A Missing Piece in the FASB/IASB Conceptual Framework: Cost of Capital Is Not Stable

Transcription

1 A Missing Piece in the FASB/IASB Conceptual Framework: Cost of Capital Is Not Stable Yoshitaka Fukui Aoyama Gakuin University Graduate School of International Management (GSIM) Shibuya, Shibuya-ku, Tokyo , Japan November 15, 2006 Preliminary draft, comments solicited Abstract To make accounting information useful for investment decision, The FASB/IASB Conceptual Framework Project must carefully study such economic concepts as income, and take an established piece of empirical evidence seriously: cost of capital is not stable, let alone constant. Acknowledgements I wrote this as a sequel to a critique of Bullen and Crook (2005) by Bromwich, Macve and Sunder (2005), though not solicited.

2 Would you like to be remembered as the accountant of the economics profession? I would not in the least mind. No, I would not. Sir John Hicks 1. Introduction Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) now jointly quest for a sound conceptual framework as an anchor for accounting standard setting. In the process, Bullen and Crook (2005), senior staff at FASB, make it clear (official?) that accounting standards be consistent with not the revenue/expense view but the asset/liability view, the latter of which is purported to be based on sound economic analysis, the income concept of Hicks (1946) in particular. Although it is commendable to pay (over) due attention to economics, their argument, to say the least, not well founded. Indeed, Bromwich, Macve and Sunder (20005), three of the most respected scholars in the field, criticize Bullen and Crook (2005) devastatingly. The essence of their criticism is that the FASB staff misuse Sir John s argument by citing particular passages in an out-of-context fashion, and accordingly the whole structure that the paper attempts to build is being built on sand. (Bromwich et. 2005, p. 3) I completely agree with their criticism. However, I want to delve more into Hicks s argument and then to take up a missing piece in the conceptual framework project, that is, ever changing cost of capital. 2. Hicks and the Asset/Liability View Although Hicks (1946) uses the term income in his exposition, what he has in mind would be more appropriately called permanent income. He explains more compactly the income-as-permanent-income concept in the Note to Chapter 23. He is even terminologically explicit on this point in an interview with Klamer (1989, p. 173) claiming true income, and consequently profit, is something like (Milton) Friedman s permanent income. As pointed out by Samuelson (1967, p. 30), the general equilibrium framework in Hicks (1946) is an extension of Fisher (1997a, 1997b), but Hicks himself does not cite any of Fisher s work there. Also, the exposition in Chapter 14, on which Bullen and Crook (2005) claim to rely, is not airtight from a general equilibrium point of view. For example, when he 1

3 defines Income No. 2 (p. 174), he assumes the increased interest rate (future cash flow) and constant asset value. This assumption is only valid if the asset is a short-term monetary note or the like. Otherwise, the change of interest rate would also affect the asset value. In this regard, it may be more appropriate to listen to Fisher (1997b), a relevant part of which is included as well with Chapter 14 of Hicks (1946) in a classic anthology on income by Parker and Harcourt (1986). To the dismay of the asset/liability view advocates, Fisher (1997b, pp ) can never be more explicit: Capital, in the sense of capital value, is simply future income discounted or, in other words, capitalized. The value of any property, or right to wealth, is its value as a source of income and is found by discounting that expected income In whatever ways the ownership be distributed and symbolized in documents, the entire group of property rights are merely means to an end - income. Income is the alpha and omega of economics. Although Hicks (1946) is not as explicit as Fisher (1997b) on the income (flow) primacy, he nevertheless warns that The income which is relevant to conduct must always exclude windfall gains; if they occur, they have to be thought of as raising income for future weeks 1 rather than as entering into any effective sort of income for the current week. (p. 179) In short, Hicks (1946) does not endorse the asset/liability view, that is, making the difference of asset value between the beginning and end of period as income. Hicks also mostly avoid the change of interest rates not to complicate his argument. Only together with other restrictive assumptions, the stock-based Income No. 1 coincides with the flow-based Income No. 2. However, if those assumptions hold, why bother to argue about accounting, first of all? 3. Cost of Capital as a Prime Mover Although it is not clear whether Bromwich et al. (2005) has exerted some influence, the latest official view of FASB/IASB on conceptual framework (FASB/IASB 2006) does not mention the superiority of the asset/liability views forcefully advocated by their senior staff at all. Rather FASB/IASB (2006, p. 1) declare: 1 In Hicks (1946), week simply means a unit of period. 2

4 To help achieve its objective, financial reporting should provide information to help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity s future cash inflows and outflows (the entity s future cash flows). That information is essential in assessing an entity s ability to generate net cash inflows and thus to provide returns to investors and creditors. This statement is consistent with either the asset/liability view or the revenue/expense view depending on how to calculate cash flow. However, whichever view FASB/IASB adopts, there is a missing link in the search for decision useful financial reporting. How should we estimate cost of capital? Although we are given a definite cost of capital for calculation in a textbook valuation model, every practitioner knows how to estimate cost of capital is crucial for valuation. Fortunately, we accountants have empirical evidence on our side. Since Fama and French s seminar papers (1992, 1993), the price to book ratio (PBR) has become a respectable ingredient in asset pricing models. More concretely, it has been shown repeatedly that stocks with higher PBR tend to underperform those with lower PBR. It means much maligned book value must have a significant information content to explain (or hopefully predict) stock price behavior. Book value is valuable for asset pricing not because it tracks market value well, but because it deviates from market price: The degree of deviation, that is, PBR, is decision useful. Book value deviates from market price largely because accounting earnings or the difference of book value under the clean surplus are still based on historical cost. It might not be hyperbole to claim that wrong market price would naturally come back to historical cost-based fundamental book value. This finding is consistent with the fact that aggregate stock price indices such as S&P 500 and TOPIX go up and down wildly, while cash flow is relatively stable. This seemingly puzzling behavior of stock price has led to two interpretations. The behaviorists (e.g., Campbell and Shiller 2001) take it a revelation of investors irrationality implicitly assuming cost of capital be stable. On the other hand, the neo-classicals (e.g., Cochrane 2006) question the behaviorists premature death sentence of equilibrium asset pricing models asserting the variability of price be attributable to ever changing cost of capital. However, the question why PBR seem to predict asset price is irrelevant to the practical importance of accounting data, book value in particular, in constructing empirically supported asset pricing models, theoretical or descriptive (atheoretical). As put bluntly by Cochrane (2006, p. 61), constant discount rates are obviously implausible and We would 3

5 laugh at any paper that did this for stocks. In any case, the accounting community s standard assumption of stable, let alone constant, cost of capital is untenable if we strive for providing information useful in investment (largely stocks) decision. Bad news: cost of capital is not stable. Good news: changing cost of capital is explained in part by historical cost-based accounting information. For whatever reason, earnings, book value and other accounting information are important to know the time series behavior of the denominator (cost of capital) as well as the numerator (cash flow) of asset price. We have thus far focused our energy too partially on the latter, but time has come to correct the negligence of the former. As both camps, behaviorist and neo-classical, admit, at least in aggregate, the variability of cost of capital is far more important than that of cash flow to explain the actual behavior of asset price. If accounting information is indispensable for estimating both the nominator and denominator, a fuss over the primacy of cash flow as well as the asset/liability view is beside the point. We accountants have been envious of the spectacular success of our cousins, finance guys, in theoretical and empirical asset pricing for years. Now our turn may have come. Should we miss this golden opportunity sticking to an introductory MBA finance asset pricing model, which the smarter among our cousins are laughing at? In a slightly different context, Hicks (1940, p. 123) gives us a warning against excessive Platonic constructionism in standard setting: The appropriate concept of individual income can be nothing else but what the individual thinks he can consume without making himself worse off. This is purely subjective, incapable of objective measurement; so that in order to get a statistical measurement of this sort of income we can only proceed by taking some conventional rule about what the individual ought to reckon as his income. Probably it is worth while to do this; but we should be clear what we are doing. 4

6 References Bromwich, M., R. Macve and S. Sunder FASB/IASB Revisiting the Concepts: A Comment on Hicks and the Concept of Income in the Conceptual Framework. Working Paper, Yale School of Management. Bullen, H. G., and K. Crook Revisiting the Concept: A New Conceptual Framework Project. Financial Accounting Standards Board and International Accounting Standards Board. Campbell, J. Y., and R. J. Shiller Valuation Ratios and the Long-run Stock Market Outlook: an Update. In R. H. Thaler (ed.), Advances in Behavioral Finance, vol. 2. Princeton, U.S.A.: Princeton University Press. Cochrane, J.H Financial Markets and the Real Economy. Working Paper, Graduate School of Business, University of Chicago. Fama, E. F., and K. R. French The Cross-Section of Expected Stock Returns. Journal of Finance 47 (2): Fama, E. F., and K. R. French Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics 33 (1): Financial Accounting Standards Board, and International Accounting Standards Board Preliminary Views Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information. Financial Accounting Standards Board. Fisher, I. 1997a (1907). The Rate of Interest. London, U.K.: Pickering & Chatto. Fisher, I. 1997b (1930). The Theory of Interest. London, U.K.: Pickering & Chatto. Hicks, J. R The Valuation of the Social Income. Economica 7 (May): Hicks, J. R (1939). Value and Capital, Second Edition. Oxford, U.K.: Oxford University Press. Klamer, A An Accountant among Economists: Conversations with Sir John R. Hicks. Journal of Economic Perspectives 3 (4): Parker, R. H., and G. C. Harcourt (1969). Readings in the Concepts and Measurement of Income, Second Edition. Oxford, U.K.: Philip Allan. Samuelson, P. A Irving Fisher and the Theory of Capital. In W. Fellner (ed.), Ten Economic Studies in the Tradition of Irving Fisher. New York, U.S.A.: John Wiley. 5