Block 3, Sessions 7 & 8 - Accounting for values (creating value in the long term & a broader perspective)

What?

Shareholder value

Measuring issues

Creating Shared Value

measurement choices in financial reporting

practical examples of the different measures of valuation based on historical cost accounting (HCA) and fair value accounting (FVA)

the problems associated with measuring values from an accounting perspective

Session Summary:

  • Measurement of accounting information must be based on quality information measured in appropriate way for decision required - different base measurements = different results (HCA vs FVA)

how shareholder value can be created and the problems of short-term thinking for long-term value creation

long-term success from the perspective of accounting for values

What matters is not investor holding periods but rather the market’s valuation horizon – the number of years of expected cash flows required to justify the stock price.

Management’s responsibility, therefore, is to deliver those flows–that is, to pursue long term value maximization regardless of the mix of high and low-turnover shareholders.

Conflicts often arise between shareholders and management over the short and long term - short term decision for immediate results but destroying long term value

The competitive landscape, not the shareholder list, should shape business strategies.

Shareholders appoint managers to act on their behalf and expect management to take decisions that will maximise these returns.

Ten basic governance principles for value creation that collectively will help any company with a sound, well-executed business model to better realize its potential for creating shareholder value (Alfred Rappaport (2006))

Increasing shareholder value is still very much at the core of management decisions - other stakeholders should also have prominent role

PRINCIPLE 4: Carry only assets that maximize value.

PRINCIPLE 5: Return cash to shareholders when there are no credible value-creating opportunities to invest in the business.

PRINCIPLE 6: Reward CEOs and other senior executives for delivering superior long-term returns.

PRINCIPLE 7: Reward operating-unit executives for adding superior multiyear value.

PRINCIPLE 3: Make acquisitions that maximize expected value, even at the expense of lowering near-term earnings.

PRINCIPLE 2: Make strategic decisions that maximize expected value, even at the expense of lowering near-term earnings

PRINCIPLE 8: Reward middle managers and front line employees for delivering superior performance on the key value drivers that they influence directly.

PRINCIPLE 1: Do not manage earnings or provide earnings guidance

PRINCIPLE 9: Require senior executives to bear the risks of ownership just as shareholders do.

PRINCIPLE 10: Provide investors with value-relevant information.

For most organizations, value-creating growth is the strategic challenge, and to succeed, companies must be good at developing new, potentially disruptive businesses.

Companies focused on short-term performance measures are doomed to fail in delivering on a value-creating growth strategy because they are forced to concentrate on existing businesses rather than on developing new ones for the longer term.

Key issues raised by Rappaport:

• companies who focus purely on the short term can suffer from poor performance in the long-run

• management should be encouraged to think long term even if it has some short-term downside

• companies should think creatively and not focus on financial engineering

• companies should reward long-term thinking

• senior executives should bear the risks of ownership as shareholders do.

Movement away from the traditional basis of measurement (historical cost) towards a new basis (fair value).

When we consider measurement in financial reporting, however, there is a lot more controversy surrounding the tool that is selected to measure value. While measurements in financial reporting are expressed in monetary terms and therefore indicate value, in accounting terms value can mean different things.

Measurement is crucial because it provides decision-useful accounting information and enables the performance of management to be accurately appraised. These are the primary purposes for which financial statements are prepared. The way items are measured in accounting impacts on the quality of accounting information produced. Quality = accurately determine how well management has performed its role in managing the resources of the entity.

It is necessary for a company to undertake financial reporting to measure the financial condition of the business so that the owner(s) can make decisions.

Measurement means the process of determining the monetary amount at which the elements of the financial statements are to be included in the balance sheet and income statement of a company.

If companies align their internal performance measurement systems on short-term profits or accounting returns, this is also not a good indicator of value creation.

Historical cost accounting (HCA) is the approach favoured by most accountants. HCA records the value of an asset as the price at which it was originally purchased.

In contrast, fair value accounting (FVA) identifies the actual market value of an asset or liability at the measurement date to overcome the limitations of measuring the actual value of an asset or liability subsequent to acquisition date. FVA aims to give a fair value to an entity regardless of market conditions.

Key arguments For:
• It is the most objective measurement approach – amounts are determined based on actual transactions.
• There is a clear audit trail – amounts can usually be proven by documentation.

Key arguments For:
• It is the most relevant measurement approach for current decision-making. The amount that will be received for an item or that will need to be paid for an item is decision-useful information.
• It is objective if determined by reference to the market price for an item. The market price is set by forces outside the entity. It is not biased by judgement and cannot be manipulated or influenced by management

Key arguments Against:
• It is subjective where a market price is unavailable. Some items are not regularly traded in an active market and an estimate of the items’ fair value must be made
• The focus on exit values is not logical and contradicts the going concern assumption. Assets are measured as if they are all going to be sold off, which is not usually the case
• Market prices can be volatile and therefore sometimes may not be indicative of the true value of an item. Short-term fluctuations in fair value may be irrelevant and cause confusion from a user perspective

Key arguments Against:
• Amounts determined may not be relevant to current decision-making if there is a long time span since the transaction occurred. Historical cost does not take into account changes in the value of money over time. In other words, it ignores price inflation
• The amount paid for an item or received for an item may not necessarily be indicative of its value
• Judgement involved in determining depreciation rates can create inconsistencies and opportunities for manipulation
• Inability to determine the cost of some items, as items may be donated with no actual cost to the entity, or they may be internally generated rather than purchased

concept of shared value and explains the connections between societal and economic progress.

concept of ‘value’ from a broader perspective than an accounting exercise, which is concerned solely with company performance

explores whether shared value could unleash the next wave of global economic growth

considers the ecosystem of creating shared value and examines the key elements involved. This includes a shared measurement system and activities that can be mutually reinforced through constant communication

The impact of creating shared value has been significant

There are three key ways that companies can create shared value opportunities:

by treating societal challenges as business opportunities, companies could add a new dimension of corporate strategy to their portfolio and contribute towards social progress.

  • The counter argument:


  • The concept suffers from some serious shortcomings, namely: it is unoriginal; it ignores the tensions inherent to responsible business activity; it is naïve about business compliance; and it is based on a shallow conception of the corporation’s role in society.

argued that companies can move beyond corporate social responsibility (CSR)and can gain a competitive advantage by incorporating social and environmental considerations in their strategies

Every firm should look at decisions and opportunities through the lens of shared value. This will lead to new approaches that generate greater innovation and growth for companies—and also greater benefits for society.

The concept of ‘creating shared value’ has been discussed by Michael Porter and Mark Kramer

• By reconceiving products and markets

• By redefining productivity in the value chain

• By enabling local cluster development

How does it differ from CSR?

Corporate social responsibility is widely perceived as a cost centre, not a profit centre. In contrast, creating shared value is about new business opportunities that create new markets, improve profitability and strengthen competitive positioning. CSR is about responsibility, whereas creating shared value is clearly about creating value.

What is the connection between societal progress and productivity?

The diagram referred to shows what happens when a firm invests in a wellness program and discusses the positive benefits on society as workers and their families become healthier. The increase in synergy grows when firms approach societal issues from a shared value perspective and invent new ways of operating to address these issues.

The ecosystem of shared value

Creating shared value, defined as pursuing financial success in a way that also benefits society, has become increasingly important to companies as they look for new economic opportunities and seek to regain the public’s trust

Companies do not function in isolation and they are part of an ecosystem where societal conditions may curtail markets and restrict productivity. Further impediments might also include government policies and cultural norms. To engage with all the players in their respective ecosystems it has been suggested by some academics that businesses should initiate efforts collectively.

‘The ecosystem of shared value’, (Kramer and Pfitzer, 2016):

• The collective impact approach has resulted in successful collaborations in the social sector; it can also guide corporations to catalyse change in their ecosystems.

• Companies that turn to collective impact will not only advance social progress but also find opportunities for economic success that their competitors miss.

• Governments, NGOs, corporations, and community members all have essential roles to play.

One of the key ideas from the Kramer and Pfitzer article is the power of collective impact to change values. The five elements, which must be put in place for collective impact to achieve large-scale social change, can be summarised as follows:

• All participants have a common agenda for change including a shared understanding of the problem and a joint approach to solving it through agreed upon actions.

• Collecting data and measuring results consistently across all the participants ensures shared measurement for alignment and accountability.

• A plan of action that outlines and coordinates mutually reinforcing activities for each participant.

• Open and continuous communication is needed across the many players to build trust, assure mutual objectives, and create common motivation.

• A backbone organisation(s) with staff and a specific set of skills to serve the entire initiative and coordinate participating organisations and agencies.

Session Summary:

  • This session has focused on creating shared value. It has explored the concept of shared value and how it has been utilised by corporations. It has shown how creating shared value differs from corporate social responsibility. The weaknesses of the shared value concept have also been discussed. The wider ecosystem of shared value has been considered, in particular the power of collective impact to achieve large-scale social change. Finally, you have examined specific case studies and considered in some more detail the work that Nestlé has undertaken in creating shared value.