Value Valuation and Standards Shyam Sunder Yale University

Value , Valuation and Standards Shyam Sunder, Yale University Seoul National University, Seoul Korea, February 6, 2007 Accounting: Value and Valuation

Three Parts • Econometrics of Fair Values – Language of Debate: Labels Matter – Transforming a qualitative debate into a quantitative debate about econometric estimators of unobserved parameters of interest – Reflexivity of standards and practice in financial reporting • Accounting and Control: Creation of Value and Valuation of Stakes – Accounting and control serve dual functions creating value, and valuation of stakes – Both functions are important and mutually dependent: if accounting does not help create value, there would be nothing for shareholder value – Recent attempts to emphasize valuation at the expense of stewardship are ill-conceived, and should not be pursued (FASB) 12/3/2020 Accounting: Value and Valuation 2

I. Econometrics of Fair Values Accounting: Value and Valuation

An Overview • Language of Debate: Labels Matter • Transforming a qualitative debate into a quantitative debate – So we, as researchers can add value to social policy through evidence on falsifiable propositions (beyond mere opinions) • A framework and results to – View valuation methods as econometric estimators of unobserved parameters of interest – Choose estimators on the basis of their objective properties, not opinions of one expert or another – Identify key determinants of dominance between historical and current values: degree of price instability and magnitude of measurement errors • Reflexivity of standards and practice in financial reporting • Time Permitting: American Accounting Association 12/3/2020 Accounting: Value and Valuation 4

Labels Matter • What is common to: – Unified Budget Act (1964, Lyndon B. Johnson) – Patriot Act (2002, George W. Bush) – Fair Values (1999, FASB) 12/3/2020 Accounting: Value and Valuation 5

“Pernicious changes with deceptively reassuring titles” • Choose labels to put potential opponents on defensive before the debate begins • Oldest trick in the book of policy rhetoric – Johnson wanted to use the social security surpluses to finance increased spending on Great Society programs and the Vietnam War (who can argue for non-unified budget? ) – Bush wanted to fight the war on terror (who is against patriotism? ) – FASB wants to use current values (who can be against fair values in accounting? ) • “Fair” is a personal judgment, not a fact • To avoid misuse of language, put the rhetoric of “fair” aside, and talk about current values of which generations of accountants and researchers have thought and written about 12/3/2020 Accounting: Value and Valuation 6

The Proposal • The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date – Orderly transaction, not forced liquidation or a distressed sale – From eyes of a market participant, no entity specific assumptions – Highest and best use framework from the perspective of market participants even if the acquirer has different plans 12/3/2020 Accounting: Value and Valuation 7

The Valuation Debates • Relevance to investment decisions • Relevance to stewardship, management of enterprise resources, and contract enforcement • Other criteria for evaluation: reliability, bias, timeliness, representational faithfulness, cost of implementation 12/3/2020 Accounting: Value and Valuation 8

Qualitative versus Quantitative • Valuation debates have been largely been about qualitative characteristics of rules • Without a framework for quantified comparison, debates can go on for ever – People don’t change their minds – Theories are supposed to die only with their proponents (“science advances funeral by funeral”) – Even that is not true in case of fair values – Resurrection of current values under the new label after an interval of almost 70 years • How do we bring an element of quantified rationality to this debate? 12/3/2020 Accounting: Value and Valuation 9

Econometrics • Great achievements of econometrics arise from our willingness to – Postulate an underlying structure and unknown parameters of the problem – Characterize the properties of alternative estimators (e. g. , OLS, GLS, 2 SLS, etc. ) as a function of the underlying environment – Choose an estimator appropriate to the postulated environment – Use data to estimate the unknown parameters, holding the structure constant – Examine propositions about the underlying parameter on the basis of estimates – Use alternative datasets of examine the propriety of assumed structure – When found inappropriate, change the assumed structure 12/3/2020 Accounting: Value and Valuation 10

Econometrics of Valuation • Can we use a similar strategy for documenting the properties of valuation rules in various environments? • It may not entirely get rid of judgments • But still, will move the debates among valuation rules from the domain of opinion into data • Let me explain, starting with one postulated structure • Remember, we can always change the postulated structure if we find a better one later • For now, let us focus on thinking about choice of valuation rules as we think about choice of econometric estimators 12/3/2020 Accounting: Value and Valuation 11

Postulated Structure • There are many resources in the economy (vector ω) • Each firm is a special bundle of some or all of these resources--a vector of proportions (vector w) • Current values of resources are subject to change over time: relative changes have a given mean vector (μ) and covariance matrix (Σ) • Historical costs of resources in the bundle are known • Relative changes in current values of the resources are observed with an (unbiased) error term (vector ε) which has covariance matrix (Δ) 12/3/2020 Accounting: Value and Valuation 12

Two Sources of Error in Valuation • Consider two sources of error in valuation of a bundle of resources – Values change over time but the valuation rule ignores these changes (price movement errors) – Current values we use to revalue the bundle are prone to errors due to imperfection and incompleteness of markets (measurement errors) 12/3/2020 Accounting: Value and Valuation 13

Choose a Metric and Magnitude of Errors of Valuation Rules • Let us focus on the expected mean squared error as the metric of errors (used in most econometrics; we could also use bias or other metrics) • Magnitudes of the errors depend on – Parameters (Δ, Σ, μ, and ω), and – Valuation rule used to adjust historical to current values • The space of valuation rules is very large; even linear subject is huge; let us just focus on the three elements of this subset (historical cost, general price level and current value) 12/3/2020 Accounting: Value and Valuation 14

Historical Valuation • Has price movement errors because it ignores changes in prices from the time of acquisition to present • The size this error (MSE) depends on parameters of the economy: – The mean of the vector of relative price changes (μ), and – The covariance matrix of the vector of relative price changes, (Σ) • Greater the “magnitude” of these two parameters, greater is the movement error associated with historical valuation • Since historical valuation ignores changes in prices, it is free of measurement errors 12/3/2020 Accounting: Value and Valuation 15

Current Valuation • It has price measurement errors arising from assessment of current values • Again, the size this error (MSE) also depends on parameters of the economy: – If we assume that the relative changes in current values are measured without bias (ε = 0), the MSE arising from the mean of measurement errors is zero – The error arises from the covariance matrix of the vector of measurement errors in relative price changes (Δ) • Greater the “magnitude” of this covariance matrix, greater is the measurement error associated with current valuation • Since current valuation takes into account the changes in prices, it is free of price movement errors 12/3/2020 Accounting: Value and Valuation 16

General Price Level Valuation • GPL uses a single price index to adjust historical values towards current values • The use of a single price index reduces the price movement error associated with the historical estimator but does not eliminate it • The use of a single price index also introduces some measurement error, although it is not as large as the error associated with current value estimator • The total error associated with GPL estimator depends on the values of the parameters μ, Σ, Δ and ω. • Let us look at the picture as a schematic graph 12/3/2020 Accounting: Value and Valuation 17

Behavior of Price Movement Error with Respect to Aggregation 12/3/2020 Accounting: Value and Valuation 18

Behavior of Price Measurement Error with Respect to Aggregation 12/3/2020 Accounting: Value and Valuation 19

Behavior of Total (Valuation) Error with Respect to Aggregation 12/3/2020 Accounting: Value and Valuation 20

How Do These Estimators of Value Perform • Which estimator of is associated with lower mean squared value • It depends on the parameters of the economy • With high price volatility and low measurement errors, current value estimator dominates • With low price volatility and high measurement errors, GPL, and even historical value estimator may dominate • In general, we should not expect that the MSE minimizing estimator will be any of the three we have explicitly considered • Instead, it is likely to be some intermediate specific price index estimator of value 12/3/2020 Accounting: Value and Valuation 21

Testable Implications of Theory • Current valuation would be more informative for firms and industries whose – Assets have a large mean rate of price change – Assets have more variability in price changes – Assets are traded in relatively perfect and complete markets (accurately measured CV) • Real estate, mineral deposits, films, software, patents have large measurement errors • Instead of cross-sectional tests (e. g. , Gheyara and Boatsman 1980, Ro 1980), we could benefit from paying more attention to characteristics of assets of firms and industries 12/3/2020 Accounting: Value and Valuation 22

Testable Implications of Theory • Efficient valuation rules would vary across assets, firms and industries • Level of aggregation at which current values are chosen has a major impact on the properties of valuation (left open in FASB’s proposal) 12/3/2020 Accounting: Value and Valuation 23

What Do We Learn from This Theory? • Theories of valuation can be integrated into a framework to facilitate direct comparison of their properties in specified environments • When current prices change, and are prone to measurement errors, neither the current nor general price level valuation is necessarily the min(MSE) estimator of the unobserved economic value of assets • Generally, min (MSE) estimator is likely to be a specific price index rule • If the measurement errors are sufficiently large relative to movement errors, historical cost can be the min (MSE) estimator • Which valuation rule has min (MSE) is a matter of econometrics, not theory or principle (depends of relative magnitude of parameters of the economy) 12/3/2020 Accounting: Value and Valuation 24

References • In this summary, I have drawn on the work of many colleagues. Here are some references: • Ijiri (Econometrica 1968), Tritschler (TAR 1969), Sunder (JAR 1978), Hall (JAR 1982), Sunder and Waymire (JAR 1983), Sunder and Waymire (JAR 1984), Shriver (JAR 1986), Shriver (TAR 1987), Shih and Sunder (CAR 1987), Tippett (ABR 1987), Lim and Sunder (JAE 1990), Lim and Sunder (TAR 1991), Jamal and Sunder (CAR 1995) 12/3/2020 Accounting: Value and Valuation 25

Reflexivity of Financial Reporting • In social systems, measurement is a part of a larger cycle that cannot be ignored if we wish to understand its properties • If we measure because we wish to use the measures for deciding, the choice of measurement affects decisions, which in turn affects what we measure • The current debate on the consequences and wisdom of returning to current values could benefit greatly from consideration of reflexivity • Financial derivatives: why is it so difficult to devise accounting for them? – Derivatives beget standards, which beget more derivatives – Standard setters need to consider the larger game 12/3/2020 Accounting: Value and Valuation 26

II. Accounting and Control: Creation of Value and Valuation of Stakes Accounting: Value and Valuation

Summary of the Argument • Accounting and control serve dual functions in the firm – Help create value for participants in the firm or organization – Enable some participants, especially the owners, value their stake in the firm (valuation) • Both functions are important, emphasizing one at the expense of the other is dysfunctional – If accounting does not help create value, there would be nothing for shareholder to do valuation of • The two functions are mutually dependent • Recent attempts to emphasize valuation at the expense of stewardship are ill-conceived, and should not be pursued (FASB) 12/3/2020 Accounting: Value and Valuation 28

Outline • • • Firm as a set of contracts How firm creates value Valuation of stakes of various participants Valuation of securities Difficulties of valuing securities Role of accounting in valuation: past as anchor for assessing the future • Consequences of ignoring value creation in favor of valuation 12/3/2020 Accounting: Value and Valuation 29

1. Firm as a Set of Contracts • Alliance among people who want to do better for themselves through participation in the alliance, than they could do by acting alone 12/3/2020 Accounting: Value and Valuation 30

The Alliance • Participants promise to deliver resources • In exchange for the promise of inducements • Participants enter the alliance if they expect to get more than the opportunity cost of their contributions • To succeed, an organization must have a production function to simultaneously satisfy all contracts • Otherwise dissatisfied participants abandon the alliance, and the organization collapses unless an alternative alliance that satisfies the condition is assembled 12/3/2020 Accounting: Value and Valuation 31

Business Organizations • For present discussion, consider business organizations • Consider them as an alliance among contributors of – Capital (shareholders, creditors) – Labor (employees, managers) – Factors (vendors) – Cash (customers) – Public services (government) – Support (Community) • Each party gets resources in exchange 12/3/2020 Accounting: Value and Valuation 32

Firm as a Set of Contracts 12/3/2020 Accounting: Value and Valuation 33

2. How Firm Creates Value • The entrepreneur conceives of a set of contracts that would generate value or surplus – Excess of total output over the sum of the opportunity costs of resources contributed by the participants; the difference between the two is the total value created – Each participant must get, or expect to get, positive share of the surplus 12/3/2020 Accounting: Value and Valuation 34

Functions of the Manager • Identifies and negotiates with individuals needed for the contract • Designs, communicates, implements, and enforces the contracts over time • Finds and replaces participants and modifies their contracts over time to ensure the feasibility of contracts under changing conditions 12/3/2020 Accounting: Value and Valuation 35

Functions of Accounting • Operating mechanism for contracts • Necessary to assemble, implement, enforce, modify and maintain the contract set • Five functions – – – Measure resource contributions from agents Monitor resource outflows to agents Relate inflow and outflow for each agent Common knowledge to facilitate contract renegotiation Maintain liquidity of factor markets • The first four help create value, the fourth is achieved by helping valuation of stakes 12/3/2020 Accounting: Value and Valuation 36

How Accounting Helps Create Value • The first four function are essential to creation and preservation of value for the participants – – Measure resource contributions from agents Monitor resource outflows to agents Relate inflow and outflow for each agent Common knowledge to facilitate contract renegotiation • In absence of accounting and control that serves these functions, there will be nothing of value left for the shareholders or the other participants • These functions of accounting makes sure that the resources entrusted to the firm are preserved to serve the interest of the participants 12/3/2020 Accounting: Value and Valuation 37

Who Gets the Value or Surplus? • How is this surplus allocated among agents? – Every participant wants to capture as much surplus as possible – No one would participate if their share of surplus or value is negative – People whose resources are in short supply can capture more value – People whose resources are available in plenty can get only a small part of value 12/3/2020 Accounting: Value and Valuation 38

Division of Value • If the total surplus is negative the firm is infeasible; redesign the contracts or shut down • If the total surplus is zero, there is a unique distribution in which everyone gets zero surplus • If the total surplus is positive, there are multiple feasible allocations. There is no basis for choosing one allocation over another. Therefore, the distribution of surplus among participants is determined through bargaining 12/3/2020 Accounting: Value and Valuation 39

3. Income/Value of the Firm to Various Participants • • • Extensive income as the sum of: To the shareholders To customers To Vendors To employees To creditors To government To community, etc. Inducement from the firm – O. C. of contributions 12/3/2020 Accounting: Value and Valuation 40

Income/Value to Investors • Accounting income – opportunity cost of capital invested in the firm • Focus of current financial reports • Apply similar perspective to other participants in the firm 12/3/2020 Accounting: Value and Valuation 41

Income/Value to Customers • Customer’s “investment” in the form of search, learning, negotiation, payments, settlement of disputes • Expected PV of benefits from goods received should exceed the PV of investments • Includes immediate transaction as well as the consequences of the transaction for resource flows associated with any future transactions (reduction in time, cost, search etc. for later transactions) • In a perfect product market, consumer’s surplus from the firm is zero (may be +ve from industry) 12/3/2020 Accounting: Value and Valuation 42

Value to Government • Various levels of government provide mostly non-priced services plus some priced goods • Resources from taxation • Value of the firm to the government from providing priced services is the same as for vendors • Value of the firm to the government from providing nonpriced services is taxes plus fees minus O. C. of resources spent on providing services • Major challenge to put this in practice 12/3/2020 Accounting: Value and Valuation 43

Value of the Firm to Community • Local, national and global • Most exchanges in form of externalities • Value of the firm to the community is the sum of net externalities plus the net payments 12/3/2020 Accounting: Value and Valuation 44

4. Valuation of the Stakes of Shareholders • Investors contribute their resources to the firm in advance, and have no assurance that they will get anything back • Long time lag between contribution and distribution of profits • To facilitate liquidity of capital market, investors need information to assess the value of their claim (securities) • This is the valuation function of accounting • Is especially important for shareholders of the firm 12/3/2020 Accounting: Value and Valuation 45

5. Difficulties of Valuing Securities • We teach the fundamental or the net present value model of valuation in our classes – The value of a security is the discounted present value of the future cash flows expected to come to its holder during the life of the security • This is simple and straight forward • Except that it present serious difficulties of implementation 12/3/2020 Accounting: Value and Valuation 46

Implementing the Fundamental Valuation • The model requires future cash flows which are unknown • The model requires expectations of cash flows: whose expectations? • What about the value of the security to an investor who has no intention of holding it to its maturity (indefinitely for equity) – Most shareholders are short or medium term investors 12/3/2020 Accounting: Value and Valuation 47

The Higher Order Expectations Problem • Suppose according to my personal expectations of cash flow, value =$100 • Suppose I expect that others expect the value to be $150 next year • Should I buy or sell the security at a price of $110? • Once we allow for the possibility that our expectations may be different from others’, the NPV investment rule is not so clear 12/3/2020 Accounting: Value and Valuation 48

The Short Investment Horizon Problem • Few investors hold equity securities till maturity • Suppose, I plan to sell the security in two years. How should I value it? • My value is the NPV of cash flows for two years + the estimated market value at the end of two years • Estimated market value depends on what I expect others to expect the cash flows to be • Therefore, for a short horizon investor, value of the security to an investor is not his fundamental value; it depends on his expectations of others’ expectations • When we extend the same argument to the second and third generation of investors, valuation of the firm using the NPV becomes almost impossible (Hirota and Sunder 2005) because we must do backward induction from the future to the present through the higher order cash flow expectations of many layers of investors 12/3/2020 Accounting: Value and Valuation 49

Impossibility of Valuation through Backward Induction • The NPV model of fundamental valuation breaks down in a world without common knowledge and with short term investors • How are the investors to form expectations of the future cash flows? 12/3/2020 Accounting: Value and Valuation 50

6. Role of accounting in valuation: past as anchor for assessing the future • This is where accounting plays a key role • Being anchored in the verified events of the past, accounting provides an anchor that investors can use to make estimates of the future • This does not mean that the past cash flows can be or should be mechanical projected into the future • Accounting provides the historical record that can be exploited by investor who is willing to make projections on the basis of any relationships between the past and the future • If, on the other hand, accountants try to provide estimates of the future on their own, it is not clear that they serve the investors’ interests 12/3/2020 Accounting: Value and Valuation 51

7. Consequences of ignoring value creation in favor of valuation • By being rooted in reporting verified events of the past, accounting helps serve both objectives • It helps creation of value for the participants by making sure that the contracts of the firm are implemented • It also helps provide data from the past that the investors can combine with their model of the link between the past and the future, to make personal projections about the future • If accountants were to provide their own future projections, they would fail to serve both the value creation as well as valuation functions of accounting 12/3/2020 Accounting: Value and Valuation 52

To Summarize • Accounting and control helps firms create value for their shareholders, employees, customers, etc. by facilitating implementation of their contracts • By providing verified reports about the past, financial reports help investors make their own future projections • Letting the accountants get into the business of making future projections will not help their valuation function, and will destroy their value creation function • Conclusion: do what you are good at. 12/3/2020 Accounting: Value and Valuation 53

References • Shyam Sunder, Theory of Accounting and Control, Cincinnati: South. Western College Publishing (1997). Korean translation: Kim Gab-Ryong, Hwekewa Tongjae, Seoul: Dae Young Publishing Company, 1999. ISBN 89 -7163 -090 -6. • Shyam Sunder, "Management Controls, Expectations, Common Knowledge and Culture, " Journal of Management Accounting Research, 14, (2002), pp. 173 -187. • Shyam Sunder, " Knowing What Others Know: Common Knowledge, Accounting, and Capital Markets, " Accounting Horizons, 16: 4, (December 2002), pp. 305 -318. • Shyam Sunder, "Value of the Firm: Who Gets the Goodies? ", " September 2001. • Shinichi Hirota and Shyam Sunder, " Price Bubbles sans Dividend Anchors: Evidence from Laboratory Stock Markets, ” Revised October 2004. 12/3/2020 Accounting: Value and Valuation 54

American Accounting Association • Over eight thousand members from 75 countries of the world, each with his/her own diverse ideas, initiatives, innovations, and energy (125 from Korea) • It has been an eye-opener for me to learn about all the wonderful things AAA members do • For these few months in which you have given some of us the privilege to hold office • We see it as our responsibility to provide efficient shared facilities, services and forums to make it easier you to achieve your goals • In this spirit, let me mention a few activities now underway at AAA 12/3/2020 Accounting: Value and Valuation 55

Internet and Ideas • An academic organization is primarily about ideas • As you know, Internet is bringing about radical transformation in the way ideas, innovations and research is disseminated, and ultimately to how it is generated • What does this mean for AAA as in organization? – Aggregators, search engines, electronic publications, new platforms, competition, intellectual property, administrative structure and finances of the Association • Intellectual Property & Structure Task Force (Past President Andrew D. Bailey, Jr. , chair) will submit its interim report in Spring to help prepare us for this new, still rapidly changing environment 12/3/2020 Accounting: Value and Valuation 56

Competition of Ideas and Platforms • AAA publishes 12 journals and 16 newsletters • Many if not most academic disciplines are moving to electronic platforms (even skipping print publications in some cases) • AAA will experiment with electronic innovations by acquiring such a platform as a nursery for new ideas and forums for publication, discussion, and debate • Evolutionary (bottom up) approach to journals in contrast to top-down command-control • Let new entrants challenge the current occupants and let the latter adjust themselves to the challenges • Audit Section’s initiative on Current Issues in Auditing (CIA) in electronic form as the first step; other sections? 12/3/2020 Accounting: Value and Valuation 57

Global Digital Accounting Archives Project • Joint effort with the European and other accounting associations (Gary Previts, Chair) • Existence of accounting archives in many parts of the world, some digitized • Linking digital archives from a single Internet portal • Identify the existence of other such archives and link them • Encourage digitization of accounting and business archives • Encourage efforts to save important archives • Encourage discussion of, and research on, the academic contributions of the accounting archivists in US and abroad are doing (sessions in Chicago meetings) 12/3/2020 Accounting: Value and Valuation 58

Arthur Andersen, LLP • Glorious history of the Arthur Andersen • Important records in their archives of great value to researchers/historian of accounting • AAA Task Force to save the AAA archives and find a university home for them when the legal situation permits • Effort led by Past President Arthur Wyatt 12/3/2020 Accounting: Value and Valuation 59

We Academics • It is difficult for most people in the world to understand academics • We spend years working on things of no apparent value to the world • How many of us can explain to our moms what we do with our time, and why? • Why do deans find so difficult to herd us cats? We teach incentives, but are largely impervious to them • I think it is because of imagination • We revel in, and value, thoughts heretofore not imagined • Thoughts change the world, even without intention to do so • Let us assemble in Chicago in August, to revel in, and share our imaginations • Greg Waymire and his Program Committee is hard at work to 12/3/2020 60 make it fun for us all. Accounting: Value and Valuation

Welcome You to Chicago! www. som. yale. edu/faculty/sunder Shyam. sunder@yale. edu Accounting: Value and Valuation

Thank you • www. som. yale. edu/faculty/sunder • Shyam. Sunder@yale. edu 12/3/2020 Accounting: Value and Valuation 62