June 15, 2005 | Opinion

Shareholder value accounting

Stephen Penman explains how shareholder value accounting, an approach designed to accurately track the value of shareholders’ assets and liabilities, differs from traditional accounting methods.

Topics: Accounting

What is shareholder value accounting, and how does it differ from generally accepted accounting principles (GAAP) and other methods of accounting for stock options and related claims?

Shareholder value accounting (SVA) is accounting that reports faithfully to the shareholders. It’s a form of accounting that has as its primary goal reporting to the shareholders about what their earnings are and what their assets and liabilities are. GAAP accounting keeps track of the assets and liabilities of the firm, rather than those of the shareholders. If a firm borrows by writing a claim on the shareholders’ equity, GAAP doesn’t record that. If a firm pays off a loan by issuing stock at less than market value, GAAP doesn’t record that as a loss to the shareholders. GAAP doesn’t have the shareholders’ interests at heart.

Why and how did you develop this method of accounting for shareholders?

This notion of reporting to shareholders has been around for many years. Shareholder value accounting is really just a renaming of what for years was called proprietorship accounting, and that contrasted with entity accounting — accounting for the firm. It’s very important because management can easily confuse their own interests and the shareholders’ interests. The accounting reports are presented to the shareholders at the annual meeting — the auditors report to the shareholders — so the accounting should report to the shareholders.

Some of the details that we bring out with respect to options and so on are new details, but the idea that you report to shareholders and track losses and gains to them and their profits is the proprietorship notion. I think there’s more emphasis now, particularly since the accounting scandals a few years ago, to make sure that the shareholders’ interests are looked after. The U.S. Securities and Exchange Commission (SEC) is backing shareholder reporting. Boards now have got to be much more focused on protecting shareholders’ interests. That was always the case — boards’ basic duty is to the shareholders; that’s their fiduciary duty under law — but the mind-set wasn’t quite in place.

Why wouldn’t accounting be the same regardless of interests?

The core of the issue is defining what is a liability. Under GAAP, a liability is defined as anything that’s going to require a dispersal of cash or assets to satisfy the obligation. If a firm borrows from a bank and has to pay the bank back with cash, the loan is a liability. But if a firm borrows and says, “I’m going to pay you back with shares,” it doesn’t record that as a liability. If you were a shareholder, you’d be sort of upset by that, because you’re going to lose some value.

If you and I are two shareholders in a firm and our shares are worth $50 million each, if we give someone else a third share of the firm, the value of our shares goes down. We now own a third of the firm rather than half of the firm, and it’s still only worth $100 million. If we charge that person $50 million to come into the firm, we issue the shares at market value, so there’s no loss.

The issue is issuing shares at less than market value to satisfy liabilities. Firms do that when they pay employees with stock options, because when the options are exercised the shares are issued at less than market value. They do that when they borrow with warrants: when those warrants are exercised, they’re issued at less than market value. A few years ago, Dell computer had put options that required the firm to repurchase shares at $44 per share, when they were only worth $24 — that’s obviously a loss to the shareholder. That should be recorded as a loss, and the liability to issue shares should be recorded as a liability, even though it doesn’t require cash.

The three basic principles underlying SVA are proprietorship, completeness and timeliness. You just talked about proprietorship. Can you talk about the other two?

Given the proprietorship perspective, everything that affects shareholders should be recorded. The Financial Accounting Standards Board (FASB) and the SEC sometimes talk about comprehensive income. Completeness means your earnings should be complete or comprehensive with respect to everything that affects the shareholders. Under current GAAP accounting for employee stock options, something is left out: the cost to the shareholders of paying employees with options. So completeness means that everything that affects the shareholder is brought into the accounts. Therefore, there’s a complete reconciliation between what’s in the account and the stock price.

Timeliness means you should do it on a timely basis — there’s no use waiting until the firm has crashed. So if you incur some of these liabilities, we want to know now and we want to know the value of that liability. If the value of that liability changes, we want to know about it. If you write an option or you write warrants and these things go into the money — so they’re more likely to be exercised and you’re more likely to have to issue shares that are less than market value — we want to know about that. We want the liability revised upward and restated. So for every accounting report, we’ve got an indication of what is the expected value of the loss that the shareholder is going to incur.

SVA is obviously in shareholders’ interests. Who else benefits?

It’s certainly in the regulators’ interests, because the SEC has a mandate for this sort of thing. The FASB and the International Accounting Standards Board (IASB) have to take a position as to whether they want to faithfully report to shareholders or not. If they’re running other accounting, they’re going to realize that they’re actually violating the notion of faithful reporting to shareholders.

It might not be in managers’ interests. In fact, part of the role of accounting is to protect shareholders from management. If managers are faithfully performing their duties and being good stewards for shareholders, they should like this. Now, that’s going to mean their profits are going to be lower, typically. Those who fought any aspect of employee stock-option accounting — people who say it’s going to make us face lower profits — are confused, because there are lower profits for the shareholders if you look at earnings per share.

Management tends to have a firm view: this is not an expense, because I don’t have to pay cash for it — all I have to do is give some paper to the employees or to myself. It looks like it’s free to them. But it’s not free to the shareholders, because you’re giving away their paper. If you have lower profits, you should report lower profits. It’s more accurate and more transparent. There’s an element of truth telling, though I don’t like to use the word truth, because accounting is always approximate. If the firm’s having losses, as a shareholder you want to know so you can dump your shares or do whatever you want to do.

Have any companies started using SVA?

No. They’re now required — or will be required in 2005 — to book an expense when employee stock options are granted. Options are typically granted at the money. So if the stock is trading at $25 and you’re an employee, I give you an option that gives you a right to buy that stock at $25. If it goes to $35, you exercise the option and you make money. The fact that it might go into the money is of value. That amount, which is based on the chance that it will go into the money, is the option value. That’s recorded as an expense. But if it goes from $25 to $35 to $45, the shareholders are going to lose a lot more. That change is not recorded at all. That’s our proposal: that you should recognize that change also as a loss.

What would you like to see companies do, beyond what is required of them?

I’d like to see them record the option value as an expense when the options go into the report. As the option goes into the money, I’d like to see them record losses from having issued these options and accordingly increase the amount of the liability. Under the FASB and IASB proposals, when the option is issued, the expense is recognized but it’s just treated as equity, which does not make sense at all. When you record it as a liability, if the option went into the money, you would mark it to market, or fair-value it. Then the liability would be extinguished, and you’d have the realized loss on the exercise of the option.

Under the FASB proposals, if you lose your option at the money and it never goes into the money, you’d recognize an expense that never actually occurs. So they’re overstating the expense. Our accounting would recognize the expense, and if it doesn’t go into the money, you ultimately have a gain or reversal of the expense, because the option wasn’t exercised. One of the features of good accounting is always a truing up to value. The FASB never trues up to what the stock price is, and the stock price is what the shareholders are interested in. Our accounting trues up to the stock price.

In a capitalistic society, where you’ve got a separation of owners from management, you need very good accounting to keep track of the shareholders’ value. Certain things are necessary for capitalistic societies to work. One is you’ve got to have a good legal system so you can sort out disputes. You’ve got to have good contract law, and that basically enforces property rights. The second thing is accounting. When you’ve got corporations, the owners are separate from the management, and shareholder value accounting is very much an imperative.

 

Stephen Penman is the George O. May Professor of Accounting, the Morgan Stanley Dean Witter Research Scholar and codirector of the Center for Excellence in Accounting and Security Analysis at Columbia Business School.

Read the Research

James Ohlson, Stephen Penman

"Debt Versus Equity: Accounting for Claims Contingent on Firms' Common Stock Performance"

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