Introduction
Stephen H. Penman is the George O. May professor in the Graduate School of Business, Columbia University. Prior to this he was the L. H. Penney professor in the Walter A. Haas School of Business at the University of California at Berkeley, and has served as a visiting professor at London Business School and Stockholm School of Economics. He has a first-class honors degree in commerce from the University of Queensland, Australia, and MBA and PhD degrees from the University of Chicago. His research is on equity valuation and the role of accounting information in security analysis. He is managing editor of the Review of Accounting Studies and is on the editorial board of the Schmalenbach Business Review, and in 2002 he was awarded the Wildman Medal for his book, Financial Statement Analysis and Security Valuation.
In your recent book, Accounting for Value, you take the accounting standards-setting bodies to task for bringing speculative values into the accounts. Where do you see them going wrong?
I approach accountancy by asking what it measures that is of use to an investor. Basically, I am looking for accountancy to be a set of tools for measuring value—the real value of a business. My book was first and foremost a book on valuation, aimed at investors and those to whom they entrust their savings. This last group includes investment advisors, analysts, and portfolio managers. Beyond them, of course, I hope that it will also be useful to businesses that have an interest in ensuring that investors and their advisors are able to grasp the value of a company and its operations.
With this as my starting-point, I distinguish between accounting techniques for measuring value and models that are aimed at predicting, say, exit values on assets that the business is not actually exiting. I want to use known value as my anchor and then add to that a speculative component about future performance where value is derived from the best information available to me. In investing you are always taking a view of future performance, so a speculative dimension is inevitable. However, this should come only after you have anchored yourself on actual valuation. If your starting-point in appraising a particular company is also speculative, where are you?
With this approach it is clear that historic cost accounting is very useful to investors who like to base themselves on fundamental values, since it grounds itself in prices actually paid. My problem with the accountancy bodies begins at the point where they start to move away from historic cost accounting toward what they define as balance sheet accounting. With balance sheet accounting they are trying to put a present value on all the assets on the balance sheet, including assets such as stock, which the business has no intention of selling, but which, rather, is designated for production purposes. As such, external prices for that stock are completely irrelevant until and unless the company is in the process of winding up—at which point you would be highly unlikely to want to invest in it anyway.
There are very few companies where balance sheet accounting is actually useful for a potential investor. With a pure investment company that holds a large equity portfolio, for example, knowing the present value of that portfolio is excellent information. The company’s worth really does go up and down with the market, so you need to know where it stands. A bank’s portfolio of mortgage loans, on the other hand, is not, I would argue, something to which you need to apply a moment-by-moment “fair value.”
That mortgage portfolio is what drives revenue for the bank, and it is, by its nature, going to be held to termination. Where the bank conducts a securitization of its mortgage book and sells that part of the book, of course you have a present value for the securitized bundle, but that is a special case where the bank is literally turning part of the book into cash and there is nothing speculative about that cash value.
What you would want to know about the bank’s mortgage portfolio is not its fluctuating present value, but rather that there has been appropriate due diligence in the granting of the loans that comprise the portfolio. You want to know, in other words, that the bank’s business processes are sound and under control. If you conclude that its processes are hugely flawed, then the present value of the bank’s book is largely irrelevant since you can assume that the bank is highly likely to experience a much higher rate of default than its competitors—in other words, that the value of its book is likely to be considerably impaired over time, irrespective of what its present value might be—and you would be a fool to invest. This point, clearly, has to do with the importance of information and nothing to do with fair value, or the supposed present value of the bank’s mortgage portfolio.
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