Web3ch16 - CHAPTER SIXTEEN Creating Accounting Value and...

CHAPTER SIXTEEN
Creating Accounting Value and Economic Value
Stephen H. Penman
The web page for this chapter runs under the following headings:
What this Chapter is Doing
Metrics that Indicate the Hidden Reserves Created by Conservative Accounting and
the Release of Hidden Reserves
A Spreadsheet Program for Analyzing the Effects of Accounting Methods
Accounting Issues in Forecasting: Starbucks Corporation
Equivalences: Residual earnings and Discounted Cash Flow Approaches to Valuation
Readers’ Corner
What this Chapter is Doing
Conservative accounting that features so much in this chapter is an accounting policy that keeps
the balance sheet low, such that we always expect book value to be below market value. If LIFO
inventory methods are consistently applied, then the balance sheet number for inventory will
always be low (provided inventory costs are rising). Expensing R&D permanently results in
(R&D) assets being omitted from the balance sheet, permanently.
Conservative accounting is a feature of GAAP. Chapter 16 shows how conservative accounting
affects numbers like ROCE, earnings, earnings growth, residual earnings growth. But most
importantly, it shows how conservative accounting is handled in valuation, for conservative
accounting affects accounting value added but not economic value added. It also deals with
liberal accounting, the opposite of conservative accounting, although this is not common, except
in the relative sense of a particular accounting being less conservative than otherwise. Boxes
16.2 and 16.3 provide good summaries.
Focus on the valuations under conservative accounting. The chapter shows how the accounting
does not affect the valuation, provided that steady state is forecasted. But conservative
accounting does affect P/B ratios and P/E ratios, as the chapter demonstrates. Table 16.6
provides a summary.

Metrics that Indicate the Hidden Reserves Created by Conservative Accounting and the
Release of Hidden Reserves
Table 16.7 shows how conservative accounting creates hidden reserves and how these hidden
reserves can be liquidated, inflating earnings, if investment slows. This is not a concern for
valuation if slowing of investment is forecasted within the forecast horizon (as the example there
demonstrates). But one must be aware of earnings that are temporarily inflated by a liquidation
of hidden reserves.
A paper by Penman and Zhang, “ Accounting Conservatism, the Quality of Earnings, and Stock
Returns,” published in The Accounting Review in April, 2002 develops metrics – C scores -- that
estimate the amount of hidden reserves developed by the accounting for inventories, advertising
and promotion, and R&D. It also develops diagnostics to estimate the amount of hidden reserves
released into earnings in any period by the slowing of investment. The paper can be downloaded
at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=201048
A Spreadsheet Program for Analyzing the Effects of Accounting Methods
The following programs show how changes in accounting methods for book values change
profitability, growth, residual earnings, and P/B and P/E ratios. Make sure you understand Tables