores the question ofhow to measure the value of human capital Ofthis literature, notable studies include Lev andSchwartz (1971), Flamholtz (1971, 1972), Morse(1973), and Friedman and Lev (1978) Flam-holtz (1971, 1972) maintains that the value ofhuman capital is equal to the discounted value ofemployees’ services to the organization Ignoringthe problem of uncertainty, this value is essen-tially a function of an interaction between per-sonal attributes of the employees and the firm’sorganizational characteristics More specifically,Flamholtz (1971) presents a conceptual para-digm in which an employee’s future service is astochastic process, representing the employee’smobility within the organization Lev andSchwartz (1971) (hereafter LS) propose a differ-ent valuation method whereby the workforce ofeach firm should be divided into homogeneousgroups of employees, since each group exhibitsdifferent levels of personal earnings Summing

across these groups, the value of a firm’s

work-force is then equal to the discounted future

(expected) earnings of the members of each

group Note that according to LS the value of

human capital is a function of personal attributes,

as they are reflected in the wage profile of

homo-geneous groups of employees

Morse (1973) points out the difference

be-tween measures of human capital proposed by

Flamholtz (1971) and LS: the first is the value

that accrues to the firm whereas the latter is the

value that accrues to employees Total human

capital is the sum of the two and is shared

be-tween the owners of the firm and its employees

The stochastic approach first proposed by

Flamholtz (1971) to the valuation of human

cap-ital was further developed using Markov

pro-cesses by Jaggi and Lau (1974) and Friedman

and Lev (1978) (henceforth FL) FL propose a

proxy (or surrogate) for a firm’s stock of human

capital which is based on the difference between

the firm’s wage bill and the industry average

Lower than industry-average wage bill indicates

cost savings resulting from the firm’s specific

human capital policies FL provide the following

example to illustrate their measure: ‘‘Suppose a

given firm provides employees with subsidized

housing and consequently its annual wage bill is

$150,000 lower than the total wage bill it would

have paid based on average market wages The

value of the firm’s investment in employee

hous-ing is therefore the discounted value of the

stream of wage service ($150,000 per year,

as-suming no price changes) over the expected

ser-vice life of the workforce.’’

While each of the above mentioned studies

proposes a different valuation procedure for

human capital, they seem to agree that the

value of human capital should be reflected in

the financial statements This is because this

information may be useful to decision-making

processes by managers, investors, and other

stakeholders For example, LS suggest that

their method could help to assess the ratio of

human to non-human capital, indicate changes

in the underlying skill and talent composition of

the workforce, etc FL take a further step in

suggesting that an intangible asset should be

recognized in the balance sheet that is equal to

the estimated proxy under their proposed

method But not everyone agrees Dittman,

Juris, and Revsine (1976) seem to object to theidea that there is a need to account for humancapital Building on the distinction between gen-eral- and firm-specific training, they argue that

if human capital assets are to be recognized at all,

it is only in the case of firm specific training.Recent Empirical Research

After a long period in which no progress wasmade, the last few years have seen some signs

of revival of interest in accounting for humancapital This time, research has moved fromconceptual and theoretical considerations to em-pirically test issues related to accounting forhuman capital

Ballestar, Livnat, and Sinha (1999) attempt toquantify the percentage of labor costs that isregarded by the market as an asset (i.e., humancapital) Their sample is based on a subset of USfirms that voluntarily disclose such costs (under

10 percent of the population) Notwithstandingthe sample selection bias, they estimate that 16percent of labor costs represent unrecordedassets and the useful life of the human capitalasset is three years

There are perhaps only a small number ofcases where trading in employees’ talent andskill is carried out Amir and Livne (2004) exam-ine one such case in the context of the soccerindustry in the UK Here, soccer clubs have topay for acquiring the rights to employ playerscurrently under contract with another club.These payments, known as transfer fees, corres-pond to players’ perceived talent They are alsoreported in football clubs’ annual reportsallowing direct examination of human capitalassets Specifically, Amir and Livne are inter-ested in finding out whether transfer fees should

be treated as assets on the balance sheet Theevidence they provide only weakly supports cap-italization requirement, in that it indicates aweak association of investment in player con-tracts with three measures of future benefits(sales, operating income, and operating cashflows) The duration of this association is atmost two years, which is shorter than the dur-ation implied by the amortization periodreported by sample companies Nonetheless,other findings suggest that market participantsseem to agree with the treatment of capitaliza-tion All in all, the findings of this paper are

rather mixed with respect to the justification of

recognizing transfer fees as assets on the balance

sheet By implication, they cast doubt as to the

validity of recognizing human capital assets in

the balance sheet

Turning to the human capital of top

man-agers, Hayes and Schaefer (1999) look at stock

returns around separation of CEOs and other

top managers (non-CEOs) from their

com-panies In their sample, a separation can take

place as a result of death or change in

employ-ment when the executive moves to another firm

They postulate that firms whose CEO has

departed would seek to hire a replacement

CEO who is of high ability by attracting

incum-bent CEOs On the other hand, managers that

die while in service are more likely to have been

in the job for a long time This implies that it is

more likely the market had not valued their

talent, and therefore, their value to the

employing company is likely to be lower than

those managers who change employers

Measur-ing the stock returns around the separation date

comparatively for the two groups, Hayes and

Schaefer estimate that the median firm who

lost an executive to another firm experienced a

decline of US$1.8m dollars in their market

value, while the median firm whose manager

died experienced an increase in market value of

$3.7m While these figures seem to be relatively

small, they are suggestive of unrecognized

human capital assets (as in the case of managers

who changed jobs) or liabilities (as in the case of

managers who die while in service) One can also

conjecture that for the workforce as a whole, the

unrecognized amounts may be much higher than

just for the top managers

Abdel-kahlik (2003) attempts to construct a

managerial skill index from observed pay

schemes The basic idea is that more able

man-agers will select a pay scheme that has a greater

weight on the manager’s performance than fixed

salary (i.e., higher relative incentive

compensa-tion, or RIC) Abdel-kahlik develops a skill index

that is based on a number of individual traits,

such as experience and risk preference, as well as

firm specific characteristics that potentially

cap-ture the effectiveness of the manager’s skill

util-ization The latter set of variables includes

profitability and growth measures, among other

factors A regression analysis of RIC on these

variables provides the weights needed for thepurpose of constructing the skill index in subse-quent years In the final stage of the analysis,Abdel-kahlik shows that the skill index is posi-tively related to market value of the employingfirm and concludes that, since human capital isnot included in the balance sheet, the marketregards these skills as off-balance sheet assets

A possible technical issue in relation to thisresearch design is the extent to which thesevariables capture skill rather than other personaltraits such as experience and the CEO’s powerover the firm’s board

Regulation and Standard SettingWhile existing accounting standards still do notexplicitly allow recognition of internally de-veloped human capital assets (e.g., training),recent standards have opened up the possibilitythat in certain cases investments in human cap-ital would show up on the balance sheet More

(FRS) 10, Goodwill and Intangible Assets, bythe UK’s Accounting Standard Board, requirescapitalization of intangibles that were purchased

in an arm’s length transaction This requirementforced soccer firms in the UK to abandon apolicy of immediate expensing of transfer fees

in favor of capitalization FRS 10 also allows forcapitalization of intangibles obtained through anacquisition of another entity Thus if the pricepaid for the target entity contains an element forskilled workforce, it is conceivable that suchelement can be capitalized This is indeed anidea that the US Financial Accounting StandardBoard (FASB) seems to have opened up to quiterecently Specifically, in Section B37 of State-ment of Financial Accounting Standard (SFAS)

142, Goodwill and Other Intangible Assets, theFASB allows the recognition of specially trainedemployees as an intangible asset if they wereacquired individually or with a group of assets

in a transaction other than business combination.However, it remains to be seen if any company is

to follow this route

ConclusionDue to the complexity of the issue at hand, theaccounting literature on human capital has notdeveloped much It has yet to establish the em-pirical validity of the valuation models proposed

for human capital by early studies Researchers

face another challenge in this area: identifying a

dataset that provides expenditures on training by

a large number of firms over a sufficiently long

period This could allow an investigation of

whether training related expenditure satisfies

the accounting definition of assets This research

has the potential to change or support current

accounting rules, such as International Standard

(IAS) 38, Intangible Assets, which prohibit

cap-italization of expenditure on training

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accounting for intangibles

Alison Thomas

We all have views on the sort of things that lie

at the heart of a successful business today.The typical list would include well protectedpatents, dominant brands, a flexible organiza-tional structure, a talented and motivated work-force, an excellent reputation, a culture thatfosters innovation, and so on Harnessing thesecompetencies and resources is essential for eco-nomic growth; disregarding them, a recipe forfailure

Without an appropriate framework for ing the skill with which management have ex-ploited these fundamental building blocks ofsustainable business success, investors are leftuncertain where to deploy capital Innovation isthereby stifled And, ultimately, societal wealthsuffers And yet that is precisely the situationthat we are in: the current financial reportingmodel provides the investor with no lens on theintellectual capital or intangible assets of a com-pany This must change

assess-Relevance LostThe current financial reporting model started toevolve in earnest at the turn of the last century

At this time, demands for large amounts ofcapital to support a growing base of mass manu-facturers necessitated a shift away from the pre-viously common organizational model of theowner-manager to the inclusion of externalsources of funds As ownership became moredispersed, there grew a need to develop a mech-anism that would allow those who provided cap-ital to monitor performance Was their moneybeing efficiently deployed? Were the returns up

verifiable financial measures that were designed

to provide investors with a way of assessing:

The reporting model that emerged at this time

thus offered a lens on corporate performance

that allowed a relatively efficient allocation of

capital among competing investment

opportun-ities A mass manufacturer that has a high return

on assets and a low marginal cost of production

is more likely to prosper, regardless of the

eco-nomic environment, than less efficient peers

Investment decisions based upon this

informa-tion thus favor the strong over the weak

Conse-quently, in the era of the mass manufacturer, the

financial reporting model did its part to insure an

efficient allocation of scarce resources, to

en-hance the productivity of nations

However, the world did not stand still

Today, service industries dominate the

indus-trial landscape Typically, success in these

enter-prises is not dependent upon a large fixed asset

base Indeed, for many such companies, the

value of plant and equipment is trivial Instead,

the business model today is critically dependent

upon other factors of production – in particular,the management of intangible assets such asbrand, employees, and the capability of thefirm to innovate This is graphically illustrated

by the schematic of business today shown infigure 1

As figure 1 illustrates, we are in a worldwhere it is the company’s ‘‘latent capabilities’’and ‘‘intangible competencies’’ that allow other-wise inert tangible and intangible assets to beexploited In this environment, it is the peopleemployed, the reputation of the firm, the know-how underpinning a successful innovationstream, that are the sources of sustainable com-petitive advantage

As the sources of competitive advantagechange over time, so do the informationalneeds of the investor A company that growsearnings today by cutting back on investment

in staff training or a customer relationship agement system is a very different investmentproposition than one that grows earnings despitemaintaining a high level of investment in thesedrivers of future prosperity Investors will want

man-a reporting mechman-anism thman-at man-allows them to tinguish the first company from the latter With-out such a reporting mechanism, they willstruggle to differentiate good management

dis-www.EUintangibles.net

The resources of 21st century businesses

CAPABILITIES Leadership Workforce calibre Organizational assets (including networks) Reputation Market opportunities R&D in-process Corporate renewal capability

COMPETENCY MAP Distinctive competences Core competences Routine competences

MATERIAL SUPPLY CONTRACTS Licenses, Quotas &

Franchises

REGISTRABLE IPR

Copyright or patent protected ‘originals’ -film, music, artistic, scientific, etc including market software

Trademarks & Designs

3.

Intangible competences

4.

Latent capabilities

Measurable in $’s -Disembodied Embodied -Immeasurable in $’s

Potentially unique competition factors that are within the firm’s capability to bring about

Non-price factors of competitive advantage Rights that can be

bought, sold, stocked and readily traded -and, can be, more or less, protected

Physical assets where

ownership is clear and

from bad, luck from skill They will be unable to

differentiate between a strong investment

prop-osition and a weak one The scarce resources of

the economy are thus inefficiently allocated

Economic growth is impaired

Consider the UK government’s longstanding

recognition of a systemic lack of investment in

the intangible drivers of the future productivity

of the nation Summarized in the R&D

Score-board, they are proactively trying to understand

the barriers to this source of economic

prosper-ity Consider also the the attempt by the Danish

Department of Trade to experiment with

intel-lectual capital statements Or, more recently, the

Extended Business Reporting initiative that has

grown from a small group of interested parties in

the American Institute of Certified Public

Ac-countants to a global consortium that embraces

all stakeholders in the corporate reporting

supply chain

These bodies all recognize both the upside

and the risk of the truism that ‘‘what gets

meas-ured gets done.’’ Measure the wrong things,

leave invisible the assets that underpin good

long-term corporate performance, and

invest-ment goes awry Get the reporting mechanism

right and the productive are rewarded; relative

economic prosperity results

So how close is the current reporting model to

piecing together the picture of corporate

per-formance that is needed in today’s economy?

And what is left to be done?

Building on the Past

With its focus upon those factors that are critical

for the evaluation of the performance of a

large-scale commodity industry – return on fixed

asset, inventory position, marginal unit cost of

production, and so on – the current financial

reporting model finds its roots firmly in the

first chevron of figure 1

However, as the relevance of the reported

financial numbers in understanding corporate

performance has declined (Elliott, 1995; Collins,

Maydrew, and Weiss, 1997; Lev and Zarowin,

1999), standard setters have tried to adapt

existing accounting concepts to intangible assets

In the US, for example, Financial Accounting

Standard (FAS) 142, ‘‘Goodwill and other

in-tangible assets,’’ has pushed the scope of the

current reporting model into the second of the

chevrons in figure 1 – the intangible goods area.This accounting standard, adopted in thesummer of 2001, was a bold step towards trying

to encapsulate some of the unique features ofintangible assets

In keeping with previous standards, FAS 142allows companies to recognize the goodwillcreated during an acquisition on the balancesheet Thus, if a company pays $2bn for a com-pany whose physical assets amount to just $1bn,the difference, $1bn, can be placed on the bal-ance sheet More controversial, however, is theattempt to enshrine in the standards the fact thatintangible assets do not depreciate in the sameway as plant and machinery A brand name, forexample, is not likely to exhibit the same depre-ciation characteristics as a machine Conse-quently, under FAS 142, companies are nolonger required to depreciate an intangibleasset over a set period Instead, they are to bewritten down only if the value is deemed bymanagement and the auditors to be ‘‘impaired.’’This is a significant departure from the trad-itional model

So, provided there is some market or apparentmechanism of exchange for an intangible asset, it

is possible to extend the traditional transaction

or value-based model to intangibles That doesnot mean that all the practical difficulties inher-ent in this extension of the financial reportingmodel have been ironed out How can we tell ifthe intangible assets are ‘‘impaired’’ and thusshould be written down? Are management andauditors the best arbiters of value in the yearsthat follow the acquisition of the intangibleassets? However, despite these ongoing areas ofdispute, the possibility of extending the currentframework of evaluation to such assets, thesecond chevron of figure 1, is not beyond therealms of imagination

But where does that leave the last two rons in figure 1 – the sources of competitiveadvantage? Here the transaction-based frame-work that underpins current reporting modelsstarts to strain

chev-Intangible ProblemsWhen a mass manufacturer wishes to signalits long-term strength, it needs to demonstratethat it generates an adequate return on its hugebase of fixed assets and that it is a low-cost

manufacturer But when a technology company

wishes to signal its future prospects, how can it

convey the strength of its intellectual capital

base? In contrast to physical assets, intellectual

capital derives much of its value from unique

characteristics: it can be deployed

simultan-eously in multiple tasks, it can have increasing

returns to scale (because knowledge is

cumula-tive), and it grows through waves of

communi-cation in which all participants learn (customer

tells designer who tells engineer who tells R&D

director who tells customer who )

Despite these highly differentiated attributes,

intangibles could still be valued if there were an

organized exchange where they trade However,

this is not typically the case Furthermore, even

if there were some pricing mechanism, one

would have to address the issue of property

rights Except in the case of intellectual property

protected by a watertight patent, the ownership

of intellectual assets is often in question This

makes them inherently more risky than physical

assets

Does that mean that we will have to accept

that these areas will remain obscure to the

out-side world, that they will not be capable of

sys-tematic assessment? I would argue not

Grasping the Intangible

research in the field of intangible asset evaluation

tried to apply old reporting model concepts to

new world assets Comfortable with the concept

of a balance sheet where all assets and liabilities

are made visible, attempts have been made to

describe a routinized method for placing a value

on the intangible assets of the firm, even when

no transaction has occurred

Lev (2001) has argued that it may be possible

to value intangibles through the use of a

produc-tion funcproduc-tion

þb(Financial Assets) þ d(Intangible Assets)

where a, b and d represent the contributions of

a unit of asset to the enterprise performance

Given that physical and financial assets are

routinely evaluated by existing reporting

tech-niques, and given that one can ‘‘estimate normal

rates of return,’’ the contribution of the gible can be evaluated

intan-Although it is an interesting conceptualframework, Lev’s methodology remains insuffi-ciently tested in ‘‘real world’’ settings for invest-ors to have confidence in the reliability of theestimates of the coefficients employed and theunderlying model used to define normal rates ofreturn

This has driven others to reexamine the veryconcept of corporate reporting, pushing theboundaries of the traditional financial-basedframework to a broader basis of measures thatcan combine to present an overall picture ofcorporate – and not just financial – health.Venturing Beyond the Balance SheetOne of the earliest attempts to develop a holisticframework for reporting arose from the work ofthe Brundtland Commission In 1987 its reportentitled ‘‘Our Common Future’’ introduced thenow ubiquitous phrase ‘‘sustainable develop-ment.’’ This report emphasized the idea thatbalance and equity are essential for long-termdevelopment This fundamental tenet has beendeveloped by SustainAbility into what is nowknown as the triple bottom line Triple bottomline (TBL) encourages the expansion of trad-itional financial measures of success to a broaderunderstanding of performance Economic pros-perity, they contest, should be assessed alongsidemeasures of environmental quality and socialjustice

TBL has made a significant impact on thereporting world, with Shell’s high profile adop-tion of the framework sealing its credibility.However, the SustainAbility model was insuffi-ciently prescriptive to allow stakeholders tocompare performance over time and amongpeer groups Overcoming this limitation wasone of the motivations for the formation of theGlobal Reporting Initiative (GRI)

Originally convened by the Coalition for vironmentally Responsible Economics (CERES)and the United Nations Environment Program(UNEP), GRI is one of the most ambitiousefforts to develop a set of non-financial stand-ards It is a long-term, multi-stakeholder initia-tive, which aims to develop and disseminate

guidelines Companies can then use the

lines voluntarily to make visible their

manage-ment of the triple bottom line

Implementing the GRI is not without its

con-ceptual and practical difficulties Most notable

of these is the fact that its long list of measures

encourages some companies to ‘‘tick boxes’’

rather than communicate corporate performance

in a clear and concise fashion Despite this

limi-tation, the number of companies that report

using this framework grows each year

An alternative and highly practical attempt to

extend the corporate reporting model has been

driven by a joint taskforce established by the

Danish Trade and Industry Development

Council and the Copenhagen Business School

To investigate how one might report intellectual

capital (IC) they have encouraged leading

Danish companies to experiment with various

IC reports The intention has been to develop

an understanding of best practice so that

reporting standards may be established

The ten IC accounts studied by the Danish

taskforce all differ in their detail but share

common features which can be broadly split

into three categories: ‘‘what there is,’’ ‘‘what is

done,’’ and ‘‘what happens.’’ In the first, there is

some visualization of the company’s resources,

customers, and technology Under the second

heading, there is an attempt to describe the

processes that drive value creation by this asset

class Thirdly, there is an attempt to revealwhether the company is able to utilize the op-portunities offered by intellectual capital devel-opment and management

While it is an exciting long-term initiative, theDanish focus upon intellectual assets arguablylacks an integrated framework that brings to-gether all facets of corporate performance: intel-lectual, physical, financial, and intangible It isthe ambition to provide a framework forreporting overall corporate performance thatcurrently underpins work by Pricewaterhouse-Coopers in this area

In its Value Reporting initiative, houseCoopers has spent six years trying to build

Pricewater-an understPricewater-anding of the type of information that

is needed to communicate corporate ance Through a series of global industrysurveys, they have asked CFOs, sell-side ana-lysts, and investors to identify those factors thatthey consider critical for success for a givenindustry The results of these empirical analyseshave been codified into the Value Reportingframework (Eccles et al., 2001) The genericversion of this framework is given in Figure 2.From this, it can be seen that users of thecorporate reporting model are looking for fourbasic building blocks of information The first,the market overview, involves an analysis of theeconomic and competitive landscape of the firm

Customers People Innovation Brands Supply Chain Environmental, Social and Ethical

Financial Position Risk Profile Economic Performance Segmental Analysis

Figure 2 The Value Reporting Framework

Source: Pricewater giyse Coopers