11.5 Accounting Costs vs. Economic Value
Accounting numbers are very important
management tools.
But they can never account for all
opportunity costs. Managers must see
these within their own organization.
Sometimes managers only focus on
accounting numbers and, not
understanding them, drive firms into
bankruptcy.
Some Elementary Differences
You start a new oil company in 2013.
Accounting Expenses:
Land and oil equipment leases: $100,000
Wages and salaries: $200,000
Total expenses: $300,000
Total revenue: $0
You strike oil worth an estimated $10 million when
well is developed. What is the accounting book
value of the firm at the end of the year?
The economic value?
Primary roles
Accounting:
Following strict rules, it records and tracks receipt of
and expenditure of money.
Helps establish responsibility for assets and reduce
theft.
Help managers determine if operations are working
as expected and are required by regulatory
authorities.
It is a system of controls based on rules.
Primary roles
Economics:
Considers the value of assets determined by
usefulness to owner compared to alternative means
of producing same services and considers potential
use (opportunity cost) to other possible owners of
the assets.
Both accounting cost and economic costs are
important tools of analysis.
Economic Value
The economic value of an asset requires an
estimate of the net cash flow expected from
the asset, discounted.
 Hence, valuation is continuous and subjective
- an educated guess about expected cash
flows. Past cash flows (accounting data) from
assets can provide useful information to a
manager in making valuation decision but
may not be relevant as to future opportunities.

Need deep understanding of accounting
number meanings. U.S. banks in 2013
appeared more profitable because they
moved more cash into “net revenue.” 18%
of net revenue is cash set aside to prepare
for covering bad loans.
Practical Problem: Intangible Assets
A firm spends cash on research, development and
marketing because managers believe the
present value of the expenditures is positive.
That is, a profitable venture by the company.
But, accounting records expenditures as if no value
was created.
Similarly, costs of training personnel—all expense
in an accounting sense. There is no immediate
offsetting revenue but should be an economically
valuable activity.
Data for S&P 500
Other Practical Problems
SEC and PCAOB want assets reported at market
value annually. How much is your customer list
worth? Better come up with a defensible number.
Income and Expenses: Accounting books do not
reflect changes in assets due to changes in
demand for output of changes in replacement cost
of inventories of effects of new regulations. So
accounting expenses may go over or below
changes in real economic value. Lehman
Brothers, as a firm, was worth tens of billions but
vanished overnight.
Accounting Methods Matter
Three firms. Each buys 100 units of inputs per month
at $110 per unit in January. Price rises $10/month,
so in December cost is $220 per unit. Total
accounting cost for year is therefore $198,000.
During the year, 800 units are sold for total revenue
of $160,000.
400 units remain in inventory at the end of the year.
What is the value of the inventory?
What is the cost?
What is the profit?
It Depends on the Accounting Method
Inventory
Method
1. FIFO
2. LIFO
3. AC
Ending
Inventory
$82,000
$50,000
$66,000
Annual Cost
of goods sold
$116,000
$148,000
$132,000
Annual Gross
Profits/Sales
$44,000
$12,000
$28,000
Three firms—same number good in and out and
money flow the same, but accounting methods
differed. What is the economic value? Current
opportunity cost—none of the above. (Oil industry
uses LIFO to help cut tax burden.)
Problems that Have No Solution
If a firm produces different products, how do you
assign labor costs? Lump sum? Per unit? Based
on total wage cost or per hour estimate? You
cannot figure that out from accounting (or any
other) numbers.
Any method may be useful to managers to
understand labor costs, but same costs may
look very different across identical firms.
What about retirement benefits for workers? Is it
overhead or labor cost? A liability or a cost?
Example: GM
For decades, worker pension costs not
recognized. Not well funded nor explicitly
calculated as liability. Company falsely profitable
for decades.
Does not know how much it costs to build a car.
Part of problem traditionally came from internal
pricing gaming (gradually being corrected).
Divisions would “sell” parts to other divisions at
inflated prices to make the division look good.
The parts looked good; the whole did not.
More “Problems”
Warranty Accruals (set aside in reserve)—some firms
count call center costs as warranty cost; others do
not. Some put product recall under warranty cost;
others do not. Apple’s accruals doubled ‘11 over
‘10. Products worse? Caterpillar accruals dropped
although sales rose. Products better?
Firm adopts its own performance measure, such as
“paid memberships” or other metric. These don’t
meet FASB rules, so SEC does not like them—it
wants all companies to report similar data. Apples
to apples, but companies are apples and oranges.
What Is a Name Worth? Is the Apple
brand worth $33.5 billion or $183 billion?
Measuring Depreciation
Depreciation of assets—multiple methods are used.
All are legitimate, but same situation can look
very different to an observer of the books.
Assume an asset expected to provide net cash flow
of $200,000 at end of year one. Cash flow
expected to decrease $20,000/yr. over 6 year life
when cash flow is $100,000 and asset expected
to have scrap value of $18,000. At 10% discount
rate, present value is $818,000. Assume that is
also the purchase price of asset.
Which Method Is Best?
($ 000)
Net Depreciation Expense
Net Profit
Year Cash SL
SYD
DDB
SL SYD
DDB
1 $200 $133 $229
$273
$67 $-29 $-73
2
180 133 191
182
47
-11
-2
3
160 133 152
121
27
8
39
4
140 133 114
81
7
26
59
5
120 133
76
54
-13
44
66
6
100 133
38
36
-33
62
64
SL= Straight Line Depreciation; SYD = Sum of Year’s
Digits; DDB = Double Declining Balance. Cost is the
same, but looks very different. None are related to real
economic value, but consistency important for managers.
Impact of One Change in One Cost Rule
FASB (U.S.) and IASB (Intl.) rules differed for long-term
leases. Leases are now average cost over life (10-25
years); rather than annual obligation. Change to
IASB mean about $1 trillion in “new” costs being
recognized (front-loaded) on the books in the U.S.
Example: Whole Foods reported $639 million in longterm liabilities for 2006. New accounting rule: Must
include lease obligations on stores it does not own;
that expense rose to $4.8 billion, reducing return on
assets from 7.2% to 3.7% and increasing debt/equity
ratio from 38% to 169%.
Shift from GAAP to IFRS can cause
changes in apparent profitability
Daimler-Chrysler moved Chrysler’s books
from GAAP to IFRS.
Result: Loss suffered by Chrysler dropped
from $1.5 billion to $682 million.
Overall: most firms, when shift to IFRS report
higher earnings and higher increase in
equity value of firm.
Note: Gradual merging of IFRS and FASB in
rules employed.
Too Bad Manulife Financial Is Canadian
Posted $1.28 billion loss in 2010 under
Canadian (international) accounting
rules.
 It would have posted a $2.2 billion profit
under U.S. rules and shown $16 billion
more in shareholder value.

It’s Magic!
100 Largest Corporate Pension Plans had
funding deficit of $390.7 billion at the end
of Dec. 2012. Six months later, the deficit
was down to $179.3 billion!
 Did firms put $210 billion into the funds?
 No, the rate on corporate bonds used to
calculate the present value of payments to
retirees rose 0.80% thereby reducing the
liability.

Keep It Straight
Accounting numbers are very important
managerial tools.
But—do not think they tell the full story of
real value and real cost.
Managers must know their firm and their
market to know of opportunities that
mean changing opportunities inside an
organization and in the market.