Shareholders Value, Assets and Liabilities Perspective - Essay Example

Shareholder's Value The Accounting Picture of the Firm - An Assets and Liabilities Perspective The accountant uses a document called the balance sheet to depict the financial condition of the firm at any point of time. That comprises assets on one side, and liabilities and owner's equity on the other. Assets are resources that help the firm generate future cash inflows or reduce outflows. Liabilities are the claims to the assets of the firm. Owner's equity is the claims that remain after deducting liabilities from assets. The balance sheet equation is: Assets = Liabilities + Owner's Equity Transactions that affect the financial position of the firm are recorded in the balance sheet. The entries are counterbalanced so that the assets always equal the liabilities and owner's equity. The balance sheets of the company are examined by shareholders. The Economic Picture of the Firm - A Surplus Perspective The fundamental principles of economics are optimization and market equilibrium. The optimization principle says that people choose the best consumption patterns that they can afford. The market equilibrium principle states that prices adjust till demand equals supply. A supply curve measures how much of a good will be supplied at a given price. Suppose we reach a price p for the supply of a quantity x. The producer would be willing to supply a smaller amount at a lower price. However the entire quantity is sold at the price p. The producer's surplus measures the gains to the firm by selling all the goods at the higher price p. The concept of surplus enables us to determine the gains and losses for the firm. The consumer's surplus is the difference between the gross benefit of consuming the good and the price paid for that good. This perspective lets us understand the firm from economics theory. The concept of producer's surplus is closely linked to the concept of profit. Comparison of the Accounting and Economic Perspectives over a Time Period 1. In the accounting approach the focus is on measurements and recording of transactions, while in the economic approach the market equilibrium concept is applied. 2. The accounting picture does not include the ideal world theories that are the basis of economic analysis. 3. Accounting does not consider opportunity costs while economics includes opportunity costs. 4. While accounting focuses on the present, economic analysis are valid even in the long term. 5. The accounting perspective does not consider externalities that are factors external to the firm. The economic approach comprises externalities as well. 6. Changes in accounting methods have an economic impact on the firm and lead to changes in decisions. 7. Accounting methods reflect explicit costs while economic methods include both implicit and explicit costs. 8. Accounting measures amounts as they are while economics builds complex models to explain the behavior of variables. 9. The accounting approach does not measure the large gaps between the true value of the firm and the observed market value. The economics perspective considers all the variables that influence the market till we find a match between the actual and the calculated market values of a firm. 10. Shareholders in a firm rely on accounting practices more that economic calculations because accounting numbers are easily available for analysis. 11. Every accounting decision has an economic consequence while the changes in the economic picture are not necessarily reflected in accounting. 12. While accounting is a simple process based on conventions and numbers available with the firm, economic considerations are very complex and involve many variables. The values of economic variables are not readily available and are many times external to the firm. 13. While accounting is by nature a short term activity, economic analysis is a long term activity. 14. Accounting has methods in place for auditing the firm. Economic methods do not have established audit procedures in place. 15. While accounting is used for formal reporting, economics is used for analysis at a micro level. 16. Taxation requirements are calculated by accounting practices with income measurements, while economics considers taxes as one of the factors in financial decisions. 17. While the accounting approach considers a single firm, the economics approach considers all the institutions that are involved in the analysis. 18. While accounting is done according to the GAAP or Generally Accepted Accounting Principles everywhere, no standards have yet been set for economic analysis. 19. Accounting uses calculated values of the assets over a period of time, while the economics approach will value the asset for what it is worth in the market. 20. The accounting approach is practical and quick, while the economics approach is a matter of complex analysis and statistics. 21. While accounting expertise is usually in place, many firms do not have economists. Thus we see that the accounting perspective and the economic perspective have their differences with the accounting approach being more practical and quicker, and the economic approach being more elaborate and complex. Both approaches have their advantages and disadvantages and need to be applied carefully. The most important reason accounting practices are used is that these form an international standard. These standards provide a basis for comparison of different businesses and are also understandable to the stakeholders who invest in the company. The accounting methods have well defined methods of analysis that can be easily applied and the management can take the required decisions. The accounting framework makes us aware of every financial figure measurable by the firm in its internal operations. The economic framework is applicable to the entire economic system that includes the firm and well as the environment. The analysis helps us understand the firms operations at a micro level and determine the way a market behaves in response to economic stimuli. The economic principles that underlie the analysis are fundamental in nature and such an analysis is based on a broader picture comprising the firm and the market. The economic methods of analysis are still in the formative stage and one would expect that over time these methods may become as common as accounting practices. The Accounting Framework to Bridge the Gap between these Two Perspectives The following steps need to be taken to bridge the gap between the two perspectives: 1. The accountants need to include the demand and supply theory and its consequences on the accounting numbers. 2. The fundamental theories of economics are valid and the concepts should be included in accounting analysis. 3. Opportunity costs should be included in the accounting framework. 4. Accounting should have a long term focus and long term economic effects should be included in the factors leading to the decision. 5. Factors external to the firm should also be considered in accounting analysis. 6. Accounting standards should be designed to incorporate economic variables, if required in the form of new standard documents. 7. Accounting methods should include both implicit and explicit costs. 8. Accountants should consider all the variables in an economic model of the firm. 9. The accounting theory should be able to predict market behavior and value the firm accurately. 10. The financial statements given to the shareholders need to include the implications of the economic environment on the firm. 11. The changes in economic factors should be analyzed for their impact on the accounts as soon as these happen. 12. The firm should have a database and information policy that tracks all the variables associated with the business. 13. Accounting should not be only for a given year but should include a long term perspective as well. 14. The audit of the firm should check if all economic information has been considered in business decisions and if the relevance of all factors has been considered. 15. Accounting should include microeconomics theory perspectives to understand the consumer and producer attitudes from a scientific perspective. 16. The behavior of the firm should be analyzed in response to changes in tax policy for the optimum economic output. 17. The accounting framework should look at all the organizations involved i.e. the firm, the government, the buyers and the suppliers. The firm should not be considered an isolated entity. 18. The GAAP should include an economic perspective. 19. Accounting should use real market values for goods rather than calculated values. 20. Standard formats need to be created for complex economic analysis. 21. Firms should hire economists along with accountants. The accounting framework when suitability modified will effectively include economic analysis to present a more comprehensive picture of the world. Accounting and economics need to come together with common standards. It is crucial to integrate the methods of analysis to find more accurate solutions to business problems. To develop a new accounting perspective that includes economics phenomenal efforts will be needed. These will be made by educators, industry and governments. Shareholder's Value It is the responsibility of the firm management to maximize the shareholder value. The participants involved are the market, the management and the shareholders. When a shareholder invests in a firm he not only analyzes the financial statements but also looks at the economic conditions in the business environment. The decision to invest is made on a long term basis with an understanding of the industry potential. The shareholder value is calculated on a regular basis by the investors by using the balance sheet and associated accounting techniques. The market value is predicted by technical analysis. The economic analysis is made using the information available to the market like the price trends, industry life cycles, government policy, taxation, international factors and welfare. While conventional accounting does not explain the market value of the share, inclusion of economic factors should give a more accurate value for the market price of the share. Hence the same analysis can also be used to maximize the shareholder value. That is because we have found all the factors that influence the value of the share. We can then find optimum values for these variables and include these in our business decision. In this way the accounting framework can incorporate economics for maximum shareholder value. References Beatly, A. (2006), "Do accounting changes affect the economic behaviour of financial firms", BIS Working Papers, No 211, Bank for International Settlements, Switzerland. Demski, J. (2005), "Accounting and Economics", The New Palgrave Dictionary of Economics, 2nd edn. University of Florida Gordon, I. & Boland, L. (1998), "The accounting-economics interface: where the market fails", International Journal of Social Economics, Vol. 25, pp.1233-43. Horngren, C., Sundem, G. & Elliott, J. (2006), Introduction to Financial Accounting, 8th edn, Pearson Education, Inc., UK. Samuelson, P. & Nordhaus, W. (2006), Economics, 18th edn, Tata McGraw-Hill Publishing Company Limited, New Delhi, India. Varian, H. (1997), Intermediate Microeconomics, 4th edn, W W Norton & Company, New York. Read More